Income Tax Nexus in a Digital World

We have written extensively in this blog about nexus for sales tax and gross receipts tax purposes.  All but a few states have an income tax.  In addition to the Due Process Clause and Commerce Clause standards of nexus, out-of-state companies are protected from income tax of other states by a federal statute, Public Law 86-272, which is found at 15 U.S.C. § 381.  P.L. 86-272 provides an exemption only for state income tax and sets forth a fairly clear, but somewhat limited, standard for the exemption.

The exemption applies if a company’s activities in another state include only the solicitation of sales of tangible personal property by an employee, representative, or independent contractor for delivery of inventory located outside the state to residents of the state, if orders are accepted outside the state.  The exemption also extends to maintenance by an independent contractor of an office in the state.  Thus, while solicitation activities of an out-of state company in a state would create nexus under the Commerce Clause and Due Process Clause standards, if the solicitation is limited to the sale of tangible personal property and, subject to the other limitations in the underscored portions above, the company would be exempt from the state’s income tax.

There have been a number of cases defining solicitation (See, e.g., Wisconsin Department of Revenue v. William Wrigley, Jr., 112 S.Ct. 2447 (1992)). And the MTC has issued guidelines, which many states have adopted, defining protected and unprotected activities under P.L. 86-272.  See Statement of Information Concerning Practices of Multistate Tax Commission and Signatory States under Public Law 86-272 (Multistate Tax Commission, Third Revision adopted July 27, 2001).

The cases and guidelines make it clear that if a company solicits the sale of services as well as tangible personal property, the exemption of P.L. 86-272 does not apply. See, e.g., Amway Corp., v. Director of Revenue, 794 S.W.2d 666 (Mo. 1990).  Thus, a pertinent issue under P.L. 86-272 is whether the items being sold by an out-of-state company constitute tangible personal property or services.

Public Law 86-272 does not define the term “tangible personal property.”  Recently, the New Jersey Tax Court helped clarify that standard with regard to software.  See Accuzip, Inc. v. Director, Division of Taxation, 25 N.J. Tax 158 (2009).  In Accuzip, the New Jersey Tax Court determined that prewritten computer software constitutes tangible personal property based upon the sales and use tax law’s definition of tangible personal property and U.S. Treasury Regulations regarding the transfer of software.

In the digital world, resort to sales and use tax law or federal tax law may be helpful to taxpayers in determining whether the products they sell are tangible personal property.  For instance, in several states digital music and digital books are deemed tangible personal property subject to the sales tax.  In those states, taxpayers will argue that they are protected by the federal statute by citing the sales tax law and the New Jersey Tax Court’s decision in Accuzip.