NEXUS
Navigating Through the Rising Oceans of
Nexus- Economic Nexus and P.L 86-272,
Protected and Unprotected Activity
Ben Elliott, Deloitte Tax LLP
Scott Ewing, Deloitte Tax LLP
May 14, 2015
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Agenda
• Overview
• Corporate Income Tax Nexus
- PL 86-272
- Economic Nexus/Factor Presence
- Income/Franchise Tax Nexus Cases
• Practical Considerations
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Overview – What is Nexus?
• The connection or link that must be established with a
taxing jurisdiction before the taxing jurisdiction can subject
an entity to the responsibility of paying or collecting the
jurisdiction’s tax
• State Nexus Statutes
– A very low nexus threshold is the general rule
– Typical state statutes will assert nexus to the limits of the U.S.
Constitution
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Constitutional Restrictions
• U.S. Constitution prohibits a state from taxing a
person unless both the Due Process Clause and
Commerce Clause requirements are met
– Due Process Clause: Requires “minimal connection” between
taxpayers’ interstate activities and the taxing state
– Commerce Clause: Requires that taxpayers’ activities have a
“substantial nexus” with the taxing state
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Overview of Basic Nexus
Federal
Restrictions
Jurisdiction
to Tax
Political
Reality
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Generally define the outer limits of a
state's authority to assert nexus
A state’s right, conferred by statute, to
impose a tax on a particular entity
States prefer taxing out-of-state, as opposed to
in-state, business interests (“tax exporting”)
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Traditional Sales & Use Tax Nexus
U.S. Supreme Court Precedent:
• Physical presence still the standard
–
Quill Corp. v. North Dakota, 504 U.S. 298 (1992)
–
National Bellas Hess, Inc. v. IL Dep’t of Rev., 386 U.S. 753 (1967)
• Includes in-state activities of agents, independent contractors and/or
employees of affiliated entities
–
Scripto, Inc. v. Carson 362 U.S. 207 (1960)
–
Tyler Pipe Industries, Inc. v. Wash. Dep’t of Rev., 483 U.S. 232 (1987)
• Sellers subject to use tax collection, if it has physical presence in the
taxing state, even if the seller's activities in the state have no relation to
the transaction being taxed
–
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Nat’l Geographic Society v. CA Board of Equal., 430 U.S. 551 (1977)
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Landmark Case Law - Nexus
• National Bellas Hess, Inc. v. Department of Revenue of
Illinois, 386 U.S. 753 (1967)
– U.S. Supreme Court held that, under the Commerce and Due Process
Clauses, a vendor was required to have physical presence in a state
in order for that state to require the vendor to collect use taxes on mailorder purchases
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Landmark Case Law – Nexus
• Quill Corp. v. North Dakota, 504 U.S. 298 (1992)
– Quill was a mail-order vendor of office supplies
– Quill did not maintain an office or have any employees in the state
and delivered all of its merchandise via US mail or common carrier
– North Dakota asserted Quill created nexus in the state through
systematic solicitation via catalogs and advertising flyers and
therefore was required to collect use tax on sales to North
Dakota residents
– The U.S. Supreme Court held that although Quill’s economic
presence in North Dakota satisfied the Due Process Clause “minimum
connection” test, the Commerce Clause “substantial nexus” test was
not satisfied because Quill did not have a physical presence in North
Dakota
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Sales & Use Tax - Agency Nexus
•Scripto v. Carson, 262 U.S. 207 (1960)
•
The U.S. Supreme Court sanctioned the agency theory of nexus, finding that
an out-of-state seller who used independent contractors to solicit business
could be required to collect the state’s sales tax
•Tyler Pipe Indus., Inc. v. Washington State Dep’t of
Revenue, 483 U.S. 232 (1987)
•
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The U.S. Supreme Court ruled that representatives performing activities on
behalf of a seller while physically present in a state may create sales tax
nexus for a seller if such activities are significantly associated with the
seller’s ability to establish and maintain a marketplace in the state for its
sales
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U.S. Supreme Court Update (March 3, 2015)
In Direct Marketing Assoc’n v. Brohl, 575 U.S. ___ (2015), Justice Kennedy made statements in his concurrence indicating Quill is ripe for reconsideration and could possibly be overturned:
“Given…changes in technology and consumer sophistication, it is unwise to delay any longer a reconsideration of the Court’s holding in Quill. A case questionable even when decided, Quill now harms States to a degree far greater than could have been anticipated earlier.”
“The instant case does not raise this issue in a manner appropriate for the Court to address it. It does provide, however, the means to note the importance of reconsidering doubtful authority. The legal system should find an appropriate case for this court to reexamine Quill and Bellas Hess.”
Corporate Income Tax - Nexus
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Public Law 86-272
Public Law 86-272
• Federal law enacted in 1959
• Protects out-of-state corporations from nexus for net income tax purposes, but only if
all the requirements are met
History
Northwestern States Portland
Cement (1959)
Congress Reaction
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In Northwestern States Portland Cement
(1959), Supreme Court ruled that mere
solicitation was sufficient to create
constitutional nexus
Business community convinced Congress
that such a low threshold for nexus would
impede interstate commerce
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Public Law 86-272
A non-resident corporation is protected by P.L. 86-272 from the
imposition of a net income tax if its only in-state activity is:
• “Solicitation of orders” for the sale of tangible personal property
• Approved outside the state, and
• Shipped or delivered from a point outside state
MTC Statement of Practices under P.L. 86-272 includes a listing of:
•13 protected activities
•20 unprotected activities
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Public Law 86-272
Examples of Protected Activities
•Solicitation of orders
•Providing at no charge samples and promotional materials
•Providing a vehicle to sales personnel for their use in conducting
protected activities
Examples of Unprotected Activities
•Installation and start-up
•Customer training
•Engineering, design and technical assistance
•Warranty, maintenance and repair
•Credit and collection
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Public Law 86-272
P.L. 86-272 does NOT
protect a non-resident
corporation from a state
net income tax if its in-state
activity is:
Protection is only against
the imposition of a net
income tax, not any of
the following:
P.L. 86-272 only applies to
income tax and to the
solicitation of sales of
tangible personal property
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• Leasing of tangible personal property
• Sales of services
• Sale or lease of realty
• Sale or license of intangibles
• Sales and use tax nexus
• Modified Gross Receipts tax component of Michigan
MBT
• Washington “B&O tax” nexus
• Franchise taxes on capital or net worth (e.g., PA)
• Texas Margins Tax
• NJ’s “alternative minimum assessment” (intro. 2002)
• Sale of services is not protected, nor is
solicitation of the sale of services
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Nexus – Has Anything Changed?
• Nature of the U.S. economy has significantly changed since P.L. 86-272
enacted
– Is limitation to sales of tangible personal property still relevant?
• Application service providers
• Software as a Service business models
• On-line service providers
• Royalties
• Customization of canned software
– What activity exceeds mere solicitation of orders?
• Third party warranty support
• Intercompany activity
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Factor-based Nexus – Pushing Constitutional
Limitations
States are expanding their view of constitutional limitations
Multistate Tax Commission Model “Factor Nexus” Statute
Substantial nexus is established if any of the following thresholds are
exceeded during the tax period:
– a dollar amount of $50,000 of property; or
– a dollar amount of $50,000 of payroll; or
– a dollar amount of $500,000 of sales; or
– twenty-five percent of total property, total payroll or total sales.”
Does this level of activity constitute a minimum connection between the
state and the taxpayer’s interstate activities?
Factor-based nexus states currently include:
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California
New York
Colorado
Ohio
Connecticut
Washington
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Nexus: Doing Business Redefined
•
•
California has expanded its “doing business” statute to adopt bright‐line statutory nexus rules effective for tax years beginning on or after January 1, 2011.
Among other things, a taxpayer is now deemed to be “doing business” in California if any of its apportionment factors in California exceed either the fixed dollar amount or percent of total thresholds (for 2014) below:
Measure
Fixed dollar
Percent of total
$529,562
25%
Property
$52,956
25%
Payroll
$52,956
25%
Sales
For the threshold, must use the state’s market‐based sourcing rules for sales of other than TPP, regardless of the method actually used to apportion such sales (e.g., cost of performance when the single sales factor election was foregone in 2011 or 2012).
• The sales, property and payroll include the taxpayer’s pro rata distributive share of pass‐through entities. Observation: This rule can trap the unwary pass‐through owner/partner.
•
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Economic Nexus – Constitutional Limitations
• Is physical presence still a constitutional requirement to assert income tax
nexus?
• Economic Nexus - States have the right to assert nexus over taxpayers which
have an economic presence in the state, even those which lack a physical
presence in the state.
Theoretically, significant gross receipts attributable to an in-state customer
may give a company economic nexus within the state.
• Geoffrey Nexus – Geoffrey nexus applies when licensed intellectual property is
used in a state. (Geoffrey, Inc. v. South Carolina Tax Commission 437 S.E. 2d
13, cert. den. 114 S.Ct. 550 (1993)).
• Selected states with Economic Nexus statutes or rulings in place include the
following:
Maine
New Hampshire
Oregon
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Michigan (“active solicitation”)
New Jersey
Wisconsin
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Income/Franchise Tax Nexus Cases
• 2013 Indiana Tax Court decision. No. 49T10-0704-TA-24
(Ind. T.C. Sept. 16, 2013)
– The Indiana Tax Court held that Indiana does not apply an economicpresence nexus approach to its corporate income tax
• Gore Enter. Holdings, Inc. v. Comptroller of the Treasury,
437 Md. 492 (2014)
– The court held that the Maryland Tax Court did not err in holding that
the Maryland Comptroller had the authority to tax two subsidiaries
because they were subsidiaries with no economic substance as
separate business entities apart from their parent, therefore, those
subsidiaries were taxable entities
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Income/Franchise Tax Nexus Cases
• Swart Enterprises v. FTB (Fifth District Court of Appeal no. F070922, Fresno
County Superior Court no. 13CECGO2171.)
– Iowa taxpayer with .02% ownership interest in a CA LLC sought refund of taxes,
penalties, and interest assessed against it as a result of its passive investment in the
LLC. FTB contended that taxpayer's passive interest in a California LLC is sufficient
to trigger the “doing business” standard in California and minimum tax.
– On Nov. 14, 2014, California issued an order granting Taxpayer’s Motion for
Summary Judgment, holding that Taxpayer was not doing business in California and
not subject to the $800 minimum tax and a Notice of Entry of Judgment was filed on
Nov. 25, 2014.
– On January 16, 2015, the FTB filed a Notice of Appeal.
• [Taxpayer] v. FTB (Fourth District Court of Appeal no. DO64241, San Diego County
Superior Court no. 37-2011-00100846)
– Superior Court for San Diego County held that 2 special purpose entities the parent
company created to securitize loans from financing subsidiaries had nexus with
California because they were part of one corporate enterprise and “did not have a
business existence separate and apart from their parent company.”
– Court also ruled that the SPEs were "financial corporations" under California law.
– Taxpayer filed for appeal in California Court of Appeal, Fourth Appellate District. The
case is fully briefed.
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Practical Considerations Nexus
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Nexus Re-Fresh – When was the last time nexus
was analyzed?
Do the Company’s state nexus positions still make sense given its operations and
the evolving laws of the states in which it operates?
– Is there a difference in where the Company files for sales/use tax and income
tax purposes?
– Does the Company file sales/use tax and income tax returns in all of the
states in which its employees visit?
– Has the Company modified its distribution channels?
– Has the Company restructured/expanded its sales force?
– Have there been any mergers/acquisitions/dispositions?
– Did the Company migrate its intellectual property?
– Does significant customers/revenue relate to states where the Company does
not file?
– Permanent establishment versus state tax nexus
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Nexus – Other Considerations
• Always a difficult situation to address
– Nothing prevents passage and enforcement of factor-based and
economic presence nexus thresholds (even if ultimately found
unconstitutional)
– If taxpayer elects not to file, risks penalties, etc.
– Voluntary Disclosure Agreements may mitigate penalty and look
back period
– If taxpayer elects to file, possibility of no refund, even if tax held to
be unconstitutional
• Consider coalition to contest tax and or/work through non profit tax
organizations (e.g., CalTax)
– May mitigate litigation costs
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– Pick strongest facts to litigate
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Is Nexus Always Bad?
•
Nexus can be beneficial in certain circumstances
•
Taxable presence in other states can result in less than 100% of
income being taxed.
•
If throwback or throwout rule exists, taxpayer must have nexus in
the destination states to avoid throwback/throwout
•
In certain states, only nexus affiliates may join in filing a
consolidated return. Nexus required to use carryover losses to
offset income.
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California Sales Factor Throwback
Overview
• Generally, sales originating from California of tangible personal property to another state or foreign jurisdiction in which the “taxpayer” is not “taxable” must be “thrown back” to California.
• Focus on whether taxpayer is “taxable” in destination state.
California approach – either (i) taxpayer actually files in other state, or (ii) other state has right to tax.
Some states focus on whether taxpayer actually files.
Observation: California’s economic nexus rules can minimize throwback in a number of situations.
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Effect of Bright-Line Nexus Standard on
Throwback
Does a State’s Bright-line Nexus Position Largely Obviate Throwback?
California Chief Counsel Ruling 2012‐03: Taxpayer not required to throw back sales to California because it met the $500K threshold in a foreign jurisdiction and thus was “taxable” in the foreign jurisdiction. No P.L. 86‐272 protection exists for foreign‐based taxpayer. Retroactive Application of Factor Presence Nexus
FTB Technical Advice Memorandum (“TAM”) 2012‐01
State’s position that factor presence does not apply to tax years prior to January 1, 2011.
TAM asserts that physical presence is a requirement prior to January 1, 2011.
Observation: What other situations involve throwback besides sales of tangible personal property?
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Contacts
Scott Ewing
Sacramento, California
(916) 288- 3350, eewing@deloitte.com
Ben Elliott
Sacramento, California
(916) 288- 3709, belliott@deloitte.com
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