Sales & Use Tax Blog

Supreme Court Rules that Physical Presence Not Necessary to Create Substantial Nexus

Today the Supreme Court of the United States has voted 5-4 to overturn the “physical presence” rule decided in Quill Corp. v. North Dakota.  According to the Supreme Court, “physical presence is not necessary to create a substantial nexus.”  The Court says that it erred in its 1992 Quill decision and that the proliferation of e-commerce sales and the Internet revolution has exacerbated that error.  As a result, South Dakota’s law relating to requiring certain remote sellers with “substantial nexus” to collect and remit sales tax is valid and Constitutional.  That law requires out-of-state sellers that deliver more than $100,000 worth of goods or services in to South Dakota or engage in 200 or more separate transactions within the state in a calendar year to collect and remit sales tax.

While both Quill and National Bellas Hess, Inc. v. Department of Revenue of Illinois interpreted having an established “physical presence” to be determinative in whether a company had “substantial nexus,” the Court today ruled that the “physical presence” rule is not a necessary interpretation of the “substantial nexus” test as decided in Complete Auto Transit, Inc. v. Brady.  “Though Quill was wrong on its own terms when it was decided in 1992, since then the Internet revolution has made its earlier error all the more egregious and harmful,” says Justice Kennedy in delivering his opinion of the Court in South Dakota v. Wayfair.

As a basis for their decision, the Supreme Court cited a number of facts to support how the modern-day economy has changed since its 1992 Quill ruling.  In 1992, less than 2% of Americans had access to the Internet while today that number is nearly 90%.  In 1992, it was estimated that states were losing between $694M and $3B per year in sales tax revenues because of the “physical presence” rule while today the estimates range between $8B to $33B in lost sales tax revenue.  Since the U.S. Department of Commerce began tracking e-commerce sales in 1999, those sales have increased from a mere 0.8% of the total U.S. retail sales to 9.4% in the 1st quarter of 2018.  In 2015, Amazon, a remote seller, became the world’s largest retailer by surpassing Wal-Mart.

Furthermore, the Court found that Quill “creates rather than resolves market distortions” by establishing a judicially-created tax shelter or loophole for businesses that limit their physical footprint.  With the modern economy and the ease with which online storefronts are able to display and sell products to customers regardless of location, the “physical presence” standard encourages retailers to avoid the regulatory burdens of tax collection and puts in-state businesses at a competitive disadvantage.  The “physical presence” rule essentially prevents states from their right to collect sales taxes which would otherwise be lawfully due.  This shift to “substantial nexus” enables states to seek fair enforcement of sales taxes which are an indispensable, key source for raising revenue.

Finally, the Court found that the “physical presence” requirement established in Quill “imparts the sort of arbitrary, formalistic distinction” that the Court disavows.  The Court illustrates this point by providing an example of two hypothetical situations which would result in different sales tax compliance obligations for the companies in question.  In the example, the location of the hypothetical company’s warehouse is the determining factor as to whether it must collect and remit South Dakota sales tax.  It goes on to discuss how a company that sells into a state still avails itself of the benefits the state offers even if it has no established physical presence within the state.  Examples the Court provides include a solvent state and local government that provides its residents well-maintained public roads and other municipal services such as fire and police protection.

As we documented here during the oral arguments the Supreme Court heard on April 17, 2018, several Justices raised concerns about the burden that would be placed on small businesses if the Court overturned Quill.  It seems that the Court resolved this issue in large part because of three key features of South Dakota’s law.  First, “[t]he law at issue requires a merchant to collect the tax only if it does a considerable amount of business in the State.”  The Court found this threshold key to establishing “substantial nexus” because only companies with a certain level of involvement with the state of South Dakota will be obligated to collect and remit sales tax.  Second, “the law is not retroactive.”  This means that taxes on previously untaxed sales within the open statute of limitations will not be pursued by the South Dakota Department of Revenue through sales and use tax audits of those prior periods.  Some other states including Alabama and Georgia are also on record stating that they will not pursue retroactive taxes, but will only require companies to begin collection on a prospective basis.  Third, “South Dakota is a party to the Streamlined Sales and Use Tax Agreement.”  The Court found this to be helpful because membership in the Streamlined Sales and Use Tax Agreement (“SSUTA”) requires uniform definitions and taxability of products and services.  States that are not members of the SSUTA can have widely varying definitions of terms and taxability of products and services making sales tax compliance an even greater challenge for companies.   In short, the Court felt that South Dakota’s law requiring remote sellers to collect and remit sales tax offered small businesses a reasonable degree of protection from an undue burden of sales tax compliance.

As it did in its 1992 Quill decision, the Court invited Congress to “legislate to address these problems if it deems it necessary and fit to do so.”  The Court also acknowledged that the current inconsistency of the laws that states have drafted, including Colorado, Massachusetts, New York, and Ohio in contrast to South Dakota, means that a great many issues remain undecided.  However, the Court found that “these other issues need not be resolved here.”  Regardless, the Court decided today that the era of “physical presence” being the determining factor as to whether a company has nexus in a state has come to an end.  Going forward “substantial nexus” will be determinative.  How each state will define “substantial nexus” remains to be seen.

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