Finishing what Quill started: the transactional nexus test for state use tax collection.

• Author: Hoti, Anna M.

1. INTRODUCTION II. BACKGROUND

   1. Due Process Limitations on Use Tax Collection

   2. Commerce Clause Limitations on Use

      Tax Collection III. THE CURRENT PARAMETERS OF THE PHYSICAL PRESENCE REQUIREMENT

   1. The Bright-Line Rule: Contacts by Mail or

      Common Carrier

   2. Vendor's Retail Outlets in the Taxing State

   3. Vendor's Personnel in the Taxing State

   4. Independent Contractors in the Taxing State

   5. Other Contacts IV. THE TRANSACTIONAL NEXUS TEST V. CONCLUSION

1. INTRODUCTION

   With the rise of large mail-order companies such as L.L. Bean and the Home Shopping Network, the mail-order industry in the United States is expanding rapidly.(1) Small businesses are facing increased competition as more and more consumers choose to purchase merchandise from mail-order firms.(2) This growth is, in part, attributable to consumers' ability to evade state sales and use taxes when mail-order companies do not collect them.(3) Local businesses, which must collect sales tax on most retail sales, are at a disadvantage to the extent that their customers cannot realize the same cost savings. In addition, states lose billions of dollars in annual revenue due to their inability to collect taxes on out-of-state sales.(4)

   This situation stems from the differences between sales and use taxes. Because the dormant Commerce Clause prohibits taxation of out-of-state transactions, states cannot tax sales occurring outside of their borders.(5) Therefore, to protect local businesses and state tax revenue, states that impose a sales tax on purchases made within their borders also impose a compensating use tax on outside purchases consumed within the state.(6) The subject of the use tax is an in-state transaction, the use of the product within the state, rather than an outside sale. The use tax thus "complement[s] the sales tax" by "fill[ing] gaps where the States could not constitutionally impose a sales tax."(7)

   States generally impose both sales and use taxes on the consumer,(8) but enforcing use tax collection is difficult. While states rely on in-state retail vendors to collect and remit the sales tax,(9) the Due Process and Commerce Clauses restrict their ability to impose a use tax collection obligation on out-of-state retailers.(10) Thus, when the out-of-state retailers do not collect the use tax, consumers can realize a savings relative to similar purchases made within the state.(11)

   Out-of-state vendors have resisted collecting the use tax on Due Process(12) and Commerce Clause(13) grounds.(14) These provisions of the United States Constitution allow a state to impose use tax collection obligations only on businesses that have a certain nexus with the state.(15) The Due Process Clause requires minimum contacts with the taxing state, while the dormant Commerce Clause requires a substantial nexus with the state.(16) Since Quill Corp. v. North Dakota,(17) only the dormant Commerce Clause substantial nexus requirement mandates that a mail-order vendor (also referred to as a "direct marketer") have a physical presence within a state before that state can require it to collect use taxes.(18) The existence of "`retail outlets, solicitors, or property within a State'" generally amounts to physical presence, but contacts solely by "`mail or common carrier'" are insufficient.(19) The Due Process Clause, according to Quill, does not require that a direct marketer be physically present in the state and, therefore, contacts by mail or common carrier may be sufficient to meet the due process minimum contacts nexus requirement.(20)

   The concept of physical presence, then, remains important under the Commerce Clause. However, Quill only clarified that contacts made solely by mail or common carrier, regardless of the extent of solicitation within the state, do not amount to physical presence.(21) This Comment explores the contacts that do satisfy the physical presence requirement. In addition, this Comment proposes a substantial nexus test that, by requiring a transactional nexus, is more consistent with the purposes of the Commerce Clause and provides superior guidance to the courts than the current standards. Part II discusses the evolution of the Supreme Court's Due Process and Commerce Clause jurisprudence, including an analysis of the differences between the two and how these differences justified abandoning the physical presence requirement for the Due Process Clause, but not the Commerce Clause. Part III analyzes the physical presence requirement as it currently applies to use tax collection. Part IV argues that the substantial nexus test should require that a direct marketer's contacts with a given state be related to the obligation imposed on it by that state.

2. BACKGROUND

   In National Bellas Hess, Inc. u. Department of Revenue,(22) the Supreme Court held that states could impose use tax collection obligations on mail-order vendors with a physical presence in the taxing state, but not on vendors whose only connection with the state was by mail or common carrier.(23) Bellas Hess attributed the physical presence requirement to both the Due Process Clause and the Commerce Clause, in that "[t]he same principles have been held applicable in determining the power of a State to impose the burdens of collecting use taxes upon interstate sales."(24)

   A quarter of a century later, in Quill Corp. v. North Dakota, the Supreme Court eliminated the physical presence requirement for purposes of the Due Process Clause, and reaffirmed it for Commerce Clause purposes.(25) In addition, it reaffirmed the Bellas Hess "bright-line" rule that "a vendor whose only contacts with the taxing State are by mail or common carrier lacks the `substantial nexus' required by the Commerce Clause."(26) The Court further explained that, while such bright-line tests remain useful in certain circumstances, more flexible balancing analyses are favored in others.(27)

   Cases involving state taxation of interstate businesses often involve both the Due Process and Commerce Clauses.28 However, while these two provisions have been characterized as "closely related,"(29) they place distinct and separable limitations on state power to tax interstate commerce.(30)

   1. Due Process Limitations on Use Tax Collection

      Pursuant to the Due Process Clause, a state has jurisdiction over a company only where the company's contacts with the state constitute "fair warning" that it may be subject to that state's jurisdiction.(31) Accordingly, due process limitations on taxing jurisdiction are based on the belief that it is "fundamentally unfair" for a state to tax a business (or to require that it collect a tax) where it lacks minimum contacts with that state.(32)

      At first, questions regarding the constitutionality of use taxes addressed their validity per se and generally focused on Commerce Clause limitations. Specifically, the issue was whether use taxes imposed an undue burden on or discriminated against interstate commerce.(33) Where the use tax was the same amount as the sales tax, and where the state gave credit for any sales tax paid to another state, the use tax was held to be valid under the dormant Commerce Clause.(34) As the validity of use taxes per se became settled, the focus began to shift to the application of use taxes to particular businesses.(35) As a result, the concept of a nexus between a business and a taxing state became increasingly important.

      The due process requirement that there be some kind of nexus between a business and the state attempting to tax it was implied in Felt & Tarrant Manufacturing Co. v. Gallagher.(36) Felt & Tarrant was an Illinois retailer that challenged having to collect a California use tax on both Due Process and Commerce Clause grounds.(37) It had two offices and two sales agents in California for the purpose of soliciting orders, and made deliveries either directly to the purchasers or through the sales agents.(38) The issue with respect to the Due Process Clause was whether Felt & Tarrant had sufficient contacts with California so that California could exercise control over it.(39) Finding sufficient contacts, the Court upheld California's imposition of the use tax collection obligation.(40)

      One year after Felt & Tarrant, in Wisconsin v. J.C. Penney Co.,(41) the Court for the first time clearly stated that the Due Process Clause requires a nexus between a business and a taxing state.(42) J.C. Penney was an out-of-state retailer which argued that Wisconsin violated the Due Process Clause by imposing on it a corporate income tax based on the privilege of declaring and receiving dividends from in-state earnings, regardless of where the dividends originated or were ultimately distributed.(43) The Court remanded the case for determination in accordance with its due process nexus test: "whether the taxing power exerted by the state bears fiscal relation to protection, opportunities and benefits given by the state. The simple but controlling question is whether the state has given anything for which it can ask return."(44)

      The Court applied this same test in Nelson v. Sears, Roebuck & Co.(45) to determine whether a use tax, as applied to a nonresident mail-order business, violated the Due Process Clause.(46) The Court upheld Iowa's imposition of a use tax collection obligation on an out-of-state business with separate retail outlets in the state.(47) It reasoned that Sears' mail-order business incidentally benefited from the presence of these retail stores.(48) The determining factor was that Sears was doing business in Iowa, and not solely taking orders and shipping merchandise from outside the state.(49)

      The development of the due process nexus requirement from hereon is significant in that the issue became whether physical presence within a state was essential to finding a nexus. In addition, the development of the due process nexus requirement in the area of state judicial jurisdiction foreshadowed the ultimate elimination of the physical presence...