Closing the Use Tax Loophole: Why Consumer Self-assessment Is a Viable Solution

• Publication year: 2017

Closing the Use Tax Loophole: Why Consumer Self-Assessment Is a Viable Solution

Rubinder Bal

CLOSING THE USE TAX LOOPHOLE: WHY CONSUMER SELF-ASSESSMENT IS A VIABLE SOLUTION

Abstract

With the surge in online shopping, use tax has become an increasingly elusive source of tax revenue for states. The constitutional constraints of due process and the Commerce Clause establish limits that often frustrate states' attempts to impose tax collection obligations on remote retailers. Due process is largely uncontroversial. It requires only that a retailer have minimum contacts with a state as to fairly fall under its taxing authority. The Commerce Clause has proven far more contentious, particularly after the Supreme Court's decision in Quill v. North Dakota. In Quill, the Court held that a state could only impose a collection obligation on a retailer that was physically present in the taxing state. The Quill decision has been chastised for grounding taxation on the seemingly arbitrary line of physical presence, particularly in an era where online transactions have largely obscured state lines.

This Comment analyzes post-Quill cases that exemplify the absurdity of treating local retailers differently from remote retailers that economically exploit the same market. The cases also demonstrate how physical presence is readily susceptible to manipulation from states and retailers alike, making it a wholly unsuitable mechanism for governing which retailers are susceptible to tax collection and which are not. The Comment then considers, and ultimately rejects, four alternative mechanisms that have been proposed by scholars. The Comment concludes by proposing a novel solution, which shifts the burden of use tax collection away from remote retailers and onto the consumer, allowing states to circumvent the Commerce Clause obstacle altogether.

[Page 886]

Introduction.............................................................................................887

I. Differentiating the Use Tax from the Sales Tax...................888
II. Constitutional Limitations on Imposing Use Tax Collection on Out-of-State Retailers................................................................890

A. The Quill Decision.................................................................... 891
B. Repercussions of Quill.............................................................. 894

1. Establishing a Nexus for a Subsidiary Based on the Physical Presence of Its Parent Company ........................................ 895
2. The Degree of Physical Presence Needed to Satisfy the Quill Test ..................................................................................... 896
3. The Use of Intangible Personal Property to Satisfy the Physical Presence Test ...................................................................... 897
4. Whether Temporary Physical Presence Satisfies the Commerce Clause Nexus ...................................................................... 898

III. Proposed Solutions and Their Shortcomings..........................899

A. Economic Nexus ....................................................................... 899

1. Overview............................................................................. 899
2. Shortcomings ...................................................................... 900

B. Streamlined Sales and Use Tax Agreement.............................. 902

1 Overview............................................................................. 902
2. Shortcomings ...................................................................... 903

C. Colorado's Reporting Approach .............................................. 904

1. Overview............................................................................. 904
2. Shortcomings ...................................................................... 905

D. New York's Click-Through Nexus Approach............................ 906

1. Overview ............................................................................. 906
2. Shortcomings ...................................................................... 907

IV. An Alternative Solution............................................................907

A. Step 1: Eliminate the Commerce Clause Nexus Requirement Altogether ................................................................................. 908
B. Step 2: Consolidate the Colorado and SSUTA Approaches and Create a Simplified Reporting System for Remote Retailers .... 910
C. Step 3: Shift the Burden of Collection from the Remote Retailers to the Consumer ............................................................................ 912
D. What Problems Still Remain?................................................... 914

Conclusion.................................................................................................915

[Page 887]

Introduction

The tax gap—defined as the disparity between what taxpayers should pay and what they do pay¹ —has perpetually plagued state and federal governments alike. For states, one vital source of tax revenue, the use tax, has remained elusive since it was first enacted in the 1930s.² The use tax was intended to act as a corollary to the sales tax. While sales made within a state's borders are generally subject to a sales tax, the use tax purports to tax goods purchased by a state's residents outside state lines that are consumed within the state.³ The frustration for states in collecting use tax revenue lies in the constitutional constraints of the Due Process and Commerce clauses that limit a state's ability to exercise its taxing authority over an out-of-state retailer.⁴

The states' frustrations were heightened after the 1992 Supreme Court case of Quill v. North Dakota.⁵ In Quill, the Court created two formalistic nexus tests for due process and the Commerce Clause—the minimum contacts test and physical presence test.⁶ Both tests must be satisfied before a retailer can come under a state's use tax jurisdiction.⁷ This bifurcated analysis has led to considerable confusion among the lower courts over what constitutes physical presence.⁸ Moreover, scholars have criticized basing tax collection obligations on the arbitrary distinction of whether a retailer is physically present in a state.⁹ Such a test relieves high volume remote retailers who exploit a state's economic market from any tax liability while conferring no such benefit on brick-and-mortar stores located within state lines.

[Page 888]

Despite calls to overturn Quill, the Supreme Court has refused to hear a use tax case since its landmark decision. However, recently in Direct Marketing v. Brohl,¹⁰ Justice Kennedy, in a concurring opinion, articulated concerns about the continuing validity of the physical presence test, and suggested that the Supreme Court may be willing to reconsider the issue.¹¹ According to Justice Kennedy, "[t]he Internet has caused far-reaching systemic and structural changes in the economy" and, "[a]s a result, a business may be present in a State in a meaningful way without that presence being physical in the traditional sense of the term."¹² As a result, Justice Kennedy denounced Quill for "inflicting extreme harm and unfairness on the States"¹³ and urged the "legal system [to] find an appropriate case for this Court to reexamine [its holding]."¹⁴

This Comment identifies the shortcomings of the physical presence test and proposes a novel solution that obviates the need for a Commerce Clause analysis by shifting the burden of use tax collection away from remote retailers and onto the consumer. This Comment proceeds in four Parts. Part I distinguishes the use tax from the sales tax and explains why it has historically been an untapped source of tax revenue for the states. Part II provides an in-depth analysis of the Quill decision and evaluates post-Quill cases that exemplify the level of confusion created by the Court's physical presence test. Part III evaluates the merits of various solutions that have been proposed, as well as their inadequacies and shortcomings. Finally, Part iV proposes an alternative solution that would facilitate states' collection efforts without unduly hindering interstate commerce.

I. Differentiating the Use Tax from the Sales Tax

Most consumers are familiar with the sales tax. A consumer who goes to a store and picks up an item priced at $9.99 expects to pay more than that at the register. This excess cost is the sales tax, a consumption tax imposed on consumers by the state in which the sale occurs.¹⁵ Today, forty-five states

[Page 889]

impose a sales tax on the sale of goods and services within their jurisdictions.¹⁶ For these states, sales tax is a vital source of revenue, accounting on average for approximately 12% of the states' total revenues.¹⁷ Economists have noted that the sales tax has proven more stable than state income taxes during economic downturns.¹⁸ Moreover, sales tax is often a more immediate source of state revenue than the income tax or property tax because it can be "hidden" in prices and collected incrementally, rather than in an annual lump sum.¹⁹ Notably, although sales tax is a tax imposed on consumers, it is retailers who often bear the burden of collection.²⁰ For administrative efficiency, states generally compel retailers to collect the tax on their consumers' behalf at the point of sale, and subsequently remit the payments to the state.²¹

With the advent of Internet technology, mail-order and e-commerce sales have taken a large chunk of market share from traditional brick-and-mortar stores.²² Consumers are no longer limited to making purchases in the state in which they reside.²³ With the click of a mouse, a consumer in New York can purchase an item from a California retailer. Given the proliferation of online ordering, states have attempted to ensure that such purchases do not escape taxation.²⁴ However, in McLeod v. J.E. Dilworth Co., the Supreme Court held that a...