State & Local Taxes
The Tennessee Court of Appeals held that a corporation that sells books and other publications through the mail to students in schools and home-schooled students had substantial nexus with Tennessee because teachers and parents of the students purchasing the books and publications assisted in ordering and distributing them.
Background
Scholastic Book Club, a Missouri corporation, sells books and other publications by mail to students and has done so for over 50 years. Scholastic conducts its mail-order business by mailing catalogs monthly during the school year to classrooms at primary, secondary, and nursery schools across the United States, including in the state of Tennessee. It also mails catalogs to the homes of home-schooled students. Teachers and parents of home-schooled students, at their discretion, decide whether to distribute these catalogs to students. Scholastic has no right to control whether a teacher or parent will respond to or distribute its catalogs, or whether that teacher or parent will place orders, and teachers and parents are under no obligation or commitment to assist their students in purchasing books.
Students, with the assistance of their teachers and parents, may select books for purchase. Students give their book orders to their teachers and parents, together with payment for the books, and the teachers and parents enter their own orders and those of their students on a master form. The teachers and parents can forward the order, along with total payment for the order, to Scholastic’s offices in Missouri, or the teachers and parents can submit the total order over the telephone to Scholastic’s offices in Missouri and submit the payment by mail. Scholastic accepts and fulfills these orders at its facilities in Missouri and delivers the books, by common carrier, to the classes or homes that ordered them. In the case of student orders, the teachers and parents of the students who ordered the books distribute the books to the students.
Scholastic does not own or lease real or personal property in Tennessee and has no employees, agents, salesmen, independent contractors, or representatives in the state. The company maintains no bank accounts, data, telephone listing, web address, or mailing address in Tennessee, and it claims that Tennessee has never provided it any direct state or local governmental services. The company contends its only connection to customers in Tennessee is through mail order.
In 2008, the Tennessee Department of Revenue (DOR) conducted a sales and use tax audit of Scholastic. As a result of the audit, the DOR asserted Scholastic was liable for taxes, penalties, and interest totaling $5,705,087.52. The DOR determined that Scholastic had nexus with Tennessee because the teachers and parents who participated in Scholastic’s book-selling programs had an implied agency relationship with Scholastic and were sales agents of the company.
Scholastic requested an administrative review of the audit determinations. After the review, the DOR advised Scholastic that it was liable for the assessed sales and use tax. Scholastic challenged the assessment in the Chancery Court for Davidson County, Tennessee (the trial court). In the trial court, Scholastic asserted it conducted its business exclusively by mail order and via the internet, and that it was not liable for sales and use taxes in Tennessee. It further asserted that no agency relationship exists between Scholastic and teachers who participate in its program, but that teachers act as agents of their students when they place orders for Scholastic’s products. Thus, the company argued that Tennessee had neither taxing nexus nor taxing jurisdiction over it, and that the tax assessment was impermissible under the Due Process Clause of the Fourteenth Amendment and the Commerce Clause of the U.S. Constitution, as well as Article I, Section 8, of the Tennessee Constitution.
On May 26, 2011, the trial court held in favor of Scholastic, finding that the assessment of sales and use taxes against the company violated the Commerce Clause because the company did not have substantial nexus with Tennessee, as was required under the U.S. Supreme Court case Quill Corp. v. North Dakota , 504 U.S. 298 (1992), and the Tennessee case Arco Building Systems, Inc. v. Chumley , 209 S.W.3d 63 (Tenn. Ct. App. 2006). The DOR appealed the trial court’s decision to the Tennessee Court of Appeals.
Court of Appeals Decision
The Tennessee Court of Appeals reversed the trial court, holding that Scholastic did have substantial nexus with Tennessee for purposes of the sales and use tax, and therefore the DOR’s assessment did not violate the Commerce Clause. However, because the parties agreed that the trial court had not addressed Scholastic’s federal Due Process or Tennessee constitutional claims, the court remanded the case for further proceedings on those claims.
The DOR argued that, regardless of whether an agency relationship exists between Scholastic and Tennessee teachers, Scholastic’s use of Tennessee teachers to effectuate sales is sufficient under Quill to sustain the assessment of sales and use taxes against the company. Scholastic countered that the undisputed facts in the case established that it did not have the “physical presence” in Tennessee necessary to sustain the DOR’s assessment under Quill . The company asserted that Tennessee teachers are not agents of Scholastic but act on behalf of students to assist them with the ordering process.
The Court of Appeals stated that the issue in this case was not whether Tennessee teachers may be considered agents of Scholastic, but whether Scholastic’s connections with Tennessee’s schools and teachers establishes a substantial nexus such that the DOR’s assessment may be sustained under the Commerce Clause. The court pointed to Arco Building Systems and several pre– Quill federal cases as support for the proposition that a company could have substantial nexus without having employees or agents in a state if persons who were not regular employees or agents of the company carried on substantial business activities in the state on the company’s behalf.
The Court of Appeals also noted that the safe harbor from a state’s ability to assess sales and use tax that the Supreme Court reaffirmed in Quill applied strictly to vendors whose only connection with customers in a state is by common carrier or U.S. mail. According to the Court of Appeals, the undisputed facts of the case demonstrated that Scholastic’s contacts with customers in Tennessee were not only by common carrier or mail. Describing the various ways that teachers and parents of home-schooled children facilitated Scholastic’s sales to students in Tennessee, the court found that Scholastic had “created a de facto marketing and distribution mechanism within Tennessee’s schools and utilizing Tennessee teachers to sell books to school children and their parents.” The court further found that, contrary to Scholastic’s contentions, because Tennessee schools and teachers are funded in large part by taxes, the company was using public services in the state when it sold its products there. Thus, the court concluded that Scholastic did not fall within the safe harbor afforded by Quill .
Reflections
As the Supreme Court went to great lengths to emphasize in Quill , the physical presence test is a bright-line test: A company has nexus with a state if the company has a real physical presence (in the form of employees, agents, or property) in the state, and a company does not have nexus with a state if does not have a real physical presence. The Tennessee Court of Appeals, like other state courts before it, seeks to change the Supreme Court’s bright-line test to a balancing test to allow a state to greatly expand the reach of its sales and use tax laws.
Scholastic runs a traditional mail-order business, albeit one that is aided by the voluntary, unreimbursed efforts of parents and teachers. Scholastic appears to have carefully tailored its operations to fit within the clearly articulated Quill safe harbor. It is interesting that the Court of Appeals did not decide—or even feel that it needed to decide—whether the parents or teachers were agents of Scholastic. It held that Scholastic’s relationship with the parents and teachers is sufficiently close to create nexus with Tennessee even if the parents and teachers are not agents of the company. By characterizing the teachers and parents as a “ de facto marketing and distribution mechanism,” the Court of Appeals on its own changes the rules for the Quill safe harbor to draw Scholastic into Tennessee’s tax base.
By focusing on such an old and established business model to expand nexus, Tennessee seems to be taking an unusual tack; other states looking to expand nexus recently have focused on more modern sales vehicles, namely the internet. Scholastic has had mixed success in avoiding sales tax nexus in other jurisdictions (compare In re Scholastic Book Clubs, Inc ., 920 P.2d 947 (Kan. 1996), and Scholastic Book Clubs, Inc. v. State Bd. of Equalization , 207 Cal. App. 3d 734 (1989) (sales and use tax assessments upheld); with Pledger v. Troll Book Clubs, Inc ., 871 S.W.2d 389 (Ark. 1994), Scholastic Book Clubs, Inc. v. Department of Treasury , 567 N.W.2d 692 (Mich. Ct. App. 1997), and Scholastic Book Clubs, Inc. v. Commissioner of Rev. Servs ., No. CV 07 4013027 S (Conn. Super. Ct. 4/9/09) (sales and use tax assessment not permitted)). Whether Tennessee’s actions will spawn imitators remains to be seen.
For more on state efforts to expand sales tax nexus, see Jensen and Thurber, “The Evolution of Sales Tax Nexus Expansion Laws,” p. 252.
Scholastic Book Clubs, Inc. v. Farr , M2011-01443-COA-R3-CV (Tenn. Ct. App. 1/27/12), rev’g No. 09-587-II (Tenn. Ch. Ct. 5/26/11).
