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April 29, 2012 The Tax Lawyer

Untangling Substantial Nexus

Vol. 64, No. 4 - Summer 2011

William Joel Kolarik II


    The dormant Commerce Clause is the most important and controversial federal limitation on state and local taxation. In 1977, the United States Supreme Court’s opinion in Complete Auto Transit v. Brady provided a four-prong test to determine if a state or local tax regime creates an undue burden on interstate commerce. The first prong of the Complete Auto Transit test requires that the taxpayer have “substantial nexus” with the taxing jurisdiction.

    In Quill Corp. v. North Dakota, the United States Supreme Court attempted to give content to the substantial nexus prong of the Complete Auto Transit test. In Quill, the United States Supreme Court held that physical presence is required before a state may compel a taxpayer to collect and remit the state’s use tax. The physical presence test in Quill generated a substantial amount of controversy. Nevertheless, the United States Supreme Court has not addressed the substantial nexus requirement in a substantive manner since Quill.

    Bright-line rules mandating that a person be physically present in a state before the state can exercise power over him are not new. For example, from the founding of the until the 1940s, a state court could not exercise personal jurisdiction over a person unless the person was physically present in the state. During the late 1800s and early 1900s, maintenance of the physical presence standard for personal jurisdiction necessitated the creation of a series of legal fictions, and these legal fictions became increasingly unworkable. Therefore, in 1945 the United States Supreme Court moved away from the physical presence standard to a more flexible test to determine whether a state court could exercise personal jurisdiction over a person. Post-Quill litigation is similar to pre-1945 personal jurisdiction litigation in that it relies on increasingly tenuous legal fictions to maintain the physical presence requirement.

    The question at the heart of the substantial nexus debate is whether a taxpayer’s contacts with a state are sufficient to justify the state’s exercise of power over the taxpayer. Said another way, when may the state compel the taxpayer to comply with a tax? For many taxpayers, Quill stands for the proposition that a state may not compel a taxpayer to comply with a tax unless the taxpayer is physically present in the state. States, on the other hand, take the position that the bright-line physical presence rule of Quill applies only to sales and use tax collection obligations.

    Several recent developments serve to raise the stakes in the Quill controversy. First, technological innovation and fundamental changes in business models, specifically the rise of the Internet, led to the proliferation of remote sellers. Quill exempts remote sellers from state use tax compliance obligations. As a result, remote sellers have an advantage over local retailers, and states and localities lose a substantial amount of revenue. Second, the states are in a precarious financial situation and desperately need to raise revenues. Finally, there is an increasing interest in enacting a federal indirect tax, either a value-added tax or a retail sales tax, to fund the government. A federal indirect tax would require some measure of coordination with state and local sales and use taxes. Since resolution of the substantial nexus question is a necessary predicate to solving these issues, there is a pressing need for a workable substantial nexus standard.

    Quill’s physical presence requirement created a substantial amount of litigation. In analyzing whether a taxpayer’s contacts with a state meet the Commerce Clause’s substantial nexus requirement, both the state courts and the commentators generally start with the conclusion that the contact in question satisfies or does not satisfy Quill. Having answered the question first, most post-Quill analysis then provides justifications for its conclusion. Providing reasons in support of an answer and divining an answer through reason are not the same thing. The lack of a functional methodology for determining what constitutes substantial nexus and continuing post-Quill litigation are direct results of the reasoning discussed above.

    This Article proposes a framework for determining when a taxpayer has substantial nexus with a taxing jurisdiction. This Article asserts that the administrative compliance costs imposed on taxpayers by tax regimes is the undue burden on interstate commerce that concerns the substantial nexus prong of the Complete Auto Transit test. Furthermore, this Article asserts that the contacts with a jurisdiction that satisfy substantial nexus vary with the compliance costs imposed on the taxpayer. From the above propositions, this Article proposes that balancing the national administrative burden with sound tax policy will create workable substantial nexus standards.

    Part I of this Article provides an overview of the dormant Commerce Clause and General Retail Sales Taxes. Part II traces the evolution of the modern substantial nexus standard. Part III discusses the problems created by Quill and state court reactions to Quill. In addition, Part III examines the evolution of the minimum contacts test used to determine nexus for purposes of the Fourteenth Amendment and notes similarities in the development of the substantial nexus prong of the Complete Auto Transit test. Part IV of this Article develops a framework for analyzing whether a taxpayer has substantial nexus with a taxing jurisdiction. Part V examines how the proposed framework, discussed in Part IV, functions in the context of both direct and indirect taxes. Part VI is a brief conclusion.

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