Circa 1959. The legislation “is not a permanent solution to the problem,” but rather is aimed to “serve as an effective stopgap or temporary solution while further studies are made of the problem.” (U.S. Senate Report No. 658 (8/11/59)).
The more things change, the more they stay the same. Fifty-two years following the enactment of U.S. Public Law 86-272 as a “temporary” fix, we are struggling to make this jurisdictional standard work in an economy that resembles nothing like what it was in a bygone era. Perhaps, as some argue, P.L. 86-272 needs an update. Perhaps state policymakers should look less at the literal words on a page and carry out Congressional intent through the lens of current times. This article is not intended to be a comprehensive thesis on the subject, but merely a reminder that the application of P.L. 86-272 requires a little bit of art and a little bit of science.
In 1959, the U.S. Supreme Court delivered a decision in Northwestern States Portland Cement v. Minn., 358 U.S. 450. The holding would hardly be a surprise today. The Court held that Minnesota had the right to impose an apportioned net income tax on an Iowa-based cement manufacturer that had a small office in Minnesota and took orders for cement that ultimately was delivered to Minnesota customers from locations in Iowa.
Overreaching? Hardly by today’s standards. But that very same year, the U.S. Supreme Court denied certiorari in two cases decided by the Louisiana Supreme Court: Brown-Forman Distillers Corp. v. Collector of Revenue, 234 La. 651, appeal dism'd, 359 U.S. 28 (1959) and International Shoe Co. v. Fontenot, 236 La. 279, 280, (1958), cert. denied, 359 U.S. 984 (1959). Both cases dealt with companies that, unlike Northwestern States Portland Cement, did not own or rent real or personal property in the state. In the former case, the company’s contact with Louisiana was limited to “missionary men” who visited wholesalers to increase name recognition and occasionally made visits with salesmen.
In the latter, the company’s Louisiana activities were limited to 15 salesmen who solicited orders from customers. The Louisiana Supreme Court concluded that both companies had taxable nexus. While one should never read anything into the Court’s decisions not to grant certiorari, the business community (primarily small and medium-sized businesses) did just that, panicking over this perceived overreaching by the states. The furor caught the eyes and ears of their lawmakers. Seven short months following the Court’s decision in Northwestern States, Congress enacted U.S. Public Law 86-272.
U.S Public Law 86-272 — The Basics
P.L. 86-272 provides:
"No State, or political subdivision thereof, shall have power to impose . . . a net income tax on the income derived within such State by any person from interstate commerce if the only business activities within such State by or on behalf of such person during such taxable year are the solicitation of orders by such person, or his representative, in such State for sales of tangible personal property, which orders are sent outside the State for approval or rejection, and, if approved, are filled by shipment or delivery from a point outside the State."
Simply put, a state cannot impose a tax on net income if a company sells tangible property across state lines but limits its in-state presence to solicitation and delivers the property from a point outside the state.
For decades, the primary debate between taxpayers and the states was the scope of the term “solicitation.” In its haste to promulgate this temporary solution, Congress failed to define the term. The U.S. Supreme Court shifted the debate in 1992, in Wisconsin Department of Revenue v. William Wrigley Jr. Co., 505 U.S. 214 (1992). The Court held that solicitation includes "those activities that are entirely ancillary to requests for purchases — those that serve no independent business function apart from their connection to the soliciting of orders" and excludes "those activities that the company would engage in anyway but chooses to allocate to its in-state sales force."
Thus, the key is whether the activity is associated with requesting orders. Even if an activity is not, however, the Court also held that a “bad” activity is not fatal as long as all of the “bad” activities, taken together, are de minimis. The standard to be applied is whether the activity establishes a nontrivial additional connection with the taxing state.
Fitting a 2011 Peg Into a 1959 Hole
As Dorothy so aptly put, “I have a feeling we’re not in Kansas anymore.” The world is a different place than it was in 1959. Back then, the nation’s gross domestic product (GDP) was $506.6 billion. Estimates for 2010 peg GDP at $14 trillion. In 1959, we lived in a mercantile economy, predominantly based on the sale of goods. Today, the number of “pure” sellers of tangible personal property as a percentage of all sellers is significantly lower. A decade ago, the services economy in the United States surpassed the goods economy, and the delta continues to grow. It is no wonder why companies struggle to make nexus decisions interpreting a law that could not have contemplated how business is done today.
A case in point, and an example of combining art with science, is a well-reasoned ruling by the Virginia Department of Taxation. See Ruling of Commissioner, P.D. 10-279 (Dec. 22, 2010). The ruling involves a parent and four subsidiaries. Three subsidiaries manufacture goods that are sold by the fourth. The fourth subsidiary is also a manufacturer. None have real or tangible property in Virginia. The parent licenses patents, trademarks, know-how, etc. to its subsidiaries in exchange for an arm’s length royalty. The fourth subsidiary sells into Virginia through two salespeople who are based in an out-of-state location; the orders are sent out of state for approval, and the goods are shipped from a point outside Virginia. The taxpayer asked for a ruling that these business activities were not sufficient to create nexus.
The Virginia Department of Taxation ruled that none of the companies were subject to Virginia income tax. The real issue presumably was the taxation of the parent, whose intangibles were imbedded into the products sold by its subsidiary to customers in Virginia. With a very forward-looking view, the ruling states that “although P.L. 86-272 applies to tangible personal property, the Department’s policy has been to extend the ‘solicitation test’ of P.L. 86-272 to situations involving sales other than sales of tangible personal property.” With a view toward pragmatism, the Department went on to explain that even if the use of intangible property in Virginia created taxable nexus, there would be no tax because, under Virginia’s “cost of performance” rules, the parent’s Virginia apportionment factor would be zero.
Footnote: While the Department’s view on this issue should be applauded, as this article was being finalized, Virginia lawmakers introduced “loophole closing” economic nexus bills in the Virginia House and Senate: S.B. 1006 and H.B. 1604. With Virginia’s reticence to increase taxes, however, some believe these bills will likely not survive.
Alvarez & Marsal Taxand Says:
There are other examples of states and taxpayers framing issues and drawing conclusions with a modern view of P.L. 86-272. There are more, however, that rely on strict construction — a more articulate way of saying “head in the sand” or “tunnel vision.” Granted, this may be a bit harsh, as these states would argue they are simply applying the literal words on the page. Perhaps the Public Law needs to be modernized. Until then, and even in developing a framework for a modern version, taxpayers are encouraged to fight for their rights and against efforts by states to overreach and overtax. At the same time, companies are reminded that a P.L. 86-272 inquiry is fact intensive. In a service-oriented economy, it is all too easy to trip over the de minimis threshold. The corporate tax department can play a key role in ensuring that the business understands the potential costs associated not only with activities of its sales force but also with operating personnel who may cross the line.
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