Nexus: The Starting Block for State and Local Taxation
3/31/2009
Nexus—the point at which a state and its localities may be able to tax the in-state activities of a business—is a hotly contested issue that was and continues to be redefined.
The U.S. Commerce Clause grants the U.S. Congress the power to regulate trade among the states. Congress, however, has done little concerning interstate taxation, forcing the courts to deal with the validity of state taxes. Given current budget deficiencies, states are aggressively pushing to broaden their nexus reach. Consequently, a new wave of court cases dealing with nexus has begun and will likely grow unless Congress evokes its power to clearly define what in-state activities give rise to nexus. These debates lead to the question: At what point do the in-state activities of a business give rise to nexus? The following are activities, broadly defined, that we know establish nexus, and others that may, in some cases, establish nexus. Keep in mind that some states are more aggressive than others or may provide specific nexus exemptions.
· State of Incorporation—A business always has nexus with the state of its incorporation, organization, or formation. However, some states (viz., Delaware) provide income tax exemptions for businesses that lack any other in-state activities.
· Physical Presence—Generally, a business always has nexus with a state where it has an in-state physical presence. Physical presence refers to activities such as an office, inventory, other personal or real property, and employee activities. However, physical property that remains in transit or employees who travel through the state without performing any other in-state activities do not typically create nexus.
There are some exceptions to the general rules of physical presence. For example, many states have exemptions for businesses that attend certain in-state trade shows, while others include inventory kept at third-party fulfillment, publishing, or public warehouse facilities; the use of call centers; and the delivery of products via company vehicles.
During the late 1950s, Congress became concerned with case rulings that expanded the ability of the states to tax out-of-state businesses. In a rare act, Congress responded by enacting Public Law 86-272 to prevent the states from imposing a net income tax on an out-of-state business whose in-state activities are limited to the solicitation of tangible personal property via employee or third-party representatives.
However, P.L. 86-272 is a case of needing to read the fine print. It’s a narrow exemption in that it fails to protect those businesses that do not sell tangible personal property or against taxes that are not imposed on net income. There are many other requirements that must be met in order to fall under the law’s protection. The more prevalent requirements are: (1) the in-state sales rep cannot perform activities outside of solicitations such as installation, providing technical support, collecting funds, and regularly replacing spoiled products; (2) all orders obtained must be sent out-of-state for acceptance and fulfillment from an out-of-state location; and (3) the business cannot have an in-state office, including a company owned sales rep office.
· Attribution of Physical Presence—The physical in-state presence of a third party will generally be attributed to an out-of-state business if the in-state third party either creates or maintains a market share for the out-of-state business. A classic example of this scenario is an out-of-state computer manufacturer that hires an in-state computer repair business to provide warranty services on its behalf. Without this in-state warranty service arrangement, the out-of-state manufacturer would likely have less of an in-state market share. Thus, the physical presence of the in-state repair business is attributed to the out-of-state manufacturer under the rationale that it’s no different than if the manufacturer had sent its own employees in-state to perform the warranty services. It matters not whether the in-state third party is legally an agent of the out-of-state business.
Most recently, New York State has further expanded this concept of attribution for purposes of its sales tax, thereby starting a new nexus trend. In brief, New York assumes that an out-of-state business has established sales tax nexus when it contracts with in-state persons for consideration to directly or indirectly refer potential customers via a link on an Internet website or otherwise. After certain dollar thresholds are exceeded, New York attributes the in-state physical presence of the “referral network” to the out-of-state internet retailer. Amazon.com and Overstock.com have sued the state over this provision, but they have yet to win in court. Because of this, all eyes are on New York. California, Connecticut, Hawaii, and Minnesota have recently proposed similar legislation while New Jersey has informally stated that they intend to follow New York’s lead.
· An Affiliate with Physical Presence—Many states consider an out-of-state business with an in-state affiliate (e.g., parent/sub or brother/sister corporate relationship) to have established nexus when both affiliates sell the same or a substantially similar line of products. While many states assert this notion, several have lost in various state court cases.
· Economic Presence—Economic presence refers to the in-state presence of an intangible asset (such as a trademark, patent rights, and, potentially, loans) of an out-of-state business. This is where sales tax and income tax nexus splits. Pursuant to U.S. Supreme Court cases, there must be an in-state physical presence in order for a sales tax to be valid. However, when it comes to other taxes (viz., net income taxes) it’s uncertain whether physical presence is needed in order to establish taxable nexus. Many states have adopted an economic nexus provision for their income taxes; and consequently, most have been litigated with mixed results. New Jersey enacted such a provision and it scourts ultimately upheld the provision.
A few states have indicated they wish to further extend the reach of their economic nexus provisions by way of imbedded economic presence. For example: A business solely located in New Hampshire licenses a patent to a business solely located in New York. The New York business uses such patents while manufacturing widgets at its New York facility. The New York manufacturer sells its widgets via telephone to customers located in New Jersey. Under the imbedded economic presence theory, New Jersey would claim that the New Hampshire business has nexus with the state (because of the imbedded patents within state) and therefore must file and pay New Jersey income taxes. This is a scary proposition. How would the New Hampshire business be able to collect the necessary data needed to prepare a proper (in the state’s view) income tax return?
To make a final determination of whether it has established nexus with a given state, a business must perform a facts and circumstances analysis. Due to a large amount of court cases, businesses are faced with much uncertainty when performing such an analysis. Ultimately, this uncertainty will only be solved when the U.S. Supreme Court clearly rules on the matter or the U.S. Congress takes definitive action.
In our view, the U.S. Supreme Court seems frustrated that Congress has done very little concerning nexus and is trying to force the hand of Congress to do something by not accepting new nexus cases. Perhaps if a state attempts to enforce an imbedded economic nexus standard, either the U.S. Supreme Court or Congress will finally act to clearly define what in-state activities create nexus for both sales tax and income tax purposes.
Ernest J. Barbarise, CPA, MST, is a partner and director of J.H. Cohn's State and Local Taxation Group. He can be reached at ebarbaris@jhcohn.com or 609-844-3010.
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