The Problems of State Taxation of Interstate Commerce and Why Congress Should Act

• Author: Drew Newman
• Position: Student at American University s Washington College of Law
• Pages: 07

Drew Newman (drew.newman@american.edu) is a third-year law student at American University's Washington College of Law and is a political economy and leadership studies graduate of Williams College, Williamstown, Mass. Last summer, he served as a legal intern to the Clerk of the Supreme Court of the United States. Previously, he interned for the Office of the U.S. Attorney for the District of Columbia and U.S. District Judge John D. Bates. This fall, he will begin clerking for the senior judges of the District of Columbia Court of Appeals.

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Introduction

Thanks largely to the Internet, businesses increasingly sell their products throughout the nation with ease. While the Internet has opened the channels of commerce in unimaginable ways, it has also subjected small businesses to over six thousand different taxing jurisdictions in America.¹ Legal uncertainties about when a state or a city can tax an out-of-state business complicate matters further.² Seeking to increase tax revenue, more state and local governments are levying taxes on interstate corporations. The resulting maze of taxes and related litigation may hurt consumers by increasing the cost of doing business and encumber interstate commerce in ways that the Constitution sought to prevent.³ This article discusses the complexities and constitutionality of state taxation of interstate commerce. It then considers how Congress may clarify state taxation of interstate commerce and examines the implications of tax legislation on both small businesses and state taxing authorities. The article concludes with the recommendation that Congress enact the Business Activity Tax Simplification Act, which would create a bright line rule establishing when states may tax activities of out-of-state businesses and thereby foster interstate commerce.

The Problem of Aggressive, Unclear, and Non-uniform Taxation of Interstate Commerce

States may impose a number of taxes on out-of-state businesses and in recent years, states have become particularly aggressive in taxing foreign corporations.⁴ A corporate income tax, the tax most frequently assessed on out-of-state companies, is levied by forty-six states and the District of Columbia.⁵ States may also impose a number of other business activity taxes on foreign corporations, such as franchise taxes, single business taxes, and taxes on gross sales.⁶ Much of the controversy surrounding the imposition of these taxes arises not out of the amount levied, but out of the confusion caused by states imposing different types of taxes, methods of application, and standards. This lack of uniformity in application makes it difficult for businesses to know when they will be taxed as standards vary from state to state and municipality to municipality.⁷ In particular, state taxation of nonresident corporations engaged in interstate commerce has generated extensive litigation.⁸ In National Bellas Hess v. Illinois, the Supreme Court identified the burdens of having a nonuniform system of interstate taxation.⁹ In that case, the Court noted that "the many variations in rates of tax, in allowable Page 47 exemptions, and in administrative and record-keeping requirements could entangle [a company's] interstate business in a virtual welter of complicated obligations to local jurisdictions with no legitimate claim to impose a fair share of the cost of the local government."¹⁰ Additionally, subjecting out-of-state businesses to dozens of different business activity taxes may create a regulatory burden for small businesses, which may further inhibit interstate commerce.

There are two rationales underlying why states vigorously tax out-of-state companies. First, these taxes act as a means of increasing state revenue. Second, states may also be making a strategic choice based on their belief that corporations find it more cost effective to pay taxes rather than incurring the expense of hiring local counsel to challenge the taxation in court. In Quill v. North Dakota, the Supreme Court explained that the Constitution protects interstate commerce from unreasonably inconsistent interstate taxation.¹¹ The Quill Court noted that, "the Framers [of the Constitution] intended the Commerce Clause as a cure for . . . structural ills" such as "state taxes and duties [that] hinder and suppress interstate commerce."¹² Writing about these problems in The Federalist, Alexander Hamilton expressed concern that state taxation of interstate commerce would destroy the long-standing policy of free trade among the states, possibly leading to discontent between the states and severance of the union.¹³

There are numerous examples of how states are aggressively taxing foreign corporations. Tennessee taxed an out-of-state bank solely because it issued credit cards through the mail to Tennessee residents.¹⁴ In 2002, New Jersey stopped a Smithfield Foods truck passing through its state; though Smithfield had no physical presence in New Jersey, the state demanded a business activity tax payment in exchange for release of the driver and truck.¹⁵ Other states have even speculated that an Internet service provider, which connects a company's website to the Internet, could be considered an agent for the company and therefore cause the company to be "doing business" in the state.¹⁶ "[T]he existence of a plethora of conflicting jurisdictional taxing criteria for outof- state businesses burdens interstate commerce."¹⁷ There is an enormous amount of legal uncertainty surrounding when states can tax foreign corporations. In his Congressional testimony, Arthur Rosen, Chairman of the Coalition for Rational and Fair Taxation, stated that the uncertainty of tax liabilities and aggressiveness of states has "placed a real drag on American business, hurting American job growth and harming the entire U.S. Economy."¹⁸ Lyndon William, tax counsel for Citigroup, testified that the present situation has "lead to a great uncertainly and unpredictability in the manner in which multistate business are taxed...."¹⁹

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The Constitutionality of State Taxation of Interstate Commerce

The Constitution's Due Process and the Commerce Clauses govern the ability of states to tax interstate commerce.²⁰ While both clauses are "closely related,"²¹ each "pose[s] distinct limits on the taxing power of the States."²² Thus, although a state may have Due Process Clause jurisdiction to tax an out-of-state corporation engaged in interstate commerce, such taxation may still violate the Commerce Clause.²³

A To Impose a Tax on Out-of-State Businesses, States Must Prove that Such Businesses Have Minimum Contacts Pursuant to the Due Process Clause

The Fourteenth Amendment's Due Process Clause limits a state's authority to tax individuals and businesses residing outside its borders.²⁴ In discussing how the Due Process Clause limits state taxation, the Quill Court stated that [t]he Due Process Clause "requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax," and that the "income attributed to the State for tax purposes must be rationally related to ?values connected with the taxing State.²⁵"The Court further noted that a state may tax a corporation -even if it lacks physical presence in the state-if the business "purposefully avails itself of the benefits of an economic market in the forum State."²⁶

In Quill, the North Dakota Tax Commissioner required a mail order company that had no physical presence in the state to collect a use tax on goods the state's residents purchased from the company, and then remit the collections to that state.²⁷ On appeal, the Supreme Court held that since Quill intentionally and directly advertised and solicited customers in North Dakota, it purposefully availed itself of the North Dakota market.²⁸ These actions were therefore sufficient to establish minimum contacts with the state.²⁹ Because the tax imposed was related to the benefits Quill received from its advertising and soliciting in the state, the Court ruled that the Due Process Clause permitted the State Tax Commissioner to require Quill to collect and remit a use tax.³⁰ While "notice" and "fair warning" are the cornerstones of due process nexus analysis,³¹ "the Commerce Clause and its nexus requirement are informed not so much by concerns about fairness for the individual defendant as by structural concerns about the effects of state regulation on the national economy."³²

B To Impose Tax on Out-of-State Businesses, Commerce Clause Nexus Must Be Satisfied to Prohibit Undue Burden on Interstate Commerce

The Commerce Clause grants Congress the authority to "regulate Commerce ... among the several States."³³ The Supreme Court has interpreted the Commerce Clause not only as a grant of power to Congress but also as a limitation on states' power to interfere with interstate commerce,³⁴ a doctrine is known as the Dormant Commerce Clause. In Complete Auto Transit v. Brady, the Supreme Court...