Software as a Service: Is it a Nontaxable Service?

Many non-state and local tax experts mistakenly believe that subscription charges for Software as a Service ("SaaS"), are not taxable because SaaS is the provision of services. However, there are many states that treat SaaS as taxable. See, e.g., New York TSB-A-11(17)S (June 1, 2011). Fortunately, the majority of states do not tax SaaS. Recently, the Georgia Department of Revenue published an opinion that the provision of SaaS is not taxable, because it does not include the transfer the personal property on a physical medium. See Georgia Letter Ruling SUT No. 2014-02-20-01. Thus, while pre-written software is generally taxable as tangible personal property in Georgia, the Georgia Department of Revenue requires that the transfer take place on a physical medium, such as a diskette or CD, in order to be taxable. Several other states have adopted a similar analysis. The mistake, however, is to believe that such a position is universal among the states. It is not.

Did Wyoming Just Become an Internet Affiliate Nexus State?

We have written often about state Internet “click through” nexus laws, including the New York affiliate nexus statute unsuccessfully challenged by Amazon.com and Overstock.com, and the Illinois Internet affiliate nexus law stuck down by the Illinois Supreme Court in response to a suit brought by the Performance Marketing Association (for which Brann & Isaacson served as counsel). In most states, meaningful risk of Internet affiliate nexus for an out-of-state seller arises only after the legislature adopts a statute that, like New York’s law, creates a rebuttable presumption of “click through” nexus. In our view, even such a rebuttable presumption suffers from serious constitutional failings. Thus, an even more aggressive position, such as asserting that an Internet affiliate relationship, by itself, can create nexus for an out-of-state vendor without providing any opportunity to rebut the presumption, is plainly at odds with the Constitution.

On April 3, 2014, the Wyoming Supreme Court waded into the “click through” nexus arena and raised the possibility that, under Wyoming case law, the mere existence of an Internet affiliate relationship with an in-state website may be deemed sufficient to create nexus for an out-of-state retailer. See Travelocity.com et al. v. Wyoming Department of Revenue, 2014 WY 43 (Apr. 3, 2014). The case is one in an extensive series of cases around the country involving challenges to state tax assessments brought by online travel companies. At issue typically in these cases is the question of whether online travel companies (“OTCs”) are subject to a state sales/use tax collection obligation on the portion of their charge to consumers that is not paid to the hotel that provides the room (as to which tax is often collected by the OTC, paid to the hotel, and remitted remitted to the state). The OTCs have argued that the portion of the charge not paid to the hotel is a service fee collected by the OTCs, not a part of the charge to the consumer for the room.

The OTC cases raise numerous issues under both state sales and use tax law and federal constitutional principles, including substantial nexus. Since nexus requires a sufficient connection between the state and both the seller and the activity/transaction being taxed, see Complete Auto Transit Inc. v. Brady, 430 U.S. 274, 279 (1977), the OTCs have argued that nexus is lacking with regard to the transaction in question, since their sales occur on servers located outside the state in which the room is provided. In other words, the OTCs assert that the state lacks nexus with the activity being taxed, regardless of whether there is sufficient nexus with the OTCs themselves as sellers.

State Sales Tax Enforcement After the Supreme Court’s Denial of Cert in Amazon/Overstock

As we have discussed in prior posts, Amazon and Overstock.com filed petitions for certiorari with the U.S. Supreme Court seeking review of the New York Court of Appeals decision that the New York affiliate click-through nexus statute, on its face, did not violate the Commerce Clause. Late last year, the U.S. Supreme Court denied the petitions and, therefore, the New York Court of Appeals’ decision stands.

While the denial of cert means that the New York statute is constitutional on its face, it is not an indication that the U.S. Supreme Court agrees with the New York Court of Appeals’ decision or that the Court has blessed affiliate click-through nexus laws. It simply signifies that the issues presented in that case did not warrant review. Less than 5% of all petitions for certiorari are granted.

States, however, have taken the denial of cert as a prompt to propose affiliate click-through nexus laws. Thus, representatives have introduced bills in the legislatures of four states—Hawaii, Indiana, Tennessee, and South Carolina—that are modeled after the New York statute. There are some variations among this proposed legislation, but in general each provides for a presumption of nexus if the remote seller pays commissions to a person (the affiliate) who resides in the state for referrals by a website link or otherwise, if the retailer’s sales in the state from such referrals exceed $10,000. The bills would also permit the retailer to overcome the presumption by showing that the affiliate does not otherwise solicit sales on behalf of the retailer or otherwise make a market in the state. The New York Court of Appeals in the Amazon/Overstock cases stated that the presumption was rebuttable, so that the retailer could prove that the affiliate did not engage in solicitation activities on behalf of the retailer in New York. The rebuttable presumption saved the constitutionality of the statute.

Supreme Court Denies Petitions for Cert of Amazon and Overstock

As we recently wrote, last spring New York State’s highest court, the Court of Appeals, issued a decision upholding the state’s Internet affiliate nexus law after a challenge made by Overstock.com and Amazon.com. The Court of Appeals found that the law, which creates a rebuttable presumption of nexus for out-of-state vendors who employ in-state affiliates, satisfies substantial nexus requirements and does not violate the Due Process clause.

In September, Overstock.com and Amazon.com sought review of the decision of the Court of Appeals by filing petitions for certiorari with the United States Supreme Court. After extensive briefing by the petitioners, the State of New York, and many amicus curiae, on December 2, the Supreme Court denied the petitions for cert. (See the cases’ status here and here.)

This ends the petitioner’s facial constitutional challenge to the New York affiliate nexus law as Overstock.com and Amazon.com have now exhausted their appellate options. The decision by the Supreme Court not to hear the case, however, does not mean that every state’s affiliate nexus law is valid and enforceable. For instance, the Illinois Supreme Court held in October that Illinois’s Internet affiliate nexus statute was preempted by the Federal Internet Tax Freedom Act. The Supreme Court’s decision Monday has no impact on the now unenforceable Illinois law.

Amicus Briefs Filed in Amazon.com and Overstock.com Supreme Court Case

On September 23, 2013, several organizations and companies filed briefs as amici curiae in support of the petitions for a writ of certiorari filed by Overstock.Com, Inc., Amazon.com., Inc., and Amazon Services, LLC, requesting review by the United States Supreme Court of the New York Court of Appeals decision in Overstock.com, Inc. v. New York Department of Taxation and Finance, 20 N.Y.3d 586, 987 N.E.2d 621 (2013). Among the briefs filed was the Brief of Newegg, Inc. and the Direct Marketing Association, Inc. (the "DMA") as Amici Curiae in Support of the Petitioners. In their brief, Newegg and the DMA argue that the New York “click through affiliate nexus” statute, N.Y. Tax Law sec. 1101(b)(8)(vi), through an improper legislative presumption, narrows the zone of protected interstate advertising activity for out-of-state retailers under the Commerce Clause by shifting onto the retailers the burden of disproving “substantial nexus” with the state, in violation of the due process rights of retailers. Newegg and the DMA argue that the Constitution’s Due Process Clause prohibits states from using presumptions to interfere with matters that are removed from their authority by the Constitution, such as the regulation of interstate commerce. Brann & Isaacson partners Martin I. Eisenstein, George S. Isaacson, and Matthew P. Schaefer prepared the brief of amici on behalf of Newegg and the DMA.

Among the other organizations filing briefs were the Tax Foundation and the National Taxpayers Union, the American Legislative Exchange Council, the American Association of Attorney-Certified Public Accountants, and Scrapbook.com, Assisted Living Store, Inc., et al.

Amazon.com and Overstock.com Petition U.S. Supreme Court over New York Affiliate Nexus Law

We’ve written frequently about developments in Amazon.com and Overstock.com’s challenges to the New York State affiliate nexus law (a law which has inspired similar laws in many other states). Last spring, the New York Court of Appeals, the State’s highest court, upheld the law, stating that, in regards to the parties’ Commerce Clause claims, the “statute plainly satisfies the substantial nexus requirement. Active, in-state solicitation that produces a significant amount of revenue qualifies as ‘demonstrably more than a ‘slightest presence’’” under the Tax Appeals Tribunal’s 1995 ruling in the Orvis case. The Court continued by saying that “The bottom line is that if a vendor is paying New York residents to actively solicit business in this State, there is no reason why that vendor should not shoulder the appropriate tax burden.” The Court rejected the parties’ due process claims, as well.

Late last month, both Amazon.com and Overstock.com took their challenge to the United States Supreme Court, each filing a petition for a writ of certiorari, seeking review of the New York affiliate nexus law and of the New York Court of Appeals Decision (see status of the petitions here and here). New York has until October 23 to file a response in each case. However, as the Supreme Court’s review is discretionary, it is unclear whether the matter will be actually be heard by or decided by the Supreme Court. If not, the New York decision will stand, and other states’ versions of the affiliate nexus law will not be impacted. Meanwhile, the Marketplace Fairness Act, which could, in theory, make challenges such as these moot, remains in committee in the House of Representatives.

We will continue to track developments and keep our readers posted.

Despite Prior Veto, Missouri Governor Signs Click-Through Internet Affiliate Nexus Provision into Law

As we reported last month, on June 5, Missouri Governor Jay Nixon vetoed a bill that included an Internet affiliate nexus provision. What a difference a month makes. On July 5, Governor Nixon signed a different bill, S.B. 23, that amends Missouri’s definition of “engages in business activities in this state” under Mo. Stat. § 144.605(2) to add a presumption of nexus for retailers with “click-through” online advertising agreements with residents of the state. Under the Missouri statute, “a vendor shall be presumed to engage in business activities within this state if the vendor enters in an agreement with one or more residents of this state under which the resident, for a commission or other consideration, directly or indirectly refers potential customers” to the vendor by an Internet link or otherwise, so long as the vendor realizes at least $10,000 in sales from such referrals. The presumption may be rebutted by submitting proof that the affiliates were not engaged in activities that were significantly associated with the retailer’s ability to make or maintain a market for sales in the state. In particular, such proof may consist of “sworn written statements from all of the residents with whom the vendor has an agreement stating that they did not engage in any solicitation in the state on behalf of the vendor during the preceding year.” See Mo. Stat. 144.605(e), (f).

The Missouri statute continues a disturbing trend among state “click-through” Internet affiliate nexus laws under which a presumption of nexus is created regardless of whether the compensation paid to the in-state affiliate is based on sales completed by the retailer. Statutes recently enacted in Kansas, Maine, and Minnesota contain similar language, as do statutes already on the books in Arkansas, North Carolina, Rhode Island, and Vermont (although Vermont’s statute is not yet in effect). By the plain terms of such statutes, a passive “pay-per-click” advertising arrangement would be sufficient to create a presumption of nexus. Such a presumption is inconsistent with the reasoning of the New York Court of Appeals’ decision upholding the New York affiliate nexus law. See Overstock.com, Inc. v. Department of Taxation and Finance, 20 N.Y.3d 586 (2013). In Overstock, the Court emphasized that “no one disputes that a substantial nexus would be lacking if [in-state] residents were merely engaged to post passive advertisements on their websites.” 20 N.Y.3d at 596. These several states’ affiliate nexus statutes are at odds, on their face, with this fundamental principle.

Kansas Enacts Internet Affiliate Nexus Law

On April 16, 2013, Kansas Governor Sam Brownback signed SB 83, which includes a provision patterned after the New York Internet affiliate nexus law recently upheld by the New York Court of Appeals in Overstock.com v. New York Department of Taxation and Finance. The law amends the definition of “retailer doing business in the state” in K.S. § 79-3702(h)(1) to create a presumption of nexus if a retailer enters into an agreement with one or more Kansas residents under which the resident, for a commission or other consideration, refers customers to the retailer “by a link or an Internet website, by telemarketing, by an in-person oral presentation, or otherwise.” The presumption will apply so long as the cumulative gross receipts of the retailer for sales to Kansas customers purchasing through such referrals is at least $10,000 in the preceding 12 months. The presumption may be rebutted by a retailer submitting proof that the affiliates did not engage in activity that is significantly associated with the retailer’s ability to make and maintain a market in the state. Such a rebuttal “may consist” of sworn statements obtained from all affiliates that they did not solicit sales in the state on behalf of the retailer. The law takes effect 90 days after enactment, or on July 15, 2013. Ecommerce vendors should evaluate their Kansas affiliate relationships to determine how to respond to the law.

February 2013: An Eventful Month In The Debate Regarding Use Tax Collection By Internet Retailers

If it seems like there has been a lull in the debate regarding whether ecommerce vendors should be required to collect sales and use tax, this month has seen a series of developments that demonstrate the conflict continues apace.

On February 6, 2013, New York’s highest court heard oral arguments by attorneys for Amazon.com, Overstock.com, and the state Department of Taxation and Finance in the Internet retailers’ respective constitutional challenges to the New York affiliate nexus law enacted in 2008. (The cases are captioned Amazon.com v. New York State Department of Taxation and Finance, Court of Appeals Case No.APL-2012-00045, and Overstock.com v. New York State Department of Taxation and Finance, Court of Appeals Case No. APL-2012-0001.)  Recall that, under the New York law, an out-of-state retailer is presumed to be soliciting sales through representatives in the state if it enters into a contract with a New York resident for the placement of a link on the resident’s website that refers internet users to the out-of-state retailer’s website, pays the New York resident compensation based on sales to customers completed through the link, and makes a minimum $10,000 in such sales to New York customers.  See N.Y.Tax Law § 1101(b)(8)(vi).  A retailer with an in-state representative that solicits sales is required under New York law to collect and remit use tax on sales to New York customers.  The state prevailed before the trial court and intermediate appellate court finding that the law was not unconstitutional on its face.  According to reports, the Justices on the Court of Appeals appeared somewhat receptive to Amazon’s arguments that (1) the law violates the Due Process Clause because the presumption cannot be effectively rebutted and (2) the law violates the Quill “physical presence” standard of nexus.  That said, the state has the advantage of having prevailed below.  Decisions by a state high court are usually issued several months after argument, and we will continue to monitor the case.

Traps for the Unwary: Taxation of Digital Products

Recently, I presented at a webinar hosted by Strafford Publishing on the subject of sales and use tax on digital products and services.  It almost goes without saying that the interstate sale of digital products—whether books or software—is complicated, if for no other reason than it requires analyzing the sales and use tax consequences of such transactions based upon forty-five states’ (and the District of Columbia’s) sales tax laws, which were adopted long before the advent of the digital age.  For example, the starting point for sales tax analysis in most states is whether the transaction involves the sale of “tangible personal property.”  Is a digital product such as a digital book that is downloaded by the customer tangible personal property?

The states do not provide for uniform treatment of the taxability of digital products from state to state, nor are all digital products taxed similarly within a given state.  Colorado, for example, taxes digital books and music, but does not tax digital software.  Twenty-five states tax digital books, music and videos, while thirty states tax prewritten software.

What makes analysis in this field even trickier are the different methods of delivery of digital products and the various pricing plans under which such products are sold.  For example,  under one delivery method, the seller provides the buyer an electronic access code to permit the buyer to download the digital product at the buyer’s convenience.  For a sale such as this, in addition to analyzing whether the underlying product is taxable, the seller must also determine whether the sale of the access code is taxable at the time of such sale.  The SSUTA, of which there are 24 member states, treats the sale of a “digital code” that entitles the purchaser to download a taxable digital product as a taxable transaction.  See Section 332(G).  But not every state, of course, is a member of the SSUTA and non-member states do not always follow this principle.  For instance, the non-member states of Texas, New York, and Illinois treat the sale of such access codes as tantamount to selling a gift card.  These states treat the sale of a gift card or access code as the sale of an intangible.  It is only when the gift card is redeemed that a taxable sale of tangible personal property has occurred.  See, for example, Ill. General Information Letter ST 10-0052-GIL (June 4, 2010).

Florida Introduces Affiliate Nexus Legislation

For the sixth year in a row, Florida legislators introduced a bill that (like many states before it) would create a rebuttable presumption that any out-of-state Internet retailer or mail order seller which enters into an agreement with a Florida resident (an “affiliate”) for paid referrals is subject to the State’s sales and use tax.  Referrals which subject out-of-state sellers to Florida tax are broadly defined and can be via “a link on an Internet website, an in-person oral presentation, telemarketing, or otherwise.”  Out-of-state sellers who have cumulative gross receipts of $10,000 or less from the referrals would not be subject to Florida tax.  As in several other states, the bill would allow sellers to rebut the presumption that they are subject to tax by submitting evidence that the affiliates “did not engage in any activity within [Florida] which was significantly associated with the dealer’s ability to establish or maintain the dealer’s market…during the 12 months immediately before the rebuttable presumption arose.”

As we have written previously, in response to a challenge by Amazon.com to a similar law enacted in 2008 in New York, a New York State appeals court held that the law was not unconstitutional on its face because it allows a retailer to rebut the presumption of solicitation.  The court remanded the case to the lower court to determine whether the law violated the Constitution’s Commerce and Due Process Clauses as applied to Amazon.com.  In the meantime, as similar affiliate nexus laws have been passed in a handful of other states, many retailers have terminated their affiliate relationships.  Also, last spring, in a case argued by George Isaacson and Matt Schaefer of Brann & Isaacson, an Illinois court found that Illinois’ affiliate nexus law, which does not allow an affected retailer to rebut the statute’s conclusive determination that having affiliates in the state creates nexus, violates the Commerce Clause as well as the Internet Tax Freedom Act.

Tennessee Ruling Provides Another Wrinkle for Cloud Computing Services

A recent ruling by the Tennessee Department of Revenue (Ruling #12-11) illustrates some of the anomalies and pitfalls in properly taxing cloud computing services. The request for ruling concerned a service that provided Tennessee users access to software maintained on remote servers located outside of Tennessee. This is otherwise known as an SaaS service. In addition, the charge for the service permitted users access to certain databases, including certain reference materials such as dictionaries and encyclopedias. It would appear that the users did not download the references to their computers.

One of the anomalies in the ruling is that the Department stated that the SaaS portion of the service was not taxable, but access to the databases was taxable because the Department deemed the access to include the right to license and use digital books. As of January 1, 2009, the right to license and use digital books is taxable pursuant to an amendment to the Tennessee sales and use tax statute adopting the Streamlined Sales and Use Tax Agreement (“SSUTA”).

The Department’s basis for this distinction in taxability appears to be that access to software is not taxable because “title, possession, and control” of the software always resides outside of Tennessee. On the other hand, the taxability of digital books is predicated on the following underscored clause from Tenn. Code Ann § 67-6-233(a), which provides for the taxation of digital books when there has been the “retail sale, lease, licensing, or use of specified digital products transferred to or accessed by subscribers or consumers in this state.” (emphasis added). Section 67-6-231(a), providing for the taxation of software, includes only “software transferred by tangible storage media or delivered electronically,” but does not include access to the software. The difference between the two statutory provisions is subtle. On the one hand, digital books are taxable if the consumer in Tennessee has “access” to the books, without being required to download them. On the other hand, computer software is not taxable, even if the consumer has access to the software, so long as the consumer does not download the software to his or her computer in Tennessee.

Borders’ Gift Card Holders Not Permitted Recovery in Bankruptcy

We’ve written about gift cards in this space in the past, and have covered escheat issues related to gift cards, as well. But, in a different wrinkle, last month, the Bankruptcy Court for the Southern District of New York addressed the impact of bankruptcy law on companies’ requirements to honor gift cards.

By way of background, in February 2011, Borders filed a voluntary petition for relief under chapter 11 of the Bankruptcy Code. In general, retailers are not obligated to honor gift cards in bankruptcy, despite any state requirements that gift cards be honored for a certain period of time. Instead, gift card holders are generally treated like all other creditors and are required to timely file proofs of claim prior to a bar date set by the court in order to receive the value (or a portion of the value) of the gift cards. Note though, that in California, at least, retailers in bankruptcy may be required to honor gift cards.

But, via a motion filed with the Bankruptcy Court, Borders indicated that it planned to honor gift cards issued prior to the petition date. That is, customers could continue to use Borders gift cards in Borders stores and on its website. Later, following the September 2011 liquidation of Borders’ retail stores and the end of its e-commerce operations, Borders no longer honored its gift cards since it no longer had any retail channels through which it could do so. In January 2012, after confirmation of the bankruptcy plan, several holders of gift cards who had not yet redeemed the cards filed a motion seeking to allow late proofs of claim so that they could recoup the value of their unused gift cards. They argued that because of data systems Borders had in place, Borders should have been required to provide each gift card holder actual, individual notice of the bar date to file claims, rather than the general notice provided via publication in the New York Times. Since they did not receive adequate notice, they argued, their failure to file proofs of claim was due to excusable neglect and late claims should have been permitted.

Are You Minding The Store? Executives Held Personally Liable For Unreported Sales Tax

Two recent decisions provide an important reminder for executives and tax managers of Internet retailers and remote sellers: Make sure that you: (1) understand your company’s sales and use tax obligations; (2) have a defensible position on state tax issues; and (3) pay attention to notices from state revenue departments, including those that come from outside your home state ― or you could find yourself subject to personal liability for unreported sales and use tax.

Most states’ tax laws deem sales/use taxes collected by a company to be held in trust for the state, and allow the state to impose personal liability upon responsible corporate officers for the failure to report and remit such “trust fund” taxes. Some state statutes go farther and impose liability on corporate officers for unreported tax.

In a New York State Tax Tribunal Decision (DTA No. 822971) issued on February 23, 2012, the CEO of a publicly-traded, online vendor of wireless phone devices and accessories was determined to be personally liable for unpaid sales tax, largely with respect to shipping and handling fees charged by his company on sales to consumers. The CEO argued that he could not be held personally liable because, among other things: (1) the company had a tax department that handled such matters, on which he relied, and that reported to the company’s CFO; (2) the company further relied upon outside accountants and auditors to ensure tax compliance; (3) the size of the company and number of transactions involved made monitoring them impossible for the company’s chief executive; and (4) the CEO did not sign the company’s sale tax returns. The Tax Tribunal rejected all of the CEO’s arguments, holding that he was a responsible officer with the power to exercise oversight over all functions related to sales tax compliance, and could not avoid liability by arguing that he relied upon others – even a full tax department and outside tax professionals – to ensure the company’s compliance.

In Eberhardt v. Michigan Department of Treasury, Michigan Court of Appeals No. 299532 (March 8, 2012), the Court upheld the imposition of personal liability against the sole shareholder and responsible corporate officer of an Indiana retailer of spas and related supplies, for unreported tax on sales to Michigan residents. The Department had previously issued an assessment for unpaid sales/use tax to company, which failed to respond. The Department subsequently assessed the shareholder for the amounts not paid by the company on the theory that he was personally liable as a responsible corporate officer. The appellant responded by arguing that the State of Michigan lacked jurisdiction to issue the earlier assessment to the company. The Michigan Tax Tribunal upheld the assessment, and the Court of Appeals affirmed. The Court found that the corporate officer was barred by the company’s failure to respond to the original sales tax assessment to raise the issue of lack of jurisdiction over the company as a defense. The Court therefore affirmed the imposition of liability of over $225,000 against the appellant.

These recent decisions should be a wake-up call for all corporate officers and tax managers – whether they work in a sole proprietorship, small private company, or even in a large, publicly traded company – to be certain that the they are confident the company’s state sales/use tax affairs are being handled appropriately, and tax counsel consulted where they have meaningful doubt or uncertainty regarding the company’s compliance. Failure to exercise proper oversight responsibility could mean the company’s tax liabilities become their own.

Tax Agencies Should Read the Language of the Statute and May Not Expand the Law’s Requirements

As some of our readers are aware, on June 28, 2011, California’s Governor Brown signed into law a bill (ABX1 28) that provides for “click-through nexus” under certain circumstances. This law is similar to “click-through nexus” legislation adopted in New York, Rhode Island, North Carolina, and Arkansas (which we have written about extensively in the past), inasmuch as it creates a rebuttal presumption of nexus if a company’s annual sales to California exceed $500,000 and if the company’s California sales exceed $10,000 from links or other referrals from companies (“affiliates”) who receive a commission from such referrals.

Unlike the Illinois and Connecticut statutes, which automatically create nexus in the event that sales from affiliates exceed the threshold, the California law provides that the retailer can rebut the determination of nexus based on affiliate relationships. Nevertheless, in a recent notice issued by the California Board of Equalization (Notice L-284, issued July 2011), the Board states that there are only two conditions to a finding that a retailer must be registered for sales and use tax collection: (1) that sales from affiliates exceeded $10,000 in the last 12 months; and (2) that the retailer’s total sales to California exceed $500,000 in the last 12 months. According to the Board, if a business meets the foregoing requirements and is not already registered with the Board, it must complete a “California Certificate of Registration—Use Tax.”

Connecticut Amends Its Affiliate Nexus Law To Mirror Illinois

We have written frequently in recent months about affiliate nexus legislation introduced this legislative session in a number of states, and enacted recently in Illinois, Arkansas, Connecticut and, on a deferred basis (to take effect only after 15 states have adopted similar legislation) Vermont. (A similar bill has been passed in California, but has not yet been signed by Governor Brown.) Nearly every such bill has closely paralleled the affiliate nexus law adopted in New York in 2008, which provides for a presumption of nexus that can be rebutted by a retailer if the retailer can establish that its in-state affiliates have not engaged in any active solicitation in the state, but have merely posted online advertisements on behalf of the retailer that link to the retailer’s website. Illinois was the only state to adopt a law without such a rebuttable presumption.

The Connecticut legislature has now amended the affiliate nexus statute it passed in May 2011, to eliminate the rebuttable presumption and, instead, to closely mirror the Illinois law. Connecticut HB 6652, signed by Governor Malloy on June 21, repeals the affiliate nexus statute adopted in May, and instead modifies the definition of “retailer” (as well as the definition of “engaged in business in the state”) to classify as a Connecticut retailer any company that has affiliate relationships with persons in Connecticut pursuant to which the affiliates refer customers to the retailer in return for commissions or other consideration based on sales, via an online link or otherwise. The retailer must realize cumulative gross receipts of at least $2,000 on sales to Connecticut customers as a result of such referrals in order to be “engaged in business in the state.” In addition, HB 6652 makes the change in the definitions of “retailer” and “engaged in business” retroactive to May 4, 2011 – prior to the date on which the previously enacted affiliate nexus law was even adopted.

It warrants mention that the Connecticut legislature amended its affiliate nexus statute after the Performance Marketing Association filed suit in federal court in Chicago challenging the constitutionality of the Illinois law. Brann & Isaacson represents the PMA in that action.

Another State Adopts Nexus Click Through Legislation

Following the model of New York, Rhode Island, North Carolina and Arkansas laws, Connecticut recently adopted click-through nexus legislation that is effective on July 1, 2011. The new law states that any retailer that has an agreement with a Connecticut resident, under which the resident, for a commission or otherwise, refers potential customers (by a web site link or other contact) to the retailer, is presumed to have nexus with Connecticut if its sales as a result of such agreements in Connecticut exceed $2,000 for the preceding year. As is the case in the four states described above, the presumption can be rebutted by proof that the residents do not undertake in-state solicitation activities that would create nexus under the constitutional standard.

The Connecticut statute differs from the statutes enacted in New York and other states, in that the threshold for sales is a lower amount–$2,000 as opposed to $10,000 (or $5,000 in the case of Rhode Island). It also differs from the recently-enacted Illinois statute inasmuch as the Illinois statute does not permit a retailer to rebut a finding of nexus that is based upon a relationship with an affiliate located in Illinois that provides a link to a retailer’s Internet site that facilitates the sale of tangible personal property.

Additional States Introduce Affiliate-Nexus Legislation

On March 2, an Internet-affiliate nexus bill was introduced in the Arkansas State Senate (SB 738). Arkansas joins Arizona, California, Connecticut, Hawaii, Illinois, Massachusetts, Minnesota, Mississippi, New Mexico, Tennessee, Texas, and Vermont, as the thirteenth state this legislative season to consider such a measure. Nearly all of the bills -- with the exception of Illinois’s HB 3659, which was passed by the Illinois legislature and is now awaiting signature or veto by Governor Quinn, and Connecticut’s SB 5545 -- are patterned directly upon the New York affiliate nexus law enacted in 2008 and challenged in court, so far unsuccessfully, by Amazon.com. In other words, 11 of the 13 proposed laws create a rebuttable presumption that an out-of-state Internet retailer is obligated to collect and remit the state’s sales and use taxes if the retailer enters into an agreement with an in-state resident (an “affiliate”) pursuant to which the affiliate places a link from the affiliate’s website to the retailer’s site, and the retailer realizes at least $10,000 in sales to customers referred to it by the affiliate’s links. The presumption can be negated by proof that the in-state affiliates did not engage in any in-state solicitation on behalf of the retailer.

In its November 2010 ruling, the Appellate Division of the New York Supreme Court found that the ability of a retailer to rebut the presumption of solicitation was an important factor in determining that the New York law is not unconstitutional on its face. The Court, however, remanded the case for further proceedings on the issue of whether the law violates the Commerce Clause and Due Process Clause as applied to specifically to Amazon. As the ongoing proceedings in the New York case make clear, the constitutionality of such “New York-style” affiliate-nexus legislation is far from resolved.

At the same time, it is worth noting that the Illinois and Connecticut bills differ from the New York law in that neither bill provides that the presumption that a retailer must collect sales and use tax as a result of having in-state Internet affiliates may be rebutted. Imposing an irrebuttable presumption of nexus is highly suspect under both the Commerce Clause and Due Process Clause. Without a rebuttable presumption in place to protect retailers, Illinois and Connecticut would subject Internet retailers to burdensome state tax collection obligations when the retailers are effectively doing nothing more than advertising. For that reason, the progress of each of these bills bears watching. Stay tuned.

A Reminder About The State Tax Implications of Passive Partnership Interests: U.S. Supreme Court Declines To Review State Court Ruling That Mere Partnership Interest Creates Income Tax Nexus

E-commerce companies that have affiliates doing business as (or even just investment interests in) partnerships or other pass-through entities in states in which the e-commerce company has no direct presence should be aware that such partnership interests may be deemed to create income tax nexus for the company.  A number of state laws and regulations provide that ownership in a pass-through entity establishes nexus for the owner.  See, e.g., 34 TAC Sec. 3.586(c)(13) [Texas]; 830 CMR 63.39.1(8) [Massachusetts]. To date, state tax tribunals have agreed. See, e.g., Shell Gas Gathering Corp. #2, N.Y. Tax Appeals Tribunal, DTA Nos. 821569 and 921570 (Sept. 23, 2010).

Distribution of Promotional Materials in Indiana is Not Taxable

In D.H. Holmes Company, Ltd. v. McNamara, 486 U.S. 24 (1988), the U.S. Supreme Court held that a state did not violate the Commerce Clause when it imposed a use tax on the distribution of catalogs and other promotional materials mailed from outside of the state since the company on whose behalf the catalogs were distributed had nexus with the state. Prior to that date, there were some state courts and tax commentators which had declared that a destination state’s imposition of tax on catalogs printed and mailed from outside of the state to residents of the state violated the Commerce Clause.

As a result of the D.H. Holmes decision, a large number of states have imposed a use tax on promotional materials distributed in their state on behalf of a company with nexus in the state (e.g. Arizona, Colorado, Connecticut, Florida, Georgia, and Tennessee).  There have been some exceptions to this rule (See e.g., Michigan (Sharper Image Corp. v. Department of Treasury, 550 N.W.2d 596 (1996)), New York, Ohio, California, and Pennsylvania).

Recently, the Indiana Tax Court ruled in the case of AOL, LLC v. Indiana Department of State Revenue that the distribution of CD ROMs and other marketing materials on behalf of AOL by AOL’s printer and assembly house was not taxable. The basis for the decision was that AOL had supplied the components—the CD ROM discs, paper, and other components of CD ROM packages—to the assembly house and printer. Thus, the assembly house and printer were merely providing a service, and not selling tangible personal property. Under the Indiana statute, the provision of services is not taxable. It is only the sale of tangible personal property that is taxable. Nor were the components themselves taxable because only the final CD ROM package and printed materials were distributed in Indiana. The components were transformed by the assembly houses and printers into final products.

This decision is in line with prior decisions of the Indiana Tax Court, including Ameritech Publ’g, Inc. v. Ind. Dep’t of State Revenue, 916 N.E.2d 752 (Ind. Tax Ct. 2009) and Morton Bldgs., Inc. v. Ind. Dep’t of State Revenue, 819 N.E.2d 913 (Ind. Tax Ct. 2004).  Thus, any direct marketer which has been distributing promotional materials in Indiana and paying use tax on those promotional materials should consider filing a claim for refund for taxes paid if the direct marketer supplied the underlying raw materials to the printer or other party assembling the promotional materials.