Earlier this month, Massachusetts became the latest state to more aggressively pursue sales tax on online purchases, going beyond other states to expand the definition of physical presence to include cookies, apps and server presence with a new directive effective July 1. While these changes may mean a significant revenue bump for Massachusetts, legislative and legal challenges have already begun.
What does the Directive Do? Under the State’s existing sales tax rules, retailers that are engaged in making “taxable sales” in Massachusetts or that sell “taxable products” for use in Massachusetts are required to collect and remit sales tax if the retailer is engaged in a business in Massachusetts. The directive provides that any “internet vendor” that makes 100 or more sales per year in Massachusetts with a total value in excess of $500,000 is “engaged in business” in Massachusetts because it is “exploiting the state’s retail sales market through ‘computer networks’ and other ‘communications medium’.” The directive provides that internet retailers have sufficient in-state physical presence if, for example, Massachusetts consumers download the retailer’s app or other software, if the retailer stores cookies on a Massachusetts consumer’s device, if the retailer’s data is stored on local servers, if the retailer uses a third-party online marketplaces with respect to which services are provided in-state and if the retailer uses local delivery and logistics services that go beyond the basic services of a mail and common carrier.
Why does it Matter? Most online retailers do not collect state sales tax on sales to customers located in that state without a more substantial physical presence in the state (e.g., the company’s headquarters or a physical store). This has garnered protests from both “brick and mortar retailers” and states across the country. In recent years, sales have increasingly shifted from in-person to online (by about 15% per year according to one survey), decreasing state sales tax revenue. Taxpayers are technically still required to individually calculate and pay the sales tax due for online purchases on their own state tax returns, but the reality is that few people comply (and we are not aware of any states actively enforcing this requirement). As a result, the National Conference of State Legislatures estimated that in 2015, states lost approximately $26 billion in uncollected taxes from online sales.
Other States? Massachusetts is not the first state to push back. In recent years a handful of states have passed “click through nexus” and “affiliate nexus” laws. For example, Louisiana and New York have passed laws that extended the requirement to collect and remit sales tax to online retailers that contract with state residents or businesses to link to the retailer’s website, or that have affiliated agents in-state who sell the same or similar products. Other states, such as Alabama, Indiana and South Dakota have taken a different approach, dispensing with the need for physical nexus altogether by deeming a retailer to have nexus if sales to customers located in-state exceed a certain threshold.
Why the Controversy? The crux of the legal issue involves the U.S. constitution’s Commerce Clause, and the 1992 Supreme Court decision Quill Corp. v. North Dakota (504 U.S. 298 (1992)). In Quill, the Court overturned a North Dakota law that required mail order companies that met certain requirements to collect sales tax from customers. In finding the law unconstitutional, the Court held that the law ran contrary to the Commerce Clause, and its oversight of state regulation within a national economy.
Specifically, the Court found that the law failed the first part of a four-part Commerce Clause test articulated in Complete Auto Transit, Inc. v. Brady: the law did not apply to an activity with a substantial nexus with the taxing State (the other three prongs are that the law (i) is fairly apportioned, (ii) does not discriminate against interstate commerce, and (iii) is fairly related to the services provided by the State.) The Court cited to a previous case, Bellas Hess, which established a bright line rule that companies “whose only connection with customers in the [taxing] State is by common carrier or the United States mail” are not required to collect taxes on behalf of the state, so as not to impose on interstate commerce and the Commerce Clause’s ‘substantial nexus’ test, as articulated in Complete Auto.”
The Court did, however, leave open the possibility for Congress to make a change in this realm, asserting that “Congress is now free to decide whether, when, and to what extent the States may burden interstate mail order concerns with a duty to collect use taxes.” Following the Court’s direction, federal legislation that would require online sellers to collect sales tax (or prohibit states from collecting tax on online sales) has been introduced, but no bill has made it into law (yet). Congress did enact the Internet Tax Freedom Act in 1998, which bars state and local governments (as well as the federal government) from taxing internet access or imposing “multiple or discriminatory taxes” on ecommerce. This law was intended to prohibit taxes on internet access (such as bit taxes, bandwidth taxes, email taxes, and taxes imposed only on online sales (or at a higher rate than otherwise imposed on in-person sales)), in an effort to promote expansion of the internet. While the Act was not intended to prohibit states from imposing sales tax on online sales (in a non-discriminatory manner), some critics of state attempts to more aggressively pursue sales tax on online sales have argued that extending sales tax laws to cover online retailers without a brick and mortar presence constitutes a prohibited “discriminatory tax” that targets online retailers precisely because they engage in business through electronic commerce.
What’s Next? While the Massachusetts law is by no means alone in trying to expand the scope of online retailers required to collect and remit sales tax, its conceptual underpinning – that cookies, apps and server space located in-state constitutes physical presence – is unprecedented. The Massachusetts directive takes great care to distinguish online retailers from the mail order retailers at issue in Quill, explaining precisely why the test articulated in the directive is consistent with Quill and its substantial nexus requirement.
From the directive: “The specific standard that Quill articulated was that a vendor can be made subject to a state’s sales or use tax collection duty when it has an in-state ‘physical presence.’ . . . However . . . Quill made clear that the determination of the existence of a vendor’s in-state physical presence is to be evaluated on a case by case basis . . . and that physical presence includes the situation where a vendor owns, leases or licenses in-state property, or relies upon one or more in-state representatives ‘to establish and maintain a market’ in the state for its sales. . . . The business and activities of Internet vendors are factually distinguishable from the business and activities of mail order vendors. Internet vendors do not limit their contacts with the state to mail and common carrier. Further, modern-day Internet vendors with a large volume of in-state sales . . . invariably have one or more contacts with the state that will constitute an in-state physical presence. . . . See Direct Marketing Assn., 135 S.Ct. at 1135 (Kennedy, J., concurring) (‘Today buyers have almost instant access to most retailers via cell phones, tablets, and laptops. As a result, a business may be present in a State in a meaningful way without that presence being physical in the traditional sense of the term.’)”
Will the directive withstand legal challenge that it violates the holding in Quill? NetChoice has already filed suit, seeking an injunction to stop the directive from going into effect on the grounds that it is unconstitutional (citing Quill), and that it violates the Internet Tax Freedom Act. The judge’s ruling on that request may serve as an early indication of the directive’s future.
While we wait for the judiciary to rule on Massachusetts’ directive, Congress may take the matter out of the states’ hands altogether. Last week Senator Sensenbrenner reintroduced the No Regulation Without Representation Act of 2017, which would prohibit states from requiring businesses to collect sales tax absent a physical presence in-state. The bill has been referred to the House Committee on the Judiciary. Meanwhile, some individual companies such as Amazon have begun to charge sales tax in all 50 states (perhaps a sign of what’s to come).