Fifteen years ago the Supreme Court in Quill v. North Dakota made it absolutely clear that the U.S. Constitution bars states from collecting sales or use taxes from businesses that don't have physical presence in the state. What it didn't make clear, though, is whether states could impose on these companies other types of taxes, such as franchise and net income taxes. That lack of clarity has plagued the businesses community ever since.

“Since Quill, there has been no common standard by which companies without a physical presence in a state can determine and finance their liability for business tax,” says Jamie Yesnowitz, a senior manager in Grant Thornton's national tax office.

Recently, the Supreme Court had a golden opportunity to clear up the mess when it considered review of the West Virginia Supreme Court of Appeals' September 2006 ruling in MBNA America Bank N.A. v. Tax Commissioner of the State of West Virginia. A divided state court had concluded that West Virginia could impose income and franchise taxes on businesses that didn't have a physical presence in the state. Unfortunately, the Court denied cert on the case June 18–and, as usual, gave no reasons for its decision.

“This means we will continue to see a patchwork of different criteria for taxing out-of-state companies,” Yesnowitz says.

MBNA's Battle

MBNA, a Delaware corporation, had no property or employees in West Virginia in the 1998 and 1999 tax years. Its primary business was issuing and servicing Visa and MasterCard credit cards and promoting that business by way of mail and telephone marketing. Some West Virginia residents responded to those marketing efforts and received MBNA credit cards.

As a result, MBNA's gross revenue from West Virginia customers in 1998 and 1999 was some $18.5 million. For that period, it paid state income tax of about $369,000 and franchise tax of $75,000.

After paying the tax, MBNA filed refund claims on the basis that the state lacked jurisdiction to impose the taxes. The state denied the refund, reasoning that its tax laws applied to any company “regularly engaged in business” in West Virginia.

MBNA appealed to the state's Office of Tax Appeals (OTA), which in October 2004 ruled in the company's favor. The OTA concluded that West Virginia couldn't tax an activity unless it had a “substantial nexus to the state.” The OTA reasoned that only business carried out through a physical presence in the state satisfies the substantial nexus test.

West Virginia appealed to the Circuit Court of Kanawha County, which ruled that physical presence wasn't necessary to show substantial nexus, and that MBNA's significant business in West Virginia demonstrated an “economic presence” sufficient to attract the state's jurisdiction.

Finally, the case landed in the West Virginia Supreme Court of Appeals, which upheld that decision by a 2?? 1/2 1 majority. The court ruled that the language of Quill expressly limited its scope to sales and use taxes, and that a bright-line physical presence test “makes little sense in today's world” where electronic commerce is common.

The court noted Quill turned on the compliance burdens associated with collecting and remitting sales and use taxes on behalf of the 6,000 state and local jurisdictions that existed at the time.

“In contrast to the sales and use taxes described [in Quill], the franchise and income taxes at issue in this case do not appear to cause the same degree of compliance burdens,” the majority stated.

By way of example, the court noted, companies paid franchise and income taxes directly to the government on an annual basis, whereas businesses had to collect, keep track of and remit sales and use taxes on a monthly basis.

To many observers, however, the court's compliance analysis is flawed.

Complex Reasoning

“The complexity of state taxes has multiplied many times over in the 15 years since Quill was decided,” Yesnowitz says. “And that has created an increasing compliance burden.”

For example, Michigan has just passed a hybrid tax, consisting of income tax, gross receipts and margin tax components to replace its single business tax. Ohio is currently phasing out its tax regime to accommodate a new hybrid system.

Similarly, the “economic presence” tests that states rely upon to tax out-of-state companies could be as varied and complex as the tax schemes themselves. Ohio, for example, has legislated a gross receipts tax that assumes jurisdiction on the basis of gross sales in the state.

Equally confusing could be the maze of jurisprudence that interprets the validity of these schemes. Massachusetts, for example, requires only a minimal connection to satisfy the economic presence test, while Texas and Tennessee are still using the physical presence standard.

“It would be better if the Supreme Court had resolved the out-of-state taxation issue now before businesses find themselves dealing with a host of varying tax regimes that end up stifling economic growth,” says Chris Atkins, senior tax counsel at the Tax Foundation.

That would prove counter-productive to what the West Virginia Supreme Court may have been trying to achieve.

“MBNA represents an interpretation of the commerce clause that … recognizes that states have to adapt their tax policies if they're going to get their fair share of revenue from the new economy,” says Jeffrey Mehalic, a sole practioner.

According to the decision's critics, however, that's exactly what's wrong with the reasoning in MBNA.

Slippery Slope

“The chief problem with economic nexus is that is seems designed to protect or enhance state coffers rather than commerce,” Atkins says. “It's a good deal for states–particularly market states without a lot of labor and capital–but not for the businesses that ply their trade in interstate commerce.”

To combat that problem, Rep. Robert Goodlatte introduced H.R. 1956 in April 2005. The law, known as the Business Activity Tax Simplification Act of 2006, would have prohibited states from taxing companies without a physical presence.

Perhaps not unexpectedly, the proposed legislation attracted fierce opposition from the states. In September 2005 the National Governors Association released a report estimating that the states would lose $8 billion if H.R. 1956 became law. Although a debate on the bill was scheduled for July 2006, the Congressional session ended before it could take place, and it died on the order paper.

There has been no attempt since to revive similar legislation. But if Congress doesn't act soon, things may get worse before they get better.

“It won't be long before states will be looking for a way around Quill and trying to collect sales and use taxes from corporations that don't have a physical presence,” Mehalic says.