Economic Nexus and the Uncertainty of Quill’s Physical-Presence Test

By Marianne Evans, CPA, J.D., LL.M.; Sarah McGahan, J.D., LL.M.

Editor: Mary Van Leuven, J.D., LL.M.

In March 2007, two petitions for certiorari were filed with the U.S. Supreme Court that, if granted, could potentially decide one of the most important unanswered questions facing state taxpayers. That question involves the issue of economic nexus—specifically, whether it is Constitutional for a state to impose tax on a taxpayer with no physical presence in that state.

The question of nexus for sales and use tax collection responsibilities was addressed in Quill v. North Dakota, 504 US 298 (1992). There, the Court held that the Commerce Clause requires a physical presence in the state before a state can require an out-of-state seller to collect sales and use taxes. However, Quill did not specifically state that the physical-presence nexus requirement also applied to other types of taxes, such as income and franchise. This lack of clarity has generated uncertainty for taxpayers, because states are split on the question of whether an out-of-state taxpayer that does not have a physical presence in a state can be compelled to file income or franchise tax returns there.

Recent Cases

In both Lanco, Inc. v. Dir., Div. of Tax’n, NJ Sup. Ct., Dkt. No. A-89-05, 10/12/06, and Tax Comm’r of WV v. MBNA America Bank, N.A., 640 SE 2d 226 (WV 2006), the states’ highest courts held that the physical-presence requirement applied only to sales and use taxes, and that physical presence was not required to establish nexus under the Commerce Clause for income and franchise tax purposes.

MBNA: The taxpayer in MBNA was principally involved in the business of issuing and servicing credit cards and extending unsecured credit to cardholders. Under West Virginia law, a financial organization is presumed to have nexus in the state if it solicits business with 20 or more persons in the state or has annual gross receipts of at least $100,000 from in-state sources; see WV Code §§11-23-5a and 11-24-7b.Thus, MBNA was deemed to have nexus with West Virginia under state law, even though it had no employees or property in that state.

The state supreme court concluded that Quill’s physical-presence requirement applied only to sales and use taxes:

because Quill’s physical-presence test for sales and use taxes was based in large part on the mail order industry’s reliance on Bellas Hess, we are not compelled to apply Quill’s physical presence standard to the present circumstances.

The court concluded that a reasonable construction of the language in Quill implies that the ruling applies only to sales and use taxes. The court noted that there are significant distinctions between sales and use taxes, and franchise and income taxes—specifically, sales and use tax laws are far more burdensome than compliance with the taxes at issue. Finally, the court concluded that the physical-presence test made little sense in today’s world, in which technology makes it possible to conduct business in a state without having a physical presence.

Lanco: Lanco was a Delaware corporation that licensed trademarks, tradenames and service marks to an affiliated corporation operating retail clothing stores in New Jersey. Lanco’s only connection to New Jersey was the receipt of royalty income from the licensing of its intangibles to an affiliate in the state. In upholding the state’s assertion that Lanco had nexus with the state, the N.J. Supreme Court substantially adopted the reasoning articulated in the lower court’s opinion (379 NJ Super. 562 (2005)). The lower court had relied heavily on the North Carolina Court of Appeals’ decision in A&F Trademark, Inc., 167 NC App. 150 (2004), which held that:

  1. Quill did not provide a sweeping endorsement of physical presence.

  2. Quill’s reliance on stare decisis is not analogous outside sales and use taxes.

  3. There are significant distinctions between the two types of taxes.       

Acknowledging the discrepancies in state tax decisions, the New Jersey court stated that a “better interpretation of Quill is the one adopted by those states that limit the Supreme Court’s holding to sales and use taxes.” The court also asserted that it does “not believe that the Supreme Court intended to create a universal physical-presence requirement for state taxation under the Commerce Clause.” Most important, the court did not specifically limit its holding to instances involving the licensing of intangible property between related parties.


Both taxpayers filed petitions for certiorari almost simultaneously, perhaps hoping that the existence of two cases will compel the Court to decide to grant the petitions. Whether they will be granted, however, is another compelling question. The Court generally hears only about 100 cases of the 7,000 petitions it receives per term. On the other hand, there is clearly a split in state court decisions addressing the applicability of the physical-presence rule to taxes other than sales and use. The facts in MBNA are nearly identical to those in a Tennessee Court of Appeals decision in J.C. Penney Nat’l Bank v. Johnson, 19 SW 3d 831 (2000), in which the court held that the imposition of franchise and excise taxes against an out-of-state credit card company with no physical presence in Tennessee was unconstitutional. Further, although a number of state courts have held that the physical-presence rule does not apply in cases involving the licensing of intangibles to related parties, a number of state judicial and administrative decisions uphold the physical-presence rule. The lack of clarity on the Constitutional limits on states’ powers to tax has produced inconsistency among states and complicates the filing burdens of many multistate taxpayers. 

Financial Reporting Implications

The lack of clarity may also affect financial reporting. Under Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes, effective in 2007, a company must determine whether it is more likely than not that each of its tax positions would prevail under the laws, regulations and administrative practices applicable to the tax position. Detection risk cannot be considered. If a company’s position that it is not required to file an income tax return in a state does not meet this threshold, it must accrue for related liabilities, interest and potential penalties in its financial statements based on the more-likely-than-not tax position that would prevail if the tax position were examined.

The state and local tax communities are waiting anxiously for a possible resolution of these issues. If the Court does not grant certiorari in these cases, the likely result is more costly litigation for both sides. Of course, there is no guarantee that a grant of certiorari will result in a bright-line test for taxpayers and states. Nevertheless, many are hopeful that the Court will issue a ruling that can be used to provide certainty for state tax compliance and financial reporting purposes. 


Mary Van Leuven, J.D., LL.M. is a Senior Manager at Washington National Tax KPMG LLP in Washington, DC.

Unless otherwise indicated, contributors are members of or associated with KPMG LLP. The views and opinions are those of the authors and do not necessarily represent the views and opinions of KPMG LLP. The information contained herein is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser.

© 2007 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved.

If you would like additional information about these items, contact Ms. Van Leuven at

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