Wayfair ruling overturns Quill physical presence requirement

Ecommerce mobile checkoutOn June 21, 2018, in a 5-4 decision, the U.S. Supreme Court decided South Dakota v. Wayfair, Inc., a landmark case concerning sales and use tax nexus standards.1 Last year, the South Dakota Supreme Court held that a law requiring certain remote sellers to collect sales tax on sales made in the state was unconstitutional because it violated the physical presence requirement for sales and use taxes under Quill Corp. v. North Dakota2 and its application of the Dormant Commerce Clause3. In an opinion drafted by Justice Anthony Kennedy, the U.S. Supreme Court expressly overruled Quill because the physical presence rule is “unsound and incorrect.” The Court concluded that the South Dakota statute satisfies the substantial nexus standard that is a component of determining whether a tax can survive Dormant Commerce Clause scrutiny. The Court vacated the South Dakota Supreme Court’s decision and remanded the case to consider whether the South Dakota statute could be challenged on an alternative basis under the Commerce Clause.
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Kevin Herzberg
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Jamie C. Yesnowitz
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Background Under the contested legislation, certain remote sellers that sell tangible personal property, products transferred electronically, or services for delivery into South Dakota are subject to the state’s provisions governing the retail sales and service tax and uniform municipal non-ad valorem tax, and are required to remit sales tax as if they had a physical presence in the state4. Remote sellers are subject to these provisions if they meet one of two thresholds in either the previous or the current calendar year:

  • The seller’s gross revenue from the sale of tangible personal property, any product transferred electronically, or services delivered into South Dakota exceeds $100,000; or
  • The seller sold tangible personal property, any product transferred electronically, or services for delivery into South Dakota in 200 or more separate transactions5.

Based on the U.S. Supreme Court’s holdings in National Bellas Hess, Inc. v. Department of Revenue of Illinois6 and Quill, the South Dakota Supreme Court held that the contested law, S.B. 106, could not impose an obligation on the sellers to collect and remit sales tax because none of them had a physical presence in the state. The South Dakota Supreme Court did not find a “distinction between the collection obligations invalidated in Quill and those imposed by Senate Bill 106.”

Physical presence requirement overruled The U.S. Supreme Court in Wayfair overruled the long-standing physical presence requirement that was first enunciated by the Court in Bellas Hess in 1967 and reaffirmed by the Court in Quill in 1992. As a result, the Court is changing a fundamental aspect of the sales tax nexus requirements that were historically applicable under the Dormant Commerce Clause.

Commerce Clause principles explained The Commerce Clause grants Congress the power to “regulate Commerce . . . among the several States.”7 This is phrased as a positive grant of power to Congress, but the Court has “consistently held this language to contain a further, negative command, known as the [D]ormant Commerce Clause, prohibiting certain state taxation even when Congress has failed to legislate on the subject.”8 Under this principle, states are prohibited “from discriminating against or imposing excessive burdens on interstate commerce without congressional approval.”9 Wayfair concerns application of the Dormant Commerce Clause concept.

In reaching its decision, the Court reviewed its Commerce Clause principles and their application to state taxes. The Court provided the standards for applying the Commerce Clause to state taxes in Complete Auto Transit, Inc. v. Brady.10 The four-prong Complete Auto Transit test requires that: (1) there must be a substantial nexus between the taxpayer and the state; (2) the tax must be fairly apportioned; (3) the tax must not discriminate against interstate commerce; and (4) the tax must be fairly related to the services provided by the state. Prior to Complete Auto Transit, the Court considered in Bellas Hess an Illinois statute that required remote retailers to collect and remit sales tax for goods that were purchased for use in the state. The Court held that the remote seller did not have the necessary connection to Illinois required by the Due Process and Commerce Clauses because it did not have a physical presence in the state.

In 1992, the Court considered the physical presence standard again in Quill. The Court overruled the Due Process Clause holding, but reaffirmed the physical presence requirement as it applied to sales tax under the Commerce Clause. The Court in Quill acknowledged that intervening cases such as Complete Auto Transit might dictate a different result if the issue were being considered for the first time, but the physical presence requirement was necessary to prevent undue burdens on interstate commerce. Three of the Justices in Quill affirmed the physical presence requirement based solely on stare decisis.

Criticism of physical presence rule In Wayfair, the Court explained that the physical presence requirement has been widely criticized for years. According to the Court, the physical presence rule is moving further from economic reality and causing the states to experience significant sales tax revenue decreases. Embracing the criticism, the Court concluded that the physical presence rule is not a correct interpretation of the Commerce Clause.

According to the Court, “Quill is flawed on its own terms.” First, the physical presence rule is not a necessary interpretation of the substantial nexus requirement under Complete Auto Transit. Second, Quill causes rather than resolves market distortion. Third, the Court explained that “Quill imposes the sort of arbitrary, formalistic distinction that the Court’s modern Commerce Clause precedents disavow.”

In determining that South Dakota may impose a sales tax collection and remittance requirement on remote sellers if there is no additional connection to the state, the Court reviewed the distinctions between Due Process and Commerce Clause standards, and the effect of modern technology on these standards. In Bellas Hess, the Court explained that the nexus requirement is “closely related” to the due process requirement of “some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.”11 The Court has held that physical presence is not necessary to satisfy the Due Process Clause. In considering due process, the Quill Court noted that modern business frequently is transacted in states in which the business has no physical presence. Although the Due Process and Commerce Clause standards for determining whether a state may impose a tax may not be identical, there are significant parallels. The reasons that the Quill Court provided for rejecting the physical presence requirement for due process support a conclusion that physical presence is not required to impose a sales tax collection requirement on remote sellers under the Commerce Clause. In Quill, the Court explained that a physical presence rule is necessary to prevent an undue burden on remote retailers that may be required to collect tax in thousands of different jurisdictions. Due to modern technology, however, the Court noted in Wayfair that administrative costs of compliance often are unrelated to whether the retailer has a physical presence.

The Court previously has explained that the Commerce Clause is intended to prevent states from engaging in economic discrimination that would divide and isolate the states, but it should not relieve taxpayers engaged in interstate commerce of their state tax obligation. As applied to modern commerce, the Quill physical presence rule results in a competitive disadvantage for local retailers and remote retailers with a physical presence compared to remote retailers that lack a physical presence. By imposing the physical presence rule, “Quill has come to serve as a judicially created tax shelter for businesses that decide to limit their physical presence and still sell their goods and services to a State’s consumers—something that has become easier and more prevalent as technology has advanced.”12 Furthermore, retailers are provided with an incentive to avoid establishing a physical presence in states. A rejection of the physical presence rule is needed to prevent the Court’s decisions from creating artificial competitive advantages to certain businesses. Also, the Court’s Commerce Clause cases have applied a case-by-case analysis that considers the dynamics of the marketplace. In contrast, the application of Quill uses arbitrary criteria for treating entities that are identical from an economic perspective in a different manner.

In Quill, the Court acknowledged that the physical presence requirement is “artificial at its edges.”13 In Wayfair, the Court emphasized that this has become increasingly true because “[m]odern e-commerce does not align analytically with a test that relies on the sort of physical presence defined in Quill.” Furthermore, the Court in Wayfair challenged an underlying predicate of the physical presence rule, admonishing that it is unclear why an employee or building constitutes substantial nexus but elements of modern technology that have physical characteristics do not establish nexus. The Court explained that it “should not maintain a rule that ignores these substantial virtual connections to the State.”14

In rejecting Bellas Hess and Quill, the Court concluded that the physical presence rule created an imposition on the ability of states to collect taxes and provide essential services. The Court noted that 42 states, two territories and the District of Columbia had requested that the Court reject the physical presence rule. The Court explained in Wayfair that the effect of the physical presence rule “is unfair and unjust to those competitors, both local and out of State, who must remit the tax.” Also, the Court concluded that the rule is unfair to states that are attempting to fairly enforce their sales tax that provides a crucial source of revenue. According to the Court, the Quill physical presence rule “has limited States’ ability to seek long-term prosperity and has prevented market participants from competing on an even playing field.”

Stare decisis no longer supports limitations on states’ taxing authority Although the Supreme Court generally is very reluctant under the principle of stare decisis to overrule its prior decisions, in Wayfair the Court explained that overruling precedent in this matter was warranted and necessary, reflecting that the Internet’s dramatic growth has changed the national economy’s dynamics. The Court determined that reversing Bellas Hess and Quill was necessary because they prevented the states from exercising their lawful sovereign power to collect sales tax. After conceding that Congress could change the physical presence rule (the core position of the dissenting opinion in Wayfair), the Court explained that it should not ask Congress to rectify the Court’s false interpretation of the Constitution. Implementation of the Commerce Clause doctrines to the modern business world necessitates rejection of the physical presence rule. The Court opined that Quill was wrongly decided in 1992, but the growth of the Internet has exacerbated the decision’s negative effects. After discussing the dramatic online retail sales statistics, the Court noted that the large expansion of Internet sales has increased the sales and use tax revenue shortfall experienced by the states. The decline in revenue created an urgency for overturning the physical presence rule. In rejecting the argument that the physical presence rule is clear and easy to apply, the Court explained that “[a]ttempts to apply the physical presence rule to online retail sales are proving unworkable.”

The Court acknowledged in Wayfair that the rejection of the physical presence rule may place a heavy burden on small Internet retailers that have a small volume of business in many states. However, available software should ease this burden and Congress may decide to enact legislation to address this problem. In Wayfair, the South Dakota law provides small merchants with a reasonable level of protection because remote sellers only are required to collect sales tax if they do a considerable amount of business in the state. Also, the law is not retroactive and South Dakota is a member of the Streamlined Sales and Use Tax Agreement.15 Finally, other aspects of the Court’s Commerce Clause doctrine may serve to protect against an undue burden on interstate commerce. The Court concluded that the physical presence rule of Quill is “unsound and incorrect” and expressly overruled Bellas Hess and Quill.

Substantial nexus satisfied by South Dakota statute The Court determined that the substantial nexus required by Complete Auto Transit is “clearly sufficient based on both the economic and virtual contacts” the remote sellers had with South Dakota. Because the statute has defined parameters that only apply to remote sellers with annual in-state sales of more than $100,000 or 200 or more transactions for the delivery of goods or services in South Dakota, the seller is engaging in the substantial privilege of conducting business in the state.

Possible other Commerce Clause violations should be considered In concluding its opinion in Wayfair, the U.S. Supreme Court vacated the decision and remanded the case to the South Dakota Supreme Court because “[t]he question remains whether some other principle in the Court’s Commerce Clause doctrine might invalidate the [statute].” Because the statute clearly violated the Quill physical presence rule, other potential Commerce Clause concerns were not litigated or briefed. As a result, the South Dakota Supreme Court is directed to consider other potential claims. However, the Court noted that the South Dakota statute has several features that should prevent discrimination or undue burdens on interstate commerce. Specifically, the statute provides a safe harbor to remote sellers that only transact limited business in the state, and prevents a sales tax collection obligation from being applied retroactively. In the view of the Court, South Dakota’s adoption of the Streamlined Sales and Use Tax Agreement also supports the state against alternative Commerce Clause challenges of the statute.

Dissenting opinion would leave solution to Congress In a dissenting opinion joined by three other Justices, Chief Justice John Roberts explained that he would decline the invitation to abandon the physical presence requirement. The dissent agreed with the majority opinion that Bellas Hess was wrongly decided, but noted that e-commerce has grown to be a significant part of the national economy under the existing Commerce Clause and physical presence rules. According to the dissent, “[a]ny alteration to those rules with the potential to disrupt the development of such a critical segment of the economy should be undertaken by Congress.” The dissent argued that Congress is better able to consider the competing interests and has more flexibility than the Court in crafting a solution. Furthermore, the dissenting Justices concluded that “[t]he Court should not act on this important question of current economic policy, solely to expiate a mistake it made over 50 years ago.” The dissent also noted that the Court historically has applied a “heightened form of stare decisis in the [D]ormant Commerce Clause context.” Further, the Court’s fundamental change in the sales tax nexus standard may impede Congress’s consideration of the issue. The dissent also disagreed with the majority’s sense of urgency concerning lost state sales tax revenue because some large Internet retailers are voluntarily collecting sales tax. According to the dissent, the majority disregarded the costs that will be incurred by retailers to collect and remit the tax on e-commerce sales. This compliance cost would fall disproportionately on small retailers.

Commentary The U.S. Supreme Court’s decision to overrule the physical presence rule that was required by the Court’s interpretation of the Dormant Commerce Clause in Bellas Hess and Quill represents a fundamental change in the constitutional sales tax nexus standard that has been applied for over 50 years. Under stare decisis, the Court is very cautious to overrule its prior decisions, and a finding by the Court that a rule developed in its own prior decisions was “unsound and incorrect” is truly rare. This decision is particularly important because it will directly affect many Internet retailers that constitute a significant portion of the U.S. economy. Many people and states have criticized the physical presence requirement for years, but it is noteworthy that the Court has decided to make such a major change.

Companies should review out-of-state activities This significant change in the sales and use tax nexus standard warrants companies to conduct a thorough review of their activities in jurisdictions in which they do not have a physical presence. Implications of existing economic nexus rules and those to be implemented in the future will need to be understood and built into a company’s reserves and compliance obligations.

States likely to enact further sales tax nexus legislation While Wayfair is remanded in order to evaluate the applicability of other possible Commerce Clause principles, Justice Kennedy’s majority opinion tacitly endorses South Dakota’s sales tax nexus threshold tests, providing the opportunity for states to establish standards that, in their judgment on application, reflect enough “substantial virtual connections” to the state to support tax nexus. States may act eagerly, and try to move quickly in response to Wayfair to adopt these types of standards.

Although the Court determined that the South Dakota statute satisfies the substantial nexus standard, it is unclear what sales or transaction thresholds are necessary to pass constitutional muster. Several states such as Illinois, Indiana, Iowa, Kentucky and Maine have enacted legislation with the same thresholds that are included in the South Dakota law. Most states have adopted the standards by enacting legislation, but at least three states, Alabama16, Massachusetts17 and Tennessee18, have accomplished this by promulgating administrative regulations. Wayfair does not address whether the promulgation of regulations is sufficient to adopt an economic nexus standard. It is possible that states may decide to enact legislation with lower thresholds.19 In contrast, some states may decide to enact legislation that has a sales threshold that is greater than $100,000 and/or a transaction threshold greater than 200.20 This may benefit some remote retailers, but will decrease uniformity among states. Alternatively, states may decide to completely change current tax laws and reporting requirements. Wayfair may encourage local governments to enact sales tax in states that allow local taxes.

Future of notice and reporting requirements As a result of this decision, states such as Colorado no longer need to rely on the notice and reporting requirement statutes on noncollecting retailers that were becoming popular as a means to circumvent the physical presence rule. Wayfair also apparently obviates the Multistate Tax Commission’s current project to develop a model sales and use tax notice and reporting statute.

Potential Dormant Commerce Clause challenges Based on the decision, it appears at first blush that it would be very difficult to challenge this law on Dormant Commerce Clause grounds if substantial nexus is no longer available, though the Court leaves the door slightly ajar for such a challenge. In Wayfair, factors such as no retroactive application of the statute, a safe harbor for limited sales, South Dakota’s adherence to the Streamlined Sales and Use Tax Agreement, and the provision of compliance software all supported a conclusion that the South Dakota statute satisfied the Dormant Commerce Clause. However, it is not clear whether states are required to adhere to all of these factors under the Dormant Commerce Clause standards.

Status of South Dakota economic nexus statute At this point, it is unclear as to exactly when the South Dakota statute will become operative. Based on the U.S. Supreme Court’s order to vacate and remand the case, the South Dakota litigation continues for now. Wayfair and other litigants will be required to decide whether they want to pursue a challenge of the statute on Commerce Clause grounds without the ability to use the substantial nexus argument. If so, the injunction against enforcement of the South Dakota statute, which was put into effect by the terms of the South Dakota statute itself, could continue for some time. An argument can be made that the Court’s action vacating the decision and allowing for litigation to determine whether another Commerce Clause violation may have occurred goes beyond the Dormant Commerce Clause analysis. There is a possibility that the Court has expanded the remand beyond an analysis of the other three factors of Complete Auto Transit.

Wayfair’s broad impact may extend to income tax Although Wayfair is a sales tax nexus decision, its impact is likely to be felt broadly. While not stated by the Court, with the elimination of the physical presence rule from sales and use taxation, the application of Quill to the income tax no longer appears possible. The Court’s decision to approve economic nexus thresholds in the sales tax context may validate economic nexus statutes and court decisions applicable to state income taxes. Because Wayfair may have income tax implications, possible ASC 740 issues should be considered. Wayfair may encourage more states to enact income tax laws that implement a bright-line nexus standard. Thus, the change in the nexus landscape may extend far beyond sales tax.

Possible congressional response In addition to expected state action in this area, Congress eventually could enact legislation to provide a uniform standard. In light of the expressed economic policy determinations underlying the Court’s conclusions in Wayfair – and the Court’s implicit invitation to Congress to address the issue if it sees fit to do so – lobbying interests on both sides of the issues can be expected to press their positions on state tax matters in the maturing Internet/e-commerce economy. Assuming that the South Dakota statute survives any further challenges, and more states adopt economic nexus standards, the non-uniformity in this area may place additional pressure on Congress to eventually address this issue.

Significant long-term effects of Wayfair In sum, the Court’s decision to overrule its long-standing physical presence rule is a profound change in state tax jurisprudence. With more to come from lower courts in this area, and states and possibly Congress to be heard from in response, we expect the significance and impact of Wayfair to reflect in commentary, analysis and ramifications for years to come.

1. U.S. Supreme Court, No. 17-494, June 21, 2018. Justice Kennedy delivered the opinion, in which Justices Thomas, Ginsburg, Alito and Gorsuch joined. Justices Thomas and Gorsuch filed concurring opinions. Chief Justice Roberts filed a dissenting opinion, in which Justices Breyer, Sotomayor and Kagan joined.
2. 504 U.S. 298 (1992).
3. 901 N.W.2d 754 (S.D. 2017), cert. granted, 199 L. Ed. 2d 602 (2018). For a discussion of this case, see GT SALT Alert: South Dakota Supreme Court Holds Law Challenging Quill’s Physical Presence Requirement Is Unconstitutional.
4. S.D. CODIFIED LAWS §§ 10-64-1 to 10-64-9, as enacted by S.B. 106, Laws 2016. For a discussion of this legislation, see GT SALT Alert: South Dakota Enacts Legislation Challenging Quill’s Physical Presence Requirement.
5. S.D. CODIFIED LAWS § 10-64-2.
6. 386 U.S. 753 (1967).
7. U.S. CONST. art. I, § 8, cl. 3.
8. Oklahoma Tax Comm’n v. Jefferson Lines, Inc., 514 U.S. 175, 179 (1995).
9. Comptroller of the Treasury of Maryland v. Wynne, 135 S. Ct. 1787, 1794 (2015).
10. 430 U.S. 274 (1977).
11. Bellas Hess, 386 U.S., at 756, quoting due process requirement from Miller Brothers Co. v. Maryland, 347 U.S. 340, 344-345 (1985).
12. Emphasis added.
13. 504 U.S., at 315.
14. Emphasis added.
15. According to the Streamlined Sales Tax Web site, “[t]he purpose of the Agreement is to simplify and modernize sales and use tax administration in order to substantially reduce the burden of tax compliance.” At present, 24 states have adopted the Agreement’s simplification measures.
16. ALA. ADMIN. CODE r. 810-6-2-.90.03.
17. MASS. REGS. CODE tit. 830, § 64H.1.7.
18. TENN. COMP. R. & REGS. 1320-05-01-.129.
19. For example, Pennsylvania has enacted legislation that requires remote sellers, marketplace facilitators and referrers with at least $10,000 in Pennsylvania sales during the immediately preceding 12 calendar-month period to file an election to either: (i) collect and remit sales tax to the state; or (ii) comply with new notice and reporting requirements. 72 PA. STAT. § 7213.1(a).
20. For instance, effective January 1, 2019, Georgia has enacted legislation requiring delivery retailers with gross revenue exceeding $250,000 from retail sales of tangible personal property or 200 or more separate retail sales in Georgia in the current or previous calendar year to either: (i) collect and remit sales tax to the state; or (ii) comply with new notice and reporting requirements. GA. CODE. ANN. § 48-8-30(c.2).

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