Nexus and Remote Sellers: the Taxation of Electronic Commerce

• Publication year: 2002
• Pages: 75

31 Colo.Law. 75 Colorado Lawyer 2002.

2002, February, Pg. 75. Nexus and Remote Sellers: The Taxation of Electronic Commerce

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75

Vol. 31, No. 2, Pg. 75

The Colorado Lawyer
February 2002
Vol. 31, No. 2 [Page 75]

Specialty Law Columns
Technology Law and Policy Review
Nexus and Remote Sellers: The Taxation of Electronic Commerce
by Nathaniel T. Trelease, Andrew W. Swain
2002 Nathaniel T. Trelease and Andrew W. Swain

Contrary to common perception, e-commerce generally is not exempt from state and local taxation. The taxability of sales originated online and the liability of vendors for those taxes ultimately is determined by the scope and structure of an e-commerce vendors operations, including its alliances with offline businesses

This month's article was written by Nathaniel T Trelease, Denver, a tax attorney and founder of an online company (720) 937-9930, ntrelease@webcredenza.com, and Andrew W. Swain, Denver, a tax manager with KPMG LLP-(303) 382-7335 aswain@kpmg.com.

Congress recently renewed the Internet Tax Freedom Act ("ITFA" or "Act").1A number of misconceptions exist about the Act's scope, and fundamental issues it does not address. The most significant issue is whether state and local jurisdictions ("taxing jurisdictions") may impose sales and use tax collection obligations on non-domiciliary Internet-based vendors ("remote vendors"). This issue is resolved by determining if a remote vendor has a sufficient physical presence in a jurisdiction ("nexus") to constitutionally justify the imposition of tax collection responsibilities for sales made to local customers. The determination is substantially complicated because of the essential nature of electronic commerce ("e-commerce"), particularly the growing prevalence of "bricks-and-clicks" relationships between online and offline businesses.

Issues of nexus and tax collection obligations have never been as important as they are now. Incremental growth of a remote vendor can expose it to substantial new tax liabilities and compliance obligations at a time when the states, under renewed fiscal pressures, are becoming more aggressive in taxing e-commerce. Failure to correctly identify the point at which tax collection obligations arise in the nation's approximately 7,500 taxing jurisdictions2 also potentially subjects a remote vendor itself to liability for all past uncollected taxes on sales. The effect on even a robust remote vendor could be devastating.

This article outlines the federal constitutional and statutory limitations on a taxing jurisdiction that seeks to establish nexus with a remote vendor. This focus can assist counsel in advising Colorado-based clients on "out-bound" e-commerce transactions' that is, where a local vendor seeks to sell its goods in out-of-state markets. The article also discusses Colorado-specific nexus issues, which can assist counsel in advising non-Colorado clients that wish to sell goods in Colorado over the Internet--so-called "in-bound" transactions. Finally, the article offers some practical advice to legal counsel and remote vendors.

Sales and Use Taxes:
A Primer

States generally impose a sales tax on the retail sale of tangible personal property and certain services in the state.3 Most states impose the sales tax on the vendor, which customarily collects the tax from its customers at the time of the sale.4

To make their taxing schemes comprehensive, nearly all states also impose a complementary "use tax" that purports to reach out-of-state sales of property to a state's residents for use, storage, or consumption in the state.5 Use taxes are designed to prevent the erosion of states' individual tax bases when their residents make purchases in other states. Use taxes may be imposed on individual taxpayers as well as vendors,6 but taxing jurisdictions generally rely on individual self-assessment for collection of the tax. Because states could not possibly audit all of their residents for use tax purposes, they must rely on remote vendors to collect and remit use taxes.

Use tax requirements underscore the necessity for taxing jurisdictions to establish nexus with remote vendors, particularly in the context of e-commerce. Without establishing nexus with remote vendors, an estimated $26 billion in sales and use taxes will go uncollected by taxing jurisdictions.7

The Internet Tax
Freedom Act

The ITFA is frequently misconceived as having suspended nexus rules regarding purchases made over the Internet, thereby freeing Internet sales from sales and use tax. However, the Act is substantially narrower in scope and only reaches certain Internet-related activities. The Act does not modify the duty of a remote vendor with nexus in a state from collecting sales and use tax on sales made to customers in that state. Because nexus is undefined in the Act,8 states must resort to general case law.

The Act provides that taxing jurisdictions may not: (1) impose taxes on Internet access unless such taxes were generally imposed and actually collected prior to October 1, 1998,9 or (2) impose multiple or discriminatory taxes on electronic commerce.10 The moratorium's application to Internet access means that, unless the taxing jurisdictions imposed taxes on Internet access charges before October 11, 1998, a taxing jurisdiction may not tax any fees paid to an Internet Service Provider ("ISP"), such as America Online, the Microsoft Network, Earthlink, or small local providers. The Act's definition of "Internet access service" does not include telecommunications services.11

The Act prohibits multiple or discriminatory taxation, which affects remote sellers. This prohibition prevents a taxing jurisdiction from imposing a duty to collect sales or use taxes on: (1) a remote seller that does not have nexus with the jurisdiction in which the purchaser resides, or (2) an ISP as an agent providing the remote vendor a means to conduct sales.12 Colorado has enacted a substantially similar moratorium on the taxation of certain Internet-related activities.13

"Nexus" as a
Constitutional Principle

The Dormant Commerce Clause14 is the principal restraint15 on a taxing jurisdiction's efforts to establish nexus with a remote vendor. In the seminal 1992 case of Quill Corp. v. North Dakota,16 the U.S. Supreme Court reaffirmed the long-standing rule that a taxing jurisdiction may establish nexus with a remote vendor only if the vendor is physically present in the jurisdiction. Although it seemingly established a formal rule, Quill largely left open the crucial inquiry of what level of physical presence is required for a jurisdiction to establish nexus.

In Quill, the remote vendor was a Delaware corporation that sold approximately $1 million worth of office supplies through direct-mail advertising to approximately 3,000 customers in North Dakota. Except for the presence of software that it licensed to its customers, the vendor did not have any property in the state. All of its products were delivered in North Dakota by common carriers.17The court held that delivery of goods through a common carrier alone did not constitute a physical presence.

In National Geographic Society v. California Board of Equalization,18 a case that predates Quill, the U.S. Supreme Court held that a remote vendor's "continuous presence" in the state, which consisted of two offices, was sufficient to establish nexus. Still, the Court rejected the lower court's ruling that the "slightest presence" in state was sufficient to establish nexus.19

Within this spectrum from Quill (requiring a physical presence) to National Geographic (establishing that "continuous presence" is sufficient, but the "slightest presence" is not) there is great room for factual variation, inconsistency, and confusion. South Carolina has established nexus with a remote vendor through the in-state presence of intangible property, such as accounts receivable and royalty agreements.20 Similarly, New York interprets Quill as requiring only "demonstrably more than a 'slightest presence,'" and has found that as few as twelve sales-related visits by personnel of a remote vendor over three years is sufficient to establish nexus.21

Some states have extended the common carrier exclusion of Quill and refused to find nexus where the remote vendor has only an attenuated presence in the state. In Tennessee, for instance, the presence of a credit-card issuer's direct-mail flyers and plastic credit cards together are not sufficient to establish nexus.22

This principle of nexus is extensible to a vendor's transient presence in a state. For instance, in Department of Revenue v. Share International, Inc.,23 the Florida Supreme Court did not find nexus with a remote vendor whose sole employee was present in the state for only three days a year at a sales conference. In Kansas, eleven four-hour visits by a remote vendor's technicians to assist customers in installing equipment was held not sufficient to establish nexus.24 However, when a vendor's presence in a state is longer in time and greater in collateral activities, courts are more likely to find a physical presence. In Cole Bros. Circus, Inc. v. Huddleston, for example, a circus operator was in Tennessee for only twenty-nine days over two and a half years. Despite this, the company extensively used the state's highways, advertised on the radio and newspapers, and applied for a business license. Together, these factors were sufficient for the court to find nexus.25

Generally, Internet-based remote vendors that deliver their tangible products via common...