Client Alert

State & Local Tax Insights - Winter 2000

In this issue:

Colorado Supreme Court Rules That Fleeting Presence of Property Triggers Unapportioned Denver Use Tax
by Thomas H. Steele and Neil I. Pomerantz

On December 6, 1999, the Colorado Supreme Court ruled that the City of Denver ("City" or "Denver") constitutionally could impose an unapportioned use tax on General Motors ("GM") vehicles having only a transient presence within the City. The court held that the City's tax -- based upon the original materials cost of the vehicles -- did not offend the Commerce Clause of the United States Constitution, notwithstanding that GM typically constructed the vehicles years before the vehicles entered the City, and notwithstanding that the vehicles generally spent less than 1%, and never spent more than 4%, of their useful lives within the City. General Motors Corp. v. City and County of Denver, No. 98SA220, 1999 Colo. LEXIS 1195 (Colo. Dec. 6, 1999) ("General Motors"). In reaching this decision, the court reversed a trial court's determination that the tax violated both the "fair apportionment" and "substantial nexus" prongs of the four-part test articulated by the United States Supreme Court for determining whether a tax satisfies the Commerce Clause. See Complete Auto Transit, Inc. v. Brady, 430 U.S. 272 (1977). (Morrison & Foerster LLP represented GM in this case.)

Put simply, the Colorado Supreme Court's decision raises the following question:

May a jurisdiction impose an unapportioned tax upon the full original cost of transient property passing through its boundaries when it cannot make a plausible claim that the tax serves as a traditional, complementary use tax designed to preserve its sales tax base?

The Colorado Supreme Court answered this question in the affirmative. It rejected any notion that the City must calibrate its tax to reflect the fleeting presence of the subject property within its jurisdiction, finding that the existence of a credit mechanism would resolve any external consistency concerns. Moreover, it rejected the notion that the City must demonstrate a meaningful connection between the event which triggers the tax (i.e., mere use of property within the jurisdiction) and the purchase and sale transaction that produced the tax base.

The Colorado court's decision apparently permits the City to tax the full purchase price of any business property (not otherwise exempted by statute) that passes through its boundaries, regardless of when the property enters the City, regardless of why the property enters the City, and regardless of how long the property remains in the City. As such, we believe, the decision raises fundamental questions about the nature of the use tax and the purposes the tax is intended to serve. Relatedly, it prompts one to consider whether there are, or should exist, any exceptions to the general rule that so-called "use taxes" need not be apportioned. This article considers these issues. (The authors note that GM also argued before the Colorado courts that certain exemptions found within the City's ordinance prohibited taxation of GM's vehicles. However, because the implications of the court's interpretation of these exemptions arguably are not as broad as the implications of the court's interpretation of the constitutional strictures, we do not discuss the exemptions in this article.)

Facts of the Case

During the period at issue, GM owned property within the Denver city boundaries, consisting of an emissions testing lab, employee offices, and parking space for numerous vehicles. The Denver facility served as one location in a constellation of similar sites around the country (and indeed, the world) which GM operated to facilitate its testing of prototype engines and transmissions for future automobile models. Virtually all of the vehicles GM brought to the Denver facility each year were so-called "testing mules," which GM subjected to nearly continuous testing throughout North America.

Slightly more than half of the vehicles at issue in the case used GM's Denver facility as a staging area for design and development activities that took place outside the City. These vehicles fell into two categories. One category consisted of vehicles GM shipped to its Denver facility in order to facilitate road testing in surrounding geographical areas. Typically, GM engineers flew into Denver to meet these vehicles shortly after their arrival at the Denver facility, and promptly drove the vehicles outside the City to conduct the road tests. In many cases, upon completion of the road tests, the engineers did not return the vehicles to the Denver facility, but instead drove the vehicles to other destinations for additional tests. In some cases, the engineers returned the vehicles to GM's Denver facility for prompt shipment to other locales. The second category of vehicles consisted of vehicles that first arrived in Denver after GM engineers had completed long road tests outside the City. Shortly after these vehicles arrived at the Denver facility, GM shipped these vehicles by common carrier to other destinations.

The undisputed testimony revealed that these vehicles spent no more than a few days -- and often only a few hours -- within the City. These vehicles spent less than 1% of their useful lives, and traveled less than 1% of their total miles, in Denver. Testimony in the record also indicated that vehicles in these two categories visited the Denver facility solely because the facility represented a convenient location at which to begin or terminate road testing in the region. None of these vehicles underwent any testing at the Denver emissions lab. -- comprising the remaining automobiles at issue -- consisted of vehicles GM shipped to Denver in order to conduct emissions testing at its Denver lab. These vehicles typically spent the entirety of their useful lives undergoing a battery of emissions-related tests at various locations around the country. GM conducted the vast majority of these emissions tests at its labs in Michigan. However, GM also transported the vehicles to various locations around the country and in Canada for discrete tests under conditions not available in Michigan. The Denver lab provided a venue for GM to conduct high-altitude emissions tests on certain of its prototype vehicles.

Before visiting the Denver facility, vehicles in this third category typically completed between one and two years of tests at GM labs in Michigan. Thereafter, GM typically shipped the vehicles to the Denver facility for one to two weeks of emissions testing at high altitudes. Following the Denver testing, GM personnel generally shipped or drove the vehicles to other GM testing facilities around the country and in Canada for similar testing. In virtually all cases, the vehicles ultimately returned to Michigan for additional development and testing programs during the final stages of their useful lives. GM registered and plated each of the emissions testing vehicles outside Denver, most commonly in Michigan. The evidence indicated that the vehicles subjected to emissions testing in Denver typically spent 2-4% of their useful lives in Denver.

Following an audit of GM's Denver operations, the City asserted the right to impose its 3.5% use tax on each of the three categories of vehicles. Due to limitations in its ordinance, the City ultimately imposed its tax on the full cost of the materials GM used to construct the vehicles, rather than upon the value of the constructed vehicles. The assessment amounted to a tax of approximately $300 on each GM vehicle that visited the Denver facility.

Though the subject vehicles made similar visits to a host of other jurisdictions, no other state or municipality attempted to collect an unapportioned tax on the vehicles. Only three other jurisdictions -- the States of Michigan, Arizona, and Colorado -- imposed any tax at all on the vehicles. Though their approach to GM's vehicles differed slightly, at bottom, Michigan, Arizona, and Colorado apportioned their tax by requiring GM to pay the tax on a prorated portion of the value of each vehicle for each month the vehicle spent in the state.

Though GM paid almost $1 million in taxes to these other jurisdictions, the City ultimately denied GM any credit against its own tax. The City relied upon language in its ordinance which required the City to grant a credit only for taxes paid to other municipalities, and not for taxes paid to other states.

The District Court struck the City's assessment in its entirety, finding that the City's application of its use tax violated the Commerce Clause (in addition to exemptions found within Denver's ordinance). The District Court concluded that the City's tax, in this case, bore no resemblance to a traditional use tax. Proceeding from this premise, the District Court determined that the City's levy violated the Commerce Clause because (1) the levy was externally inconsistent in that the unapportioned tax did not reflect the limited presence of the vehicles within its jurisdiction; and (2) the City could not demonstrate a "substantial nexus" with the transactions which produced the gross receipts subject to the tax, namely GM's original purchase of the vehicles' component parts. The District Court took a notably practical approach to the issue, acknowledging that, under the City's interpretation of its tax, all conventioneers visiting Denver would be subject to an unapportioned tax upon the items they displayed.

The Colorado Supreme Court reversed the District Court's ruling. Interestingly, the court first concluded that the City's denial of credit for taxes paid to other states rendered the levy upon GM internally inconsistent. The court recognized that Denver's credit scheme could result in multiple taxation if every other taxing jurisdiction imposed a similar crediting mechanism. (The danger arises when states and their sub-jurisdictions impose the same cumulative tax rate, but divide the tax rates differently.) However, it found that another section of the Denver use tax operated to save the tax from failure. That section reads: "There shall be exempt from taxation . . . all sales which the city is prohibited from taxing under the Constitution or laws of the United States or the Constitution of the state." Denver Revised Municipal Code § 53-97(11). The court concluded that this statute granted the court license to construe the Denver use tax in a manner that would avoid any constitutional infirmity. Under this perceived authority, the court held that Denver must grant a credit for taxes paid to other states, as well as for taxes paid to other municipalities. The court then declared the newly constructed statute internally consistent.

The court then rejected the District Court's determination that the tax violated both the external consistency and substantial nexus requirements of the Commerce Clause. The court reasoned that a tax is externally consistent provided it offers a credit mechanism that effectively eliminates the danger of multiple taxation, and found that Denver's credit, as modified, met that standard. The court also held that the substantial nexus prong of Complete Auto only required that Denver demonstrate nexus with the vehicles it sought to tax. It concluded that the presence of the vehicles in the City provided Denver with the requisite nexus.

The court remanded the case for a determination of the proper credit due GM. Although the court devoted relatively little attention to the mechanics of the credit, the court apparently endorsed two significant limitations to the credit the City must provide. First, the court held that Denver need not provide a credit for taxes paid upon uses that occurred after the vehicles left the City. This limitation apparently extends to apportioned taxes GM subsequently paid to other jurisdictions (e.g., Arizona and Michigan). Second, the court held that Denver may deny a credit for any taxes paid on a base greater than that employed by the City. Thus, the City apparently may treat as eligible for the credit only taxes paid upon the materials cost of the vehicles.

The City's Tax Is Not a Traditional, Complementary Use Tax

The authors believe the Colorado Supreme Court misapplied the relevant constitutional standards. The authors further believe that this error arose from a misperception regarding the true nature of the City's tax. Though the Denver use tax, by its literal terms, suggests a traditional use tax (i.e., it nominally reaches the "privilege of storing, using, distributing or consuming" tangible personal property within the City), the tax, as applied, serves none of the purposes for which jurisdictions traditionally impose such a levy. Under these circumstances, any attempt by the City to reach the full proceeds of the parts purchased to construct the vehicles represents impermissible overreaching, in violation of the Commerce Clause.

It is well known that a conventional "use tax" operates as a complement to the sales tax. As the United States Supreme Court acknowledged decades ago in Henneford v. Silas Mason Co., 57 S. Ct. 524, 526 (1937), the use tax serves two related purposes. First, it "avoid[s] the likelihood of a drain upon the revenues of the state, buyers being no longer tempted to place their orders in other States in the effort to escape payment of the [sales] tax on local sales." Second, it permits local retailers to "compete upon terms of equality with retail dealers in other states who are exempt from a sales tax or any corresponding burden." Thus, the paradigm case addressed by a use tax is one in which a purchaser travels to a jurisdiction with a low sales tax or no sales tax to make a purchase and then returns with the property for subsequent use in his state or city of residence. Because the purchaser is subject to use tax when he returns home, the use tax both protects the sales tax base and minimizes the competitive harm faced by local retailers.

To identify situations in which the use tax acts as a truly compensatory levy, jurisdictions generally rely upon certain indicia to evaluate whether the property owner intends to use or consume the subject property principally or substantially within the taxing jurisdiction. Typical among such indicia are: first use of the property in the jurisdiction, use of the property in the jurisdiction by a resident of the jurisdiction, or use of the property within the jurisdiction for a significant period of time. These benchmarks provide a measure of comfort that taxing the gross sale proceeds will serve the policy goals underlying the traditional, compensatory use tax. Conversely, they provide some measure of assurance that a jurisdiction will not attempt to impose its tax on fleeting and non-unique uses of property within its borders.

By any measure, the City's levy upon GM serves none of the purposes underlying the truly compensatory use tax. (Indeed, neither the City in its briefing nor the Colorado Supreme Court in its opinion made any claim that it does.) The tax serves neither to prevent GM from structuring its purchases to avoid Denver's tax nor to equalize the market position of Denver retailers, as it is clear that GM would not have purchased the vehicle parts at issue in Denver for a manufacturing process that occurred in Michigan years before the manufactured vehicles first visited the City. In reality, then, the City's tax is not a traditional "use tax," as such a tax is commonly understood; instead, the City's tax, as applied, more appropriately is viewed as a tax on the mere transient presence of property within its jurisdiction.

The City's Levy Constitutes Impermissible Overreaching in Violation of the Commerce Clause

The policies described above find expression in the restrictions imposed by the Commerce Clause. At a minimum, the authors believe the City's tax, as applied, violates the "external consistency" requirement articulated in modern Commerce Clause jurisprudence. The external consistency test requires that a tax reach "only that portion of the revenues from the interstate activity which reasonably reflects the in-state component of the activity being taxed." Goldberg v. Sweet, 488 U.S. 252, 262 (1989); see also Oklahoma Tax Comm'n v. Jefferson Lines, 514 U.S. 175, 185 (1995) (holding that external consistency looks to "whether the tax reaches beyond the portion of value that is fairly attributable to economic activity within the taxing State"). Put simply, a tax on purely interstate activity -- i.e., a tax on activity conducted across multiple jurisdictions -- must be calibrated to reflect the amount of that interstate activity which occurs within the taxing jurisdiction.

To be sure, the U.S. Supreme Court has carved out a narrow exception to the general rule that a tax must be fairly apportioned to satisfy the external consistency requirement. In Jefferson Lines, supra, the Court rejected the notion that a jurisdiction must apportion a sales tax imposed upon an item purchased for interstate consumption (a bus ticket, in Jefferson Lines). The Court founded its decision on the grounds that a traditional sales tax is imposed on a set of unique events (e.g., transfer of title or delivery of the goods) that occur in a single jurisdiction:

A sale of goods is most readily viewed as a discrete event facilitated by the laws and amenities of the place of sale, and the transaction itself does not readily reveal the extent to which completed or anticipated interstate activity affects the value on which a buyer is taxed. We have therefore consistently approved taxation of sales without any division of the tax base among different States, and have instead held such taxes properly measurable by the gross charge for the purchase, regardless of any activity outside the taxing jurisdiction that might have preceded the sale or might occur in the future. [Citations omitted.]

Jefferson Lines, 514 U.S. at 186. Thus, a sales tax need not be apportioned, even if the purchased property will be used or consumed outside the jurisdiction of sale, because the tax is imposed upon a "discrete event" (i.e., the sale) which can occur in only one jurisdiction.

In the years since the Court articulated the external consistency requirement, it has not had occasion to apply that requirement in the context of a challenge to a use tax. Nonetheless, the Court's decision in Jefferson Lines seemingly provides insight into how the Court might apply the test to a tax such as the one at issue here. One might conclude that a truly complementary use tax, like a sales tax, is imposed on a unique set of events that take place within the taxing jurisdiction, and therefore, may be afforded the same constitutional protection as transactional sales taxes. For example, where a taxpayer first uses or substantially uses property within the taxing jurisdiction, one might view that use as a discrete event which likely will not be replicated elsewhere.

However, we do not believe Jefferson Lines shields a tax from the fair apportionment requirement merely because it is denominated a "use tax." Rather, we believe, Jefferson Lines suggests that an unapportioned "use tax" will not pass constitutional scrutiny where it is imposed on a non-unique event (e.g., any use of the property for a fleeting period) which can and will be replicated in a multitude of jurisdictions. Under such circumstances, the taxing jurisdiction must adhere to the general rule of fair apportionment.

In GM's case, the presence of its vehicles within the City is both fleeting and non-unique. GM does not commit the vehicles to any "first use" in the City; nor does GM principally or substantially use or consume the vehicles in the City. Indeed, the very activities which triggered Denver's tax occur in virtually every jurisdiction through which the vehicles pass. Given such facts, we believe, the City's tax represents an impermissible attempt to reach values plainly attributable to other jurisdictions, and therefore, violates the Commerce Clause's external consistency requirement.

We believe that a tax on mere transient use of property, if constitutional at all, must be based upon some rough approximation of the value of the property's use in the jurisdiction. Such value could be measured in a number of ways, perhaps by estimating the rental value of the property during the period the property is present in the jurisdiction or by apportioning the property's original purchase price to reflect the relative presence of the property in the jurisdiction (as Michigan, Arizona, and the State of Colorado have done). However, the external consistency test is not met, as the Colorado Supreme Court concludes, simply because Denver provides a credit against its tax. Were the external consistency test so easily satisfied, Denver could impose an income tax upon GM's worldwide income and meet the constitutional requirement of fair apportionment simply by providing a credit for taxes imposed by other states or foreign countries.

Even if one were to agree that a jurisdiction could overcome external consistency concerns by avoiding multiple taxation, it does not appear that the Colorado Supreme Court's credit mechanism eliminates such a danger. First, the court's decision allows Denver to treat as ineligible for the credit all taxes paid upon uses that occur after the vehicles leave the City. However, where such "later-in-time" jurisdictions impose an apportioned tax (as Michigan and Arizona have done here), one might argue that those jurisdictions have a higher priority claim to the tax base (akin to source-based income taxes). If a taxpayer pays a tax to the City on 100% of the original sales price, and later-in-time jurisdictions demand an additional, apportioned tax, multiple taxation will result.

Second, from a more practical perspective, the decision arguably requires transient visitors of the City to be prepared to produce documentation of taxes paid to other jurisdictions if they wish to receive a credit for those taxes. Quite often, one might imagine, the taxpayer may not have kept such documentation, particularly where the taxpayer anticipated consuming the property primarily in another jurisdiction. Absent such documentation, the taxpayer can expect to pay a second tax to Denver. (Of course, the danger will be compounded if many jurisdictions seek to tax transient property within their borders.)

Alternatively, we believe one may conceptualize the deficiencies in the City's tax by reference to the "substantial nexus" requirement articulated in Complete Auto. Outside the realm of traditional sales and use taxes, the U.S. Supreme Court has embraced a firm rule that a jurisdiction must bear some meaningful connection (or "substantial nexus") with the tax base it proposes to reach. See Allied-Signal, Inc. v. Director, Div. of Taxation, 504 U.S. 768, 778 (1992) (holding that, "in the case of a tax on an activity, there must be a connection to the activity itself, rather than a connection only to the actor the State seeks to tax").

Here, we believe, if the City wishes to use as its tax base the gross proceeds from GM's original purchase of the automotive parts, it must demonstrate some meaningful connection or substantial nexus with those sales transactions. Simply, on the facts of the case, the City cannot demonstrate any such connection with transactions that occurred years before in other jurisdictions. Again, because the City's tax resembles the complementary use tax in name only, it cannot claim the rights (particularly, the right to reach the full original sales price) traditionally afforded use taxes.

We believe the Colorado Supreme Court's decision sends an ominous message to other jurisdictions, which may now seek to expand their use taxes beyond all traditional bounds. We will keep readers informed of related developments in future issues of this newsletter.

States Continue Aggressively To Pursue Sales Tax Nexus Based Upon Activities Of Distinct Legal Entities

by Craig B. Fields and Meredith L. Friedman

The law is now clear that the Commerce Clause of the U.S. Constitution prohibits a state from subjecting a corporation (or any person) to use tax collection responsibilities unless the corporation is physically present in the jurisdiction. Quill Corp. v. North Dakota, 504 U.S. 298 (1992). Recognizing this limitation (at least in the context of use tax collection responsibilities), some states are attempting to assert jurisdiction over corporations not based upon the physical presence of the corporation itself but, instead, based upon the physical presence of others. As the following demonstrates, the states have met with mixed success in their aggressive assertions of nexus.

Maryland Rules Common Carrier Is Not Common Enough

In a case that is symptomatic of the aggressive position many states are taking regarding nexus, a Maryland court recently upheld the imposition of a use tax on a North Carolina furniture retailer and the corporation that delivered its furniture. This was so despite the fact that the retailer was not itself physically present in the state and the delivery corporation was qualified as a common carrier by the Interstate Commerce Commission. Furnitureland South, Inc. and Royal Transport, Inc. v. Comptroller, C-97-37872-OC (Cir. Ct. for Anne Arundel County Aug. 13, 1999).

Furnitureland South, Inc. ("Furnitureland") was a furniture retailer located in North Carolina that did not have a physical presence in Maryland. The corporation did not send unsolicited promotional material into Maryland or otherwise initiate direct contact with Maryland customers; nor did it employ any salesmen or other representatives within Maryland to solicit or take orders. The corporation advertised primarily through the local North Carolina yellow pages as well as the Internet.

Furnitureland did make sales to Maryland residents. (In 1997, such sales totaled $3.5 million.) It did not, however, make any furniture deliveries into Maryland using its own trucks. Furnitureland did not collect or remit Maryland use tax on its sales to Maryland residents.

In 1991, Royal Transport, Inc. ("Royal") was established as a for-hire motor carrier. Royal subsequently received motor common carrier authority and motor contract authority from the ICC. Furnitureland and Royal were not related, and did not share any employees, officers, or directors. Royal was, however, formed due to the desire of Furnitureland's owner and president to separate the interstate delivery portion of the business from the retail operations.

Furnitureland generated "trip sheets" for Royal, which identified the delivery stops for each trip; the order in which the deliveries were to be made; the time span during which each delivery was to be made; the names, addresses, and telephone numbers of the customers; and the amount to be collected from each customer. Significantly, as part of its shipping for Furnitureland, Royal employees made stops to pick up furniture which was to be returned to Furnitureland for repairs. Additionally, Royal employees sometimes made minor repairs or assembled furniture for Furnitureland's customers.

Prior to July 1998, all 35 of Royal's trucks and 39 of its 44 trailers displayed Furnitureland advertising. Until 1998, Royal had no customers other than Furnitureland. In 1998, Royal also began performing some trucking for a transportation broker. However, this work accounted for a very small percentage of Royal's gross revenues.

Maryland asserted that Furnitureland and Royal were each subject to Maryland's sales and use tax and sought to have the corporations judicially compelled to collect the tax from Maryland residents purchasing furniture from Furnitureland.

The Circuit Court agreed. The court first looked to the definition of "vendor" to determine whether Furnitureland and Royal were engaging in business in Maryland. The court found that since Royal provided delivery, set-up, and repair services to Furnitureland's Maryland customers, Royal was Furnitureland's agent in Maryland for the purpose of delivering or selling furniture. Therefore, the Court concluded, Furnitureland was a vendor pursuant to the Maryland use tax statute.

The court then looked to the U.S. Constitution to determine whether the imposition of the use tax on Furnitureland and Royal would violate the Commerce Clause. Although Furnitureland was not itself physically present in Maryland, the court held that imposition of the use tax was permissible based on Royal's activities. The court found that Royal's deliveries, which exceeded 100 per month, as well as Royal's collection of money from Maryland customers and its repair of items purchased from Furnitureland by Maryland customers, established the existence of a representative relationship between Furnitureland and Royal. Relying on Scripto, Inc. v. Carson, 362 U.S. 207 (1960), the court found that this relationship satisfied the "substantial nexus" requirement of the Commerce Clause.

The court stated that Furnitureland's advertising efforts within the state also supported a finding of substantial nexus with Maryland. The court noted that, although the corporation did not send unsolicited promotional materials to Maryland residents, it maintained a Web site to which Maryland residents had access, and prominently displayed its logo on Royal's trucks, which were seen regularly on Maryland roads.

In holding that the substantial nexus requirement was satisfied, the court rejected Furnitureland's argument that, since Royal was a common carrier, the "safe harbor" as set forth in National Bellas Hess, Inc. v. Department of Revenue of Illinois, 386 U.S. 753 (1967), applied to Furnitureland. Because the U.S. Supreme Court did not define the term "common carrier" in the context of substantial nexus, the Maryland court determined that "it is the holding out to the public on a non-discriminatory, arm's-length basis and the lack of control over the delivery that seems to make the service provided by a ‘common carrier' inherently similar to that of the U.S. Mail." After analyzing Royal's relationship with Furnitureland, the court concluded that Royal was not a common carrier as envisioned by the Supreme Court in Bellas Hess. The fact that Royal charged a higher rate for other clients, and lacked control over the time, manner, and means of delivery, compelled the court's conclusion that Royal was not a common carrier, but rather, an agent of Furnitureland.

Massachusetts Rules That Advertising on Affiliate's Cable Television Station Creates Nexus

The Massachusetts Department of Revenue ("DOR") issued a Letter Ruling which provided that an out-of-state Corporation ("Corporation"), which was not itself physically present in the Commonwealth but engaged in a nationwide mail order business, was required to collect use tax due to its relationship with a 100%-owned Subsidiary ("Subsidiary") which operated a local cable television station in Massachusetts. Letter Ruling 99-1, 1999 Mass. Tax LEXIS 22 (Mass. Dep't of Rev. Jan. 6, 1999).

Corporation's advertisements comprised approximately 83% of Subsidiary's broadcasting activity. Subsidiary used the remainder of its broadcasting time to air commercials of other clients and programming. Corporation's Massachusetts customers ordered products by calling a toll-free telephone number and paid for their purchases via credit card or personal check. All orders were approved outside the state and shipped via common carrier.

Similar to Furnitureland, the Massachusetts DOR first determined that Corporation was engaged in business in Massachusetts because it regularly and systematically solicited orders in Massachusetts via its broadcast advertising. The DOR then determined that imposition of a use tax collection responsibility on Corporation passed constitutional muster, relying on Scripto, supra, and Tyler Pipe Industries, Inc. v. Washington Department of Revenue, 483 U.S. 232 (1987).

Specifically, the DOR determined that Corporation had a physical presence in Massachusetts through its affiliation with Subsidiary. It looked to Subsidiary's contractual obligations to perform certain activities on behalf of Corporation, such as advertising, to establish Corporation's physical presence in the Commonwealth. The DOR stated that its conclusion was not based upon common ownership of Corporation and Subsidiary, but rather, on the fact that Subsidiary performed activities on behalf of Corporation which were significantly associated with Corporation's ability to establish and maintain a market in Massachusetts. These factors, according to the DOR, established Corporation's physical presence in and nexus with Massachusetts.

Corporation argued that Subsidiary did not operate its business on the Corporation's behalf, but rather, engaged in the independent business of selling broadcasting time. According to Corporation, since it was only one of Subsidiary's many clients, those in-state activities of Subsidiary could not be attributed to it. The DOR disagreed. The DOR looked to Corporation's 100% ownership of Subsidiary as enabling Corporation to broadcast its commercials in Massachusetts on a continuous basis. The DOR viewed Corporation's purported domination of Subsidiary's broadcasting activity as evidence that Subsidiary engaged in business in Massachusetts on Corporation's behalf. Finally, the DOR stated that Subsidiary's broadcasting enabled Corporation to attract and obtain Massachusetts customers on a full-time basis. This establishment and maintenance of a market in Massachusetts in turn established, in the DOR's opinion, the Commonwealth's use tax jurisdiction over Corporation.

California Determines Advertising on Cable Television Station Does Not Create Nexus

Unlike Massachusetts, California, when faced with a fact pattern similar to that discussed above, found that the State could not constitutionally impose the burden of use tax collection and remittance upon a corporation that was not itself physically present in the State. JS&A Group, Inc. v. State Board of Equalization, No. A075021 (Cal. Ct. App. 1997) (unpublished opinion). Group, Inc. ("JS&A") was an Illinois corporation engaged in the business of direct mail merchandising of tangible personal property. It solicited sales through catalogs and direct mailings, and shipped all of its orders via common carrier. JS&A also advertised on broadcast and cable television, as well as in magazines. The corporation was not physically present in California.

The State Board of Equalization (the "Board") determined that JS&A was a retailer engaged in business in California and subject to use tax collection responsibilities. As discussed in more detail in the March 1997 issue of State & Local Tax Insights, that determination was ultimately reversed in court.

In its opinion, the court found that the facts of JS&A were nearly identical to those in Quill. The court rejected the Board's assertion that JS&A's advertising on broadcast and cable television pursuant to a contract with a local television station had created a substantial nexus between JS&A's commercial activities and California. The court found that the solicitation of business through catalogues, fliers, advertisements in periodicals, and telephone calls -- all of which were held not to constitute physical presence within a state in Quill -- were no different from advertisements on broadcast and cable television. The court also rejected the Board's argument (which was similar to the conclusion of the Massachusetts DOR) that JS&A's contractual relationship with the cable television operators to air advertisements converted the broadcasters into representatives of JS&A. The court found the contractual relationship insufficient to establish an agency relationship.

In so holding, the court distinguished Scripto on the basis that JS&A did not employ a sales force within California. The California court noted that the business of advertising, by its nature, has the effect of informing potential customers about products, and thus, may create a market in the target jurisdiction. The mere fact that a broadcaster or cable operator promotes a product pursuant to a contract does not convert that broadcaster into an agent or sales representative of an out-of-state retailer. Accordingly, JS&A did not have a physical presence in, nor a "substantial nexus" with, California.

Virginia Declines to Find Agency Relationship

Earlier this year, the Virginia Department of Taxation, in a private Letter Ruling, advised an out-of-state corporation that it did not have an agency relationship with the independent contractors hired to install and repair signs that it manufactured. P.D. 99-94, 1999 Va. Tax LEXIS 93 (Va. Dep't of Taxation Apr. 30, 1999). In so ruling, the Department did not look to Scripto, supra; rather, the Commissioner looked only to the common law definition of "agency," which required a showing that (1) the agent was subject to the principal's control with respect to the work to be performed and the manner of performing it, and (2) the work had to be performed on the business of or for the benefit of the principal.

The Commissioner found that the independent contractors, who installed and repaired the signs manufactured by the corporation, were performing work for the benefit of the customer, rather than the corporation. The Commissioner further found that the work performed, including the manner of performance, was not controlled by the corporation. Accordingly, the Commissioner did not find an agency relationship that would establish a nexus with Virginia.


These cases illustrate the aggressive attempts by some states to extend their jurisdictional reach. The lack of consistency among the states does not provide for much guidance to those out-of-state businesses which are affected by the continual attempts by states to expand their constitutional grasp. The recent Furnitureland decision, while touted as a victory for the Maryland Comptroller, may be somewhat of an anomaly, and limited to its unusual factual situation. However, the decision's reliance on the ability of Maryland residents to use a Web site as a basis for nexus is certainly troubling.

An obvious problem for out-of-state businesses is that they may be found to have nexus in one state while not having nexus in another, based on the same facts. This makes decisions regarding business transactions, where certainty is so important, difficult. This is particularly so in states that look to their particular agency law to determine nexus. Indeed, in several cases involving very similar factual situations, tribunals reached different decisions as a result of differences in the states' agency laws. Compare Pledger v. Troll Book Clubs, Inc., 871 S.W.2d 389 (Ark. 1994) (finding no agency relationship between a vendor of children's books and the teachers who took book orders from students, collected and remitted monies to the vendor, and distributed the books to the children), and Scholastic Book Clubs, Inc. v. State of Michigan, Dep't of Treasury, 223 Mich. App. 576 (Mich. Ct. App. 1997) (as in Arkansas case, declining to find teachers the agents of the out-of-state vendor), with Scholastic Book Clubs, Inc. v. State Bd. of Equalization, 207 Cal. App. 3d 734 (Cal. Ct. App. 1989) (finding an agency relationship under substantially similar facts), and In re Scholastic Book Clubs, Inc., 920 P.2d 947 (Kan. 1996) (also finding agency relationship between vendor and teachers). These results illustrate the complexities currently faced by businesses.

Thus far, these assertions of attributional nexus primarily have been made in the sales and use tax context. However, should the courts ultimately invalidate states' metaphysical presence nexus arguments in the income tax context (e.g., nexus arguments based upon "economic presence"), it is highly likely that states will begin a similar campaign to subject non-physically present corporations to their income tax based upon commercial relationships between the taxpayer and independent legal entities.

California Supreme Court In Agnew Holds That Accrued Interest Need Not Be Paid To File Either A Refund Claim Or A Suit For Refund Of Taxes

by Eric J. Coffill

In August 1999, the California Supreme Court, in Agnew v. California State Bd. of Equalization, 21 Cal. 4th 310 (Cal. 1999), a case of first impression, held that a taxpayer need not pay both accrued interest on a tax deficiency assessment and the tax itself as a prerequisite to the State Board of Equalization's ("SBE") consideration of the taxpayer's claim for refund of sales/use taxes. Agnew also marks the demise of the SBE's and the California Franchise Tax Board's ("FTB") policies that accrued interest must be paid as a condition to litigating a tax assessment.

In Agnew, the SBE issued two assessments for sales and use taxes based upon the taxpayer's interest in two thoroughbred racehorses, Hail Bold King and Desert Wine. The taxpayer filed administrative challenges to both assessments with the SBE, but ultimately lost. He then paid the use tax and accrued interest assessed regarding Hail Bold King, and filed a superior court suit for refund of those amounts. With respect to the Desert Wine matter, the taxpayer paid the assessed sales tax, but not the accrued interest on the tax. He subsequently filed a sales tax refund claim with the SBE, and when that claim was denied, filed a superior court refund action.

Separately, the taxpayer filed another superior court action, the action ultimately heard by the California Supreme Court. This action sought a declaratory judgment that the SBE must (1) refrain from requiring payment of interest prior to acting upon a refund request when the sales or use tax has been paid in full; and (2) segregate or immediately return to the taxpayer the interest paid by the taxpayer for the Hail Bold King assessment.

The SBE responded by arguing that the declaratory judgment action was barred either by section 32 of article XIII of the California Constitution ("section 32") or by section 6931 of the California Revenue and Taxation Code ("section 6931"). Section 32 reads, in relevant part: "No legal or equitable process shall issue in any proceeding in any court against this State or any officer thereof to prevent or enjoin the collection of any tax." Cal. Const. art. XIII, § 32. Similarly, section 6931 provides: "No injunction or writ of mandate or other legal or equitable process shall issue in any suit, action, or proceeding in any court against this State or against any officer of the State to prevent or enjoin the collection under this part of any tax or any amount of tax required to be collected." Cal. Rev. & Tax. Code § 6931. The SBE reasoned as follows: (1) the taxpayer essentially was attacking the validity of the interest assessment, (2) this attack amounted to a challenge to an aspect of the tax itself, and (3) as such, the challenge represented an attempt to prevent or enjoin the collection of tax.

The trial court ruled in favor of the SBE and dismissed the taxpayer's action. On appeal, the California Court of Appeal reversed the trial court, and ruled for the taxpayer. The Court of Appeal held: (1) that the action was not one to prevent or enjoin collection of a tax because the taxpayer had paid the delinquent tax assessed by the SBE; (2) that the interest accrued on the delinquent tax was not part of the tax; and (3) that payment of accrued interest on a tax deficiency is not a prerequisite to either an administrative refund claim or a subsequent court action for refund of taxes.

The California Supreme Court then reviewed the Court of Appeal's decision at the request of the SBE. The SBE continued to argue that accrued interest on a sales/use tax deficiency is an integral part of the tax, and that, pursuant to section 32 and section 6931, interest must be paid before a legal action challenging the assessment may be brought. The court rejected each of the SBE's arguments, and affirmed the judgment of the Court of Appeal in favor of the taxpayer.

The court first addressed the SBE's argument under the California Constitution. It found that the "difficulty" with the SBE's position was that section 32 ambiguously states that an action may be maintained after payment of "a tax claimed to be illegal," and makes no mention whatsoever of payment of interest. Agnew, 21 Cal. 4th at 323. Relying on earlier precedent, the court held that, "‘[w]here the language of a statute or constitutional provision is clear and unambiguous, judicial construction is not necessary and the court should not engage in it.'" Id. (quoting Ventura County Deputy Sheriffs' Assn. v. Board of Retirement, 16 Cal. 4th 483, 492-93 (Cal. 1997)). Applying this standard, the court found that neither the history nor the language of section 32 suggested any intent on the part of the drafters to require the payment of accrued interest on a delinquent tax as a condition precedent to challenging a tax assessment in court. The court specifically rejected the SBE's argument that the word "tax" in section 32 constituted "a global reference to the entire universe of terms that may accompany a tax, in particular interest and penalties." Agnew, 21 Cal. 4th at 323.

The court concluded that the drafters of section 32 could not have intended for the term "tax" to encompass interest paid on delinquent taxes because, at the time the first constitutional bar to prepayment litigation appeared in 1910, state statutes did not even authorize the collection of interest on delinquent taxes. From that time to the present, the constitutional bar has continued to provide that only "the tax" must be paid. Given these facts, the court held, section 32 cannot be interpreted to require the prepayment of accrued interest on a delinquent tax as a legal condition to litigating an assessment.

The court next addressed, and rejected, the SBE's second argument -- that section 6931 precluded the taxpayer's action. The SBE contended that by enacting section 6931, the California Legislature decided to make prepayment of accrued interest, in addition to prepayment of a delinquent tax, a precondition to an action challenging the validity of the tax. The court observed that, given the similarity in language between section 6931 and section 32, it was "doubtful" the Legislature intended the scope of the statute to be broader than that of the constitutional law. Id. at 327. The court then pointed out that section 6931 "is not ambiguous," and that interest is not mentioned in the section. Id. at 330. The court added that the SBE had made no attempt to explain why the Legislature would selectively omit any reference to "interest" in section 6931 when the word is used repeatedly in other parts of the SBE's Sales and Use Tax Law. Id.

Agnew marks the end of the dispute between taxpayers on one side, and the SBE and the FTB on the other side, regarding whether payment of accrued interest, in addition to payment of the disputed tax, is required prior to commencing a refund action. The FTB and the SBE, at various times, have taken the position that a taxpayer's administrative refund claim will not be considered valid unless both tax and accrued interest have been paid. In addition, the FTB and the SBE have nearly always taken the position that a judicial suit for refund of taxes is jurisdictionally flawed where the taxpayer has not paid all accrued interest in addition to the tax in dispute. It is now clear under Agnew that payment of accrued interest is not required prior to filing a valid refund action at either the administrative or the judicial level.

Approximately two years ago, the Court of Appeal stated in Garg v. Board of Equalization, 53 Cal. App. 4th 199, 208 (Cal. Ct. App. 1997), that article XIII, section 32 bars adjudication of the validity of a tax "before the tax, together with interest and penalties, has been paid in full." Following Garg, the FTB announced that in refund actions in court, if tax and interest had not been paid in full at the time the action was filed, then the FTB would raise the taxpayer's failure to pay all such amounts in full as a jurisdictional defense. FTB Notice No. 97-8 (Sept. 4, 1997). Garg has now been overruled on this point by Agnew, so presumably FTB Notice 97-8 will be withdrawn in the near future.

Taxpayers who have been either unwilling or unable to proceed with California refund claims for sales/use or income/franchise taxes because they could not or did not wish to pay the accrued interest on the disputed tax are the immediate beneficiaries of Agnew. Although California still remains a "pay to play" state with respect to state tax litigation, Agnew is certainly a step in the right direction. And this is not an insignificant step. Given the glacially slow pace of so many FTB audits (less so for SBE audits), accrued interest is often many, many times the amount of the underlying alleged tax deficiency. Clearly, payment of tax only, as opposed to payment of tax and accrued interest, will serve to open the courthouse doors to cash-strapped taxpayers who previously could not afford the "cost" of litigation in California.

The next step in California to ease tax litigation may well be "bond to play." Several such bills have been introduced in recent sessions of the California Legislature. One such bill to watch is AB 1392 (Hertzberg), which would permit a taxpayer to proceed with an action to determine the validity of a franchise or income tax assessment if the taxpayer files a bond to guarantee payment of the amount of the assessment. AB 1392 has passed the California Assembly. It currently is in the suspended file of the Senate Appropriations Committee, meaning that the Senate may not determine the fate of the bill for a few more months. The bill is strongly supported by the California Manufacturers Association.

What's Happening -- A Sampling Of Our Current Work

The firm, together with SALTNET partners Horwood, Marcus & Berk Chartered and Professor Walter Hellerstein, are representing Hunt-Wesson, Inc. before the United States Supreme Court in challenging the constitutionality of California's controversial interest offset provision, which, in general, operates to offset a taxpayer's interest expense deduction against nontaxable dividend and interest income. The Supreme Court granted certiorari in the case on June 22, 1999 and heard oral argument on January 12, 2000. Although the interest offset provision is unique to California, the Court's decision could have broad implications both for the Court's Due Process and Commerce Clause jurisprudence and for the methods by which other states allocate interest expense to taxable and nontaxable income. A decision is expected before the end of the Supreme Court's current term in June.

The firm scored bi-coastal victories in two cases addressing whether pension reversion funds constituted apportionable business income or allocable nonbusiness income. In Union Carbide Corp. v. Offerman, No. 453A98, 2000 N.C. LEXIS 2 (N.C. Feb. 4, 2000), and Hoechst Celanese Corp. v. Franchise Tax Bd., 76 Cal. App. 4th 914 (Cal. Ct. App. 1999), modified and reh'g denied, 2000 Cal. App. LEXIS 1 (Cal. Ct. App. Jan. 3, 2000), the North Carolina Supreme Court and the California Court of Appeal, respectively, held that the funds -- generated when the taxpayers recaptured surplus amounts in their pension plans that were not needed to cover benefits for employees -- constituted nonbusiness income. The courts reached this conclusion upon applying both the transactional and functional tests. (The California Court of Appeal's decision is not yet final, and the FTB has filed both a Petition for Review and a Petition for Writ of Mandate with the California Supreme Court, which are pending.)

The firm is representing several clients in the seemingly endless saga to obtain Kentucky corporation income tax refunds under GTE and Subsidiaries v. Revenue Cabinet, 889 S.W.2d 788 (Ky. 1994). In that decision, where the taxpayer was represented by Paul Frankel, Bruce Clark, and Scott Clark, the Kentucky Supreme Court ruled that a unitary group of corporations may file on a combined basis. Determined not to pay refunds to other taxpayers, the Revenue Cabinet has attempted, now for the second time, to seek a legislative "fix" by promoting legislation (House Bill 541) that would bar any refund claim based upon a consolidated or combined report that was filed after December 22, 1994 for taxable years ending before December 31, 1994.


To the State of Massachusetts for repealing its "pay-to-play" requirement. Under new subsection (e) of Mass. Gen. Laws ch. 62C, § 32, a taxpayer no longer must pay the tax alleged to be due before appealing most tax disputes to the Massachusetts Appellate Tax Board. The repeal of the old policy is retroactive to July 1, 1999.




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