Recent U.S. Supreme Court decisions on state and local tax issues.by Bensome, Cesar E.
The U.S. Supreme Court handed down decisions on a number of cases that impact state and local taxes. An understanding of the Court's rationale will assist taxpayers and their advisers in planning and may provide a basis for filing refund claims.
The March 1992 issue of The CPA Journal addressed three cases that were to be reviewed by the U.S. Supreme Court during the term ending May 1992. Decisions have now been handed down on these and other cases relating to state and local tax issues. They have a significant impact on the landscape upon which both taxpayers and the states operate. These cases also offer some guidance that will enable taxpayers to develop appropriate tax planning strategies to minimize the ever increasing state and local tax burden. Some of the issues before the Court directly involved long-standing principles of state and local taxation. For example, in Quill Corp. v. North Dakota, the Court addressed the constitutional limitations on nexus for sales and use tax purposes. The Court also considered the propriety of the unitary business standard in Allied-Signal, Inc. v. Director, Division of Taxation. In addition, the Court defined the scope of the income tax nexus standards set forth by Public Law 86-272 in Wisconsin Department of Revenue v. William Wrigley, Jr., Co.
Sales and Use Tax Nexus Issue
On May 26th, the U.S. Supreme Court, in Quill Corp. v. North Dakota, 1992 U.S. LEXIS 3123, upheld on commerce-clause grounds its landmark 1967 decision in National Bellas Hess, Inc. v. Department of Revenue of Ill., 386 U.S. 753, and barred states from imposing a use tax collection obligation on sales to their residents by out-of-state mail order companies. However, the Court indicated that Congress is better qualified to resolve this issue, and left the door wide open for Congress to do so without conflicting with the Court on the issue of due process.
By way of background, Quill, a Delaware corporation, has no physical presence (i.e., offices, employees or tangible personal property) in North Dakota.(1) Quill makes deliveries of merchandise to its North Dakota customers by mail or common carrier from out-of-state locations. In 1987, North Dakota amended its statutory definition of "retailer" to include every person who engages in regular or systematic solicitation of a consumer market in the state. Regular or systematic solicitation is defined by North Dakota regulations as three or more advertisements within a twelve-month period. By virtue of these provisions, North Dakota sought to impose a use tax collection obligation on Quill for sales to North Dakota customers.
The Court initially determined that the due process clause of the Fourteenth Amendment did not bar enforcement of the North Dakota use tax against Quill. In doing so, the Court overruled its prior decisions to the extent that physical presence in a state was required for due process purposes. The relevant inquiry was whether a defendant's contacts (rather than a physical presence) with a state made it reasonable, in the context of the federal system of government, to require it to defend a suit in that state. The Court noted that Quill had purposefully directed its activities at North Dakota residents, that the magnitude of those contacts was more than sufficient for due process purposes, and the use tax was related to the benefits Quill received from access to the state.
The Court then determined that North Dakota's enforcement of its use tax against Quill placed a burden on interstate commerce in violation of the Commerce Clause of the United States Constitution. In doing so, the Court rejected the holding of the North Dakota Supreme Court that Quill's "economic presence" in the state provided a constitutionally sufficient nexus for the imposition of North Dakota's use tax collection obligation.
Three Pronged Analysis
The Court's commerce clause analysis was threefold. First, the Court noted that its holding in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), did not render the Bellas Hess holding obsolete. The four part test set forth in Complete Auto governs the validity of state taxes under the Commerce Clause. Complete Auto provides that a tax is constitutional under the Commerce Clause so long as the tax 1) is applied to an activity with a substantial nexus with the taxing state; 2) is fairly apportioned; 3) does not discriminate against interstate commerce; and 4) is fairly related to the services provided by the state. The Court stated that Bellas Hess is consistent with Complete Auto, and under the first Complete Auto test, stands for the proposition that a vendor whose only contacts with the taxing state are by mail or common carrier lacks the substantial nexus required by the Commerce Clause.
Second, the Court distinguished its due process nexus concerns from those of the Commerce Clause. The Court stated that the former involves the fundamental fairness of governmental activity, with notice or "fair warning" being the analytical touchstone. In contrast, the Court noted that the latter involve structural concerns about the effects of state regulation on the national economy, rather than concerns about fairness for the individual defendant. Thus, an entity could establish the minimum contacts with a taxing state necessary to satisfy due process concerns, and still lack the substantial nexus with the state required by the commerce clause.
Third, the Court found that the bright-line rule established by Bellas Hess (physical presence requirement) continues to be of value in determining sales and use tax nexus. Therefore, the Court determined that the Bellas Hess rule remains good law.
Congress is the One
The Court indicated in its opinion that Congress is best suited to determine whether, when, and to what extent states may saddle interstate mail order companies with use tax collection responsibilities. Although Congress had the power to make this determination prior to Quill, the Court's holding paves the way for Congress to impose such responsibilities without conflicting with the Court on the issue of due process. Nevertheless, given the controversy surrounding the issue, and the strong coalition of groups opposing mail order taxation, it appears unlikely that Congress will act to burden out-of-state mail order companies with a use tax collection obligation on sales to nonresidents.
Quill is a significant taxpayer victory with far-reaching implications. If the U.S. Supreme Court had upheld the ruling of the North Dakota Supreme Court, Quill might have represented the first in a series of aggressive efforts by the states to pursue taxpayers based on a theory of "economic presence." In addition, taxpayers can look to Quill from a planning perspective for guidance on how to structure operations to minimize their overall sales and use tax liability.
AFFIRMATION OF THE UNITARY BUSINESS PRINCIPLE
On June 15, the U.S. Supreme Court, in Allied-Signal, Inc. v. Director, Division of Taxation, 1992 U.S. LEXIS 3682, held that it is unconstitutional for New Jersey to tax a nondomiciliary corporation on the capital gain it derived from the sale of a minority stock interest in another corporation when the two corporations are not engaged in a unitary business. In doing so, the Court upheld the unitary business principle as the appropriate means of measuring the amount of income earned within a state, and rejected New Jersey's attempt to expand the definition of apportionable income so as to include virtually all the income of a corporation in the apportionable tax base.
The taxpayer in Allied-Signal was a Delaware corporation that maintained its commercial domicile and corporate headquarters in Michigan. The taxpayer conducted business in the automotive, aerospace/electronics, industrial/energy, and forest products areas. Pursuant to a long-term corporate strategy of diversification through corporate acquisitions and dispositions, the taxpayer purchased 20.6% of ASARCO, Inc., a producer of nonferrous metals and nonmetallic minerals. As stipulated by the parties, the taxpayer and ASARCO were unrelated business enterprises, and the taxpayer exerted no control over ASARCO. Approximately three years after purchase, the taxpayer sold the stock back to ASARCO at a gain of $211.5 million. The taxpayer did not attribute any portion of the gain to New Jersey, and the state issued an assessment for taxes based on an apportioned amount of the gain.
The New Jersey Supreme Court upheld the assessment, stating that it was constitutional to consider the gain as earned in the taxpayer's unitary business. The court found that the taxpayer had a business function of corporate acquisitions and divestitures that transformed the ASARCO purchase from a passive investment into an integral operational activity. The court supported its conclusion by noting that the taxpayer intended to use the ASARCO proceeds to acquire a company whose aerospace business might complement the taxpayer's own aerospace/electronics business. In essence, the New Jersey Supreme Court's ruling constituted an abandonment of traditional unitary business principles.
Supreme Court is Unyielding
The U.S. Supreme Court invoked the doctrine of stare decisis and refused to overrule its prior decisions that set forth and followed the unitary business standard. In doing so, the Court rejected New Jersey's contention that all income of a corporation doing any business in a state is, by virtue of common ownership, part of the corporation's unitary business and, therefore, apportionable. The Court noted that such contention could not be reconciled with the concept that the U.S. Constitution places limits on a state's power to tax value earned outside its borders.
The unitary business standard, as set forth in Mobil Oil Corp. v. Commissioner of Taxes of Vermont, 445 U.S. 425 (1980) and Exxon Corp. v. Wisconsin Department of Revenue, 447 U.S. 207 (1980), and as applied in ASARCO, Inc. v. Idaho State Tax Commission, 458 U.S. 307 (1982), F.W. Woolworth Co. v. Taxation and Revenue Department of New Mexico, 458 U.S. 354 (1982), and Container Corp. of America v. Franchise Tax Board, 463 U.S. 159 (1983), prescribes the constitutional (due process and commerce clauses) limitations on states attempting to tax value earned outside their borders. Pursuant to these cases, the indicia of a unitary business are functional integration, centralization of management, and economies of scale. The Court found that functional integration and economies of scale did not exist between the taxpayer and ASARCO because the entities were unrelated business enterprises. In addition, there was no centralization of management since the taxpayer did not control ASARCO by virtue of its 20.6% ownership interest. Therefore, the operations of the taxpayer and ASARCO did not form a unitary relationship.
The Court noted that a unitary relationship between a payor and payee corporation is not a prerequisite to apportionment where a capital transaction serves an operational rather than an investment function. For instance, a state may include within the apportionable income of a nondomiciliary corporation the interest earned on short-term deposits in a bank located in another state if such income forms part of the working capital of the corporation's unitary business, even though there is no unitary relationship between the corporation and the bank. However, this principle was not applicable to the facts at hand. The Court held that the ASARCO acquisition was not converted from an otherwise passive investment to an operational function merely because the acquisition was made pursuant to a long-term corporate strategy of acquisitions and dispositions. In this regard, the taxpayer's intended use of the ASARCO proceeds was deemed irrelevant by the Court.
A Significant Victory
Allied-Signal is a significant taxpayer victory since the Court reaffirmed the unitary business principle as the law of the land in establishing whether income can be taxed by a particular jurisdiction. A state victory in Allied-Signal could have been extremely costly to taxpayers. Taxpayers that structured their activities in reliance on the unitary theory established in prior U.S. Supreme Court decisions would have lost all the benefits of such planning in certain states. Some states would also have taken the position that virtually all of a taxpayer's income is subject to apportionment in each state in which business is conducted.
Taxpayers should carefully evaluate the potential to file refund claims based on the principles of Allied-Signal. In addition, taxpayers may also be able to restructure their activities to minimize their overall state and local tax burden. Allied-Signal confirms that the linchpin of apportionability is still the unitary business principle, and that income is not subject to apportionment unless derived from unitary sources. Consequently, the decision helps to solidify any filing position that excludes non-unitary income (such as investment income) from the apportionable tax base in certain states such as New Jersey.
THE INCOME TAX NEXUS STANDARDS
In Wisconsin Department of Revenue v. William Wrigley, Jr., Co., 1992 U.S. LEXIS 3694, June 19, 1992, the U.S. Supreme Court reviewed the net income tax nexus standards set forth by Public Law 86-272, and held that a taxpayer whose activities in Wisconsin included 1) the replacement of stale gum by sales representatives, 2) the supplying of gum through "agency stock checks," and 3) the storage of gum, was subject to franchise tax in the state. Public Law 86-272 prevents a state from imposing its income tax on a taxpayer whose only activity within the state is the solicitation of orders for the sale of tangible personal property, provided these orders are sent outside the state for approval and, if approved, are filled and delivered from a stock of goods located outside the state. The Court in Wrigley determined that the taxpayer's activities in Wisconsin went beyond the scope of "solicitation of orders" and were not protected by Public Law 86-272.
The taxpayer, a chewing gum manufacturer, did not own or lease real property, operate any manufacturing, training or warehouse facility, or have a telephone listing or bank account in Wisconsin. In addition, the taxpayer was not licensed to do business in the state. The taxpayer solicited orders of chewing gum in Wisconsin using sales representatives. All Wisconsin orders were sent to the taxpayer's Chicago office for acceptance, and were filled by shipment through common carrier from outside Wisconsin. The taxpayer's credit and collection activities were handled by the Chicago office. Although the taxpayer engaged in print, radio, and television advertising in Wisconsin, the purchase and placement of such advertising was managed by an independent advertising agency located in Chicago.
The taxpayer's sales representatives were provided with company cars, but not with offices. The representatives were also supplied with a stock of chewing gum (with an average wholesale value of about $1,000), a supply of display racks, and promotional literature. The representatives stored these items at their homes, except for one instance in which storage space was rented by a salesman whose apartment was too small for storage.
In addition to distributing promotional materials, free samples, and directly requesting orders for chewing gum, the representatives provided free display racks to retailers. If a retailer could not fill the racks with existing stock and did not want to wait for a new order of chewing gum, the representative would fill the racks from his own stock of gum and issue an "agency stock check," which allowed the Chicago office to bill the retailer for the gum supplied. The representative also checked the retailer's stock of gum for freshness on a regular basis, and replaced stale gum at no cost to the retailer.
The taxpayer employed a regional manager who resided in Wisconsin but was not provided with an office. The regional manager had general responsibility for sales activities in the region, and spent the vast majority of his time working with the sales representatives in the "field" or contacting important accounts. The regional manager also had administrative responsibilities including writing and reviewing company reports, recruiting sales representatives, making recommendations concerning the hiring, firing, and compensation of sales representatives, and evaluating their performance. The regional manager held full-day sales strategy meetings for all regional sales representatives once or twice a year at his home or in a hotel, and occasionally intervened in credit disputes between the Chicago office and important local accounts.
Applying the Facts to the Law
Each of the parties offered a differing view on the application of Public Law 86-272 to the facts at hand. Wisconsin urged the Court to interpret "solicitation of orders" narrowly to include only the ultimate act of inviting an order. Under such interpretation, Wisconsin contended that the taxpayer had established contacts with the state beyond the protection of Public Law 86-272 by virtue of the following: 1) the replacement of stale gum by sales representatives; 2) the supplying of gum through "agency stock checks;" 3) the storage of gum, racks, and promotional materials; 4) the rental of space for storage; 5) the regional manager's recruitment, training, and evaluation of employees; and 6) the regional manager's intervention in credit disputes.
The Court rejected Wisconsin's interpretation as unreasonable, stating that "solicitation of orders" includes not merely the ultimate act of inviting an order, but the entire process associated with the invitation (i.e., more that what is strictly essential to making requests for purchases). The Court noted that an extremely narrow interpretation would result in a reversion to the law existing prior to the enactment of Public Law 86-272.
The taxpayer maintained that its activities in Wisconsin were protected by Public Law 86-272 because "solicitation of orders" broadly includes activities routinely associated with solicitation or customarily performed by salesmen. The Court also rejected this interpretation, stating that such interpretation would cause differing results when applied on an industry-by-industry basis.
A New Standard
The Court then set forth a new standard for determining activities protected by Public Law 86-272. "Solicitation of orders" covers those activities that are entirely ancillary to requests for purchases, i.e., those activities that serve no independent business function apart from their connection to the soliciting of orders. Examples of such activities include the use of company cars and free product samples by sales representatives because their only purpose is to facilitate purchase requests. On the other hand, "solicitation of orders" does not include those activities that a company would have to engage in anyway, but chooses to assign to its in-state sales force. For example, employing salesmen to repair or service a company's products is not ancillary to requesting purchases because this activity will be performed whether or not the company has a sales force. In setting forth this new standard, the Court refused to hold that all post-sale activities as a rule were not ancillary to requests for purchases.
The Court also held that Public Law 86-272 incorporates a de minimis rule. Therefore, where a taxpayer's in-state activity other than "solicitation of orders" is sufficiently de minimis, the tax immunity conferred by Public Law 86-272 is not forfeited by such activity. On the other hand, where such activity establishes a nontrivial additional connection with a taxing state, the de minimis rule does not prevent the loss of tax immunity granted by Public Law 86-272.
Turning to the facts at hand, the Court concluded that the in-state recruitment, training, and evaluation of sales representatives, use of hotels and homes for sales-related meetings, and intervention in credit disputes by the taxpayer's regional manager served no independent business function apart from their connection to the solicitation of orders. However, the Court also held that the replacement of stale gum, supplying of gum through "stock agency checks," and storage of gum by the taxpayer's sales representatives were not entirely ancillary to requests for purchases, as the taxpayer would choose to attend to these activities whether or not it employed a sales force. The Court also found that such activities, taken together, constituted a nontrivial additional connection with Wisconsin outside the scope of the de minimis rule. The Court concluded that the taxpayer was subject to Wisconsin franchise tax since its activities went beyond the protection afforded by Public Law 86-272.
The Wrigley decision clarifies the complex issue of income tax nexus and specifically the protection afforded by Public Law 86-272. Over the years, there has been much uncertainty as to what activities can be conducted in a given state without going beyond solicitation and establishing income tax nexus. Wrigley establishes a framework for taxpayers to work within when planning to enter a particular state for purposes of solicitation.
Wrigley is also a significant taxpayer victory since the holding protects activities that are entirely ancillary to requests for purchases, and establishes a de minimis exception to Public Law 86-272. Wrigley, coupled with the holding in Quill, has put the states on notice that the U.S. Supreme Court will not stand for an overly aggressive interpretation of nexus by the states. Wrigley also provides the basis for refund opportunities for taxpayers conducting activities which were deemed acceptable by the Court in states which interpret Public Law 86- 272 beyond the parameters set forth in Wrigley.
OTHER SIGNIFICANT CASES
In Kraft General Foods, Inc. v. Iowa Department of Revenue and Finance, 1992 U.S. LEXIS 3685, June 18, 1992, the Court held that Iowa's taxation of foreign dividends violates the foreign commerce clause of the U.S. Constitution. The Iowa corporate tax structure included dividends received from non-U.S. subsidiaries in the tax base while excluding dividends received from U.S. subsidiaries. Taxpayers should consider filing refund claims for all open years in Iowa as well as other states that similarly tax dividends received from non-U.S. subsidiaries without taxing dividends received from U.S. subsidiaries.
On June 18th, in Nordlinger v. Hahn, 1992 U.S. LEXIS 3688, the Court upheld California's Proposition 13 in the face of a Fourteenth Amendment equal protection clause challenge. Proposition 13 treats newer and older property owners differently by imposing a higher ad valorem property tax on newly acquired property. Taxpayers contemplating property acquisitions (either directly or indirectly through acquisitions of entities) should carefully focus on the potential property taxes associated with such transaction in light of Nordlinger.
In Chemical Waste Management, Inc. v. Hunt, 1992 U.S. LEXIS 3253, June 1, 1992, the Court held that Alabama's imposition of higher fees on hazardous waste imported into the state for dumping than on such waste generated within the state violates the commerce clause of the U.S. Constitution. Taxpayers should consider filing refund claims for all open years in Alabama as well as other states that discriminate by imposing a higher fee on the disposal of out-of-state hazardous waste.
WATCH OUT FOR THE STATES
States can be expected to react aggressively to the U.S. Supreme Court decisions. Some states may focus on new tax impositions, while others may narrowly interpret some of these decisions to minimize the associated revenue loss. In any event, taxpayers must carefully monitor the states responses to these cases in the coming months, and develop the appropriate action plan to minimize their overall state and local tax burden.
1 Quill licensed a computer software program to some of its North Dakota customers. However, the Court considered the presence of a few floppy diskettes in the state irrelevant to its due process analysis, and insufficient to cause nexus for commerce clause purposes.
Richard W. Genetelli, CPA, is the founder of the state and local tax consulting firm of Genetelli & Associates. He is a member of both the NYSSCPA and AICPA, and an assistant professor at the Lubin Graduate School of Business, Pace University.
David B. Zigman, JD, is a senior associate with Genetelli & Associates. He is a member of the New York State Bar Association.
Cesar E. Bencosme, CPA, is a senior associate with Genetelli & Associates. He is a member of both the NYSSCPA and AICPA.
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