The emergence of factor presence nexus standards
INSIGHT ARTICLE |
In this era of electronic commerce and record state budget deficits, several states, in their efforts to increase tax revenues, have replaced traditional nexus standards with factor presence nexus standards to trigger taxes based upon gross receipts and income. The term nexus when used in connection with state taxation refers to the due process requirement that there must be some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax. Nexus is the contact that must be established with a taxing jurisdiction before it can impose a tax (Miller Bros. Co. v. Maryland, 347 U.S. 340, 74 S. Ct. 535 (1954)).
Statutory apportionment factors imposed by states are typically utilized to apportion income among states where the company has nexus. Apportionment of income is required to avoid double taxation by states. Typically, the company's in-state property, payroll, and sales, compared to its total property, payroll and sales, are factors utilized by states for apportionment of income. The methodologies vary among states. Under a factor presence nexus standard, a company's business activities or income will be subject to tax in a particular state if one of the company's apportionment factors (property, payroll or sales) exceeds the state's statutory threshold. Since Jan. 1, 2010, five states have instituted these nexus standards based on the company's level of sales, property or payroll. With this recent wave of new standards, it is likely other states will impose similar nexus standards as well.
The most controversial aspect of these new standards is that companies deriving revenue from sources within a state will be treated as having nexus with the state and, thus, will be subject to tax, even though they have no physical presence in the state. The August 2010 tax determination ruling by the Ohio Tax Commission in L.L. Bean v. Levin, discussed below, demonstrates the impact of these nexus standards on companies lacking a physical presence within a state. L.L. Bean's circumstances were such that the Interstate Tax Limitations Act, Public Law 86-272 (codified in 15 U.S.C. sections 381-384) did not apply. Public Law 86-272 provides that a state cannot impose a net income tax if a seller's only business activity within a state is the solicitation of orders for sales of tangible personal property. Since Ohio imposes a gross receipts tax and not an income-based tax, P.L. 86-272 was not available to L.L. Bean as an exemption to taxation.
Origin of factor presence nexus
In an effort to promote uniformity among states and create a bright-line nexus test for business activity taxes, the Multistate Tax Commission (MTC) adopted a model statute, Factor Presence Nexus Standard for Business Activity Taxes, on Oct. 17, 2002, which calls for nexus to be established if any of the following thresholds are exceeded during a tax period:
- $50,000 of property
- $50,000 of payroll
- $500,000 of sales
- 25 percent of total property, total payroll or total sales
The concept originated with Professor Charles McLure, Senior Fellow with the Hoover Institution at Stanford University, in his December 2000 National Tax Journal article, Implementing State Corporate Income Taxes in the Digital Age. Professor McLure reasoned that potential taxpayers should be found to have nexus with a state where they engage in significant amounts of activities that would create tax liabilities if that taxpayer were profitable. Under McLure's analysis, nexus rules and apportionment rules should be intimately related and not tied to the potential taxpayer's degree of physical presence in the state, especially in an age of increased electronic commerce. The factor presence nexus standard is also based upon the theory that a company's ability to exploit a market is a source of income and provides states with the entitlement to tax. Factor presence nexus standards are now effective in seven states.
Business activity taxes
- Ohio: Effective July 1, 2005, Ohio became the first state to impose a factor presence nexus standard, adopting the MTC's model thresholds for purposes of determining commercial activity tax (CAT) nexus.
- Washington: Effective June 1, 2010, Washington adopted a factor presence nexus standard for the business and occupation tax. Taxpayers engaged in "apportionable activities" are deemed to have substantial nexus if (1) property in Washington exceeds $50,000; (2) payroll in Washington exceeds $50,000; (3) Washington receipts exceed $250,000; or (4) at least 25 percent of the taxpayer's total property, payroll, or receipts are in Washington. The term "apportionable activities" is defined by the state to include several types of service activities. Taxpayers who engage in business activities that do not fall within the definition of "apportionable activities" must use a physical presence standard to determine nexus.
Additionally, for all Washington taxpayers subject to the Business and Occupation Tax, nexus exists and tax returns must be filed for as long as the taxpayer meets the nexus requirements, plus one year.
- Oklahoma: Effective Jan. 1, 2010, Oklahoma adopted the MTC's model factor presence nexus thresholds for the state's new business activity tax.
Michigan business tax
The Michigan business tax (MBT), which became effective Jan. 1, 2008, is a tax on modified gross receipts, as well as net income. Substantial nexus for MBT purposes occurs when (1) a taxpayer has physical presence in Michigan for more than one day, or (2) a taxpayer activity solicits sales in Michigan and has $350,000 or more of gross receipts attributable to Michigan.
Effective Jan. 1, 2012, Michigan has repealed the MBT and instituted a corporate income tax (CIT). Michigan maintains that substantial nexus for CIT purposes occurs when (1) a taxpayer has physical presence in Michigan for more than one day, or (2) a taxpayer actively solicits sales in Michigan and has $350,000 or more of gross receipts attributable to Michigan. The key difference is that because the CIT is an income-based tax, P.L. 86-272 protection is available to taxpayers.
- Connecticut: Effective Jan. 1, 2010, as part of the state's economic nexus standard, Connecticut imposed nexus upon any taxpayer with receipts from Connecticut-sourced business activities that exceed the bright-line test of $500,000.
- Colorado: Effective April 30, 2010, Colorado adopted the MTC's factor presence nexus thresholds for the state's income tax.
- California: Effective Jan. 1, 2011, California adopted the MTC's factor presence nexus thresholds for the state's income and franchise tax.
Questions of constitutionality
With Ohio as the first state to implement a factor presence nexus standard, it is not surprising that the first challenge to the constitutionality of these standards comes from Ohio as well. On Aug. 10, 2010, the Ohio Department of Taxation issued a final determination ruling (No. 0000000198) in L.L.Bean v. Levin that L.L. Bean, Inc. had nexus for CAT purposes. L.L. Bean sells various apparel and consumer goods through orders received via telephone, mail and the Internet. The company made sales to customers located in Ohio exceeding $500,000, but had no stores, employees or other physical presence in the state.
L.L. Bean argued the constitutionality of the tax, stating that it was in violation of the Commerce Clause of the U.S. Constitution since the company did not possess the bright-line physical presence in Ohio required by National Bellas Hess, Inc. v. Illinois Department of Revenue (386 US 753 (1967)), and Quill Corp. v. North Dakota (504 US 298 (1992)). In National Bellas Hess and as reaffirmed in Quill, the U.S. Supreme Court ruled that substantial nexus exists only if a corporation has physical presence in a state for sales and use tax purposes. The Supreme Court has not ruled on whether the physical presence requirement applied to taxes other than sales and use taxes. However, the highest courts in many states, including the Ohio Supreme Court in Couchot v. State Lottery Commission (74 Ohio St.3d 417 (1996)), have ruled that the physical presence requirement in Quill applies only to sales and use taxes. On the other hand, other states have held that the physical presence requirement applies to other taxes as well, not just sales and use tax.
The Ohio Department of Taxation does not have jurisdiction to rule on the issue of constitutionality and, thus, concluded that nexus was present since L.L. Bean had sales to customers in Ohio exceeding $500,000. On Oct. 8, 2010, L.L. Bean filed a Notice of Appeal to the Ohio Board of Tax Appeals. While the Ohio Board of Tax Appeals also does not have jurisdiction to rule on issue of constitutionality, as a matter of state procedure, L.L. Bean was not able to circumvent this step. The challenge would need to ultimately go before the Ohio Supreme Court or U.S. Supreme Court. Therefore, a significant amount of time is likely to pass before there is more certainty on this issue.
As factor presence nexus standards become codified in an increasing number of states, it is very likely that challenges to the constitutionality of these standards will be seen in other states as well. Ultimately, until the U.S. Supreme Court decides to rule on the issue, uncertainty will remain.
This article was first published in The Tax Adviser, June 2011, and updated April 5, 2012. Copyright AICPA. Reprinted with permission.