Under U.S. constitutional principles, a taxing jurisdiction cannot require a retailer to collect and remit state and local sales and use taxes unless the retailer has a physical presence in the jurisdiction. 1 When a retailer has more than a de minimis physical presence in a state, it usually has nexus with the state and must collect and remit that state’s sales and use taxes. Having a physical presence does not necessarily mean that the retailer operates a retail establishment in the state or has employees always present in the state. It simply means that the retailer, its employees, or its property are physically present in the taxing jurisdiction in furtherance of some business-related purpose, even if the in-state presence is infrequent and sporadic. If an agent, affiliate, or representative performs services in a state that allows the out-of-state retailer to establish and maintain a marketplace in the state, the physical presence of the agent, representative, or affiliate is often attributed to the retailer, thus creating nexus for the retailer. 2 This phenomenon is called affiliate or attributional nexus.
With the advent of e-commerce, cross-border sales have increased substantially. It is estimated that by 2012 over $12 billion in sales taxes will go uncollected annually on e-commerce sales because of the physical presence standard. 3 Affiliate nexus principles enable states to assert jurisdiction over out-of-state retailers that would not otherwise be required to collect and remit sales tax due to their lack of a physical presence. Not surprisingly, given the current budget shortfalls most states are facing, they have become increasingly aggressive in asserting affiliate nexus.
New York: The Birthplace of Click-Through Nexus
In New York, a vendor of tangible personal property is required to collect sales tax. 4 The term “vendor” includes a person who solicits business “by employees, independent contractors, agents, or other representatives . . . and by reason thereof makes sales to persons within the state of tangible personal property.” 5
In 2008, New York’s tax law was amended to provide that a seller will be presumed to be soliciting business through an independent contractor or other representative if the seller enters into an agreement with a New York resident, directly or indirectly, through a link on an internet website or otherwise, to refer potential customers to the seller in exchange for consideration. The presumption applies only if the seller has cumulative gross receipts in excess of $10,000 from sales to New York customers resulting from such agreements during the preceding four quarterly periods. The seller can rebut the presumption by demonstrating that the in-state resident with whom it has entered into an agreement did not engage in any solicitation activities on behalf of the seller that would satisfy the nexus requirements of the U.S. Constitution during the time period in question. 6
The first retailer to challenge the constitutionality of these new provisions was Amazon.com (Amazon). 7 Amazon has a program whereby “associates” maintain links to Amazon’s website on their own websites in return for a percentage of the sales proceeds generated through the link. Amazon has hundreds of thousands of associates, some of which have New York addresses. Amazon generates more than $10,000 per year in sales to New York customers through its associates program. Accordingly, the revised law appeared to create a sales and use tax collection responsibility for Amazon. Amazon filed a lawsuit alleging that the 2008 amendment was unconstitutional under the Commerce Clause—both facially and as applied to Amazon—as well as the Due Process and Equal Protection clauses. In response, the New York Department of Taxation & Finance filed a motion to dismiss the case.
The trial court first addressed Amazon’s Commerce Clause challenge, observing that under the Complete Auto 8 test, a state may require an entity to collect taxes on its behalf if the tax is (1) applied to an activity with a “substantial nexus” with the state, (2) is fairly apportioned, (3) does not discriminate against interstate commerce, and (4) is fairly related to the services provided by the state. The court noted that in determining whether a vendor has substantial nexus with the state, a certain degree of physical presence of the vendor is required, but that physical presence may be imputed based on in-state solicitation of sales by an employee, agent, or independent contractor of the vendor on its behalf.
Amazon argued that the New York statute at issue was facially unconstitutional because it imposed a tax collection obligation based on activities that are insufficient to create substantial nexus with New York. After concluding that Amazon’s assertion was “wrong,” the court observed that a tax-collection duty is imposed only when an out-of-state seller makes a conscious decision to contract with in-state residents who refer, in total, more than $10,000 of New York business. Furthermore, the court observed that the law contained an “added safeguard” by providing that the seller can rebut the presumption by showing that the in-state residents did not engage in any solicitation in New York. Accordingly, the court determined that the law was not facially unconstitutional under the Commerce Clause.
Next, the court addressed Amazon’s as-applied challenge. Amazon argued that it lacked substantial nexus with New York, asserting that it had no physical presence in the state. It claimed that the agreements with New York residents simply provided for a link on a website and that participants in the program were akin to advertisers and not salespeople. In addition, Amazon argued that it was nearly impossible to determine which participants are New York residents and then to disprove that they were soliciting business. The court noted that Amazon could inquire about New York resident status on its participant application. Furthermore, the court wrote, “Amazon should not be permitted to escape tax collection indirectly, through use of an incentivized New York sales force to generate revenue, when it would not be able to achieve tax avoidance directly through use of New York employees engaged in the very same activities.” Accordingly, the court held that the law—as applied to Amazon—did not violate the Commerce Clause. The court also rejected the taxpayer’s Due Process and Equal Protection clause challenges.
In November, the New York Supreme Court, Appellate Division, upheld the trial court’s determination that the law was not unconstitutional on its face under the Commerce Clause. 9 It also upheld the trial court’s rejection of Amazon’s Equal Protection Clause challenge. However, the appellate court remanded Amazon’s as-applied claims under the Commerce and Due Process clauses to the trial court for further discovery, holding that it could not decide these issues based on the evidence in the trial court record.
The Amazon.com case raises interesting questions about the extent to which certain activities performed in-state by third parties create nexus for out-of-state taxpayers. The trial court cited to other cases in which the activities of the in-state independent contractors allowed the out-of-state taxpayer to establish and maintain a market in the state. The solicitation activities in those cases, however, were performed by salespeople generally charged with actively soliciting sales of the taxpayer’s products. In Amazon.com, the associates were not generally in the business of soliciting sales of Amazon’s products and, as the taxpayer argued, appeared somewhat more akin to advertisers. It is certainly not clear that Amazon’s associates are the “incentivized” sales force the court found them to be.
Meanwhile, two additional states—North Carolina 10 and Rhode Island 11—have adopted similar click-through nexus provisions, and a number of other states (including California) have considered similar legislation. 12 Interestingly, in a recent survey, 14 states indicated that, even absent explicit statutory provisions, a click-through relationship would create nexus for an out-of-state retailer. 13 Ostensibly, this would be under a broad reading of the state’s “doing business” nexus statute. In fact, North Carolina took this position when, after it adopted click-through nexus provisions, the Department of Revenue held a retailer’s compliance initiative for those remote retailers that had previously failed to collect and remit sales tax on remote sales to North Carolina customers. One state—Colorado—initially proposed legislation adopting click-through nexus provisions, but ultimately legislators took a drastically different approach.
Colorado: A New Approach
Colorado House Bill 1193 started off as a run-of-the-mill click-through nexus bill similar to those enacted in New York, North Carolina, and Rhode Island. However, the Senate substantially amended the bill before it was enacted. Under the new law, the definition of “doing business” in Colorado was revised to provide that any retailer that (1) does not collect Colorado sales and use tax and (2) is part of a controlled group of corporations that has a component member with a physical presence in Colorado is presumed to be doing business in the state. 14 “Controlled group” and “component member” are defined with reference to Sec. 1563. The presumption that the out-of-state retailer is doing business in Colorado can be rebutted by proof that the in-state component member did not engage in any “constitutionally sufficient” solicitation activities on behalf of the noncollecting retailer. There is no statutory guidance on what establishes constitutionally sufficient solicitation activities.
This new “doing business” presumption, however, was not the only significant component of the bill. Specifically, the bill also imposed certain information-reporting requirements on retailers that do not collect Colorado sales tax. The statutory definition of a retailer was revised to include all retailers and vendors doing business in Colorado. “Doing business” is broadly defined and includes making sales to Colorado residents via a website. Such noncollecting retailers are subject to three separate information-reporting requirements. 15
The first requirement is a notice to purchasers. A retailer that does not collect Colorado sales tax must notify a purchaser that Colorado sales and use tax is due on certain purchases and that the Department of Revenue (DOR) requires the purchaser to file a Colorado sales and use tax return. Failure to provide such notice will subject a retailer to a $5 penalty for each failure (unless reasonable cause is shown).
The second requirement is an annual notice to purchasers. In addition to the notice discussed above, by January 31 of each year a retailer that does not collect Colorado sales tax must notify all Colorado purchasers of the total amount of goods purchased in the previous calendar year and certain other types of information, such as the categories of purchases, the dates the purchases were made, and the amount of each purchase. This notice must also reiterate the requirement that a Colorado sales and use tax return should be filed for certain purchases made from the noncollecting retailer. The retailer must send the document separately to all Colorado purchasers via first-class mail, and the exterior of the mailing should state “important tax document enclosed.” Failure to send this notification will subject the retailer to a $10 penalty for each failure (unless reasonable cause is shown).
Finally, any retailer that does not collect Colorado sales tax must file with the state an annual statement for each purchaser on forms provided by the DOR that identifies the total amount paid by Colorado purchasers for purchases where sales tax was not collected during the preceding calendar year. The retailer must file the annual statement each year by March 1. Failure to file the annual statement will subject the retailer to a $10 penalty for each purchaser that should have been included in the annual statement (unless reasonable cause is shown).
Regulations adopted a de minimis exemption from the reporting requirements for noncollecting retailers with less than $100,000 in Colorado sales. 16 The regulations also cap the penalties for noncompliance with the first use tax notice requirement at $5,000 for those retailers that had no actual notice of the requirement and that began to provide the required notices within 60 days after demand by the DOR. The penalties are capped at $50,000 per year for those taxpayers who fail to provide the notice for the first calendar year they are obligated to do so.
Some commentators have suggested that Colorado’s burdensome reporting requirements are intended to essentially coerce retailers into collecting and remitting sales and use taxes, rather than facing the hassles and potential penalties associated with the information-reporting requirements. 17 Concerns have also been expressed about consumer privacy if Colorado requires retailers to disclose details on purchased items. 18 The Direct Marketing Association recently filed suit in a Colorado district court alleging that Colorado’s information-reporting requirements are unconstitutional. Specifically, the complaint alleges that the requirements:
- Impose discriminatory treatment on out-of-state retailers lacking any physical presence in the state;
- Trample the right to privacy of Colorado residents, as well as certain nonresidents;
- Chill the exercise of free speech by certain purchasers and vendors of products that have expressive content;
- Expose confidential information about consumers and their purchases to the risk of data security breaches; and
- Deprive retailers, without due process or fair compensation, of both the value of their proprietary customer lists and the substantial investment made to protect such lists from disclosure. 19
It is unknown at this time whether the Colorado information-reporting requirements will pass constitutional muster in federal court, but if they do other states are likely to follow suit. In fact, Oklahoma recently jumped on the information-reporting bandwagon and adopted use tax notification requirements. 20 However, Oklahoma’s requirements are less burdensome than Colorado’s, and there are no monetary penalties for noncompliance.
In addition to using information-reporting requirements as a means of combating revenue loss associated with e-commerce, states will continue to aggressively assert affiliate nexus. The trend appears to be for states to adopt provisions whereby it is presumed that nexus exists solely on the basis of the out-of-state retailer’s relationship with an in-state resident. These statutes look to the relationship between the parties (e.g., click-through affiliate arrangement, controlled group member, etc.) rather than the activities, or lack thereof, performed by the in-state resident on behalf of the remote retailer. For companies involved in selling goods over the internet or through mail order, close monitoring of these developments is warranted. The costs of noncompliance with information-reporting requirements like Colorado’s could be significant if penalties are assessed. In addition, if sales and use tax returns are not filed in a state where nexus is deemed to exist based on the in-state activities of an affiliate or agent, the statute of limitation never closes and the state can assess taxes, penalties, and interest from the day the taxpayer was first deemed to have a filing requirement.
1 Quill Corp. v. North Dakota, 504 U.S. 298 (1992).
2 See generally Hellerstein and Hellerstein, 1 State Taxation ¶19.02 (Warren, Gorham and Lamont 2004) (discussing whether nexus over an out-of-state seller may be established by the activities of independent contractors in the state in the context of sales and use taxation).
3 Bruce, Fox, and Luna, “State and Local Government Sales Tax Revenue Losses from Electronic Commerce,” 52 State Tax Notes 537 (May 18, 2009).
4 NY Tax Law §§1131(1), 1105.
5 NY Tax Law §1101(b)(8)(i)(C).
6 NY Tax Law §1101(b)(8)(vi).
7 Amazon.com LLC v. New York State Dep’t of Tax’n & Fin., 877 N.Y.S.2d 842 (N.Y. Sup. Ct. 2009).
8 Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977).
9 Amazon.com LLC v. New York State Dep’t of Tax’n and Fin., No. 1534 1535 601247/08 107581/08 (N.Y. App. Div. 11/4/10).
10 NC Gen. Stat. §105-164.8.
11 RI Gen. Laws §44-18-15.
12 Click-through nexus legislation was passed in Hawaii and California but was vetoed by the states’ governors.
13 Survey of State Tax Departments, 2010 (BNA Tax & Accounting 2010). Those 14 jurisdictions are Arizona, the District of Columbia, Florida, Iowa, Maryland, Missouri, Nevada, New Mexico, North Dakota, Pennsylvania, South Dakota, Tennessee, Texas, and Washington.
14 CO Rev. Stat. §39-26-102(3)(b)(II).
15 CO Rev. Stat. §§39-21-112(3.5) (reporting requirements) and 39-26-102(8) (defining “retailer”).
17 Kranz, Smith, and Freeman, “Colorado’s End Run: Clever, Coercive, and Unconstitutional,” 56 State Tax Notes 55 (April 5, 2010).
19 The Direct Mktg. Ass’n v. Huber (D. Colo.), petitioner’s complaint filed June 30, 2010.
20 OK Stat. tit. 68, §1406.1. Note that Oklahoma also adopted expanded affiliate nexus provisions. See OK Stat. tit. 68, §1401.9(d).
Harlan Kwiatek is with Rubin Brown LLP in St. Louis, MO, and is chair of the AICPA Tax Division’s State & Local Tax Technical Resource Panel. Sarah McGahan is with KPMG LLP in Washington, DC. For more information about this column, please contact Ms. McGahan at smcgahan@KPMG.com.