State income tax jurisdiction: a jurisprudential and policy perspective

William and Mary Law Review, Oct, 2003 by John A. Swain

INTRODUCTION

One of the most contentious issues in state taxation is the reach of the states' jurisdiction to tax net income. The failure to resolve this issue is a leading cause of the recent dramatic decline in state corporate income tax revenues. (1) Familiar forces of change are at work: the ongoing shift from a mercantile to a service economy, (2) the increasing mobility of capital, (3) electronic commerce, (4) and the "coming of age" of state tax planning techniques aggressively promoted by the national accounting firms. (5) These forces allow corporations to do (or appear to do) business in a state from afar. Thus, traditional markers of nexus to tax--such as physical presence--are absent.

Unfortunately, the Supreme Court has not directly answered the question of whether mere economic presence is a sufficient ground for a state to assert its income tax jurisdiction. Students of the Court's due process jurisprudence may find this surprising. The Court held long ago that economic presence is sufficient for a plaintiff to hale a foreign corporation into court or for a state to assert its regulatory jurisdiction. (6) The Court's state tax jurisprudence has taken a different tack, however, riding the winds of the dormant Commerce Clause into "uncharted and treacherous" waters. (7)

The voyage began in 1967, when the Court held in National Bellas Hess v. Department of Revenue (8) that a physical presence was required for a state to impose a use tax collection obligation on a mail-order company. (9) Curiously, the Bellas Hess Court took no note of its earlier due process decisions affirming state regulatory jurisdiction based solely on economic presence. (10) Twenty-five years later in Quill Corp. v. North Dakota, under essentially identical facts, the Court conceded that due process could be satisfied by economic presence alone. (11) Nevertheless, the Court reaffirmed the physical presence test on Commerce Clause grounds alone. (12)

Until that time, the Court had not indicated that the Due Process and Commerce Clause nexus standards diverged in any meaningful way. (13) By removing state tax nexus from its due process moorings, the Court seems to have discarded the traditional source of content for nexus inquiries (tax or otherwise). (14) Its replacement--the Commerce Clause prohibition against undue burdens--is not well adapted for this purpose, and offers no rich nexus jurisprudence that it can call its own. (15)

Like the Bellas Hess decision, Quill did not expressly address income tax nexus. (16) Indeed, dictum in Quill suggests that the nexus standard for taxes other than sales and use taxes may not be physical presence. (17) Thus, Quill seems only to add to the uncertainty surrounding state income tax jurisdiction. These uncertainties have materialized in post-Quill state court litigation. Less than a year after the Quill decision, the South Carolina Supreme Court held that Quill's physical presence test was not applicable to state income taxes. (18) Courts since then have split. (19) Again, uncertainty prevails. (20)

There is no line of Supreme Court income tax nexus decisions parallel to Quill. The Court's exploration of the constitutional limits of income tax jurisdiction has been stymied by the affirmative exercise of Congress's Commerce Clause powers. In 1959, Congress statutorily curtailed the states' power to impose a net income tax on sellers of tangible personal property whose in-state activities do not exceed mere "solicitation." (21) Though intended as a temporary measure--allowing Congress to study the ramifications of several judicial decisions that were perceived to have expanded state income tax jurisdiction--the statute remains on the books to this day. (22) Indeed, state and local tax professionals still refer to the measure as P.L. 86-272, despite having been incorporated into the United States Code.(23)

P.L. 86-272 provides a safe harbor for sellers of tangible personal property, but it says nothing about services or intangibles. (24) Thus, as the service sector of the economy continues to expand, so too does corporate concern about exposure to state income taxes. Further, as technological advances permit more businesses to provide goods and services from remote locations, policymakers fear that jurisdictional rules based on an anachronistic physical presence test threaten the tax base and provide inappropriate tax avoidance opportunities. (25) At the same time, many of the growing number of firms that do business remotely resist the notion that they should be liable for taxes imposed by geographically distant jurisdictions. (26)

Two conflicting proposals reflect this resurgence of concern over the state income tax. Taxing authorities have proposed a "factor presence standard" that would allow a state to tax an economically present business so long as the business' in-state sales meet a certain threshold. (27) Business taxpayers, on the other hand, are backing legislation that would expand P.L. 86-272's safe harbor to cover services, intangibles, and numerous other in-state contacts that go far beyond the "mere solicitation" protection of the current statute. (28) Sparks have flown. (29)