State + Local Tax Insights: Winter 2014

Edited by Nicole L. Johnson and Rebecca M. Ulich

RINGING IN THE NEW YEAR: ISSUES FROM 2013 THAT WILL LIKELY IMPACT 2014

By R. Gregory Roberts and Rebecca M. Ulich

The past year brought many important judicial decisions across all areas of state and local taxation. In this article, we will focus on several of those decisions that we think are likely to have an impact beyond the jurisdictions in which they were decided and beyond the specific facts involved in the appeals. Accordingly, in this article we will analyze decisions from the past year that highlight: (1) the continued resurgence of the Due Process Clause as a viable limitation on state taxing authority; (2) the potential use of the federal Internet Tax Freedom Act as a tool against the states' ability to tax electronic commerce; and (3) the potential impact of challenges to state modifications to the Multistate Tax Compact.

The Due Process Clause

For many years the Due Process Clause was largely viewed as a feeble means of challenging a state's authority to assert tax against an out-of-state corporation. That began to change with the U.S. Supreme Court's decisions in Goodyear and J. McIntyre Machinery in 2011, in which the Court embraced a "purposeful availment" standard for personal jurisdiction under the Due Process Clause.1 Following closely thereafter, the Oklahoma and West Virginia Supreme Courts in Scioto and ConAgra, respectively, were the first state tax cases in years to be decided largely on due process grounds.2 The resurgence of the Due Process Clause as a limitation on the states' taxing power continued in the past year with decisions from two federal courts in In re Washington Mutual, Inc. and Gordon v. Holder.3

In In re Washington Mutual, Inc., the Bankruptcy Court found that Oregon's imposition of tax on Washington Mutual, Inc. ("WMI") was improper under the Due Process Clause.4 WMI was a bank holding company that owned subsidiaries, including subsidiaries that conducted banking-related operations in Oregon. WMI and its subsidiaries filed consolidated federal tax returns as well as consolidated Oregon corporate excise tax returns. In 2008, as a result of downgrades in its credit ratings and the global credit crisis, WMI filed for bankruptcy. After WMI had filed for bankruptcy, Oregon issued an assessment against WMI and its subsidiaries asserting additional corporate excise taxes, interest and penalties.5

In reaching its determination, the court explained that "[t]he initial inquiry regarding due process . . . is whether a defendant had minimum contacts with the jurisdiction such that the maintenance of the suit does not offend traditional notions of fair play and substantial justice," and that "[d]ue process is not satisfied unless, in addition to finding 'minimum contacts,' the court determines that the income a state seeks to tax relates to a benefit received from the state."6

Although WMI's subsidiaries conducted business in the State, the court found that WMI "was simply a parent holding company" that "conducted no business activity within or directed towards Oregon," and, therefore, WMI lacked the minimum contacts required by the Due Process Clause.7 Further, the court explained that, in order for a subsidiary's use of intellectual property in the State to be imputed to the parent company, due process requires that the parent must derive substantial revenue from the intellectual property.8 As WMI did not earn any income from the use of the intellectual property in the State, the court found that WMI received no benefits from Oregon for its subsidiaries' use of intellectual property in the State.9 Thus, the court concluded that the assessed tax violated the Due Process Clause because WMI lacked the necessary minimum contacts and the asserted tax was not rationally related to values connected with Oregon.10

The District of Columbia Circuit Court in Gordon similarly recognized the Due Process Clause as an important limitation on a jurisdiction's authority to tax.11 In Gordon, Robert Gordon, who owned a business that sold tobacco products across state lines, requested a preliminary injunction against the enforcement of the provisions of the Prevent All Cigarette Trafficking Act ("PACT Act").12 The PACT Act was enacted, in part, to prevent remote purchasers from avoiding state taxes and prohibits "delivery sales" of cigarettes and smokeless tobacco products unless all applicable state and local taxes are paid "in advance of the sale, delivery, or tender."13 Moreover, under the PACT Act, delivery sellers "must collect any taxes that state or local laws require in-state retailers to collect," and "[t]hey are subject to federal criminal and civil penalties if the applicable taxes have not been paid in advance."14 Among other arguments, Gordon argued that the taxing provisions violated the Due Process Clause.15

The Circuit Court found that Gordon presented two substantial and novel constitutional questions: (1) whether the Due Process Clause requires minimum contacts between the state or local taxing authority and the nonresident seller, even when the federal government is the source of the seller's duty to collect taxes; and (2) if due process requires minimum contacts with the state or local taxing jurisdiction, does a single delivery sale to a buyer in that jurisdiction create the requisite minimum contacts?16 In affirming the District Court's injunction against the enforcement of the taxing provisions on due process grounds because it found the underlying constitutional questions to be "close," the Circuit Court noted that "[s]tates require retailers to collect applicable taxes from resident buyers and remit the receipts to the state," but that "[a] state may not . . . impose such an obligation on a retailer with whom the state lacks minimum contacts."17 The court noted that "[t]he minimum contacts requirement derives from the Due Process Clause" and observed that "[t]his means that most out-of-state retailers operate beyond the state's regulatory reach."18

In analyzing the underlying rationale of the Due Process Clause, the court explained that "due process jurisprudence ensures democratic legitimacy by relying on the mechanism of 'fair warning'" because, "[f]airly warned that a state might tax them, persons can participate, at least through petitioning and speech, in the political process that decides whether it will [tax them]."19

The court also explained that "[a]nother simple but controlling question to test the lawfulness of an exercise of taxation power is whether the state has given anything for which it can ask return," because, "when minimum contacts with that state or locality are lacking, the state or locality offers no services or protections to justify the tax it receives."20

The Washington Mutual and Gordon cases continue the recent trend of decisions that look to whether a taxpayer has purposefully directed its economic activities at a particular jurisdiction so as to establish the requisite minimum contacts under the Due Process Clause. Taken together, these decisions highlight that the Due Process Clause is a viable means of challenging states' ever increasing attempts to tax activities with only the slightest connection to the state.

Taxpayers should also be aware of DaimlerChrysler Ag v. Bauman, which is pending before the U.S. Supreme Court.21 Daimler presents the Court with an issue that was not addressed in Goodyear: Whether a state has jurisdiction over a parent company based on the activities of a subsidiary in the state.22 Thus, Daimler has the potential to significantly impact state and local taxing authority, as the Court may be forced to address whether due process nexus can be established based on an "enterprise" theory, which entails an analysis similar to a unitary business analysis.23

Affiliate Nexus Provisions and the Taxation of Electronic Commerce

As in previous years, challenges to statutes involving affiliate or "click-through" nexus provisions (i.e., the "Amazon" laws) have continued, with decisions rendered regarding such provisions in New York and Illinois and an appeal pending in Colorado.24 In a unique twist on prior decisions, on October 18, 2013, the Illinois Supreme Court, in Performance Marketing Association v. Hamer, found that Illinois' affiliate nexus provisions were "void and unenforceable" because they were "expressly preempted" by the federal Internet Tax Freedom Act ("ITFA").25

In 2011, Illinois amended its statutory definitions to impose use tax collection obligations on an out-of-state internet retailer or serviceman that contracts with a person in the State to refer potential customers to the retailer or serviceman's website with an internet link, if the gross receipts generated from such referrals exceed $10,000 during the preceding four quarters.26 The Illinois Circuit Court found that the statute was invalid because it was (1) unconstitutional under the Commerce Clause and (2) expressly preempted by the ITFA. On appeal, however, the Illinois Supreme Court limited its decision to a finding that the provision was invalid under the ITFA and, therefore, did not decide whether the provision was also unconstitutional.

Among other restrictions, the ITFA prohibits a state from imposing "discriminatory taxes on electronic commerce."27 A "discriminatory tax," is defined, in part, as "any tax imposed by a State or political subdivision thereof on electronic commerce that . . . imposes an obligation to collect or pay tax on a different person or entity than in the case of transactions involving similar property, goods, services, or information accomplished through other means."28

In reaching its determination, the court noted that "Illinois law does not presently require out-of-state retailers who enter into performance marketing contracts for 'offline' print or broadcast advertising which is disseminated nationally, or internationally, to collect Illinois use tax;"...