By Rich Molina, CPA
This is part one of a two-part article on the history of taxing out-of-state retailers
For 50 years, taxing jurisdictions have grappled with the issue of whether they might cause out-of-state retailers to collect taxes on purchases made by buyers resident in their taxing jurisdictions. The issue is almost generational in the sense that the U.S. Supreme Court weighed in on the matter in 1967, 1992, and now, some jurisdictions are causing the Court to possibly once again revisit the issue. A recent Wall Street Journal article1 reported on a situation where some tax administrators are requiring out-of-state retailers to collect taxes even though the retailers are likely to challenge the requirement under current law. The hope is there will be enough litigation percolating within the courts so that the Supreme Court might revisit its last ruling.
The initial significant U.S. Supreme Court decision dealing with the issue of whether an out-of-state retailer might be required to collect on taxes was National Bellas Hess, Inc. v. Department of Revenue of Illinois, 386 U.S. 753,(1967). National distributed its catalogues twice a year to residents of Illinois along with occasional advertising flyers. Orders for merchandise were typically mailed by customers to National. As was customary back then, orders were filled and merchandise was shipped to customers by mail or by common carrier. National had neither employees nor physical assets in Illinois. Illinois imposed a use tax on its residents. The use tax was meant to apply where residents purchased goods from out-of-state for use within Illinois. Because consumers purchasing goods from out-of-state retailers almost never voluntarily pay the use tax on purchases, and the state had no means for even verifying whether purchases were made, the state imposed the collection obligation on the seller, National. National challenged the imposition of this collection obligation under the due process and commerce clauses of the U.S. Constitution.
Due process analysis prevents the imposition of burdens upon a party by a state where the party has no meaningful contact with the state. Such a burden might consist of an obligation to collect and to remit a tax to a state taxing authority. Under due process, the court found that because National had no meaningful connection with Illinois, notions of fair play should prohibit Illinois from imposing a collection and remittance obligation.
The commerce clause analysis is similar to due process but serves an entirely different purpose. The commerce clause is designed to prevent a state from unfairly burdening interstate commerce. A state is only free to burden (via a tax compliance or payment obligation) a party conducting interstate commerce in cases where it is appropriate to make that commerce bear a fair share of the cost of the state government when it enjoys some benefits provided by that state. Because National had no physical presence in the state, had no employees in the state, and conducted business through the mail and third party carriers, the court found Illinois could not impose a use tax collection obligation on the company in accordance with the commerce clause. Consequently, interstate commerce could not be expected to pay a fair share of the cost of government unless it has a physical presence in the state seeking to impose a burden.
National was the law of the land for a quarter of a century, but tax administrators were cognizant of changes occurring in the business world and sought to challenge that holding. The court reconsidered National in Quill Corp. v. North Dakota, 504 U.S. 298 (1992). Quill was another mail order company selling office equipment and supplies to customers in North Dakota. Quill had no employees, no ownership of tangible personal property (except for property considered by the court to be insignificant) and solicited business through catalogues, flyers and advertisements in national publications. Deliveries to customers were made by common couriers. North Dakota’s tax authorities demanded that Quill collect and remit use taxes on purchases made by North Dakota customers. The demand was challenged and ultimately made its way to the North Dakota Supreme Court. That court upheld the requirement to collect use taxes. Key to that court’s holding was its findings that much had changed in the way business was conducted since the days of when National was decided. The mail order business had grown significantly from a small part of the market. Moreover, advances in computer technology would greatly ease the burden of compliance to collect and remit use taxes imposed by state and local taxing authorities. These points were considered more important than having a mere physical presence in a state. The court also noted a loosened standard adopted by the U.S. Supreme Court since National that allowed the nexus standard for due process to be satisfied when a company exploits the realm of economic activity of a state held together by the government in that state.
On appeal, the U.S. Supreme Court analyzed the case once again using due process and commerce clause analyses. With respect to the due process analysis, the court noted that changes in the law had occurred since the National decision. No longer should a court focus merely on whether a business has a sufficient presence in the state to make it subject to the state’s authority to tax it or to require it to comply with a collection obligation. Rather, the test was whether a business such as Quill availed itself of the benefits of an orderly economic market created in North Dakota regardless of its physical presence in the state. The court concluded that because Quill had taken advantage of an orderly economic environment in North Dakota as created and policed by state and local governments, due process would not prohibit North Dakota from imposing a tax collection obligation.
With respect to its commerce clause analysis, however, the Court maintained the physical presence requirement. Although the court admitted physical presence was a “bright line test,” it considered it a necessary test so that businesses engaged in interstate commerce knew the boundaries for when they would be subject to use tax obligations. The court found that businesses relied upon this test and planned their activities in accordance with this test and it would inappropriate to disturb this test now. The court made very clear in its opinion, however, that Congress could write a law (using its Constitutional authority to regulate interstate commerce) that could dispense with the physical presence test required under the court’s bright line test.
Rich Molina, CPA, is an adjunct professor at Cleveland State University.