In late June 2018, the U.S. Supreme Court reversed a long-standing position and ruled that a physical presence was not required in order for a state to impose a sales and use tax collection obligation on an out-of-state business. The Court’s recent decision in South Dakota v. Wayfair, Inc. overturned the Court’s 1992 Quill Corp. v. North Dakota decision, which had upheld the physical presence nexus standard established by the Court in 1967 in National Bellas Hess v. Department of Revenue of Illinois. The Court in Wayfair concluded that the physical presence rule it had previously endorsed was “unsound.”
Although Wayfair specifically addresses sales and use tax, the decision has tangential implications for other taxes levied by states. In 1993, a year after Quill, South Carolina’s highest court ruled that the concept of economic nexus could be applied to the state’s income tax. In Geoffrey, Inc. v. South Carolina Tax Commission, the South Carolina Supreme Court concluded that Quill applied only to sales and use tax. The court held that notwithstanding the lack of a physical presence, an out-of-state company that licensed trademarks, trade names, and other intellectual property of Toys R Us (including Geoffrey the Giraffe) was subject to the state’s income tax because it was regularly exploiting the markets of the state. In the years that followed, the supreme courts of several other states similarly held that economic nexus could be applied to state taxes other than sales and use tax.
In 2006, West Virginia’s Supreme Court in Tax Commissioner of West Virginia v. MBNA America Bank upheld the imposition of the state’s business franchise and corporation net income taxes on an out-of-state bank with no physical presence in the state. The court found the taxpayer continuously had engaged in direct mail and telephone solicitation in West Virginia. According to the court, the “systematic and continuous business activity” in the state “produced significant gross receipts attributable to its West Virginia customers.”
Since Quill and prior to Wayfair, the U.S. Supreme Court had declined to accept taxpayer petitions to review state income tax economic nexus decisions issued by state courts. This refusal led some taxpayers and tax practitioners to question the constitutionality of state assertions of economic nexus. Wayfair effectively solidifies the position of a majority of states (more than 40 at last count) that a physical presence is not required for the imposition of state income and franchise taxes.
Wayfair and banks
From a sales tax perspective, Wayfair’s implications for many banks are limited. Most banks don’t sell products and services that would be subject to sales tax. On the use tax side, banks can expect their vendors to charge sales tax on most transactions, reducing the need to self-assess use tax. The good news is that this will minimize use tax assessments if a bank is audited by a state. On the other hand, banks may overpay sales and use tax since vendors likely will charge sales tax on virtually everything.
In fact, Wayfair might have favorable income and franchise implications for some taxpayers, including banks. Since the 1992 Quill decision, there had been a presumption that any physical presence in a state was sufficient to establish tax nexus (although this wasn’t specifically articulated in the decision itself). In Wayfair, the Court essentially concluded that physical presence was irrelevant, or as stated in the decision, nexus based on physical presence is an “incorrect interpretation of the Commerce Clause.”
The key determinant for Commerce Clause substantial tax nexus now might be whether, and the extent to which, a taxpayer is establishing and maintaining an in-state market. Accordingly, a bank could have a nominal amount of presence in a state, a few loans or depositors (or actually have a physical presence, say a foreclosed parcel of real property or a remote employee), and not have tax nexus, as long as the bank was not establishing or maintaining a market in the state.
Moreover, the negative impact of the so-called tax apportionment throwback or throwout rules that exist in some states might be mitigated by Wayfair. Under a typical throwback provision, receipts that generally would be sourced to another state are assigned to the taxpayer’s commercial domicile if the taxpayer is not subject to an income tax or privilege tax in the other state. Throwout is similar except that if a taxpayer is not subject to tax in the other state, receipts otherwise sourced to the other state effectively are eliminated from both the numerator and the denominator of the taxpayer’s receipts factor. Throwback and throwout rules typically increase tax liability in the taxpayer’s headquarters state. The broad application of an economic nexus standard by many states, however, can reduce the unfavorable tax consequences of throwback and throwout rules.
In its second quarter 2018 SEC Form 10-Q, one global money-center bank recorded a significant state tax expense, citing the Wayfair decision as the cause. Likewise, even though Wayfair primarily is focused on sales and use tax, many banks and other taxpayers are regarding the decision as an opportunity to re-examine their multijurisdictional activities and the related impact on financial statement income tax provisions.