| ||State Tax Jurisdiction and the Mythical “Physical Presence” Constitutional Standard|
Michael T. Fatale*
* Michael T. Fatale is a tax attorney with the Massachusetts Department of Revenue. This article represents the opinions and legal conclusions of the author and not necessarily those of the Massachusetts Department of Revenue. The author acknowledges the helpful comments on drafts of this paper by Alan L. Feld, Professor of Law, Boston University Law School; Stephen M. Kane, Partner, Rich, May, Bilodeau & Flaherty, Boston; Thomas J. Chappell, Manager, Arthur Andersen L.L.P., Boston; and by Thomas K. Condon, Tax Attorney, Massachusetts Department of Revenue.
“In today’s economy physical presence frequently has very little to do with a transaction a State might seek to tax.”
The notion that the U.S. Constitution requires a corporation to be "physically present" in a state to be subject to that state’s tax has been a recent focus of legislators seeking to explicate the tax liabilities of multi-state Internet vendors. It has also been the focus of numerous recent state court cases, including a Tennessee case for which the Supreme Court denied certiorari during its 2000-2001 term. This article evaluates what the U.S. Supreme Court has previously stated about what contacts or "nexus" are constitutionally required for a state to assert its tax jurisdiction and how the state courts have applied this precedent in practice. The analysis reveals that the so-called physical presence requirement is not a requirement in fact.
The idea that there is a physical presence constitutional requirement for purposes of state tax jurisdiction is a recent one that dates only to the Supreme Court’s 1992 decision in Quill Corp. v. North Dakota. Quill used the phrase "physical presence," to explicate by negative inference the type of contacts that are required between an out-of-state mail order vendor and a state’s residents before that vendor will be subject to the state’s use tax collection duty. Quill reaffirmed the Court’s determination in a prior case, National Bellas Hess v. Department of Revenue, that a state cannot assert its use tax collection duty against a vendor that limits its contacts with a state to communications effected solely by mail and common carrier. Quill concluded that when a vendor’s contacts with a state are limited to those of mail and common carrier, it does not have the required physical presence for a state to assert its use tax collection duty.
The rule of law stated by Quill apparently applies to an Internet vendor. Hence, federal legislation is probably not necessary to prohibit a state from imposing its use tax collection duty upon an out-of-state Internet vendor. Quill emphasized the peculiar burdens that arise in the context of the use tax collection duty and noted that mail order vendors had developed a strong reliance interest based on Bellas Hess. Internet vendors substantially resemble mail order vendors, except that their sales are effected through Internet sites and not through the dissemination of catalogs. It is no less burdensome for an Internet vendor to comply with the use tax collection duty, and it would seem that Internet vendors, like mail order vendors, are justified in their reliance upon Quill.
One of the recent congressional bills assumes, as have many tax practitioners, that the Quill physical presence standard applies outside the context of the use tax collection duty, particularly in the context of an income tax. However, there are numerous conceptual difficulties with this assumption. For one thing, the physical presence requirement dates back to Quill, and no further. That is, this phrase was not used in reference to a taxpayer in any prior Supreme Court decision that pertains to the notion of state tax jurisdiction, even though there are cases that delineate the constitutional requirements for this jurisdiction that date back over a hundred years. These older cases suggest that, to the contrary, a taxpayer’s physical presence is not a necessary pre-condition for the assertion of state tax nexus.
Most of the cases that evaluate the notion of physical presence relate to a corporate taxpayer. However, a corporation, though designated as a "person" for purposes of various legal requirements including tax filings, is a mere legal construct that is not in fact present anywhere. Therefore, to ascribe meaning to the notion of physical presence as applied to a corporation, one must attribute this presence to the corporation, for example, in the form of persons that act on the corporation’s behalf or property that is used by the corporation. However, the determination whether to attribute property or personnel to a corporation for purposes of finding an in-state physical presence merely "begs the question to be decided." Indeed, the state cases that grapple with the notion of a corporation’s physical presence generally attribute this presence in such a way as to render the parameters of the notion amorphous and open-ended. For example, these cases determine that physical presence can be attributed to a corporation based upon the activities of persons that are neither officers nor employees of the corporation and upon property that is not owned by the corporation.
In contrast to a corporation, an individual or "natural" person is physically present only where he or she breathes. However, although these persons have an actual physical presence, there is no physical presence constitutional standard that applies to them for purposes of state taxation. Rather, the Supreme Court has long held that an individual can be taxed in a state, in which he or she neither lives nor conducts business under certain circumstances.
Much of the confusion concerning the breadth of the physical presence standard apparently relates to a misconception concerning Quill. Quill distinguished between the Commerce Clause test to be applied in the context of the use tax collection duty and that applicable to other types of taxes. The former is subject to a "stringent physical presence test," while the latter is subject to a "flexible balancing" analysis. The Court clearly noted that it has not extended the physical presence requirement to taxes other than the use tax collection duty.
The state cases decided since Quill have wrestled with the definition of the term "physical presence" both as applied in the context of the use tax collection duty and otherwise. In general, these cases conclude that the physical presence standard merely describes the rule of law that applies in the context of the use tax collection duty. That is, a mail order vendor will not be subject to a state’s use tax collection duty when it limits its contacts with a state to communications effected by the non-physical contacts of mail and common carrier.
Consistent with Quill’s concern regarding vendors that have reasonably relied upon Bellas Hess, recent state cases extend the application of the use tax safe harbor to situations in which the vendor has some kind of additional in-state property or representative presence that is directly ancillary to a mail order business. The notion in these cases is that, although this additional presence may be in the nature of physical presence, this presence is de minimis within the meaning of Supreme Court precedent. On the other hand, when a vendor has in-state property or representatives that relate to a significant business practice that is not ancillary to a mail order business, the state cases tend to find a physical presence that permits the imposition of the state’s use tax collection duty. Under established constitutional doctrine, this obligation applies to the vendor’s mail order sales even though the vendor’s mail order business is itself not physically present in the state.
Although the notion of physical presence helps describe the results in the use tax collection cases, it does not resolve these cases. The decided state cases merely conclude that a mail order vendor and a vendor that substantially resembles a mail order vendor are not subject to the states’ use tax collection duty. Sometimes there are questions concerning whether a particular vendor is a mail order vendor or substantially resembles one. However, the analysis on this question is not furthered by the notion of physical presence.
Outside the context of the use tax collection duty, the Quill physical presence concept is useless as an analytic tool. Thus, although recent state cases often phrase their holdings in terms of the taxpayer’s in-state physical presence, this presence seldom explains the court’s result. Although these state cases pay lip service to Quill, the important Supreme Court precedents are usually Tyler Pipe Indus., Inc. v. Washington Dep’t of Revenue and Standard Press Steel Co. v. Dep’t of Revenue—the two cases Quill cited when referring to the Court’s "flexible substantive" approach to nexus. In each of these two cases, the corporate taxpayer had a representative located in the state that assisted the corporation with its in-state sales. However, the Court’s holdings glossed over this "physical" presence and explained the results based upon the corporations’ in-state market exploitation. In general, this is the approach that has been adopted in the recent state court cases.
This article evaluates the cases decided by the Supreme Court and the various states as they pertain to constitutional nexus in general, and the physical presence requirement in particular. The thesis of the article is that in substance there is no physical presence requirement for purposes of determining whether a non-domiciliary corporation is subject to a state’s taxing jurisdiction, either for purposes of the use tax collection duty or for purposes of other types of state taxes. Under Quill, a mail order vendor and vendors that substantially resemble a mail order vendor are not subject to a state’s use tax collection duty. In the context of other state taxes—most notably corporate income taxes—the question is whether the taxpayer has significantly exploited the state’s economic market or its resources.
The notion that physical presence is required for constitutional nexus is potentially dangerous. It was the basis for Senate Bill 2401, which—if enacted—would have the effect of sheltering entire industries from state tax, even in the absence of careful consideration as to what these industries might be. In addition, it provided the basis for J.C. Penney National Bank v. Johnson, in which the Tennessee appeals court effectively concluded that credit card and similar lending companies are immune from state income tax. The Tennessee court reached that result despite the fact that neither the Supreme Court nor Congress has acted to shield these companies from income tax under the Commerce Clause and despite the fact that the Supreme Court has repeatedly stated that the Commerce Clause is not intended to prevent corporations from paying their fair share of tax.
If an industry is to be immunized from state tax, this decision should be specific and deliberate, as it was in Quill and as it was when Congress enacted Public Law 86-272, which protects certain vendors of tangible personal property from a state’s income-based tax under specific circumstances. This tax protection should not be afforded in a broad-brush way based upon terminology (i.e., "physical presence") that is ultimately ambiguous.