The physical presence nexus standard is becoming a thing of the past as state governments try to shift the tax burden from in-state to out-of-state taxpayers. If a state has jurisdiction to tax either the business entity or the subject matter, then a taxpayer has nexus in a state with or without physical presence. The nexus determination may vary by the type of state tax (income, sales, gross receipts, etc.) or specific state rules.
The nexus requirements must satisfy the Due Process (minimum connection with taxing state) and Commerce Clause (regulation of interstate commerce) of the United States Constitution. In the case, Complete Auto, substantial nexus is defined as a United States Constitutional requirement that is subject to interpretation by respective state tax authorities and further established a four-prong test for constitutionality under the Commerce Clause: fair apportionment, substantial nexus, nondiscrimination and fairly related to services received in the state. Public Law 86-272 is specific to income tax and sales of tangible personal property, yet prohibits a state from imposing a net income tax if the out-of-state taxpayer’s only business activity in the state is solicitation of orders. More specific to sales and use tax, the case law to define nexus begins with National Bellas Hess and Quill Corp. For these two cases, physical presence was required before a remote vendor could be required to remit sales or use tax.
Recently, states have established factor presence or “bright-line” and economic nexus rules, and the Multistate Tax Commission has recommended a model factor presence nexus standard since 2002. A factor presence standard means if a taxpayer has a certain amount of property, payroll or sales in a state, then the taxpayer automatically has nexus in the state. For example, substantial presence (triggering nexus) may be established with $50,000 property or payroll, or $500,000 of sales. Economic nexus is a more complicated concept and subject to broad interpretation by tax authorities. Economic nexus may be described as generating a benefit from a state without an in-state physical presence. With the case, Geoffrey, South Carolina established a model for economic nexus and taxing income from intangible activities in a state. The states taxing approach of remote businesses with economic or factor presence nexus will continue to develop as the digital economy grows.
Agency and affiliate nexus with regard to income tax was affirmed in 2015 by California in the Harley Davidson case. The state has the authority to tax an out-of-state entity only on the basis that the entity has a relationship with another entity which is subject to tax in the particular state. Similarly, click-through nexus for sales and use purchases establishes a filing requirement under certain circumstances. For example, a vendor may be required to collect and remit sales tax if the retailer has a contract with a person located in the state under which the person refers potential customers to the retailer by a link on the person’s internet website and the vendor has more than $10,000 of sales for the previous four quarters.
The physical presence requirement as established in National Bellas Hess and Quill Corp. has been challenged in new cases during the past two years. Direct Marketing Association (DMA) v. Brohl upheld that Colorado’s use tax notice and reporting requirements were constitutional. As a result, Judge Kennedy wrote a concurring opinion in DMA suggesting that the U.S. Supreme Court should reconsider the Court’s holding in Quill. Emphasis being that 1992 mail-order sales totaled $180 billion and as of 2008, e-commerce sales alone totaled $3.16 trillion. In 2016, Alabama and South Dakota enacted factor presence and economic nexus rules for sales tax, and Tennessee has a similar rule for out-of-state retailers effective in 2017. In November 2016, the Ohio Supreme Court upheld the constitutionality of the Ohio Commercial Activity Tax factor presence nexus standard for gross receipts. The Court concluded that physical presence is not required because Quill does not apply to business privilege taxes, and the factor presence standard complies with Complete Auto’s substantial nexus requirement. For three consolidated taxpayers, physical presence was deemed not required in Ohio simply because the Quill case was a use tax issue and not a business privilege or gross receipts tax determination.
Based on the Ohio business privilege cases, laws enacted for factor presence standards for sales tax, and growth of the e-commerce market, the physical presence requirement is quickly fading. The physical presence requirement for income tax has been minimalized in most states. The sales tax rules and other indirect taxes that previously required physical presence in the past are changing to target out-of-state taxpayers.
