Tennessee court rules that AOL does not have nexus in the state.

• Author: Madden, David
• Position: State taxes

In a decision that is possibly the first court-level opinion to address nexus with regard to Internet service providers, the Tennessee Chancery Court for Davidson County struck down a $9.6 million audit assessment against America Online (AOL) (America Online, Inc. v. Johnson, No. 97-3786-III (Mar. 13, 2001)). In response to a summary judgment motion, the court ruled that the assessment of sales and use, franchise and excise, and business taxes against AOL violated the Commerce Clause of the U.S. Constitution, because AOL did not have substantial nexus with Tennessee. The court specifically held that physical presence is necessary to satisfy constitutional nexus standards for all tax types, not just sales and use taxes.

The court's ruling relied heavily on J.C. Penney National Bank v. Johnson, 19 SW3d 831 (1999), in which the Tennessee Court of Appeals held that an out-of-state bank with no physical presence in Tennessee could not be subject to the financial institution franchise/excise tax merely because it had customers with credit cards in the state or affiliates with a presence in the state. However, the court's decision in AOL goes even further than J.C. Penney, holding definitively that physical presence is the standard for substantial nexus for all taxes (not just sales and use). Further, while J. C. Penney was significant because it rejected Tennessee's financial institution economic-nexus statute, AOL could have even broader implications, because it rejects the application of economic nexus for purposes of the state's franchise/excise (i.e., general corporate income) tax.

In AOL, the court found that none of six categories of activities offered by the state as evidence that AOL had nexus in Tennessee satisfied constitutional nexus standards. The activities were as follows:

1. AOL entered into contracts with Tennessee residents;

2. AOL'S services originated or were received by customers in Tennessee;

3. AOL distributed free promotional items in Tennessee;

4. AOL owned the software loaded on its customers' computers;

5. AOL's customers could access local numbers in Tennessee; and

6. AOL leased equipment to a subsidiary in Tennessee.

The court dismissed four of the categories, noting that physical presence is not established by entering contracts, providing services, owning intangible software or providing access to local telephone numbers in a state.

Moreover, the court ruled that the presence of the tangible promotional items and leased...