Multistate Taxation: The Foundation for Economic Nexus in Washington State

With more and more states searching for additional sources of tax revenue, the limits are being pushed for how far-reaching the states can extend their ability to tax. At the same time, the United States Supreme Court has declined to hear any cases addressing the physical presence requirement for states to assert taxes other than sales or use.

Accordingly, the actions of states and the inaction of the Supreme Court have arguably eroded the protections in the U.S. Constitution that limit interstate taxation. Such an environment has allowed states, including Washington, to adopt economic nexus standards.

General background
The protection of the Due Process Clause¹ limits the state’s power by asking whether an individual’s connections with a state are substantial enough to legitimize the state's exercise of power.² The purpose of the Commerce Clause³ is to prevent undue burdens on the free flow of interstate commerce and avoid the possibility of multiple taxation.

Congress has the power to protect interstate commerce from intolerable or even undesirable burdens. he Supreme Court has recognized that the underlying issue here is one that Congress may be better qualified to resolve. The U.S. Constitution gives Congress the ultimate authority to regulate commerce among the states. Congress exercised this authority after the U.S. Supreme Court issued its Northwestern⁴ decision in 1959. In response to that decision, Congress passed Public Law 86-272 that same year, which bars a state from imposing its net income tax on a business conducting only certain qualifying activities, such as in-state solicitation. Unfortunately, Public Law 86-272 is limited to state net income tax only.

Over time, a general principle developed that a state must demonstrate a taxpayer’s physical presence in their state before imposing a sales or use tax collection responsibility on an out-of-state company. The Supreme Court upheld this principle first in National Bellas Hess⁵ and reaffirmed it twenty-five years later in Quill.⁶

Between those cases, the Supreme Court spelled out the standards needed for state taxation under the commerce clause as a four pronged test in Complete Auto Transit.⁷ In order to be constitutionally valid, a challenged tax must pass each of the four prongs. Which are: 1) the activity being taxed must have substantial nexus with the state; 2) the tax must be fairly apportioned to activities carried on in the state by the taxpayer (internally consistent); 3) the tax must not discriminate against interstate commerce (externally consistent); and 4) the tax must be fairly related to services provided by the state.

A variation from the physical presence requirement first came about in Scripto⁸ when the court found sufficient nexus in Florida based on the activities of independent contractors despite the fact they had no property or employee presence there. Washington State expanded the Scripto decision to its gross receipts tax with Tyler Pipe,⁹ in which the taxpayer was found subject to the business and occupation (B&O) tax based on the use of independent contractors who performed activities to establish and maintain their market in the state.

Other states have questioned the applicability of the physical presence requirement for taxes other than sales and use. The court’s interpretation of this issue has been mixed. In J.C. Penney National Bank v. Johnson,¹⁰ Tennessee courts agreed the physical presence requirement in Quill did extend to income and franchise tax. But in Geoffrey Inc. v. South Carolina Tax Commission, the South Carolina Supreme Court ruled that even with no physical presence, an out-of-state holding company that owned the trademark and trade name of a toy store that licensed the use of those intangibles to an affiliate’s South Carolina stores, was sufficient basis to impose tax. The South Carolina Supreme Court noted that this type of structuring was being used to create “nowhere” income that escapes taxation.¹¹

To combat this structuring, the Multistate Tax Commission approved factor presence or “economic” nexus standards on Oct. 17, 2002.¹²

Two recent cases that validate this shift to economic nexus are MBNA¹³ and Capital One,¹⁴ both of which involved financial institutions lacking physical presence in the state at dispute. In both cases, they were found to have an income tax or financial institution excise tax liability because they were using in-state services to conduct business activities, such as: collection agencies, courts and the Attorney General. The U.S. Supreme Court declined to hear these cases.

Application to Washington B&O
As discussed above, the Court in Tyler Pipe set the stage for Washington’s move from a physical presence nexus standard to an economic nexus standard.

In Ford Motor,¹⁵ the Washington Supreme Court emphasized the inherent difference between sales or use tax and other taxes such as the B&O tax.

The court held that Ford was subject to B&O tax because the tax was imposed on the privilege of doing business as a wholesaler, not on the actual sale at wholesale. Ford was taxable because they engaged in a variety of activities within the City of Seattle, including advertising, sending representatives to meet with dealers and their part managers to impart a variety of information, the purpose of which was to sell Ford products to dealers.

Recently, the court again examined the nexus standard for B&O tax in Lamtec.¹⁶ The court held that a manufacturer/wholesaler of vapor barriers and insulation products had substantial nexus with the state and therefore, the imposition of B&O tax did not violate the commerce clause.

Lamtec sold its product wholesale to customers primarily by telephone orders made from its headquarters in New Jersey. Lamtec shipped its product from its New Jersey facility F.O.B. via common carrier with title passing at the time of shipment. They maintained that they had no property or employees in Washington. However, to maintain existing accounts as well as to encourage continued business, three Lamtec employees visited, at most 12 customers. Lamtec admitted that its employees engaged in efforts to maintain Lamtec’s Washington market by providing information to customers, addressing customer concerns and participating in calls the customer placed to the technical/customer service department located in New Jersey.

Lamtec argued that it did not have substantial nexus with Washington because it did not maintain a physical presence in the state. Lamtec contended that the department had to show a physical presence akin to “a small sales force, plant or office within the taxing state.” The court held that Lamtec’s activities significantly contributed to its ability to establish and maintain its Washington market. It noted that the “in-person customer visits were crucial to maintaining a customer relationship” and that maintaining a customer relationship was establishing its market for future sales. The fact that Lamtec employees did not solicit sales was of no consequence. In short, the court held that employee visits and activities constituted substantial nexus and therefore the imposition of B&O tax did not violate the commerce clause.

Economic nexus in Washington state
With many states having adopted economic nexus standards, Washington state will soon join their ranks with new legislation effective June 1, 2010.¹⁷ After numerous court cases affirming the inapplicability of the physical presence requirement to taxes other than sales and use, Washington’s gross receipts tax will now become a liability of many out-of-state businesses.

An out-of-state business that provides services to Washington customers will now be required to register and pay tax if they have any of the following:

• More than $50,000 of property or at least 25% of total property in Washington state
• More than $50,000 of payroll or at least 25% of total payroll in Washington state
• More than $250,000 or receipts or at least 25% of total receipts in Washington state

Washington state had always followed the physical presence requirement for nexus. However the combination of the State’s budget shortfall at a record high and the Department of Revenue’s belief that out-of-state companies are structuring their way out of a Washington tax liability prompted the enactment of an economic nexus standard.

Such legislation indicates that the economic nexus standards appear to be the future of tax administration in Washington as well as a growing number of other states. Unless the U.S. Supreme Court agrees to hear an economic nexus case or Congress finally intervenes with legislation, economic nexus will be the new movement in state taxation.

Kirsten Moritz-Baune, manager, Tacoma, Wash.

¹U.S. Const amend XIV ²Quill Corp v. North Dakota 504 U.S. 298 (1992) ³ U.S. Const art 1 s 8 ⁴Northwesters States Portland Cement Co. v. State of Minnesota 358 U.S. 450, 79 S. Ct. 357, 67 A.L.R.2d 1292 ⁵National Bellas Hess Inc. v. Department of Revenue of State of Illinois, 386 U.S. 753 (1967) ⁶Quill Corp. v. North Dakota 504 U.S. 298 (1992) ⁷Complete Auto Transit Inc. v. Brady, 430 U.S. 274 (1977) ⁸Scripto Inc. v. Carson, 362 U.S. 207 (1960) ⁹Tyler Pipe Industries v. Dept. of Revenue, 483 U.S. 232 (1987) ¹⁰J.C. Penney National Bank v. Johnson, No. M1998-00497-COA-R3-CV, 1999 Tenn. App. LEXIS 826 (Tenn. Ct. App. Dec. 17, 1999) ¹¹Geoffrey Inc. v. South Carolina Tax Commission, 437 SE2d 13 (Sup Ct), cert denied 510 US 992 (1993) ¹²Op. Ct. Appendix D, Factor Presence Nexus Standard for Business Activity Tax ¹³Tax Commissioner v. MBNA America Bank, N.A., West Virginia Supreme Court of Appeals, No. 33049, dissenting opinion Jan. 2, 2007, concurring opinion Jan. 8, 2007 ¹⁴Capital One Bank v. Commissioner of Revenue, 899 NE2d 79 (Mass. 2009) ¹⁵Ford Motor Co. v. City of Seattle, 160 Wn. 2d 46 (2007) ¹⁶Lamtec Corporation v. Department of Revenue of the State of Washington, 151Wash App 451, 215 P3d 968 (Wash. Ct. App. 2009) ¹⁷2ESSB 6143