Defining the Issue
It is no secret that the annual growth rate of internet retail sales is far outpacing the yearly hike in sales generated by standard “bricks and mortar” retail establishments. A recent study tabbed United States on-line retail sales at approximately $350 billion for 2015 and predicted that number would increase to $550 billion by 2020. Moreover, another study by the U.S. Commerce Department found that e-commerce accounted for 60.4% of total retail sales growth in 2015. According to the numbers published by the Commerce Department, 2015 represented the sixth year in a row that U.S. on-line sales have shown an annual growth rate near or above 15%. Given this volume, it should come as no surprise that various states have tried increasingly aggressive approaches in an effort to capture some of the sales tax revenue they view as being lost as a result of e-commerce.
How Did It Start
Although a full body of case law in the sales tax area had developed over the years, the real beginning of the problem for the states in the remote sales era began with the U.S. Supreme Court’s holding in Quill Corp. v. North Dakota, 504 U.S. 298 (1992). In that case, the Court determined that under the Commerce Clause of the Constitution, some form of physical presence by a company in a state is necessary before that company can be said to have sufficient contact, or nexus, with the state for it to be able to assert its taxing authority over the company. In Quill, South Dakota was seeking to enforce a sales tax collection responsibility on a mail order company that had no physical connection with the state. Although the Court did not expressly limit its determination to sales tax, over the years a majority of Federal Circuit Courts have interpreted the case to apply only to sales tax issues.
As the growth of retail sales via the internet evolved, the Supreme Court’s holding in Quill left the states in a quandary: How could they apply their sales tax laws to internet retailers when many such retailers had absolutely no physical connection to the subject states? As could be expected, with so much potential tax revenue at stake, many states have attempted to “bridge the gap” between the requirements of Quill and the realities of their budgets by employing somewhat “creative” methodologies.
“Click-Through” Nexus
In 2008, when faced with the spectacular growth of such on-line companies as Amazon, tax officials in New York State developed the concept of “click-through” nexus and began to apply it in an effort to require on-line retailers to collect and remit sales tax to the state. Under New York’s law, e-commerce companies that had relationships with in-state residents with websites, whereby potential customers could “click-through” from the residents’ websites to the companies’ websites to make purchases, were considered to have enough physical presence in the state to satisfy the Quill standard. The in-state residents were generally compensated by the out-of-state internet retailers based on the number of potential customers referred to the companies’ sites, or on a percentage of sales basis. The New York provisions set forth a floor of $10,000 of annual sales to state residents before requiring a company to collect sales tax on the state’s behalf. Further, such provisions established a presumption of nexus being created by the click-through relationships, which presumably could be rebutted by the out-of-state companies. Although the New York law has been challenged in court, thus far the state has prevailed.
Since New York’s development of the concept, eighteen additional states have grabbed on to the “click-through” nexus idea as a way to generate additional revenue. The various state statutes and regulations have assorted provisions, but they all flow from New York’s original concept.
Use Tax Notice and Reporting Obligations
Since the scope of the click-through nexus statutes often could be avoided by non-resident companies merely severing ties with in-state residents and their websites, thus eliminating their deemed “physical presence” within the state, certain states looked to other strategies for avoiding the brunt of Quill. In the case of Colorado, the focus was placed on the use tax paying obligations of state residents. Accordingly, in 2010 the Colorado legislature passed a bill which required non-resident retailers with no obligation to collect sales tax to: (1) send a transactional notice to purchasers informing them that they might be subject to Colorado use tax; (2) provide Colorado purchasers who buy goods from the retailer totaling more than $500 per year with an annual purchase summary; and (3) file an annual customer information report with the Colorado Department of Revenue.
The Colorado law was challenged by a retail trade group, Direct Marketing Association, which group alleged that it was unconstitutional in that it violated the Constitution’s dormant Commerce Clause because it discriminates and unduly burdens interstate commerce. On February 22, 2016, the U.S. Court of Appeals for the Tenth Circuit issued a decision in which it reversed a District Court decision and held for the state. The Circuit Court found that the Supreme Court’s holding in Quill is limited to sales and use tax collection and does not forbid states from imposing regulatory reporting requirements on non-collecting retailers. See Direct Marketing Ass’n v. Brohl, No. 12-1175 (10th Cir. February 22, 2016). It is interesting to note that in an earlier U.S. Supreme Court decision involving a procedural challenge by Colorado regarding the right of Direct Marketing to contest its law, Justice Kennedy, in his concurring opinion, expressed his concern that it might be time for the Court to reconsider the constraints of its holding in the Quill decision. See Direct Marketing Ass’n v. Brohl, 135 S.Ct. 1124 (2015).
Since the Direct Marketing decision was rendered, Louisiana, Vermont and Oklahoma have passed similar legislation. It is likely that more states will hop on the bandwagon to try to force their residents to comply with the applicable use tax laws.
Economic Sales Tax Nexus – Direct Challenge to Quill
The most recent development in the battle to corral out-of-state on-line retailers is the adoption of economic nexus standards by several states. The application of economic nexus measures to sales tax represents a direct challenge to the Quill physical presence requirement. The first state to apply economic nexus to sales tax was Alabama. That state adopted a regulation in 2015 which requires retailers with no physical connection to Alabama to collect and remit sales tax to the state with respect to taxable sales made to residents if those sales exceed $250,000 annually. Interestingly, the state acknowledged that its adoption of economic nexus represented an unequivocal confrontation with Quill, inviting protesting retailers to litigate the matter.
Since Alabama’s foray into the economic nexus area, South Dakota and Tennessee have decided to offer similar challenges to the physical presence requirement of Quill. Currently, a bill is pending in the Wyoming legislature that would add that state to the list of challengers.
Conclusion
What can we expect from all this? It is likely that the states will continue to press the issue until the U.S. Supreme Court rules on whether the standard it established in Quill is still viable in today’s marketplace. In fact, the states invoking economic nexus rules appear to be inviting litigation in the hope that it will ultimately lead to Quill being overturned. Until that time, on-line retailers are often placed in the unenviable position of either complying with state rules which appear to be unconstitutional, or facing possible penalties and additional harsh treatment if they don’t comply. Stay tuned, as the fight will certainly continue.
If you have questions concerning the content of this article, please contact the author at 212.842.7019 or, if you prefer, via email at tcorrie@friedmanllp.com. As an alternative, contact your Friedman LLP tax advisor.
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