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U.S. Supreme Court to Review E-Commerce Use Tax Nexus Standard

Published: February 8th, 2018

Mark E. Holcomb

In a surprising move, the U.S. Supreme Court has agreed to revisit the physical presence nexus standard that states must abide before imposing use tax collection responsibilities on remote sellers – a benchmark first adopted by the Court some fifty years ago[1] and reaffirmed just over twenty-five years ago.[2]  The Court’s anticipated decision in South Dakota v. Wayfair, Inc.[3] has the potential to fundamentally alter the state tax landscape for remote sellers and their customers, equalize tax burdens for traditional brick-and-mortar businesses, and significantly boost state tax collections.  For added complexity, Congress may yet step in and take charge of setting these nexus rules, either before the Court’s decision or after.  Interested taxpayers should consult their tax advisors to determine the potential impact of this decision, which is expected by June 2018.

What’s at Stake 

Wayfair will determine whether remote sellers lacking a physical presence in a state may be required to collect and remit use tax on sales to customers in that state.  A state’s use tax complements its sales tax:  states that impose sales tax on in-state purchases also impose the equivalent use tax on out-of-state purchases that are shipped into the state.  The use tax is owed by the customer on out-of-state purchases, just as the customer owes sales tax on in-state purchases.  The question posed by National Bellas Hess, Quill, and now Wayfair, is whether the state may require a remote seller to collect and remit use tax from in-state customers, or whether the state is relegated to collecting that use tax directly from the in-state customers.

National Bellas Hess and Quill held that, under the Commerce Clause of the U.S. Constitution,[4] a remote seller that does not have a physical presence in a state cannot be required to collect and remit that state’s use tax on sales to in-state customers.  Rather, the customer is obligated to self-accrue and remit the use tax to the state.  States use various means to try and enforce that obligation on in-state customers but, by and large, there is a high rate of non-compliance (particularly for individuals).  States claim that they are losing “tens of billions of dollars” in annual revenue due to uncollected use taxes.  While e-commerce has grown dramatically over the past two decades,[5] some observers dispute that claim as hyperbole.

The Push Toward Economic Nexus

States have chafed under the physical presence standard.  There is no question that the use tax is due; the only question is whether the state can require remote sellers to collect and remit that tax, or whether the state must pursue each in-state purchaser for the tax.  Finding their enforcement efforts falling short, and simultaneously eyeing the explosive growth of (first) mail order sales and (later) e-commerce, states have long waged a concerted effort to challenge the physical presence standard.[6]

One product of that effort was South Dakota’s 2016 law, which disregarded the physical presence standard in favor of an economic nexus standard:  remote sellers with sales to South Dakota purchasers of at least $100,000 per year or 200 or more separate transactions are required to register and collect and remit the state’s use tax.  The law was intended to generate a court challenge to the physical presence standard that the U.S. Supreme Court might hear, and succeeded in that effort.[7]  Other states have enacted similar laws (with differing thresholds), or onerous reporting requirements that effectively compel remote sellers to collect and remit the use tax as a cheaper alternative than complying with the reporting scheme.

Congress Can Make the Rules

The Commerce Clause grants Congress the authority to regulate interstate commerce.  National Bellas Hess and Quill did not apply a physical presence rule adopted by Congress; rather, these cases were decided under a longstanding interpretation of the Commerce Clause known as the “dormant” or “negative” Commerce Clause.  That doctrine interprets the Commerce Clause to prohibit certain state infringements on interstate commerce, even in the absence of Congressional action.

The point is that Congress has the authority under the Commerce Clause to set the use tax nexus rules for interstate commerce, regardless of how the Court decides Wayfair.  Bills have been pending in Congress, sporadically before Quill and annually since, for Congress to make these rules.  In Quill, the Court invited Congress to act – acknowledging that, as the legislative branch of the federal government, Congress was better qualified to do so – but Congress (so far) has not.  Bills are currently pending in Congress that would achieve opposite ends:  some would affirm the physical presence rule in the name of ‘no taxation without representation,’ while others would allow states to impose use tax collection responsibilities on remote sellers.

An interesting dynamic of the Court’s decision to review Wayfair is whether Congress may now be motivated to act and exercise its Commerce Clause authority (either before the Court’s ruling or after).

What Might the New Use Tax Nexus Standard Be?

If, as many state tax commentators expect, the Court uses Wayfair to dispense with the physical presence rule, what standard would take its place?  Prior Court precedent requires something more than the “slightest presence.”  If the Court allows economic nexus to suffice, at what level – and on what principled basis would its opinion be grounded?  South Dakota’s law set minimum thresholds for that state, but not every state adheres to those same standards.  In the absence of express guidance from the Court, each state might set its own (and potentially conflicting) standards.  Such a hodgepodge would be burdensome and make remote sellers’ compliance efforts even more difficult.

Retroactivity is a Key Issue – But it is not directly before the Court

If the Court’s opinion in Wayfair recedes from the physical presence standard in National Bellas Hess and Quill, a fundamental question is whether its decision will apply retroactively.  But the issue of retroactivity is not posed by the state law under review in Wayfair, so that question is not squarely before the Court.  The South Dakota legislature imposed its economic nexus standard only prospectively from a Court decision or Congressional action overturning the physical presence standard.  Unless the Court or Congress determines otherwise, other states that have not similarly adopted prospective-only economic nexus standards would not be so inhibited.  Regardless of whether the issue is presented in Wayfair, the Court will likely be concerned with retroactivity, which it described in Quill (where retroactivity also was not an issue) as “thorny questions concerning the retroactive application of [use] taxes … better resolved by Congress than by this Court.”[8]

Conclusion

Wayfair is expected to be decided by the end of the Court’s current term in June.  The decision has potentially broad implications for remote sellers and their customers, and their in-state competitors, as well as for in-state businesses selling to customers in other states.  States may be granted more effective tools to enforce use tax due from in-state purchasers, increasing their tax burdens and bolstering state revenues.  Depending on how the Court decides Wayfair and whether Congress acts, the benefits of voluntarily disclosing potential use tax liabilities should be evaluated.  For assistance in evaluating these and other potential ramifications of Wayfair for your business, please contact a member of our State and Local Tax Team.

[1] National Bellas Hess, Inc. v. Illinois Dept. of Revenue, 386 U.S. 753 (1967).

[2] Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

[3] Docket No. 17-494, cert. granted (Jan. 12, 2018).

[4] A different nexus standard applies for purposes of the Due Process Clause, but that nexus standard is generally less stringent that the physical presence standard.

[5] The U.S. Census Bureau estimates that domestic e-commerce retail sales exceeded $115 billion for 3Q17 (adjusted for seasonal variation), accounting for over 9% of total U.S. sales.

[6] This effort is not new.  After National Bellas Hess, many states (Florida included – see Section 212.0596, F.S.) enacted laws attempting to tax mail order sales and challenging the continued validity of the physical presence rule.  Commonly known as “anti-Bellas Hess legislation,” enforcement of one of these laws led to the Court’s decision in Quill affirming the physical presence rule.

[7] Wayfair prevailed in the state trial court and state supreme court because Quill is still the law of the land, policy arguments to the contrary notwithstanding.  The U.S. Supreme Court is not similarly constrained by its own precedent.

[8] Quill, 504 U.S. at 318, n.10.