On Thursday, June 21, 2018, the United States Supreme Court announced its highly anticipated decision in South Dakota v. Wayfair, __ U.S. __ (No. 17-494, 2018) in which it revisited the Court’s long-standing precedent that a state may only tax businesses that establish “nexus” with a state by having a sufficient physical presence in that state. (See Quill Corp v. North Dakota, 504 U.S. 298 (1992)). Now the Court, in a 5-4 split decision, has concluded that physical presence is not required to establish sufficient constitutional nexus with a state because that view is too narrow given the evolving economic realities of our national marketplace. But many issues still remain in the ongoing discussion of state taxation of on-line sales.
Quill and its physical presence test have governed state taxation of interstate commerce since 1992. In the meantime, interstate commerce has changed and technology has fueled the accelerating growth of remote sales that require neither storefronts nor distribution networks of the past. Thus, the Court in Wayfair observed that, “Each year, the physical presence rule becomes further removed from economic reality and results in significant revenue losses to the states.”
The Court has long held that state regulations may not discriminate against, or impose undue burdens on, interstate commerce. But the Court has also said that interstate commerce may be required to pay its fair share of state taxes. Historically, taxation of interstate commerce has required states to meet a four pronged test:
- The taxed activity must have substantial nexus to the taxing state;
- The tax must be fairly apportioned;
- The tax must not discriminate against interested commerce; and
- The tax must be fairly related to the services the state provides.
Wayfair addresses the first and fourth of these tests. The Court expressly recognized that goods provided by on-line sellers such as Wayfair are purchased by customers who enjoy the benefits provided by state governments. Thus, the sales of such companies have a direct relationship to the services provided by the state in which a purchaser resides. Moreover, in light of changed market conditions and the rise of online sales, the “physical presence test” no longer represents our national economic reality, and that test, “must give way to the far-reaching systemic and structural changes in the economy and many other societal dimensions caused by the Cyber Age…The Internet’s prevalence and power have changed the dynamics of the national economy.” The Court found sufficient nexus with the state of South Dakota because the state limited its taxation to on-line retailers with a defined minimum dollar volume of sales or a minimum number of annual transactions. Thus, “nexus is clearly sufficient based on both the economic and virtual contacts respondents have with the state.” The seller could not have met the statutory minimums, “unless the seller availed itself of the substantial privilege of carrying on business in South Dakota.”
The lesson of Wayfair is straightforward. Because economic realities of interstate commerce have changed, then changes in states’ tax regulations to meet those changes in interstate commerce will not discriminate against or overly burden, interstate commerce. We can now expect states to move forward with new legislation that will adjust state laws to the new economic reality internet purchasing. Nexus is still a cornerstone of state taxation of interstate commerce, but nexus need not be established by physical presence alone.
During its most recent legislative session, Arizona began the debate to define the difference between digital goods and digital services. Several other states have addressed or are now addressing these issues, and we can expect that debate to continue. In Arizona, as in most states, services remain largely non-taxable. However, there remains an open issue in some states, including Arizona, concerning how content delivered solely by the Internet should be taxed. The questions for future legislatures will be to define the line between digital goods and services, and to apply the principles of Wayfair to purely digital, as opposed to physical, products. Wayfair does not resolve that issue. Wayfair clarifies the definition of nexus. It also dealt only with the taxation of physical goods purchased through the internet. The Supreme Court has not addressed the taxation of digital content or the distinction between digital goods and digital services. This debate juxtaposes state and local jurisdictions that rely on sales or transaction privilege taxes against taxpayers seeking parity in the taxation of digital and physical goods. While Wayfair resolves none of these issues, it makes clear that state tax schemes may change to reflect substantial changes in the national economy. And states must continue to debate where those lines may be drawn.
Before Wayfair, several states were already enacting legislation to challenge physical nexus. In light of South Dakota’s victory, we can expect an acceleration of state efforts to expand their tax bases. The members of the Jennings, Strouss & Salmon, PLC Tax and Estate Planning Group have extensive experience in state and local tax matters as well as federal tax matters. We will provide updated information and analysis of the impact of Wayfair concerning interstate commerce as states react to the decision and, in particular, how the Wayfair decision will influence Arizona’s upcoming legislative session.
Otto S. Shill, III is a member with Jennings, Strouss & Salmon, PLC, in Phoenix, Arizona.