Technical and policy aspects of crossing the presence nexus threshold: how much of what activities may and should cause taxability?

• Author: Rosen, Arthur R.

Introduction

Tax executives and practitioners who are deeply involved in multistate tax issues are very often confronted with seemingly straightforward questions regarding their companies and clients' taxability in a state or local jurisdiction. These questions include:

* If our corporation merely sends employees into a state to negotiate a single transaction, will that cause our corporation to be subject to tax (or to withholding or tax collection requirements) in that state?

* Will our mere retention of, and visits to, an investment banker in a state make our corporation subject to tax there?

* Can we send our buyers into a state to purchase raw material or inventory without subjecting our corporation to tax?

* Will our corporation be subject to tax if we send employees to perform due diligence work at the location of a prospective corporate acquisition?

* What will be the tax effects of our sending employees to a state to attend a meeting of the Board of Directors of a corporation in which we have a substantial investment?

* Does our sending employees to attend a seminar in a state make us subject to tax there?

* Can we perform two installations of our sold equipment in a state and yet not be subject to tax there?

* Can our executives make annual courtesy visits to our major customers in a state without thereby causing taxability there?

* Can our lobbyists visit government officials in a state and still not be subject to tax there?

* Can an employee take a paid vacation trip to a state without the employer being subject to tax in that state?

When one addresses fundamental state tax issues such as those raised by these questions, it is important to keep sovereign governments. Accordingly, they can do anything they wish unless prohibited by a specific limitation found in, or through, the U.S. Constitution. U.S. Const. amend. X. As the Supreme Court stated in Wisconsin v. J.C. Penney Co., 311 U.S. 435 (1940), "the limits on the otherwise autonomous powers of the states are those in the Constitution...." Among the most significant of these limitations in the context of state and local taxation is the prerequisite that there be certain connections between the taxing jurisdiction and both the putative taxpayer and the activities the state is seeking to tax. Consequently, connection ("nexus") issues are often the determinative factors in analyzing the most basic of all tax questions: who and what may be constitutionally taxed.

The technical, legal aspects of nexus issues are often in direct conflict with the best interests of a state and its citizens. In other words, a technical/policy dialectic often arises. This is because state constitutions and state statutes generally provide extremely broad taxing authority for the states. Moreover, federal constitutional constraints, which have been interpreted and applied through years of litigation, have not imposed truly potent constraints. Consequently, states have quite powerful taxing authority. State politicians and policy makers have a tendency to use this authority to raise increasing amounts of revenue to enable them to provide services and goods to their constituents. On the other hand, many political observers have noted that the prime objective of state politicians and policy makers is the creation of jobs (and the consequent enhancement to the wealth of the state's citizens). Discouraging visitors from coming into the state to patronize local businesses or offer them assistance undermines this objective.

In other words, asserting tax jurisdiction whenever constitutionally permissible is often an unwise governmental policy. Thus, state politicians and policy makers must contend with competing forces: (a) their deep desire to increase tax revenues, which is supported by their vast legal taxing authority, and (b) their desire, need, and responsibility to assist in the growth and profitability of their local economies.

To determine to what extent states should exercise their taxing authority, it is first necessary to establish the legal limitations on such authority. This examination requires a review of certain constitutional principles, specifically the "twin nexus" requirements, so that one of those twins, transactional nexus, can be disregarded and the other twin, presence nexus, can be isolated and analyzed in terms of quantity (or magnitude) and quality (or nature). The analysis of the quantitative aspect reveals a general rule that is eminently reasonable. The qualitative analysis, however, yields a possibly severe technical rule and a countervailing policy perspective. This article urges that serious thought be devoted to identifying those situations where there may be no legal prohibition against imposing tax but -- as a responsible policy matter -- tax should not be imposed.

Technical Framework --

Twin Nexus Requirements

A review of the significant authorities in the area of state tax jurisdiction reveals that two independent connections are required for a state tax imposition to meet constitutional nexus standards. The first of these is "transactional nexus," which mandates a connection between the state and the property, transaction, or business activity being taxed. The second is "presence nexus," which mandates a connection between the state and the taxpayer (or tax collector, in the situation of a use tax). The three cases discussed below are good illustrations of these nexus concepts.

In Connecticut General Life Insurance Co. v. Johnson, 303 U.S. 77 (1938), the taxpayer was a corporation commercially domiciled in Connecticut and licensed to do business in California. The corporation was selling insurance directly to insureds located in California and was paying tax to California on such business receipts. The corporation was also engaged in the reinsurance business, which it conducted solely in Connecticut. The underlying primary insurance that the corporation was reinsuring in some cases covered risks located in California. California was seeking to impose tax on this business activity of the corporation.

The ultimate conclusion of the Supreme Court was that although the corporation was clearly subject to the taxing jurisdiction of California and although the corporation's primary insurance business had sufficient connection with that state, the connection between the state and the corporation's reinsurance business was too tenuous to permit California taxation of that business activity.

A more recent case that represents the similar situation in terms of the twin nexus considerations is Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768 (1992). There, the taxpayer, a corporation (Bendix) commercially domiciled in Michigan, had active business operations and related property in New Jersey. It filed New Jersey corporation business tax returns covering such business activities. In addition, the corporation passively invested (by buying 20.5 percent of the common stock) in an unrelated, third party (ASARCO) with which it had no unitary relationship. This investment activity took place solely at the corporation's Michigan headquarters. As a result of this investment, the corporation earned dividends and a substantial capital gain. New Jersey sought to tax a portion of this ASARCO-related income. (The New Jersey statute did not recognize the UDITPA business/nonbusiness distinction.)

The Supreme court held that the corporation was subject to the taxing jurisdiction of New Jersey. It continued, however, that even though New Jersey could constitutionally tax business activities that occurred in that state (or that were operationally or unitarily related to such activities), the state could not impose tax on income from the investment in ASARCO because that investment was not operationally related to the corporation's (Bendix's) activities in the state. The Court explained: "[Iln the case of tax on an activity, there must be a connection to the activity itself, rather than a connection only to the actor the State seeks to tax."

Quill Corp. v. North Dakota, 504 U.S. 298 (1992), which represents the reverse situation (in the context of the twin nexus approach) to the two previously discussed cases, established the current framework and general standards applicable in all presence nexus analyses. In the case, the putative taxpayer (more accurately, "tax collector") was a corporation engaged in the mail order office supply/stationery business that made substantial sales into North Dakota. Quill's only connection with that state was the mailing of promotional materials to recipients in the state, shipping orders into the state, and owning a few floppy disks that were at customer locations in the state. North Dakota sought to require Quill to collect the state's use tax on its sales of goods into the state.

Although the transactions at issue -- the use of goods in the state by the customers and the shipping of the goods by the seller -- established the requisite transactional nexus between the activity and the state, the Supreme Court held that there was insufficient presence nexus between the putative taxpayer and the state. The Court, however, first held that the Constitution's Due Process Clause, for all state tax purposes, requires only that a putative taxpayer have "minimum contacts" with the taxing state. This flows from the intent of the Due Process Clause, which is to ensure fairness and notice. The connection with the state that is necessary to satisfy this minimum contacts standard is comparable to that needed to support a state court's jurisdiction over a defendant in a civil matter (the distinction between "comparable" and "identical" warrants an independent discussion beyond the scope of this article). As articulated in cases such as Burger King Corp. v. Rudzewicz, 471 U.S. 462 (1985), that standard is met if the entity "purposefully avails itself of the benefits of an economic market in the forum state."...