Marching to the Beat of the Itinerant Drummer: States Increasingly Refuse to Get Physical Before Finding Nexus

• Author: Mark Alan McGinnis
• Pages: 149-205

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It is emphatically the province and duty of the judicial department to say what the law is. ¹

I Introduction

The nexus requirement that is a requirement for the imposition of the burden of state tax collection begs for clarification. The unsettled case-by-case resolution of the "extremely limited restrictions that the Constitution places upon the states regarding taxation powers requires untangling."²

Commerce between the States having grown up like Topsy, the Congress meanwhile not having undertaken to regulate taxation of it, and the States having understandably persisted in their efforts to get some return for the substantial benefits they have afforded it, there is little wonder there has been no end [to the] cases testing out state tax levies.³

"The resulting judicial application of constitutional principles to specific state statutes leaves much room for controversy and confusion, and little in the way of precise guides to the States in the exercise of their indispensable power of taxation."⁴ While the decisions have not always been clear, consistent, or even reconcilable, some rules have emerged.⁵

While it is true that a State may not erect a wall around its borders preventing commerce an entry, it is axiomatic that the founders did not intend to immunize such commerce from carrying its fair share of the costs of the state government in return for the benefits derived from within the State.⁶

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Several cases emerged that provided an opportunity for resolution of the issue. The Supreme Court has often turned down the invitation to make such a clarification, however, having done so most recently in 2000.⁷ By the end of its last term of 2002, the Supreme Court had failed to hear a case even related to state tax issues for another year.⁸ Its failure to do so is not surprising considering the Court's reluctance to hear state tax cases in recent years.⁹ Some business and government representatives are so frustrated that they are now considering an unprecedented formal protest on the courthouse steps.¹⁰

II The Issue Emerges

Before addressing the issue at hand, it is first necessary to discuss and distinguish some of the key lexicon relative to the imposition of business activity, sales, and use taxes. This should also serve to draw attention to this particular issue's complexity, which flows from the multitude of both horizontal and vertical lines of nexus jurisprudence. In other words, nexus jurisprudence has evolved vertically, through the trial and appellate level of state and federal courts, as well as horizontally, within each of the state and federal systems.

In its most basic form, nexus describes the amount and degree of business activity that must be present before a state can tax an entity's income.¹¹ If a taxpayer has nexus in a particular state, the taxpayer must pay, collect, and remit taxes in that state.¹² Generally, nexus arises when an entity derives income from sources within the state, owns or leases property in the state, employs personnel in the state in activities that exceed "mere solicitation," or has other capital or property in the state.¹³The amount of activity or connection that is necessary to create nexus is defined by state statute, case law, or regulation and, consequently, varies from state to state.¹⁴ In the end, states are ultimately limited by constitutional principles, judicial doctrine, and federal law.¹⁵

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The increased use of electronic commerce-commercial transactions involving the production, sale, and distribution of goods, services, and intangible property through the use of computer networks-has significant implications for the levying of state taxes at the state level. Each year, more and more people use the Internet to purchase goods and services.¹⁶The growth of Internet-based sales concerns many so-called "Main Street" merchants, who would typically prefer to treat remote sales and traditional retail sales equally for taxation purposes to avoid any competitive disadvantage. Concern is also rising among state and local governments, which worry about the impact that the growth of electronic commerce will have on their ability to raise revenue.¹⁷ It has been estimated that e-commerce costs the states and localities collectively as much as $14 billion a year in revenue.¹⁸

States that impose sales taxes on goods purchased within the state generally also impose a corresponding use tax on goods purchased out of state.¹⁹ The intent of the use tax is to protect sales tax revenues and competitively position local retailers with out-of-state retailers who are exempt from the sales tax.²⁰

Consumers pay a sales tax when they purchase goods and services in their own state. When they buy goods from a retailer in another state, they pay a use tax. Even though the states impose both taxes on consumers, merchants typically bear the responsibility for collecting the tax and sending it to the proper state. A merchant located in the same state as the consumer must collect the sales tax and remit it to the state where both parties are located. Typically, when a consumer buys an item from an outof-state merchant, or by mail order over the Internet, the merchant mustPage 152 collect the use tax and send it to the consumer's state only if the merchant has some physical presence in the consumer's state.²¹

Those who support lessening or outright eliminating the physical presence requirement believe that requiring the collection of sales and use taxes on electronic and catalog purchases may permit states to receive their tax dollars only at the expense of small business economic development.²²Some authors also cite the administrative costs the states have incurred in litigating these issues.²³ This, combined with the massive revenue shortfalls that the states are facing, has prompted a call to Congress to provide meaningful and lasting guidance in the area.²⁴

This Article will explore the issue from its foundational cases through present day, examining each of the forks of analysis that have developed against a backdrop of increasingly sophisticated business and tax planning. The goal is to provide a broad treatise-type examination of the overall issue of nexus as it has been applied to various situations. In the end, the Article will examine the increasingly important role the states are seeking to play in the nexus issue, and will call upon Congress, not the courts, to act pursuant to its constitutional role to clarify the area.

III Foundational Cases

A The Saga Begins: The Supreme Court is Weighed Down by Apportionment Formulas in Portland Cement

No overview of this area of jurisprudence would be complete absent at least a brief discussion of the Portland Cement case.²⁵ In Portland Cement, a state brought an action against a foreign corporation to collect income taxes.²⁶ The Supreme Court considered the constitutionality of "state . . . income tax laws levying taxes on that portion of a foreign corporation's net income earned from and fairly apportioned to business activities within the taxing State when those activities are exclusively inPage 153 furtherance of interstate commerce."²⁷ The Court held that a foreign corporation's net income earned through interstate operations may be subject to state taxation where that taxation is properly apportioned to the corporation's local activities within the state and is not otherwise discriminatory.²⁸ Such a tax, the Court held, does not frustrate either the Commerce Clause or the Due Process Clause of the Constitution.²⁹

The Commerce Clause gives exclusive power to Congress to regulate interstate commerce; Congress's failure to act on the subject in the area of taxation requires that interstate commerce be free from any direct restriction by the states.³⁰ On one hand, this means that a state cannot "impose taxes upon persons passing through the state, or coming into it merely for a temporary purpose such as [an] itinerant drummer[];"³¹ lay a tax on the "privilege" of engaging in interstate commerce;³² impose a tax discriminating on interstate commerce by direct commercial advantage to local business;³³ subject interstate commerce to the burden of "multiple taxation;"³⁴ or allow "one single tax-worth of direct interference with the free flow of commerce."³⁵ On the other hand, "it has been established since 1918 that a net income tax on revenues derived from interstate commerce does not offend constitutional limitations upon state interference with such commerce."³⁶ This distinction hinges on the difference "between an invalid direct levy which place[s] a burden on interstate commerce, and a charge by way of net income derived from profits from interstate commerce."³⁷

In Portland Cement, the Court reviewed its jurisprudence in the area of state taxation of interstate commerce. The doctrine that ultimately emerged was "that the entire net income of a corporation, generated byPage 154 interstate as well as intrastate activities, may be fairly apportioned among...