MODULE 2

Nexus: there must be a sufficient connection between the taxpayer and the state to warrant the imposition of state tax authority. Fair Apportionment: the state must not tax more than its fair share of the income of a taxpayer.

No discrimination: the state must not treat out-of-state taxpayers differently than in-state taxpayers Related to services: the tax must be fairly related to services provided to the taxpayer by the state

Quill Corp. v. North Dakota Background: Quill, an office supplies company, had no physical presence within the state of North Dakota. In 1987, the statute, which defined "retailer" for tax purposes, was amended to include

"every person who engages in regular or systematic solicitation of a consumer market in the state." Thus, the Tax Commissioner of North Dakota sent notice to Quill stating that it owed a use tax for purchases that North Dakota residents made through Quill's mail order catalog.

Commerce Clause prohibits taxes that favor local business over interstate commerce.

###

States have nearly complete authority to tax activities within their own borders. These broad taxing powers, however, are subject to limitations of the U.S. Constitution. The most important structural limit on state tax power is the Commerce Clause.

###

###

####

To the extent state tax laws do not conflict with the federal constitution and laws, the taxing rules of the state are supreme within the boundaries of the state's taxing jurisdiction.

####

#####

#####

Complete Auto Transit v. Brady, included a ruling that would change interstate and intrastate transit forever. The courts ruled that companies that conducted business in more than one state, should be responsible for a portion of each state's tax burden.

######

>>>>>>>>>Due Process Clause<<<<<<<<< • Unconstitutional Distortion - Due Process requires that an apportionment formula must not be unreasonable and arbitrary in its application.

- An apportionment formula will not be held invalid whenever it may result in taxation in some income that did not have its source in the taxing state.

Supremacy Clause • Federal Preemptive Legislation - Pub. Law 86-272 • Communications/Media - Internet Tax Freedom Act

- Internet Tax Nondiscrimination Act - Telecommunications Act of 1996 • Retirement Plan Income - Pub. Law 104-95 - Pub. Law 109-264

>>>>>>Constitutional Restrictions<<<<<< - Powers not delegated to the U.S. by the Constitution...are reserved to the States. - U.S. system of government is federalism.

- Laws enacted by the various levels of government are not of equal weight. - U.S. Constitution prevails over both federal laws and treaties & state and local laws; federal laws prevail over state and local laws.

>>>>>>>>Commerce Clause<<<<<<<< 4 prong test of Complete Auto Transit: - Activities taxed must have a substantial nexus with the taxing state;

- The tax must be fairly apportioned; - The state tax must not discriminate against interstate commerce; and - The tax must be fairly related to the services provided by the state.

The Court then turned its attention to an analysis of the taxable activities to determine if the de minimis rule would allow Wrigley immunity. Wrigley emphasized that the gum sales through agency stock checks accounted for only

0.00007% of its annual Wisconsin sales and in absolute terms amounted to only several hundred dollars. The Court did not analyze the activities using their dollar level as the guide, but rather tried to determine if the activity constituted a nontrivial de minimis additional connection to the state.

An analysis of whether a tax burdens interstate commerce involves the four prong test in Complete Auto Transit v. Brady, 430 U.S. 274 (1977).

1. NexusThe activities taxed must have a substantial nexus with the taxing state.

3. Nondiscriminatory The state tax must not discriminate against interstate commerce. The discrimination prong is discussed below.

4. Fair relation to benefits rendered by the taxing state The tax must be fairly related to the services provided by the state which include police and fire protection, the benefit of a trained work force, and the advantages of a civilized society.

In other words, a State's taxing power is limited under the Due Process Clause to an apportionable share of the income of a multistate taxpayer's unitary business that is carried on in part in the taxing State.

A state is precluded under the Due Process Clause from taxing extraterritorial income that has nothing to do with the activities of the recipient in the taxing State, i.e. "income derived from 'unrelated business activity' which constitutes a 'discrete business enterprise.'"

2) activities that neither explicitly nor implicitly invites an order, but are entirely ancillary to requests for an order. Ancillary activities are those activities that serve no independent business function for the seller apart from their connection to the solicitation of orders.

Activities that a seller would engage in apart from soliciting orders shall not be considered as ancillary to the solicitation of orders. The mere assignment of activities to sales personnel does not, merely by such assignment, make such activities ancillary to solicitation of orders.

In order to bring the states together as a "union," the Privileges and Immunities Clause ensures that the "citizens of each State. . .be entitled to all privileges and immunities of citizens in the several States"

Although each state may have different laws or tax schemes, this clause requires that such laws apply equally to those in-state as to those out-of-state.

In Quill Corporation v North Dakota (1992), the Court looked at a North Dakota "use" tax applied to sales by out-of-state corporations (primarily catalog companies such as L. L. Bean and Land's End) to North Dakota residents. Quill Corporation raised several constitutional objections to the tax.

Although the Court found Quill's mailing catalogs into a state was sufficient to satisfy the "minimum contacts" test for due process purposes, it was Not sufficient to satisfy the "substantial nexus" requirement of Complete Auto Transit.

>>>>>>>>>DUE PROCESS CLAUSE<<<<<<<<< A. The Fourteenth Amendment to the U.S. Constitution prohibits a state from depriving any person of life, liberty, or property, without due process of law. U.S. Const., amend.

B. Taxation is regarded as the deprivation of a person's property. A state whose laws provide protection, security, and opportunities to individuals, property, and businesses may exact a toll in the form of taxes to support the government, but not without due process of law.

The Court concluded that Wrigley's activities, while not large in magnitude, were not limited to those specified in Pl 86-272.

Based on the Wrigley case, practitioners now have a clearer view of what constitutes "solicitation, of orders" and a revised view of the "de minimis" analysis that must be made.

Implications If an online retailer has a physical presence in a particular state, such as an office, store or warehouse, it must collect sales tax from customers in that state.

Conversely, if a business has no physical presence in a state, it is not required to collect sales tax for sales from that state.

If such activity either qualitatively or quantitatively creates a nontrivial connection with the taxing state, then such activity exceeds the protection of P.L. 86.272.

Establishing that the disqualifying activities only account for a relatively small part of the business conducted within the taxing state is not determinative of whether a de minimis level of activity exists.

• Fair apportionment - taxation of only the apportionment of activity that transpires within the taxing jurisdiction. • Fair relationship to services provided by the state - company enjoys services such as police protection while in a state.

Even though Complete Auto asserted that it was a part of an interstate operation, the Court agreed with Mississippi that while operating within the state, it was afforded services, such as police protection, provided for by taxation.

The Commerce Clause gives Congress the sole power to regulate commerce among the states. The Supreme Court has used the Clause to strike down state tax schemes that place an undue burden on interstate commerce.

In Complete Auto Transit v. Brady, the Supreme Court articulated a four-part test to determine if a state tax violates the Commerce Clause:

The Court noted that Quill had no physical presence in North Dakota--no salespersons, no outlets, no warehouse, no office.

In dissent, Justice White argued that it was silly to make a state's ability to tax depend upon whether or not a corporation has one travelling salesperson in the state, but the majority saw advantages in a bright line "physical presence" test.

The United States' system of government is a federalism with federal, state and local governments sharing responsibilities and authorities. Powers not delegated to the federal government under the U.S. Constitution are reserved for the states.

Laws enacted by the various levels of government are not of equal weight. The U.S. Constitution prevails over both federal laws and treaties, and state and local laws; and federal laws prevail over state and local laws.

The Wrigley Company had salesman and regional sales manages in Wisconsin who provided solicitation and performed other duties.

Originally, the Wisconsin Tax Appeal Board declared that the Wrigley activities were taxable; the State Circuit Court reversed this decision; the State Court of Appeals reversed the reversal and again declared the activities taxable.

On June 19, 1992, the U.S. Supreme Court ruled in Wisconsin Department of Revenue v. William Wrigley, Jr., Co. that the salesmen's activities were taxable and provided insight into the definition and scope of "solicitation of orders."

Providing a car and a stock of free samples to salesman as part of the "solicitation of orders" was an immune activity; the only reason to provide a car and the merchandise stock was to facilitate "requests" for purchases.

The Interstate Income Act of 1959, also known as Public Law 86-272, is a United States statute that allows a business to go, or send representatives, into a state to solicit orders for goods without being subject to a net income tax.

Public Law 86-272 protects only solicitation of orders for tangible personal property.

Jurisdiction to tax is not present where a state is prohibited from imposing its tax because the corporation's activities do not exceed the standard of mere solicitation of sales established by Public Law 86-272.

Public Law 86-272 provides in pertinent part:

The Equal Protection Clause of the Fourteenth Amendment of the United States Constitution provides that "No State shall...deny to any person within its jurisdiction the equal protection of the laws." U.S. Const.

Similarly-situated taxpayers may not be taxed differently unless the state can show a rational basis and legitimate reason for the distinction. However, classification between residents and nonresidents, resulting in discrimination of nonresidents, may be flatly rejected by the Court.

Such legislation is contrary to the Supreme Court ruling in Quill and is therefore unconstitutional.

So, a taxpayer can disagree on principal but lose in practice until challenges against the legislation work their way through the courts where it may ultimately be deemed unconstitutional.

For the in-state activity to be protected activity under P.L. 86-272, it must be limited solely to solicitation [except for de minimis activities described in Article III and those activities conducted by independent contractors described in Article V, below].

Solicitation means 1) speech or conducts that explicitly or implicitly invites an order; and,

At the time of Quill, the court noted that it was unreasonable to force Internet retailers to comply with over 7,500 tax jurisdictions, and would put a strain on interstate commerce.

Some estimates place this number even higher, with the number at 11,000. In addition, many states make certain products, such as groceries, exempt from certain taxes. Without any sort of uniform sales tax, requiring retailers to comply with every jurisdiction's tax may be unworkable.

C. The Commerce Clause prohibits taxes which favor local business over interstate commerce.

The Court has consistently held that a state tax that favors in-state business over out-of-state business for no other reason than the location of its business is prohibited by the Commerce Clause.

Holding: Under the Commerce Clause of the Constitution, a state cannot require an out-of-state retailer to collect use tax unless the retailer has a "substantial nexus" with the taxing state.

The Supreme Court sided with Quill, ruling that a taxpayer must have a physical presence in a state in order to require collection of sales or use tax for purchases made by in-state customers. Physical presence means offices, branches, warehouses, employees, etc.

Under this "dormant commerce clause" principle, taxes that have been found to unduly burden interstate commerce have been stricken.

The U.S. Supreme Court has established the analytical framework for determining whether a state tax unconstitutionally burdens interstate commerce.

The Commerce Clause provides that "Congress shall have the power to regulate Commerce with foreign Nations, and among the several states, and with the Indian tribes."

The U.S. Supreme Court has held that the Commerce Clause not only gives the authority to Congress to regulate interstate commerce, but also prohibits the states from enacting laws that discriminate against or interfere with interstate commerce.

The Wisconsin Supreme Court ruled in William Wrigley, Jr., Co. v. Wisconsin Department of Revenue, 160 Wis. 2d 53, 465 N.W. 2d 800 (1991), that the activities the salesmen had provided were not beyond the definition of "solicitation of orders."

The Wisconsin Supreme Court analyzed the legislative history to determine whether a narrow or broad construction of "solicitation of orders" should be afforded. It discussed those activities that deviated from the norm and the effect of de minimis activities.

Additionally, activities that seek to promote sales are not ancillary because P.L. 86-272 does not protect activity that facilitates sales; it only protects ancillary activities that facilitate the request for an order.

The conducting of activities not falling within the foregoing definition of solicitation will cause the company to lose its protection from a net income tax afforded by P.L. 86-272, unless the disqualifying activities, taken together, are either de minimis or are otherwise permitted by this ruling.

Complete Auto Transit was a company that transported vehicles between states. Mississippi was one state that the company travelled through, and one in which they delivered vehicles. Mississippi levied a tax on Complete Auto Transit because they were taking part in interstate and intrastate transit.

The tax was based on the "privilege of doing business in the state." Complete Auto Transit was based in Michigan and was obviously conducting interstate business. However, they disagreed with the tax and took the case to court.

2. Fair apportionment—According to the Court, it is not enough that a state have authority to levy and collect a tax against an out-of state corporation, the state also must have jurisdiction over the income or activity sought to be taxed.

Where the income sought to be taxed is derived from business activity occurring both within and without the taxing state, the taxing State may tax only that portion of the taxpayer's income that is attributable to its instate activity.

The Due Process Clause: The Due Process Clause states that no state shall "deprive any person of life, liberty, or property, without due process of law."

With respect to state taxation, the Supreme Court has interpreted this to prohibit a state from taxing a corporation unless there is a "minimal connection" between the company and the state in which it operates.

The Complete Auto test serves to protect the free flow of commerce from undue state regulation, including taxes that operate like tariffs to impede interstate commerce.

Without the Commerce Clause, states would be free to use their tax powers to benefit in-state businesses by burdening their out-of-state competitors.

De minimis activities are those that, when taken together, establish only a trivial connection with the taxing state. An activity conducted within a taxing state on a regular or systematic basis or pursuant to a company policy

[whether such policy is in writing or not] shall normally not be considered trivial. Whether or not an activity consists of a trivial or non-trivial connection with the state is to be measured on both a qualitative and quantitative basis.

C. The U.S. Supreme Court has held that with respect to state taxation of income generated in interstate commerce, the Due Process Clause requires "a 'minimal connection' between the interstate activities and the taxing State,

and a rational relationship between the income attributed to the State and the intrastate values of the enterprise."

States are thus prevented under Public Law 86-272 from taxing out-of-state corporations on income derived from business activities within the state if their activities are limited to "mere solicitation of orders" for the sale of tangible personal property

and the orders are approved and filled from outside the state. If the standard of mere solicitation of orders is not exceeded in a destination state, the throw-back rule will apply to such sales. On the other hand, if the standard is exceeded, the sales would not be subject to the throw-back rule.

E. Unconstitutional Distortion—States are generally afforded wide latitude to enact their own apportionment systems for determining the income attributable to that state. Nevertheless, due process requires that an

apportionment formula must not be unreasonable and arbitrary in its application. However, an apportionment formula will not be invalidated whenever it may result in taxation of some income that did not have its source in the taxing State.

Under PL 86-272, states are specifically barred from imposing an income tax on the sale of tangible goods if "[s]olicitation of orders by such person, or his representative, in such State for sales of tangible personal property, which orders are sent outside the State for

approval or rejection, and, if approved, are filled by shipment or delivery from a point outside the State...." However, the law does not clearly define what constitutes "solicitation orders" and case law in the various states has taken both a narrow and a broad approach to the definition.

1. The solicitation of orders by such person, or his representative, in such State for sales of tangible personal property, which orders are sent outside the State for approval or rejection, and, if approved,

are filled by shipment or delivery from a point outside of the state; ...and

In 1959, Congress wanted to establish a minimum standard that taxpayers had to exceed in order to be subject to income tax on interstate commerce. PL 86-272 prohibits states from taxing income derived from interstate commerce if the only activities within the state by the out-of-state taxpayer,

are the "solicitation of orders" that were sent outside of the state for approval. In effect, this law established immunity for taxpayers for a low level of activity within a state when their only activity meets the definition of "solicitation of orders."

An unspecified margin of error is constitutionally acceptable. Rather the taxpayer must prove by "clear and cogent evidence" that the income attributed to the State

by the challenged formula is out of all appropriate proportion to the taxpayer's activities in the taxing State or is grossly disproportionate.

The relative economic importance of the disqualifying in-state activities, as compared to the protected activities,

does not determine whether the conduct of the disqualifying activities within the taxing state is inconsistent with the limited protection afforded by P.L. 86-272.

The salesmen's activities that were not ancillary to the "solicitation of orders" in Wrigley (and, as a result, were precluded from protection under PL 86-272) were:

employing salesmen to repair or service a company's product; replacing stale gum by sales representatives; supplying gum through "agency stock checks"; and storing gum and renting storage space.

The Court emphasized that an activity other than direct solicitation would only be allowed if it was ancillary to solicitation and served no other business purpose;

for example, if found that Wrigley's in-state recruitment training and evaluation of sales representatives and their regional manager intervening in credit disputes was consistent with ancillary activities that were needed for solicitation.

2. The solicitation of orders by such a person, or his representative, in such State in the name of or for the benefit of a prospective customer of such a person,

if orders by such customer to such person to enable such customer to fill orders resulting from such solicitation are orders described in paragraph

No state, or political subdivision thereof, shall have power to impose, a net income tax on the income derived within such state by any person from intrastate commerce

if the only business activities within such state by or on behalf of such a person during the taxable year are either, or both, of the following...

2. Fair apportionment—The tax must be fairly apportioned. While this test literally requires fair apportionment, the Court has permitted taxation of interstate sales where multiple tax burdens are avoided through the use of a tax credit.

illinois tax on unapportioned charge for interstate telephone calls that originated or terminated in Illinois and charged to an Illinois address was upheld where credit provision operated to avoid actual multiple taxation.

The Commerce Clause: The Commerce clause, in part, authorizes Congress to "regulate commerce with foreign nations, and among the several States." The Supreme Court has ruled that the Commerce Clause prohibits states from enacting laws that might unduly burden

or inhibit the free flow of commerce between the states. In Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the Supreme Court ruled that the taxpayer must have "substantial nexus" with the taxing state in order for the state to impose its tax on the taxpayer.

Why It's Important: This Supreme Court ruling is significant because many states are passing legislation that contradicts the Quill ruling that a company must have substantial nexus before being required to file. It provides a real dilemma for taxpayers when a state's legislature

passes a law that provides a bright line threshold for nexus creation. For example, several states have enacted statutes that state that if a seller has a specific dollar amount of sales into the state, then nexus has been created and the company has a sales tax collection responsibility.

A state statute is void to the extent it conflicts with a federal statute or where the state law stands as an obstacle to the accomplishment and execution of the full

purposes and objectives of Congress. This principle has been applied where a state's attempt to tax activities is in conflict with federal legislation.

Once it is acknowledged, as we have concluded it must be, that |solicitation of orders' covers more than what is strictly essential to making requests for purchases, the next (and perhaps the only other) clear line is the one between those activities that are entirely ancillary to

requests for purchase--those that serve no independent business function apart from their connection to the soliciting of orders--and those activities that the company would have reason to engage in anyway but chooses to allocate to its in-state sales force. (Emphasis in original.)

>>>>>>>>Equal Protection Clause<<<<<<< • Similarly-situated taxpayers may not be taxed differently unless the state can show a rational basis and legitimate reason for the distinction.

• Classification between residents and nonresidents, resulting in discrimination of nonresidents, may be flatly rejected by the court.

>>>>>>>>>>>>Commerce Clause<<<<<<<<<<< • Commerce Clause provides that "Congress shall have the power to regulate Commerce with foreign Nations, and among the several states, and with the Indian tribes."

• Commerce Clause prohibits states from enacting laws that discriminate against or interfere with interstate commerce.

Constitutional Restrictions

• Due Process Clause • Commerce Clause • Supremacy Clause • Equal Protection Clause • Privileges and Immunities Clause • Import-Export Clause • First Amendment

>>>>>>>Commerce Clause<<<<<< • Discriminatory tax scheme must be invalidated unless state can show that it advances a legitimate local purpose.

• In addition discriminatory tax scheme cannot be adequately served by reasonable nondiscriminatory alternatives or the tax is a compensatory tax.

>>>>>>>Commerce Clause<<<<<<< • Discriminatory tax scheme must be invalidated unless state can show that it advances a legitimate local purpose.

• In addition discriminatory tax scheme cannot be adequately served by reasonable nondiscriminatory alternatives or the tax is a compensatory tax.

Equal Protection Clause • Equal Protection Clause provides that "No State shall...deny to any person within its jurisdiction the equal protection of the laws."

• Most state constitutions also include equal protection or uniformity provisions that may further limit a state's power to tax (i.e., Ohio).

>>>>>>Due Process Clause<<<<<< • Due Process Clause requires a "minimal connection" between interstate activities and taxing state.

• Nexus and Fair Apportionment components of Due Process distinguished.

>>>>>>>>>>First Amendment<<<<<<<<<< • First Amendment provides that "Congress shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof; or abridging the freedom of speech, or of the press."

• Several state tax cases have been decided under the First Amendment.

>>>>>>>>>Supremacy Clause<<<<<<<< • Supremacy Clause dictates that the "Constitution, and the Laws of the United State...shall be the Supreme Law of the Land."

• Statute is void: - to the extent it conflicts with a federal statute, or - stands as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress.

The Supreme Court ruled in favor of Mississippi. The ruling issued that Complete Auto established a "four-prong" test for constitutionality of a tax under the Commerce Clause:

• Substantial nexus - connection between a state and a potential taxpayer clear enough to impose a tax. • Nondiscrimination - interstate and intrastate taxes should not favor one over the other.

>>>>>>>>Due Process Clause<<<<<<<< • 14th Amendment prohibits a state from depriving any person of life, liberty, or property, without due process of law.

• Taxation regarded as deprivation of a person's property.