State income tax jurisdiction: a jurisprudential and policy perspective.

• Author: Swain, John A.

INTRODUCTION

One of the most contentious issues in state taxation is the reach of the states' jurisdiction to tax net income. The failure to resolve this issue is a leading cause of the recent dramatic decline in state corporate income tax revenues. (1) Familiar forces of change are at work: the ongoing shift from a mercantile to a service economy, (2) the increasing mobility of capital, (3) electronic commerce, (4) and the "coming of age" of state tax planning techniques aggressively promoted by the national accounting firms. (5) These forces allow corporations to do (or appear to do) business in a state from afar. Thus, traditional markers of nexus to tax--such as physical presence--are absent.

Unfortunately, the Supreme Court has not directly answered the question of whether mere economic presence is a sufficient ground for a state to assert its income tax jurisdiction. Students of the Court's due process jurisprudence may find this surprising. The Court held long ago that economic presence is sufficient for a plaintiff to hale a foreign corporation into court or for a state to assert its regulatory jurisdiction. (6) The Court's state tax jurisprudence has taken a different tack, however, riding the winds of the dormant Commerce Clause into "uncharted and treacherous" waters. (7)

The voyage began in 1967, when the Court held in National Bellas Hess v. Department of Revenue (8) that a physical presence was required for a state to impose a use tax collection obligation on a mail-order company. (9) Curiously, the Bellas Hess Court took no note of its earlier due process decisions affirming state regulatory jurisdiction based solely on economic presence. (10) Twenty-five years later in Quill Corp. v. North Dakota, under essentially identical facts, the Court conceded that due process could be satisfied by economic presence alone. (11) Nevertheless, the Court reaffirmed the physical presence test on Commerce Clause grounds alone. (12)

Until that time, the Court had not indicated that the Due Process and Commerce Clause nexus standards diverged in any meaningful way. (13) By removing state tax nexus from its due process moorings, the Court seems to have discarded the traditional source of content for nexus inquiries (tax or otherwise). (14) Its replacement--the Commerce Clause prohibition against undue burdens--is not well adapted for this purpose, and offers no rich nexus jurisprudence that it can call its own. (15)

Like the Bellas Hess decision, Quill did not expressly address income tax nexus. (16) Indeed, dictum in Quill suggests that the nexus standard for taxes other than sales and use taxes may not be physical presence. (17) Thus, Quill seems only to add to the uncertainty surrounding state income tax jurisdiction. These uncertainties have materialized in post-Quill state court litigation. Less than a year after the Quill decision, the South Carolina Supreme Court held that Quill's physical presence test was not applicable to state income taxes. (18) Courts since then have split. (19) Again, uncertainty prevails. (20)

There is no line of Supreme Court income tax nexus decisions parallel to Quill. The Court's exploration of the constitutional limits of income tax jurisdiction has been stymied by the affirmative exercise of Congress's Commerce Clause powers. In 1959, Congress statutorily curtailed the states' power to impose a net income tax on sellers of tangible personal property whose in-state activities do not exceed mere "solicitation." (21) Though intended as a temporary measure--allowing Congress to study the ramifications of several judicial decisions that were perceived to have expanded state income tax jurisdiction--the statute remains on the books to this day. (22) Indeed, state and local tax professionals still refer to the measure as P.L. 86-272, despite having been incorporated into the United States Code.(23)

P.L. 86-272 provides a safe harbor for sellers of tangible personal property, but it says nothing about services or intangibles. (24) Thus, as the service sector of the economy continues to expand, so too does corporate concern about exposure to state income taxes. Further, as technological advances permit more businesses to provide goods and services from remote locations, policymakers fear that jurisdictional rules based on an anachronistic physical presence test threaten the tax base and provide inappropriate tax avoidance opportunities. (25) At the same time, many of the growing number of firms that do business remotely resist the notion that they should be liable for taxes imposed by geographically distant jurisdictions. (26)

Two conflicting proposals reflect this resurgence of concern over the state income tax. Taxing authorities have proposed a "factor presence standard" that would allow a state to tax an economically present business so long as the business' in-state sales meet a certain threshold. (27) Business taxpayers, on the other hand, are backing legislation that would expand P.L. 86-272's safe harbor to cover services, intangibles, and numerous other in-state contacts that go far beyond the "mere solicitation" protection of the current statute. (28) Sparks have flown. (29)

The purpose of this Article is twofold: first, to identify the constitutional nexus standard for state income tax; second, to evaluate whether the constitutional standard reflects good tax policy. Part I discusses the relevant authorities and constitutional framework. The centerpiece of the discussion is Quill. In recognition of the varied approaches that commentators have taken to Quill, "Burdens Quill," "Stare Decisis Quill," and "Disappearing Ink Quill" interpretations are developed. Of equal importance are the income tax nexus cases that preceded Quill. The Court's combined reporting cases also provide some illumination, and the post-Quill state court income tax decisions are briefly discussed.

Part II applies the authorities discussed in Part I to the question of state income tax jurisdiction. Are they controlling? Are they relevant, and how? Is physical presence required? If not, then what is the Commerce Clause standard? The constitutional inquiry is based on existing precedent. The authorities are critiqued as well as explained, but it is the explanations on which the legal reasoning is grounded.

Part III applies the basic tenets of good tax policy--equity, efficiency, and administrability--to the competing nexus standards of economic and physical presence. This normative inquiry is important because Congress has the authority to establish a nexus standard by exercise of its affirmative Commerce Clause powers, and because tax policy norms should inform the dormant Commerce Clause analysis of future Courts.

1. THE AUTHORITIES

   1. The Complete Auto Test and Substantial Nexus

      The Court has held that a state tax passes dormant Commerce Clause muster if it (1) is assessed against a taxpayer with whom the state has substantial nexus, (30) (2) is "fairly apportioned," (31) (3) is nondiscriminatory, and (4) is "fairly related to the services provided by the State." (32) The elements of this test were articulated in Complete Auto Transit, Inc. v. Brady, although it took later decisions to enshrine Complete Auto as the definitive four-pronged test for the validity of a state tax under the dormant Commerce Clause. (33) Further, none of these elements were new to the Court's state tax jurisprudence at the time Complete Auto was decided, although earlier treatments of the nexus, fair apportionment, and fairly related prongs of the test were often rooted in Due Process rather than dormant Commerce Clause analysis. (34)

      The focus of this Article is the nexus prong of the Complete Auto test. However, "nexus" carries two distinct meanings for state tax jurisdiction: (1) nexus with the taxpayer and (2) nexus with the income, transaction, activity or property sought to be taxed. (35) It is probably more analytically precise to treat the second nexus definition--nexus with the income or transaction sought to be taxed--as a fair apportionment issue.(36) This Article specifically addresses jurisdiction over the taxpayer, and so references to "nexus" mean "nexus with the taxpayer" unless otherwise indicated. (37)

   2. Quill and Its Implications for State Income Tax Jurisdiction

      Although a sales and use tax case, Quill Corp. v. North Dakota (38) takes center stage because (1) it is the Supreme Court's most recent pronouncement on state tax jurisdiction and (2) the Court decoupled Due Process Clause nexus from Commerce Clause nexus. In Quill, the Court revisited the question it had addressed twenty-five years earlier under substantially identical facts: May a state compel a mail-order company to collect use tax from its customers if the company's contacts with the state are limited to the use of the U.S. mail and common carriers? (39) In the earlier case, National Bellas Hess, Inc. v. Department of Revenue,(40) the Court answered in the negative, citing both the Due Process and Commerce Clauses. (41) In Quill, the Court again answered in the negative, but on Commerce Clause and stare decisis grounds alone. (42)

      1. Due Process Quill

         Regarding due process, the Court observed that its "jurisprudence has evolved substantially in the 25 years since Bellas Hess." (43) In a modern economy "it matters little that [] solicitation is accomplished by a deluge of catalogs rather than a phalanx of drummers: The requirements of due process are met irrespective of a corporation's lack of physical presence in the taxing State." (44) The Court then expressly overruled its earlier cases "to the extent that [they] have indicated that the Due Process Clause requires physical presence in a State for the imposition of duty to collect a use tax." (45) In effect, the Court applied the minimum contacts test found in International Shoe v. Washington (46) and its progeny.

      2. Quill and the Commerce Clause

         Quill Corporation fared better...