Sales And Use of Taxation of Internet Transactions

(Originally published July 10, 2003)

1. Constitutional Limitations on States' Power to Tax Remote Vendors, Including Internet Vendors.

Both the due process clause and the commerce clause of the United States Constitution limit the state's power to impose sales taxes or a use tax collection obligation on an out-of-state vendor, including an internet vendor. Both of these constitutional limitations come into play, in the main, when dealing with interstate sale transactions, and limit a state's ability to impose a sales tax or use tax collection duty on an interstate sale transaction.

2. The Due Process Clause - Actual Physical Presence Not Needed.

Section 1 of the Fourteen Amendment to the United States Constitution provides that "[n]o State shall deprive any person of life, liberty or property, without due process of law." The due process clause "requires some definite link, some minimum connection between a state and the person, property or transaction it seeks to tax." Miller Brothers Co. v. Maryland , 74 S. Ct. 535, 539 (1954). This "definite link," or "minimum connection" is referred to generally as "nexus." The focus of most cases in this area has been to determine what set of factual circumstances satisfies the requirement of that "definite link" or "minimum connection."

The due process clause applies not just to tax cases, but to other situations, as well, and particularly the question of when a state has personal jurisdiction over an out-of-state defendant for purposes of maintaining a suit in that state. One of the leading due process clause cases arose in this context. In International Shoe Co. v. Washington, 66 S. Ct. 154 (1945), the United States Supreme Court dealt with the question of what contact an out-of-state defendant needed with the state for purposes of the states' asserting personal jurisdiction over that out-of-state defendant. The inquiry as framed by the Supreme Court is whether the 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." The test dealing with personal jurisdiction has evolved from requiring the defendant to have a "presence" in the foreign state to a more flexible test of whether a person's contacts with the foreign state make it reasonable to require it to defend a suit there. See State and Local Taxation Second Edition, Vol. 1, Pomp and Oldman, page 299.

When it comes to taxation, "the controlling question is whether the state has given anything for which it can ask in return." Wisconsin v. J. C. Penney Co., 61 S. Ct. 246 (1940).

In Quill v. North Dakota, 112 S. Ct. 1904 (1992), the United States Supreme Court was faced with an out-of-state mail order retailer making mail order sales into North Dakota, and the obligation of the out-of-state retailer to collect the destination state's use tax. North Dakota imposed that use tax collection obligation on Quill and Quill challenged the state on both due process and commerce clause grounds. On the due process side, the Supreme Court essentially applied its approach to personal jurisdiction cases to the use tax collection obligation. The Court stated "if a foreign corporation purposely avails itself of the benefits of an economic market in the foreign State, it may subject itself to the State's personal jurisdiction even if it has no physical presence in the State." Id. at 307. The Court further stated that "it is an escapable fact of modern commercial life that a substantial amount of business is transacted solely by mail and wire communication across the state lines, thus obviating the need for physical presence within a State in which business is conducted." Id. at 308, quoting Burger King Corp. v. Rudzewicz, 471 U.S. 462, 476 (1985). The Court then went on to conclude that "[c]omparable reasoning justifies the imposition of the collection duty on a mail-order house that is engaged in continuous and widespread solicitation of business within a State." Id. at 308.

In so holding, the United States Supreme Court concluded that actual physical presence in a state was not necessary to satisfy due process clause concerns. Rather, the economic exploitation of the market state, by an out-of-state retailer, is sufficient. Thus, under the due process clause alone, an out-of-state mail-order retailer with no physical presence in the destination state, would be required to collect that destination state's use tax, as long as it was "engaged in continuous and widespread solicitation of business within" that state.

As will be noted, the Quill court concluded, though, that physical presence, and something more than the "slightest physical presence," is still needed to satisfy the nexus concerns of the commerce clause. As a result, the nexus focus for tax cases is now on the commerce clause.

3. Commerce Clause - Actual Physical Presence Required.

Cl. 3, section 8, article 1 of the United States Constitution provides that "the Congress shall have the power to regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes." The commerce clause focus or concern is on the effects of state regulation on the national economy. The power to regulate commerce between and among the states, was left with the Congress, and not with the individual states. While the commerce clause does not, by its own wording, expressly protect interstate commerce, the United States Supreme Court has held that the commerce clause "by its own force prohibits certain state actions that interfere with interstate commerce." Quill at 1911, citing South Carolina State Highway Dept. v. Barnwell Brothers, Inc., 58 S. Ct. 510 (1938). This facet of the commerce clause is called the "negative" or the "dormant" commerce clause.

4. The Evolution of the Dormant Commerce Clause.

The dormant commerce clause has evolved over the years. There have been three significant tests or evolutions:

(a) No tax on interstate commerce. The initial interpretation of the dormant commerce clause was that no state has the right to lay a tax on interstate commerce in any form. Leloup v. Port of Mobile, 8 S. Ct. 1380 (1988); Brown v. Maryland, 12 Wheat. 419, 6 L. Ed. 678 (1827).

(b) No direct tax on interstate commerce. The flat prohibition against a tax in any form on interstate commerce was liberalized and evolved into the interpretation that no state has the right to lay a direct tax on interstate commerce. Spector Motor Service v. O'Connor, 340 U.S. 602 (1951); Freeman v. Hewit, 67 S. Ct. 274 (1947). This distinction between a direct tax on interstate commerce and a prohibition on a tax in any form allowed an indirect tax such as a franchise tax on interstate state.

(c) States have the right to tax interstate commerce if four prong test is met. The most recent evolution of the commerce clause is found in Complete Auto Transit, Inc. v. Brady, 97 S. Ct. 1076 (1977). In that case, the Supreme Court specifically overruled Spector Motor Service, and held that all states have the right to lay a tax on interstate commerce so long as the tax:

(1) is applied to an activity with a substantial nexus with the taxing state,

(2) is fairly apportioned,

(3) does not discriminate against interstate commerce, and

(4) is fairly related to the services provided by the state.

This four prong test is generally referred to as the Complete Auto test.

In Goldberg v. Sweet, 488 U.S. 252, 109 S. Ct. 582 (1989), the United States Supreme Court applied the four prong Complete Auto test to Illinois' imposition of a sales tax on interstate phone calls. The court went through each prong, analyzed it in view of the interstate telecommunications tax in question, and concluded that the Illinois tax, under the four prong test of Complete Auto, did not violate the commerce clause. Goldberg is one of the more recent and substantial cases dealing with the application of the four part Complete Auto test.

5. The Nexus Component of the Four Part Complete Auto Test - "Substantial Nexus."

The first prong of the Complete Auto test requires "substantial nexus" between the taxing state and the activity being taxed. That substantial nexus test must be satisfied before a tax will be found not to violate the dormant commerce clause. Following is the case law development of that "substantial nexus" test in the mail-order retailer and use tax collection context.

(a) National Bellas Hess - Physical Presence Required.

In National Bellas Hess, Inc. v. Department of Revenue, 386 U.S. 753, 87 S. Ct. 1389 (1967), the United States Supreme Court was faced with the issue of what constituted sufficient nexus for a destination state to require an out-of-state mail-order vendor to collect it use tax on mail-order sales made into the state. National Belles Hess was a mail-order company with no offices, warehouses or distribution centers in Illinois. It had no employees, salesmen or agents in the state, either. Neither did National Bellas Hess have any tangible personal property or real property located in the state. It had no telephone listing in Illinois and did not advertise its products on Illinois television, radio, billboards, or in Illinois newspapers. The only contact National Bellas Hess had with Illinois were its mailings of catalogs in advertising flyers into the state through the U.S. mail common carrier.

Illinois imposed the use tax collection duty on National Bellas Hess for its Illinois mail-order sales. National Bellas Hess challenged that tax under both the due process and commerce clauses, focusing on the nexus requirement. The Supreme Court relied on the commerce clause and held:

Indeed, it is difficult to conceive of commercial transactions more exclusively interstate in character than the mail-order transactions here involved. And if the power of Illinois to impose use tax burdens upon National were upheld, the resulting impediments upon the free conduct of the...