No Property? No Payroll? No Problem! The Evolution of State Tax Nexus and Sourcing state tax nexus limitation south dakota v. wayfair
By Chau Tran, Managing Director, SALT, Income & Franchise Tax and John Damin, Senior Manager, SALT
For state tax practitioners, the 2018 Calendar Year has been the equivalent of a small child waiting for Santa Claus to come deliver gifts – only in our case, “gifts” are technical developments and guidance. As we discussed in our previous blog entry, A Definitive Answer to State Tax Reform, “It Depends”, states are slowly providing more legislative developments and insight on their responses to Federal Tax Reform. Now, we are waiting to hear the United States Supreme Court’s (“SCOTUS”) latest take on state tax nexus limitations under the U.S. Constitution with South Dakota v. Wayfair, Inc. SCOTUS last evaluated the issue in 1992 in Quill Corp. v. North Dakota (504 U.S. 298 (1992)), with SCOTUS holding that a taxpayer’s physical presence in-state was required before the state could constitutionally impose a sales/use tax on the taxpayer. state tax nexus limitation south dakota v. wayfair
Quill decision sparks e-commerce evolution
Since the Quill decision, we have seen the evolution of a digital economy thanks to the Internet. It’s no secret that e-commerce has allowed businesses to sell products and services across the United States without the need to establish a physical presence in the states of its customers. Given the Quill decision, states could not impose a sales/use tax on such businesses that lacked in-state physical presence. As such, states started taking steps to circumvent – and in most cases, completely disregard – the constitutional physical presence requirement when setting sales/use tax nexus standards and tax collection/remission obligations.
This brings us the decision of SCOTUS to grant certiorari in Wayfair, revisiting the constitutional sales/use tax physical presence nexus standard. The decision from SCOTUS in the case is expected later this month. Practitioners and businesses are keeping a close eye on this to determine the impact on its overall state sales/use tax nexus profile. But, what about the impact on income/franchise taxes?
Even though Quill (and now Wayfair) pertained specifically to sales/use tax, both businesses and client service practitioners have argued that the Quill decision stands for a physical presence nexus standard for income/franchise tax purposes. Unfortunately, it appears that businesses and practitioners are on the losing side of this battle. Over the past decades, we have seen the evolution of nexus principles to impose tax on corporations who lacked physical presence in-state. Further, states have succeeded in finding ways to shift the tax burdens from in-state taxpayers to those out-of-state, many of whom have no physical presence.
Geoffrey expands state nexus beyond South Carolina
Regarding the expansion of state income/franchise tax nexus, the first step in this regard is arguably Geoffrey, Inc. v. South Carolina Tax Commission (437 S.E. 2d 13 (1993)). Decided one year after the SCOTUS Quill decision, Geoffrey held that a corporation whose only connection to South Carolina was licensing intangible property in-state had sufficient contact with SC under the U.S. Constitution to justify corporate income tax imposition. The Geoffrey decision was in response to a popular Delaware Holding Company organizational structure that, through intercompany transactions, created state tax deductions in separate company reporting states without the intercompany income from such transactions being subject to tax in any state. Even though the taxpayer lacked any property and payroll in any state but Delaware, and even though Quill was just decided in the previous year, the Supreme Court of South Carolina stated in its holding that Quill only applied to sales/use tax. In subsequent years, the South Carolina Geoffrey decision led to a progeny of similar decisions in other states.
The Geoffrey line of decisions addressed nexus for intangible holding companies. However, as state income/franchise tax nexus continued to evolve, the next target was operating corporations that sell products and services. Several states have started to impose bright-line nexus standards where, if sales exceed a certain amount (usually between $500K and $1M, depending on the state), the corporation is considered to have nexus for state income/franchise tax purposes. If the sales volume threshold is surpassed in a tax year, nexus is imposed irrespective of the amount of property/payroll the corporation has in-state. The result in many cases is a corporate taxpayer who lacks physical presence in-state will be subject to corporate income/franchise tax because of its in-state sales volume only.
Apportionment: COP vs. MBS
The second area where in-state physical presence has become remarkably less important for income/franchise tax purposes is apportionment. One of the primary areas where this is true is in the sourcing of sales of other than tangible personal property, e.g., services. Historically, such sales were sourced using a Cost-of-Performance (“COP”) approach. In short, in determining where a service is sourced, you’d look to the state(s) where the costs were incurred. Generally, where a taxpayer has property and payroll is synonymous with where costs are incurred in performing a service. The COP approach sources sales without regard to customer location (unless the expenses are incurred at the customer location).
In this area, states have evolved to replacing the COP approach with a Market-Based Sourcing (“MBS”) approach. In short, sales under the MBS approach are sourced to the location of the customer. An analysis as to where the costs are incurred is no longer relevant. Rather, the analysis performed is more customer-location centric (e.g., where the benefit is received, where the service is delivered – the specific analysis depends on the state’s statutory language). Again, we have a situation where a sale of a service may be sourced to a state where the taxpayer has no physical presence.
Regarding apportionment, the physical location of a taxpayer’s property and payroll is becoming less important. Under the traditional apportionment model, state income/franchise tax apportionment was based on an evenly-weighted factor consisting of property, payroll, and sales – where a taxpayer had its physical locations and employees was of equal importance to where its sales were made. However, states are continually evolving to greatly reduce – and in many cases, eliminate – the weighting of the property and payroll factor. A more heavily weighted sales factor is a means intended to provide a benefit to in-state corporations; by reducing or eliminating the property/payroll factor weighting, taxpayers aren’t theoretically punished from a tax standpoint for setting up physical locations with employees in-state. However, if in-state corporations aren’t punished under this theory, the corollary theory is that the ones who are punished are out-of-state taxpayers who lack property/payroll in the taxing state.
In the past, the largest in-state tax burdens fell on those corporations who had an actual physical presence in-state. However, because of the evolution of state income/franchise tax nexus and apportionment rules, the state tax burden is shifting to many corporations who entirely lack an in-state physical presence. While state tax has been a case of “waiting for Santa” for the SALT community in 2018, it’s obvious that the proverbial lumps of coal have been given to out-of-state taxpayers over the past several years.
 Federal Law, Public Law 86-272, prohibits a state from imposing a net income tax on a taxpayer whose only activity in-state is the solicitation for sales of tangible personal property (with the orders being accepted at a point outside of the state and delivery of the product originating from a point outside of the state). Please note that, so long as a taxpayer’s in-states activities fall within Public Law 86-272 protection, a state cannot impose a net income tax on the taxpayer despite its sales exceeding a statutory bright-line threshold.
For any corporation with a multi-state tax footprint, it is highly advisable that such corporations complete a state tax nexus analysis on a regular basis. If you have questions regarding either isolated nexus issues or a more thorough nexus analysis, visit our State & Local Income Tax page or contact Chau or John directly.