As businesses evolve to meet the needs of customers in an increasingly instantaneous and borderless commercial environment, transactions are inevitably becoming more complex. Business models have increased in complexity with the use of e-commerce, supply chain management, dual branding, and multi-chain retailers. State tax codes, while arguably complex, have largely failed to keep up with the evolution of commercial transactions. Many state tax codes are still based on the premise that a sales transaction involves only two parties: a seller and a buyer. Modern transactions can involve far more than two parties. In addition, transactions involving remote sellers raise sales and use tax issues, including whether a remote seller has nexus with a state if its only connection to that state is the presence of a retailer or manufacturer that supplies goods to the seller’s customers.
Other common commercial transactions include drop shipments and flash title transactions. Drop shipments involve a customer in one location who places an order with a retailer in a second location, which requests that a supplier in yet another location fill the order and ship the item directly to the customer. The sales and use taxation of drop shipments can be complex because not all states treat drop shipment transactions the same. Another type of transaction involves something called a “flash title.” This occurs in a transaction where an out-of-state entity holds legal title to an item in the stream of interstate commerce but the item is in the control of a third party (typically a common carrier). During the course of shipment, title passes at a contractually agreed upon point at which neither the seller nor the purchaser has business operations and thus theoretically no nexus. However, some states have attempted to use flash title to assert sales and use tax nexus over a remote seller.
This column first provides an overview of the theories surrounding substantial and attributional nexus and then examines how nexus is asserted for sales and use tax purposes in drop shipment and flash title transactions.
Substantial Nexus
Before a state can impose a tax on an interstate business, the tax must overcome the limitations of the Commerce Clause, which the U.S. Supreme Court has interpreted in a number of important cases. Most notably, in 1977, in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the Court established a fourprong test that a tax must pass to withstand Commerce Clause scrutiny. One of those prongs, the Court explained, is the requirement that a challenged tax is applied to an activity with a substantial nexus with the taxing state.
Whether an activity has substantial nexus with the taxing state has been the subject of much state litigation, some of which has made its way back to the Court. The crux of the controversies has been the meaning of substantial nexus. Ten years prior to Complete Auto, the Court, without specifically defining the term “substantial nexus,” established in National Bellas Hess, Inc. v. Department of Revenue, 386 U.S. 753 (1967), the principle that nexus, for sales and use tax purposes, requires an in-state physical presence. Bellas Hess was a mail-order vendor based in Missouri that solicited orders for merchandise through the mail and made deliveries by mail or common carrier. The Court ruled that Illinois could not force Bellas Hess to collect sales tax on sales to Illinois residents because Bellas Hess had no offices, outlets, tangible property, salespersons, or any other type of physical presence in Illinois. The Court reasoned that a mail-order vendor “whose only connection with customers in the State is by common carrier or the United States mail” should not be required to collect sales tax because this could entangle the interstate business in a “welter of complicated obligations.”
In 1992, post–Complete Auto, the Court affirmed the Bellas Hess physical presence test in another mail-order/sales tax case, Quill Corp. v. North Dakota, 504 U.S. 298 (1992). Quill was a mail-order vendor of office supplies that had no physical presence in North Dakota. The Court concluded that an in-state physical presence was required to satisfy the substantial nexus test under the Commerce Clause and therefore North Dakota could not force Quill to collect sales tax on sales within the state. In addition, the Court in Quill denied the state’s argument that the in-state presence of floppy disks owned by Quill constituted physical presence within the state, thereby establishing substantial nexus. In denying that argument, the Court indicated that the “slightest physical presence” did not equate to substantial nexus under the Commerce Clause. Notably, however, the decision did not specifically address the issue of whether a physical presence test applied to income tax nexus.
After Quill, states still are grappling with what constitutes substantial nexus under the Commerce Clause. While most courts acknowledge that physical presence is required for sales and use tax nexus, the physical presence does not always have to be that of the taxpayer. A related entity or independent contractor can establish nexus for the taxpayer under the theory of attributional or affiliate nexus.
Attributional Nexus
As noted above, substantial nexus, for sales and use tax purposes, requires that a taxpayer have physical presence in the taxing state. However, for both sales and use tax and income tax purposes, courts have permitted states to assert nexus over a taxpayer on the basis of that taxpayer’s relationship with another entity that is physically present in a state. This is referred to as attributional nexus because the physical presence of the in-state entity is imputed to the out-of-state taxpayer on the basis of their relationship. Two relationships in particular have been used to create attributional nexus: agency and affiliation.
Agency
States have applied agency principles to nexus determinations and have held that the physical presence requirement may be met even in the absence of the taxpayer’s own physical presence in the state if an agency relationship exists in which the in-state agent is physically present in the state. Agency is a common law theory in which two parties enter into a relationship where the agent is authorized, expressly or implicitly, to act on behalf of the principal to create a binding, legal relationship with a third party.
To establish an agency relationship, courts have tended to focus on whether the in-state entity fits the definition of an agent. However, some commentators have suggested that this one-dimensional analysis fails to take into account whether the in-state entity is acting under the authority and control of an actual principal. In other words, if a court focuses solely on the authority and control of the principal over the agent and does not examine any other components of an agency relationship, such as consent and capacity, the court’s analysis may be insufficient.
A true agency relationship is not necessarily required, however, for attributional nexus to exist. In Scripto Inc. v. Carson, 362 U.S. 207 (1960), the Supreme Court held that constitutional nexus can exist for an out-of-state taxpayer through its in-state representatives, even where the representatives had no authority to enter into binding contracts on behalf of the out-of-state taxpayer. While arguably the facts in Scripto indicate that there was an agency relationship present, the Court declined to examine whether an agency relationship was required to establish attributional nexus. The Court concluded that “[t]he test is simply the nature and extent of the activities” of the in-state representatives.
Twenty-seven years later, the Court established a more modern attributional nexus test in Tyler Pipe Industries, Inc. v. Washington Dep’t of Rev., 483 U.S. 232 (1987). In that case, the Court quoted with approval language used by the Washington Supreme Court that “the crucial factor governing nexus is whether the activities performed in this state on behalf of the taxpayer are significantly associated with the taxpayer’s ability to establish and maintain a market in this state for sales.”
Affiliation
States also have looked at a taxpayer’s affiliations to establish attributional nexus. Several states have taken the position that if an in-state entity and an out-of-state entity are commonly owned, attributional nexus is potentially created for the out-of-state entity. Affiliated entities can include parent corporations and subsidiaries, provided one entity exercises sufficient control over another. It is important to note that simply being affiliated with an in-state entity is not sufficient to create nexus for an out-of-state entity. Rather, something more is required, but exactly how much more is unclear.
Drop Shipments
Establishing sales and use tax nexus in a complex commercial transaction can be a touchy subject. One type of transaction that is frequently used with retail transactions is drop shipments. In a typical drop shipment transaction, a customer places an order with a seller. Rather than maintaining an inventory of goods, the seller contacts a manufacturer or wholesaler (the drop shipper), who fills the order and ships the product directly to the customer. The manufacturer or wholesaler bills the seller, who bills the customer.
Drop shipments were traditionally used by large mail-order companies. Today, with the advent of e-commerce, many small companies use drop shipments because they do not maintain an inventory of goods. But drop shipments are not limited to traditional retail transactions by small retailers. Many industries use transactions that include drop shipments, and even large retailers engage in drop shipments. Despite the benefits of drop shipping, drop shipments can create tax consequences for the seller. From a sales and use tax perspective, if the seller has nexus or is voluntarily registered in the state where the sale occurred, the seller will collect sales and use tax on the sale of the product to the customer. If neither the seller nor the third-party drop shipper has nexus with the state in which the sale occurred, neither can be required to collect sales and use tax on the sale. In that situation the customer would be required to pay use tax on the purchase of the item unless an exemption applied.
Those two scenarios are relatively simple because it is clear either that the seller has substantial nexus with the taxing state or that neither the seller nor the drop shipper has substantial nexus with the taxing state. Things get a bit murkier when the seller does not have nexus and is not voluntarily registered in the state where the sale occurred but the drop shipper has nexus with the state. For example, in a situation involving an out-of-state retailer, an outof- state wholesaler that has nexus with State A, and an in-state customer, if the wholesaler sold a product and delivered it directly (from an out-of-state warehouse) to the out-of-state retailer, State A would not impose sales and use tax on the transaction. Likewise, if the out-of-state seller, who has no nexus with State A, sold and shipped a product to the in-state customer, Quill prevents State A from imposing sales and use tax collection duties on the retailer. Although a drop shipment involves those two transactions, it is treated as a single three-party transaction. The way some states treat the single “merged” transaction permits nexus to be established for the outof- state retailer through the wholesaler or drop shipper.
State Differences
Sales tax laws in several states include statutory provisions that impose sales and use tax collection obligations on the drop shipper. While not an exhaustive list, these states include California, Massachusetts, Nebraska, Nevada, Rhode Island, Tennessee, and Wisconsin. Other states, including Pennsylvania and Texas, do not have specific statutory provisions on drop shipping but have administrative rulings that impose sales tax obligations on the drop shipper, unless the drop shipper obtains a valid resale certificate from its customer.
In California, if an out-of-state retailer asks a California drop shipper to ship products to the retailer’s California customers, the drop shipper generally must report and remit sales tax based on the price charged to the ultimate consumer. If the drop shipper does not know that price, it is permitted to estimate sales tax based on its selling price to its customer plus a 10% markup. The California Court of Appeals upheld the constitutionality of the state’s drop shipment statute (CA Rev. & Tax. Code §6007) in Lyon Metal Products, Inc. v. State Board of Equalization, 58 Cal. App. 4th 906 (1997). In Lyon, the court held that the drop shipment statute did not violate the Commerce Clause because the goods that were stored in a California warehouse and delivered to California customers created substantial nexus with the state.
In Tennessee, drop shippers are required to collect sales tax on the transaction unless specific and satisfactory arrangements have been made with the commissioner of revenue before the sales and deliveries are made. That requirement was upheld in Upper East Tennessee Distributing v. Johnson, No. 03A01-9701-CH-00011 (Tenn. Ct. App. 5/13/97). Likewise, the Pennsylvania Department of Revenue issued a letter ruling concluding that a drop shipper with Pennsylvania nexus was required to collect sales tax on its drop shipment unless it had obtained a properly completed exemption certificate (PA Sales and Use Tax Ruling No. SUT-99-134 (2/2/00)). And in Texas, the comptroller of public accounts has ruled that a drop shipper shipping tangible personal property is liable to collect use tax from the purchaser if it fails to collect a valid resale certificate from its customer (TX Comptroller’s Dec. No. 9,262 (8/1/80)).
By contrast, there are other states, including New Jersey, Florida, Idaho, Illinois, Iowa, and Michigan, that do not require drop shippers to collect and remit sales tax on drop shipments. In New Jersey the Tax Court, through two cases, established that drop shippers delivering products to the in-state customers of out-of-state retailers were not required to collect sales and use tax if they provided a New Jersey resale certificate or other evidence that the sales were for resale (Steelcase Inc. v. Director, Div. of Taxation, 13 N.J. Tax 182 (1993); Solo Cup Co. v. Director, Div. of Taxation, No. 07-14-1301- 91ST (N.J. Tax Ct. 4/5/93)).
In Florida, the Department of Revenue has addressed drop shipments in several technical assistance advisements (TAAs). For example, in a 2007 TAA, the department concluded that an out-of-state drop shipper registered with Florida to collect sales and use tax is not required to collect tax on sales to an out-of-state dealer if the product is shipped into Florida via common carrier from an out-of-state location (TAA No. 07A-008 (3/29/07)). The department reasoned that the sale was not a Florida sale because both the drop shipper and the dealer were located outside the state.
Flash Title
Flash title transactions, a term gaining recognition within state taxation, create nexus issues similar to drop shipments. To grasp the nexus issues associated with flash title transactions, one first must understand what constitutes such a transaction. In a typical flash title transaction, an out-of-state seller enters into a transaction with a buyer in another state and ships a good in interstate commerce via a thirdparty common carrier. Although the common carrier controls the item during shipment, the seller retains legal title. At some point during the shipment, title is legally transferred pursuant to contract terms from the seller to the buyer. This is usually effectuated in a state where neither party has nexus.
Logically examining a flash title transaction, it does not appear that such a transaction would create nexus on behalf of either the seller or the buyer because arguably neither party has a physical presence in the state where the title passes. However, it is possible that, for purposes of sales tax, nexus may be established via the agency or contractual relationship with the common carrier. In the context of an agency relationship, the question would be whether the seller had “control” over the item when the title passed. In addition, it does not seem as though either party has satisfied the requirements for attributional nexus based on Tyler Pipe because neither party has established or maintained a market in the state of transfer.
Unfortunately, taxpayers do not have much guidance to rely on when determining whether flash title transactions create sales and use tax nexus in a particular state because no states have ruled directly on the issue. However, the Oklahoma Supreme Court has ruled on a related case. In Koch Fuels, Inc. v. Oklahoma Tax Comm’n, 862 P.2d 471 (Okla. 1993), the Oklahoma court ruled that the imposition of sales tax on the sale of fuel oil that entered a pipeline in Oklahoma but was extracted from the pipeline in Nebraska was unconstitutional because it discriminated against interstate commerce. Although the Oklahoma court did not specifically address flash title nexus, the fact pattern was similar enough to that of flash title transactions that the ruling was later referred to in other state court decisions regarding flash title transactions.
While flash title transactions have not been examined by courts with regard to sales and use tax nexus, several states have decided whether a flash title or similar transaction creates nexus for corporate income tax purposes. Although not on point, such rulings may help taxpayers determine whether such transactions will create sales and use tax nexus in the related states. In Montana, the State Tax Appeals Board determined that a taxpayer was subject to the corporate license (income) tax because it had title and possession of gas in Montana. In Williams Companies, Inc. v. Department of Revenue, No. CT-1996-1 (Mont. State Tax Appeal Bd. 12/31/98), the taxpayer purchased gas from a Canadian company at the international border, imported the gas into the United States, and resold the gas to U.S. purchasers. Because the taxpayer “held title to, and was deemed to be in control and possession of, the gas” for a period of time, no matter how long or short that period may be, the board held that the transaction created nexus in Montana on behalf of the taxpayer.
Likewise, the Indiana Department of Revenue, in Rev. Rul. No. URT 05-02, concluded that a flash title of natural gas within the state created substantial nexus and thus subjected the taxpayer to the gross utilities tax. Although holding flash title to the natural gas was the taxpayer’s only activity within the state, the department reasoned that it constituted the “ownership of inventory” in the state, thereby establishing substantial nexus. In Letter of Finding No. 03-0487, the department reaffirmed that flash title creates substantial nexus in the state. In this case, a seller located in Texas had a sister corporation located in Indiana that manufactured its products. When the seller received an order, the manufacturer produced the products and shipped them directly to the customer. The manufacturer transferred title to the seller at the time the customer received the products, and the seller immediately transferred title to the customer. Indiana ruled that the seller held inventory in Indiana for the moment that the seller held flash title to products sold to in-state customers and that the activities of the manufacturer with respect to the sales to in-state customers was sufficient to take the seller out of the protections of P.L. 86-272.
On the flip side, several states have ruled that a flash title transaction does not establish income tax nexus with the state. For example, an administrative law judge (ALJ) for the New York Division of Tax Appeals held in Wascana Energy Marketing (U.S.), Inc., No. 817866 (NY Div. of Tax. App., ALJ 7/18/02), that holding flash title to natural gas within the state would not subject the taxpayer to the corporate tax because the taxpayer was not carrying on business within the state. In addition, the ALJ ruled that such an imposition of tax would have violated the Commerce Clause.
The Missouri Department of Revenue came to a similar conclusion. In Letter Ruling LR 3885 (5/17/07), an out-ofstate retailer sold items to customers via a website, the only connection with the state being the “momentary ownership of tangible personal property.” The department held that such a brief ownership of property within the state was not enough to truly establish property ownership for purposes of the corporate income and franchise tax because it would have violated the Commerce Clause, which requires substantial nexus, not a mere de minimis contact with the taxing state.
Although the income tax holdings may be beneficial in trying to predict how states will treat flash title transactions for sales and use tax nexus purposes, they are not directly on point and as a result can be used only as guidance. The physical presence requirement for sales and use tax nexus or the potential agency analysis for attributional nexus have not been fully examined at this point. Thus, the limited guidance, coupled with the contradicting decisions among various state courts, does not lend taxpayers any clarity when trying to decipher whether a flash title transaction creates sales tax nexus in a given state.
Things to Consider
Because the transactions of many sellers may fit within the context of drop shipments or flash title, the tax issues that result from these transactions, including the assertion of nexus, may come as a surprise to taxpayers. Taxpayers must review their business models to determine whether their transactions fall within the ambit of a state’s law or court opinion on drop shipment or flash title. Taxpayers also should proceed cautiously when making drop shipments or engaging in flash title transactions to avoid unexpected sales and use tax obligations.
Conclusion
Sales and use tax nexus standards with regard to drop shipments and flash title are unclear and can vary from state to state. In addition, concepts such as attributional or agency nexus permit a related entity to create nexus for an out-of-state company. To add to the confusion, state courts have been inconsistent in defining substantial nexus under the Commerce Clause, Congress has taken little action, and the U.S. Supreme Court has been unwilling to follow up its opinion in Quill. The resulting patchwork of legal authority leaves taxpayers with little guidance yet many questions.
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Editor Notes
Karen Nakamura is director of tax knowledge management with PricewaterhouseCoopers LLP in Washington, DC. She is chair of the AICPA Tax Division’s State & Local Tax Technical Resource Panel. Cara Griffith is a manager and Stephanie Stewart is a senior associate in tax knowledge management with PricewaterhouseCoopers LLP in Washington, DC. For more information about this column, contact Ms. Griffith at cara.griffith@us.pwc.com or Ms. Stewart at stephanie.r.stewart@us.pwc.com.
