States’ reactions to MTC’s application of P.L. 86-272 to internet sales

Editor: Moshe Bell-Jacobs, J.D.

Following the August 2021 release by the Multistate Tax Commission (MTC) of a revised Statement of Information addressing the application of the Interstate Income Act of 1959, better known as P.L. 86-272, to the modern economy and internet transactions, many businesses, including internet sellers, have been closely tracking whether states would adopt the MTC’s approach.

P.L. 86-272, codified as 15 U.S.C. Sections 381–384, is a federal law that prohibits a state from imposing a net income tax on the income of a business derived from within a state through interstate commerce if its only business activities within the state consist of the solicitation of orders for sales of tangible personal property. This protection only applies to orders that are sent outside the state for acceptance or rejection. If the orders are accepted, they must be filled by shipment or delivery from outside the state. P.L. 86-272 protection does not apply to the solicitation of orders for sales of services or intangible property.

Since P.L. 86-272 was enacted, businesses have evolved from primarily engaging in sales of tangible personal property via in-person activity to engaging in substantial amounts of electronic commerce through remote means. However, Congress has never amended or updated P.L. 86-272 to address how it should be applied to modern business transactions. Furthermore, the federal government has never provided any administrative guidance to assist with applying the statute. Due to the lack of federal guidance, states and taxpayers historically have considered the MTC’s guidance, issued in the Statement of Information, in determining whether a business activity is protected under P.L. 86-272.

Since the MTC’s issuance of its revised statement, California and New York both have provided their own guidance regarding P.L. 86-272 protection as it applies to internet transactions. This column reviews the MTC’s revised statement and then addresses the approaches taken by California and New York. Also, this column briefly discusses developments in New Jersey and Oregon concerning P.L. 86-272 protection, with further general considerations concerning P.L. 86-272 and its application to business conducted over the internet.

MTC’s revised statement

Given the brevity and age of P.L. 86-272, its application to many types of business transactions is often difficult to divine. In an effort to explain and clarify the protection provided by P.L. 86-272, the MTC first issued a Statement of Information in 1986 concerning practices of the MTC and supporting states under P.L. 86-272. The statement’s introduction explains that a “supporting state” is a state “that adopts or otherwise expressly indicates support for this Statement by legislation, regulation or other administrative action.” However, the statement notes that “[o]ther states may adopt or otherwise indicate support for individual sections of this Statement.” Regarding the purpose of the statement, the introduction provides that the “contents of this Statement are intended to serve as general guidance to taxpayers and to provide notice as to how Supporting States will apply the statute.” The MTC revised its statement in 1993, 1994, and 2001. As the economy evolved over the past few decades, the lack of additional guidance made it more difficult for companies expanding into new lines of business to determine how the P.L. 86-272 safe harbor and the MTC’s interpretive statement might apply to them.

Shortly after the U.S. Supreme Court decided South Dakota v. Wayfair, Inc., 138 S. Ct. 2080 (2018), the MTC decided that the emphasis on taxpayer protection under P.L. 86-272, coupled with the growing popularity of more technology-dependent business models, required revisions to its historic Statement of Information regarding the application of P.L. 86-272. Following several hearings, the MTC adopted and released a revised statement in August 2021, including a new subsection addressing what constitutes protected versus unprotected activities and analyzing the treatment of certain internet-facilitated transactions. The revised statement adopts the Supreme Court’s analysis in Wayfair concerning virtual contacts as “relevant to the question of whether a seller is engaged in business activities in states where its customers are located” for purposes of P.L. 86-272, even though the Court did not address P.L. 86-272 in its decision. The development and issuance of this revised statement was an effort to encourage uniformity among states in applying P.L. 86-272 to internet transactions.

The MTC’s revised statement explains that the determination of whether a person that sells tangible personal property via the internet is protected under P.L. 86-272 requires the same general analysis that is applied to persons that sell tangible personal property by other means. As a general rule, when a business interacts with a customer via the business’s website or app, it is engaged in “business activity” within the customer’s state, meaning that the activities extend beyond the pure solicitation of orders for sales of tangible personal property, thereby exceeding P.L. 86-272 protection. Alternatively, if the website merely presents static text or photos, there is no engagement or facilitation within the customer’s state.

The new section of the MTC’s revised statement provides a list of examples of 11 activities conducted by internet businesses and provides a conclusion as to whether each example is protected (or not protected) by P.L. 86-272. At the beginning of the examples, the statement clarifies the underlying assumption that the business only sells items of tangible personal property, unless otherwise indicated. The examples presume that customer orders are approved or rejected, and the products are shipped, from outside the customer’s state. Other than what is indicated in the examples, the business has no contacts with the customer’s state.

Under the examples, the following eight types of activities in a customer’s state are not protected by P.L. 86-272:

• The business regularly provides assistance following the sale to in-state customers by either electronic chat or email that customers initiate by clicking an icon on the business’s website;
• The business solicits and receives online applications for its branded credit card via its website;
• The business’s website invites viewers in a customer’s state to apply for nonsales positions with the business;
• The business places internet cookies onto the computers or other electronic devices of in-state customers; the cookies gather customer search information that will be used to adjust production schedules and inventory amounts, develop new products, or identify new items to offer for sale;
• The business remotely fixes or upgrades products previously purchased by in-state customers by transmitting code or other electronic instructions to those products over the internet;
• The business offers and sells extended warranty plans on its website to in-state customers who purchase the business’s products;
• The business contracts with a marketplace facilitator that facilitates the sale of the business’s products on the facilitator’s online marketplace and the marketplace facilitator maintains some of the business’s inventory in fulfillment centers in states where the business’s customers are located; and
• The business contracts with in-state customers to stream videos and music to electronic devices for a charge.

The following three types of activities are protected by P.L. 86-272:

• The business provides assistance following a sale to in-state customers by posting a list of static frequently asked questions with answers on its website;
• The business places internet cookies onto the computers or other devices of in-state customers, but the cookies gather information that is only used for purposes entirely ancillary to the solicitation of orders for tangible personal property; and
• The business offers for sale only items of tangible personal property on a website that enables customers to search for items, read product descriptions, select items for purchase, choose among delivery options, and pay for the items, but the business does not engage in any of the nonprotected activities listed above.

In considering the MTC’s published guidance, businesses conducting internet transactions should carefully review the examples discussed above. A slight change in the business’s online activities may alter whether the business is subject to income tax in the customer’s state. For example, placing cookies onto the computers or other electronic devices of in-state customers may or may not be protected by P.L. 86-272, depending on the type of information that is ultimately obtained. The use of cookies is a protected activity if the information is only used for purposes entirely ancillary to the solicitation of orders for tangible personal property, but it is not a protected activity if the information is used to advance the business’s sales activities in the state.

States are not bound by the MTC’s interpretation and are responsible for individually adopting the principles of the revised statement. The MTC’s examples list many types of activities commonly conducted by businesses over the internet that are not protected by P.L. 86-272. As a result, internet sellers have a substantial interest in whether states decide to follow the MTC’s statement. If a state formally — or even informally — adopts the MTC’s statement, activities that a business may have believed were protected by P.L. 86-272 may suddenly subject the business to a state’s income tax, perhaps retroactively.

California’s administrative guidance

California was the first state to issue guidance that reflects the MTC’s revised statement. On Feb. 14, 2022, the California Franchise Tax Board (FTB) released administrative guidance, Technical Advice Memorandum (TAM) 2022-01, to explain its position on how P.L. 86-272 protection applies in the modern economy for companies with internet transactions. While the TAM does not actually refer to or mention the MTC in any way, the TAM generally is consistent with the positions set forth in the MTC’s statement. The release of the TAM in this manner may call into question whether California formally is a “supporting state” of the MTC’s statement, due to the lack of any explicit reference to the MTC.

The California guidance addresses the same 11 internet activities outlined in the MTC’s statement and reaches the same conclusions. The TAM analyzes each fact pattern by determining whether business activities are taking place in California and, if so, whether those activities exceed the bounds of P.L. 86-272 protection, causing the business to be subject to net income taxation. While the TAM considers the same internet activities as the MTC’s statement, it provides more detailed explanations supporting its conclusions.

Similar to the MTC’s statement, the TAM clarifies that the determination of whether a seller of tangible personal property over the internet is protected by P.L. 86-272 requires the same general analysis as sellers of tangible personal property by other means. Also, the TAM appears to follow the MTC’s statement by explaining that even though the U.S. Supreme Court was not interpreting P.L. 86-272 in Wayfair, “California considers the Court’s analysis as to virtual contacts to be relevant to the question of whether a seller is engaged in business activities in states where its customers are located for purposes of P.L. 86-272.”

California’s guidance attempts to provide clarification to out-of-state businesses to determine whether their internet activities subject them to California’s income tax. As a result of this guidance, some internet-based businesses that previously thought their activities were protected by P.L. 86-272 may suddenly learn that the FTB may not agree with their historical position. Since the TAM does not contain any effective date or limiting principle regarding how it may be applied by the FTB in auditing prior years, the FTB conceivably may apply the TAM retroactively to tax years open under the California statute of limitation. Furthermore, the TAM does not address the FTB’s existing P.L. 86-272 guidance provided in FTB Publication 1050, Application and Interpretation of Public Law 86-272, which correlated to the prior version of the MTC’s statement interpreting P.L. 86-272. Therefore, clarifying guidance addressing the interaction between the new TAM and FTB Publication 1050 would appear to be warranted.

New York’s draft regulation

In response to major corporate tax reform legislation that was effective for tax years beginning on or after Jan. 1, 2015, the New York Department of Taxation and Finance has issued a series of draft regulations to clarify and implement the legislation. Some of these draft regulations were first released several years ago, but the department announced that it intends to begin the administrative process to formally adopt these regulations in 2022. At this point, while the draft regulations are not final, they do provide valuable insight on the department’s positions in this area, and substantially similar regulations soon may be finalized. In April 2022, the department posted a revised draft nexus regulation, N.Y. Comp. Codes R. & Regs. tit. 20, Section 1-2.10 (draft), adding “[n]ew provisions, largely modeled after the MTC model statute” that “address PL 86-272 and activities conducted via the internet.” Unlike the California TAM, the introductory summary of the New York draft regulation expressly refers to the MTC.

The New York draft regulation discusses P.L. 86-272 protection as it applies to traditional business transactions as well as modern business activities via the internet. Similar to the MTC’s statement, the draft regulation provides that a corporation will not be made taxable solely by presenting static text or images on its website. The New York draft regulation includes the 11 examples provided in the MTC’s statement and reaches the same conclusions regarding whether each transaction is protected by P.L. 86-272.

While the New York draft regulation generally is consistent with the MTC’s statement, the draft regulation differs from the MTC’s statement by providing that solicitation activities that are protected “do not include those activities that the corporation would have reason to engage in apart from the solicitation of orders but chooses to allocate to its New York State sales force, or to engage in via the Internet, including interacting with customers or potential customers through the corporation’s website or computer application.” It is curious that the department decided to add this fairly broad language that is not included in the MTC’s statement and conceivably could be used to further reduce P.L. 86-272 protection for internet sellers beyond the intent of the MTC’s statement. Out-of-state corporations conducting activities via the internet should carefully consider this language and consider whether it could result in their losing P.L. 86-272 protection. Of course, the language is not final and may be changed before the regulation is officially adopted. Similar to the guidance provided by California, the draft regulations do not provide an effective date and could apply retroactively.

Developments in New Jersey and Oregon

New Jersey and Oregon reportedly are following New York’s general approach and formally promulgating regulations that discuss P.L. 86-272 protection as it applies to internet transactions. This methodology arguably is preferable to the release of administrative guidance because it provides members of the tax community an opportunity to submit comments to the state revenue departments.

Further considerations

At this point, it is difficult to determine the effect that the MTC’s revised statement ultimately will have on the application of P.L. 86-272 to modern business transactions. There is some controversy regarding the MTC’s decision to interpret a federal statute enacted in 1959 to impose an income tax filing obligation on a business conducting certain activities using the internet without having any physical presence in the taxing state. An argument may be made that the revised statement largely invalidates the federal law by limiting the scope of protected activities when applied to internet commerce. In response, the MTC contends that until Congress updates P.L. 86-272, states should determine how the federal statute applies to modern business transactions.

It is too early to tell whether the methods by which California and New York have responded to the MTC’s statement will be followed by other states, particularly those that had a significant influence over the MTC’s project that concluded in 2021. However, the decisions by New Jersey and Oregon to formally promulgate regulations on the topic may indicate that other states will follow New York’s approach. Taxpayers should monitor whether other states issue parallel guidance or regulations on P.L. 86-272 protection as applied to internet transactions.

Taxpayers also should consider that some state tax agencies may adopt internal policies on the application of P.L. 86-272 to internet transactions in lieu of formal published administrative guidance or regulations. The state’s position may not be evident for some time, perhaps until a business declaring P.L. 86-272 protection is challenged at audit. In applying the new standards, businesses that previously determined their activities were protected by P.L. 86-272 may suddenly be at risk and may not even be aware of the risk if the state does not formally publish guidance or promulgate regulations.

The MTC’s revised statement was intended to provide uniformity among states regarding the application of P.L. 86-272 to internet transactions, but there is a distinct possibility that states may follow a patchwork of different approaches. For example, the broad statement that the New York Department of Taxation and Finance added to its draft regulation may result in taxpayers that transact business over the internet receiving less protection in New York compared to other states. New York tax administrators could interpret the “interacting with customers or potential customers through the corporation’s website or computer application” language to deny P.L. 86-272 protection to internet activities that may be protected under the MTC’s statement. As a result, the same transaction that may be protected in one state may not be protected in another state.

There may be unintended consequences concerning the application and effect of P.L. 86-272 protection. In some situations, companies may benefit from losing P.L. 86-272 protection because it prevents their sales from being thrown back by states that still have sales throwback rules. Thus, an erosion of P.L. 86-272 protection may be positive for some taxpayers.

New Jersey’s entity-by-entity change

The New Jersey Division of Taxation’s significant change earlier this year in how it applies P.L. 86-272 protection also may have some unexpected results. In April 2022, the division announced a change in its policy for members of a combined group claiming protection from New Jersey corporation business tax under P.L. 86-272. Since New Jersey’s adoption of mandatory unitary combined reporting for privilege periods ending on and after July 31, 2019, the division established a policy that the protections of P.L. 86-272 did not apply to other combined group members if activities of any member exceeded the protections of the federal law. Under the recently revised policy, although a combined group is considered a taxpayer and is taxed as one taxpayer, P.L. 86-272 protection will be determined on an entity-byentity basis.

New Jersey’s policy change will allow certain combined group members to change their status from being a taxable member of the combined group to being a nontaxable member, thus allowing the combined group to exclude any New Jersey–source receipts arising from the nontaxable members from the allocation factor. Those entities claiming protection under P.L. 86-272 may experience a significant change in their New Jersey allocation factors and should therefore determine whether filing amended returns would be beneficial for tax years ending on or after July 31, 2019.

Court cases

Taxpayers also should consider that it has been many years since a federal court has considered the application of P.L. 86-272. However, limited state court decisions have addressed which activities receive P.L. 86-272 protection. In Blue Buffalo Co. v. Comptroller of the Treasury, 221 A.3d 1130 (Md. Ct. Spec. App. 2019), the Maryland Court of Special Appeals thoroughly considered whether various types of activities are protected by P.L. 86-272. For a discussion of this case, see Yesnowitz, Jones, and Shaikh, “The Catch-22 of Public Law 86-272,” 96 Tax Notes State 845 (May 18, 2020).

Continuing controversy likely

The ability of a state to issue administrative guidance or regulations to shape (or change) how a federal law should be applied is debatable. The possibility of legal challenges to the guidance issued by states may further complicate determinations of whether an internet transaction subjects a business to a state’s income tax or is protected by P.L. 86-272. In fact, the American Catalog Mailers Association filed litigation in August in California Superior Court to challenge the state’s P.L. 86-272 guidance. Undoubtedly, the debate over the scope and application of P.L. 86-272 with respect to whether its protection applies to a taxpayer’s internet transactions in a particular state will continue.

Contributors

Chuck Jones, CPA, J.D., is a director in Grant Thornton LLP’s State and Local Tax practice in Chicago. Moshe Bell- Jacobs, J.D., is senior manager of State and Local Tax, Washington National Tax, at RSM US LLP in the Washington, D.C., area and is the chair of the AICPA State and Local Tax Technical Resource Panel. For more information about this column, contact thetaxadviser@aicpa.org.