Drop shipments and flash title: establishing sales tax nexus in complex commercial transactions.

• Author: Griffith, Cara

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AS BUSINESSES EVOLVE TO MEET THE needs of customers in an increasingly instantaneous and borderless commercial environment, transactions are inevitably becoming more complex. Business models have increased in complexity with the use of e-commerce, supply chain management, dual branding, and multi-chain retailers. State tax codes, while arguably complex, have largely failed to keep up with the evolution of commercial transactions. Many state tax codes are still based on the premise that a sales transaction involves only two parties: a seller and a buyer. Modern transactions can involve far more than two parties. In addition, transactions involving remote sellers raise sales and use tax issues, including whether a remote seller has nexus with a state if its only connection to that state is the presence of a retailer or manufacturer that supplies goods to the seller's customers.

Other common commercial transactions include drop shipments and flash title transactions. Drop shipments involve a customer in one location who places an order with a retailer in a second location, which requests that a supplier in yet another location fill the order and ship the item directly to the customer. The sales and use taxation of drop shipments can be complex because not all states treat drop shipment transactions the same. Another type of transaction involves something called a "flash title." This occurs in a transaction where an out-of-state entity holds legal title to an item in the stream of interstate commerce but the item is in the control of a third party (typically a common carrier). During the course of shipment, title passes at a contractually agreed upon point at which neither the seller nor the purchaser has business operations and thus theoretically no nexus. However, some states have attempted to use flash title to assert sales and use tax nexus over a remote seller.

This column first provides an overview of the theories surrounding substantial and attributional nexus and then examines how nexus is asserted for sales and use tax purposes in drop shipment and flash title transactions.

Substantial Nexus

Before a state can impose a tax on an interstate business, the tax must overcome the limitations of the Commerce Clause, which the U.S. Supreme Court has interpreted in a number of important cases. Most notably, in 1977, in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the Court established a four-prong test that a tax must pass to withstand Commerce Clause scrutiny. One of those prongs, the Court explained, is the requirement that a challenged tax is applied to an activity with a substantial nexus with the taxing state.

Whether an activity has substantial nexus with the taxing state has been the subject of much state litigation, some of which has made its way back to the Court. The crux of the controversies has been the meaning of substantial nexus. Ten years prior to Complete Auto, the Court, without specifically defining the term "substantial nexus," established in National Bellas Hess, Inc. v. Department of Revenue, 386 U.S. 753 (1967), the principle that nexus, for sales and use tax purposes, requires an in-state physical presence. Bellas Hess was a mail-order vendor based in Missouri that solicited orders for merchandise through the mail and made deliveries by mail or common carrier. The Court ruled that Illinois could not force Bellas Hess to collect sales tax on sales to Illinois residents because Bellas Hess had no offices, outlets, tangible property, salespersons, or any other type of physical presence in Illinois. The Court reasoned that a mail-order vendor "whose only connection with customers in the State is by common carrier or the United States mail" should not be required to collect sales tax because this could entangle the interstate business in a "welter of complicated obligations."

In 1992, post-Complete Auto, the Court affirmed the Bellas Hess physical presence test in another mail-order/sales tax case, Quill Corp. v. North Dakota, 504 U.S. 298 (1992). Quill was a mailorder vendor of office supplies that had no physical presence in North Dakota. The Court concluded that an in-state physical presence was required to satisfy the substantial nexus test under the Commerce Clause and therefore North Dakota could not force Quill to collect sales tax on sales within the state. In addition, the Court in Quill denied the state's argument that the in-state presence of floppy disks owned by Quill constituted physical presence within the state, thereby establishing substantial nexus. In denying that argument, the Court indicated that the "slightest physical presence" did not equate to substantial nexus under the Commerce Clause. Notably, however, the decision did not specifically address the issue of whether a physical presence test applied to income tax nexus.

After Quill, states still are grappling with what constitutes substantial nexus under the Commerce Clause. While most courts acknowledge that physical presence is required for sales and use tax nexus, the physical presence does not always have to be that of the...