The authors represent Lanco Inc. in this case. This article was originally published in the BNA Tax Management Weekly State Tax Report and BNA Tax Management State Tax Library. [fn1]
Few issues in state and local tax practice have been as hotly contested as the issue of whether "economic nexus" --- nexus in the absence of physical presence --- is permitted under the commerce clause of the U.S. Constitution. New Jersey's Tax Court recently weighed in on the issue, rendering its thoroughly researched and well-reasoned decision in Lanco. [fn2] The Lanco court confirmed that physical presence is required under the commerce clause before nexus can be asserted, and it soundly rejected the New Jersey Division of Taxation's position that the mere receipt of revenue purportedly attributable to New Jersey-sourced intangible property is an ample predicate to tax jurisdiction. The New Jersey Tax Court got it right. The division has appealed the tax court's New Jersey Superior Court decision. We expect the appellate division to hear oral argument next year.
BackgroundWith the advent of electronic commerce and entity isolation strategies related to intangible assets, the question of whether deriving revenue from a particular jurisdiction is constitutionally sufficient to permit that jurisdiction to exert its taxing authority over the out-of-state entity has become a critical question to a growing number of businesses. After the U.S. Supreme Court's decision in Quill, [fn3] the focal point of the economic nexus conundrum has become the commerce clause. [fn4]
Unfortunately, due in large part to the Supreme Court's resistance to address issues left open by its decision in Quill, and to congressional inaction, despite the Court's proffered invitation in Quill, states and businesses alike have become emboldened. States have amended their statutes and regulations expanding their tax imposition provisions, [fn5] while businesses have restructured in reliance upon long-standing interpretations of traditional nexus.
The commerce clause [fn6] of the U.S. Constitution provides that "Congress shall have Power " to regulate Commerce " among the several states." In drafting the Constitution, its framers recognized the importance of regulating commerce among the states. [fn7] In fact, James Madison foretold (in the context of the import-export clause) the situation that continues today, with equal force, in contravention of the commerce clause: [I]t must be foreseen that ways would be found out to load the articles of import and export, during the passage through their jurisdiction, with duties which would fall on the makers of the latter and the consumers of the former. We may be assured by past experience, that such a practice would be introduced by future contrivances; and both by that and a common knowledge of human affairs, that it would nourish unceasing animosities, and not improbably terminate in serious interruptions of the public tranquility." [fn8]
Justice Marshall correctly understood that the "power to tax involves the power to destroy," [fn9] that states would not "respect the interests of others" [fn10] and that the commerce clause was necessary, "[o]r what should restrain a State from taxing any article passing through it from one State to another, for the purpose of traffic? or from taxing the transportation of articles passing from the State itself to another State, for commercial purposes?" [fn11]
The commerce clause, whose language only grants powers to Congress, has a long-standing history of having a "negative" or "dormant" power to restrain states from interfering with or discriminating against interstate commerce.
Given the shift from traditional brick-and-mortar retailers to sales activity by entities that have no physical presence in the state of their customers, and the increased prevalence of special-purpose entities whose assets and activities are largely intangible-related, questions related to the nexus of these entities have become commonplace.
In National Bellas Hess, [fn12] the Illinois Department of Revenue sought to impose a use tax collection obligation on a company lacking physical presence in Illinois, based on its liberal definition of "'[r]etailer maintaining a place of business in this State'" as including "'[e]ngaging in soliciting orders within this State from users by means of catalogues or other advertising, whether such orders are received or accepted within or without this State.'" [fn13] The Supreme Court cited several of its previously issued decisions concerning income tax impositions to support its proposition that, under the due process and commerce clauses (which the Court said were "closely related"), [fn14] a state is limited to receiving a quid pro quo. Thus, the Court referred to Freeman v. Hewit, [fn15]15 a case decided under the commerce clause, wherein it had stated that "'State taxation falling on interstate commerce " can only be justified as designed to make such commerce bear a fair share of the cost of the local government whose protection it enjoys.'" The Court was troubled both by the "virtual welter of complicated obligations" and by the fact that Illinois had "no legitimate claim to impose 'a fair share of the cost of local government.'" [fn16] The Court "decline[d] to obliterate" [fn17] the distinction between corporations with in-state property and those lacking physical presence.
Complete Auto Transit [fn18] gave the Court another opportunity to clarify the scope and limitations of the commerce clause. Overruling Spector Motor, [fn19] which had held that imposing a tax on the "privilege of doing business" if it applies to purely interstate commerce was impermissible, the Court articulated its four-prong test to determine whether a tax on the in-state portion of interstate activities would be sustained over commerce clause challenges:
The next Supreme Court case significant to the economic nexus question is, of course, Quill. [fn20] In Quill, North Dakota sought to compel an out-of-state mail order seller to collect use tax. While the North Dakota Supreme Court had concluded that "tremendous social, economic, commercial and legal innovations" rendered Bellas Hess an anachronism, the U.S. Supreme Court held fast to the physical presence requirement. In fact, even Quill's ownership of diskettes in the state was found not to meet the commerce clause's "substantial nexus" requirement.
Unfortunately, while the Quill Court reaffirmed the "bright-line, physical presence requirement," there has been some question as to whether the requirement applies to income and franchise tax matters, given the Court's statements that "although in our cases subsequent to Bellas Hess and concerning other types of taxes we have not adopted a similar bright-line, physical presence requirement, our reasoning in those cases does not compel that we now reject the rule that Bellas Hess established in the area of sales and use taxes," and "[a]lthough we have not, in our review of other types of taxes, articulated the same physical-presence requirement that Bellas Hess established for sales and use taxes, that silence does not imply repudiation of the Bellas Hess rule." [fn21] The Court, however, reiterated its position that the formalistic distinctions between direct and indirect impositions be disregarded. Its litany of reasons for continuing to adhere to the bright-line test of Bellas Hess and the evils that would occur if it were to depart from the requirement support the conclusion that physical presence is as much a prerequisite to the imposition of income and franchise taxes as it is to use tax collection responsibilities.
It is against this background that Lanco came to the New Jersey Tax Court.
Facts of Lanco
The New Jersey Division of Taxation and Lanco stipulated to the following facts:
The tax court, therefore, directly and clearly was presented with the question of whether "economic nexus" alone is sufficient under the commerce clause, without any of the factual questions that have muddied the waters in other cases. [fn22]
The division argued that Lanco engaged in ownership and use of its marks in New Jersey for business purposes, sufficient to provide a statutory basis to subject it to the corporation business tax (CBT), and that there were no constitutional impediments to imposition of the tax against Lanco. The division also relied upon its regulation, N.J. Regs. § 18:7-1.9(b), effective as of Nov. 4, 1996, which provides as an example of what constitutes "doing business": "Foreign corporation R holds trademarks that were assigned to it by its parent corporation. R receives fees as a result of licensing those trademarks to certain New Jersey companies for use in New Jersey. R is subject to the corporation business tax on its apportioned income as a result of its trademark licensing activities."
The division argued that this regulation was "consistent with the Legislature's unequivocal intent to include within the CBT those corporations that conduct business in the State by employing intangible property here," and that Lanco "cannot wiggle free by pointing [to] the irrelevant distinction that it draws between tangible and intangible property." [fn23]
With respect to the commerce clause, the division claimed that all four Complete Auto prongs were met: physical presence was not required to establish "substantial nexus"; the CBT only taxed income apportioned to the state; the CBT did not discriminate against intrastate taxation; and Lanco's CBT burden would be fairly related to the services New Jersey provided to Lanco. Specifically, the division argued that Quill's physical presence requirement was an "unnecessarily wooden interpretation of the Constitution " that may have had some surface appeal in past centuries." [fn24] Further, the division maintained that stare decisis played a "decisive role" in Quill and that Lanco's exploitation of New Jersey's marketplace distinguished Lanco from Quill. [fn25] The state's highway system, courts, educated workforce and "host of indirect benefits" entitled New Jersey to "financial recovery." [fn26]
The division also advocated that Quill has no application outside the confines of the sales and use tax area. [fn27]
Tax Court's Decision
The tax court first considered whether the fact that Lanco and Lane Bryant were commonly owned would affect its constitutional analysis. It correctly concluded that their relationship was "not material to the constitutional issue." Courts have consistently recognized the separate business realities of affiliated corporations. The U.S. Claims Court castigated the IRS for failing to do so, stating: "The creation of legal entities that have separate functions under common directors and officers is a familiar and recognized practice in the ordinary conduct of large scale business[es]." [fn28] The U.S. Supreme Court and the U.S. Tax Court have, time and again, agreed with this proposition. [fn29]
Whether Quill's physical presence requirement has continuing vitality was next addressed. After scrutinizing the majority opinion in Quill, as well as the other opinions rendered in that case, the tax court concluded that "[t]he majority clearly undertook an analysis of the physical presence requirement on its own merits."
There can be no question that the Quill Court faced head-on the question of whether Bellas Hess remained vital despite the significant technological advances and the burgeoning growth of electronic commerce since it was decided, an argument central to the division's position against Lanco. As the Court itself noted in Quill, the basis for the North Dakota Supreme Court's incorrect decision not to follow the physical presence requirement of Bellas Hess was that "'the tremendous social, economic, commercial, and legal innovations' of the past quarter-century have rendered it 'obsole[te].'" [fn30] Quill, in fact, characterized the argument that '"things have changed'" as North Dakota's "major premise." [fn31] During oral argument in Quill, moreover, North Dakota's attorney general urged the Court to overrule Bellas Hess, noting that "technological developments, make the world a very different place in 1992 than it was in 1967 when Bellas Hess was decided." [fn32] New Jersey added its voice to North Dakota's argument, claiming, just as it did in Lanco, that Bellas Hess was "outmoded" and based on "factual assumptions that are not today supportable." [fn33]
Although it found no nexus, the tax court did agree in dicta with the division that all four Complete Auto tests were met, and concluded that "[a]lthough it is not physically present in the state, Lanco clearly enjoys the same benefits provided to Lane Bryant." In this regard, the tax court missed the mark; Lanco did not receive benefits from New Jersey.
As the Quill Court asked North Dakota's attorney general during oral argument, "[w]hy does North Dakota deserve to collect the tax? That's the real -- sort of question, I would think. What do you want for nothing?" [fn34] In response to the attorney general's response that North Dakota "facilitates the transaction" for Quill, and Quill uses "phone lines in our state" and "our roads to deliver their products," and that North Dakota provides "the customer base," Chief Justice William H. Rehnquist responded, "[t]hat's the argument that was rejected in Bellas Hess after being so eloquently portrayed by the dissent." [fn35] Thus, the Court recognized that the amorphous benefits derived by an entity not physically present in a state are not sufficient to warrant collection responsibilities.
Arguably, moreover, a mere collection responsibility (for which many states compensate the collectors) could be based on a state's provision of less substantial benefits than a direct imposition of taxes where the lack of a quid quo pro given to entities not physically present becomes obvious.
Next, the tax court addressed the "decisive question" of whether Quill's physical presence requirement is limited to situations where a use tax collection responsibility is sought to be imposed, or extends to the imposition of income taxes. Its conclusion that physical presence is just as much a requirement for income taxation as it is for imposing a use tax collection responsibility was premised on:
The tax court pointed out that the benefit of having a clear, bright-line test is the same regardless of the type of tax, and properly recognized that the burden of complying with use tax collection complexities and the burden of having a direct liability to pay a tax are not dissimilar. The court summed up its position: "If physical presence is a constitutional necessity for one, it is illogical that it should not be for both." This conclusion is consistent with the post-Quill decisions of the Supreme Court, which strongly suggest that the test applies across-the-board to all taxes. [fn36]
Significantly, the court undertook an in-depth analysis of both the pre-Quill and the post-Quill cases and painstakingly considered articles supportive of limiting Quill to use tax situations. Parsing through the decisions that are consistently cited in support of taxing jurisdictions' and the authors' claims that Quill's physical presence requirement is limited to use tax collection responsibility both old -- International Harvester, [fn37] Whitney, [fn38] Curry [fn39] -- and new -- Geoffrey, [fn40] SYL, [fn41] Truck Renting & Leasing, [fn42] Couchot, [fn43] General Motors [fn44] -- it debunked each of the shibboleths in turn.
After gratuitously addressing the issue of the retroactivity of the regulation, N.J. Regs. § 18:7-1.9, and concluding that even if physical presence were not a requirement, economic nexus represented a shift in position under New Jersey law and would only be prospective, the court moved on to consider whether the use of tax-minimizing business structures would warrant departure from its legal conclusion, although nothing in the Lanco record would support a finding that Lanco was formed for tax purposes. To its credit, the court took a realistic, unjaundiced view of tax planning, so rare these days, recognizing that
"[l]egitimate means to minimize taxation are, of course the prerogative of any business and perhaps dictate the market-place competition."
Of late, the states are up to their old habits, relentlessly disregarding their borders -- the precise evil that the commerce clause was meant to address. New Jersey is the poster child for such behavior. One example is its throwout rule, enacted as part of its Business Tax Reform Act of 2002. It is nothing more than a mechanism to grab income lacking any connection to the state on the basis that other states are not taxing such income. What is even more distressing is that the states' attempts to tax income that is wholly unconnected to business activity within their borders, contrary to constitutional mandate and Supreme Court precedent, are accomplished under the guise of self-righteousness. Unfortunately, because the Supreme Court has yet to review cases presenting these issues, [fn45] the states have become more emboldened in their pursuits of taxation of extraterritorial income.
The scholarly decision in Lanco provided a welcome respite from the result-oriented decisions that often turn the law and the facts on their head to find a way to tax that which the law does not allow. The American tax landscape has long provided for exemptions and exclusions. Taking advantage of such legislatively prescribed incentives is, as the Lanco court understood, neither illegal nor even morally questionable.
Given the significant financial stakes of nexus findings -- to both parties -- the issues raised by Lanco will continue to be litigated throughout the country. Only two avenues exist for resolution -- congressional intervention or a decision by the highest court of the land.
Copyright © 2004 by The Bureau of National Affairs, Inc., Washington D.C.
1: This article was originally published in the BNA Tax Management Weekly State Tax Report and BNA Tax Management State Tax Library. The article is reprinted with permission from Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc., 1250 23rd Street, N.W., Washington, D.C. 20037 (www.bnatax.com).
5: Often the changes have been characterized as "clarifications" and not the changes that they really are. Legislative and regulatory amendments under the guise of being "mere clarifications" are a troubling practice that appears to be becoming a more frequent occurrence. One would hope that courts will see the ploy for what it usually is -- impermissible and unconstitutional retroactive legislation.
22: For example, in Kmart Properties Inc. v. New Mexico Taxn. and Rev. Dept., No. 21,140 (N.M. Ct. App. Nov. 27, 2001), cert. granted, 40 P.3d 1008 (N.M. 2002), an unpublished decision which cannot be cited as authority under Rule 12-405C of the New Mexico Supreme Court's Rules of Appellate Procedure, the New Mexico Court of Appeals formulated a "functional equivalent" test to physical presence. Given the Supreme Court's avowal of having a bright-line test, the state court of appeals' perversion of the physical presence test was a step in the wrong direction. In A&F Trademark Inc. v. Tolson, No. 02-CV-007467 (N.C. Super. Ct. May 22, 2003) (on appeal), the in-state activities of the licensees of the purported taxpayers' intangible property were imputed to the purported taxpayers based in part upon erroneous notions regarding intangible property law. These cases (and others like them) are contrary to the guidance of the Court, grounded in its goal of fostering objective, concrete determinations of nexus.
29: See, e.g., National Carbide Corp. v. Commissioner, 336 U.S. 422, 433 (1949) (which rejected an attempt to disregard subsidiaries, and stated that "[u]ndoubtedly the great majority of corporations owned by sole shareholders are 'dummies' in the sense that their policies and day-to-day activities are determined not as decisions of the corporation but by their owners acting individually"); Bass v. Commissioner, 50 T.C. 595, 601 (1968).
36: See, e.g., Allied-Signal Inc. v. Director, Div. of Taxn., 504 U.S. 768, 778 (1992) ("The constitutional question in a case such as Quill Corp. is whether the State has the authority to tax the corporation at all.").
45: The Court has rejected invitations to address the economic nexus question outside the use tax area several times. See, e.g., Geoffrey, 510 U.S. 992 (1993); Johnson v. J.C. Penney Natl. Bank, 531 U.S. 927 (2000); SYL, 124 S. Ct. 478 (2003).