NEXUS: Quill Physical Presence Test Should Apply to Gross Receipts Taxes

Since National Bellas Hess, Inc. v. Illinois Department of Revenue, 386 U.S. 753 (1967), was decided in 1967, states have attempted to avoid the physical presence test of nexus that the National Bellas Hess case established.  Thus, in the 1980’s, the Pennsylvania Department of Revenue argued that that our client, L. L. Bean, Inc., was required to collect Pennsylvania sales and use tax on all of its sales into the state because the mail order industry had changed since National Bellas Hess was decided.  The Pennsylvania Commonwealth Court squarely rejected this challenge to National Bellas Hess.  L. L. Bean, Inc. v. Department of Revenue, 516 A.2d 820 (Pa. Cmwlth. 1986).

Similarly, the State of California threatened assessment of 300 direct marketers on the ground that they had nexus with California because of their use of 1-800 numbers and acceptance of credit cards.  On behalf of the Direct Marketing Association, Brann & Isaacson sued in federal court, and the Ninth Circuit issued a judgment in favor of the DMA, on behalf of its members, declaring that in the absence of a physical presence in a state, a company is not liable for sales and use tax in that state.  DMA v. Bennett, 916 F.2d 1451 (9th Cir. 1990), cert. denied, 500 U.S. 905 (1991).

The states’ next test case, Quill v. North Dakota, 504 U.S. 298 (1992) (Brann & Isaacson filed an amicus curiae brief on behalf of the DMA in Quill), was yet another unsuccessful effort by the states to overrule and/or limit the physical presence test.

The states’ latest efforts to limit the nexus test under the Commerce Clause by adoption of an economic presence test to measure nexus for gross receipts tax should also be rejected.

Michigan (in the Michigan Business Tax (“MBT”)), Ohio (in the Ohio Commercial Activity Tax (“CAT”), Texas (in the Texas Margin Tax), and Washington (most recently in the May 2010 amendments to its Business and Occupation Tax), however, have asserted that the Quill physical presence test does not apply to gross receipts taxes, but is limited to sales tax.  Citing a footnote in the Quill decision, these states argue for a different standard; namely that the mere economic presence of a taxpayer by sales into the state should create nexus.

The states fail to recognize, however, the U.S. Supreme Court’s decision in Commonwealth Edison Company, et al. v. State of Montana, 453 U.S. 609, 101 S.Ct. 2946 (1981), which applied a physical presence test to a gross receipts tax.  In that case, the Court addressed the standard to apply to a Montana severance tax on coal extracted from Montana mines, which was a gross receipts tax.  Although the Court upheld the constitutionality of the tax, the Court noted the physical presence standard for determining  nexus.  In particular, the Court cited National Bellas Hess as the standard for finding nexus.  The physical presence test of National Bellas Hess doctrine was confirmed in the Quill case in 1992.

The states’ argument also ignores the fair relation prong of the Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279 (1977) test.  The fair relation prong requires that there be a fair relation between a tax and the benefits conferred upon the taxpayer by the State.  Although the Court has not required a detailed accounting of the services the states provide in order to be able to tax, the taxpayer must be engaged in some activity in the state in order to be subject to tax.  Thus, in Oklahoma Tax Commission v. Jefferson Lines, Inc., 514 U.S. 175 (1995), the Court defined the fair relation prong as follows “Complete Auto’s fourth criterion asks only that the measure of the tax be reasonably related to the taxpayer’s presence or activities in the state.” (Id. at 200, citing Commonwealth Edison Company v. Montana as setting forth the applicable standard).  Clearly, if the taxpayer lacks any physical presence in the state, the fair relation prong of Complete Auto cannot be satisfied.

In short, Complete Auto, Commonwealth Edison Company, and Oklahoma Tax Commission provide one basis to resist a state’s gross receipts tax enforcement efforts against online companies and direct marketers that lack a physical presence in the state.