Consequences of the MTC’s new interpretation of P.L. 86-272

Editor: Kevin Anderson, CPA, J.D.

Except to a limited extent, generally involving transportation businesses, Congress has largely refrained from enacting federal legislation that directly affects state tax policy. However, one such statute — 15 U.S.C. Sections 381–384, better known in the tax world as P.L. 86-272 (the Interstate Income Act of 1959) — was enacted in 1959 and is still alive today. Although it was passed to protect interstate businesses from state net income taxes, many now wonder whether it is outdated or offers any meaningful protection in today’s internet-based economy.

P.L. 86-272 prevents a state from imposing a net income tax on any person’s income derived within the state from interstate commerce if the only business activity performed in the state is the solicitation of orders of tangible personal property; such orders are sent outside the state for approval or rejection; and the orders, if approved, are filled by shipment or delivery from a point outside the state.

Congress enacted P.L. 86-272 in direct response to the U.S. Supreme Court’s decision in Northwestern States Portland Cement Co. v. Minnesota, 358 U.S. 450 (1959). Since its enactment, states have attempted — both successfully and unsuccessfully — to limit the statute’s protections. Meanwhile, considering that P.L. 86-272 has never been amended despite profound changes in the U.S. and global economies since 1959 and with only a few notable court cases to rely on, taxpayers typically find themselves with more questions than answers when applying it to their particular facts and circumstances. To help fill that void through the years, the Multistate Tax Commission (MTC) has issued a series of model statements or interpretations for applying P.L. 86-272 that states can choose to adopt.

For all practical purposes, the MTC’s most recent interpretation largely nullifies P.L. 86-272’s protections for businesses that engage in activities over the internet. Although the MTC’s revised interpretation will greatly restrict protections from state income taxes for these taxpayers, it could also present them with planning opportunities.

MTC’s model statement on P.L. 86-272

On Aug. 4, 2021, the MTC adopted its fourth revision to the “Statement of Information Concerning Practices of Multistate Tax Commission and Supporting States Under Public Law 86-272” (the Statement). In this most recent Statement, the MTC included a new section on activities conducted via the internet. The MTC concludes that “[a]s a general rule, when a business interacts with a customer via the business’s website or app, the business engages in a business activity within the customer’s state.” The MTC then lists eight examples of internet-based activities conducted by a business that operates a website that, if they are not de minimis, are unprotected because they are not solicitations of orders for sales of tangible personal property or entirely ancillary to solicitation. Some of the MTC’s examples of unprotected internet activities include using chatbots to provide post-sale assistance, placing certain “cookies” onto the computers of in-state customers, and allowing credit card applications or job applications to be submitted through the website.

The MTC’s new interpretation on internet-based activities virtually eliminates the federal protection for most businesses with a website. It is unlikely that any business with a website does not use cookies, chatbots, or emails in a manner that the MTC considers unprotected. And is using the internet to conduct business much different from using telephones or the U.S. mail, as businesses did in 1959? Thus, does the MTC’s interpretation render P.L. 86-272 a mere nullity? For this reason, in part, an even less narrow interpretation of P.L. 86-272 was rejected by the U.S. Supreme Court in Wisconsin Dep’t of Revenue v. William Wrigley, Jr., Co., 505 U.S. 214 (1992).

To be clear, the MTC’s Statement is simply its interpretation of P.L. 86-272. It does not have the force or effect of law. States can adopt the MTC’s Statement in whole or in part, although they are under no obligation to do so. And courts are not bound to follow the Statement. It remains to be seen how much deference, if any, courts will give to the MTC’s position on internetbased activities.

States adopting the MTC’s Revised Model Statement

California was the first state to adopt the MTC’s examples of protected and unprotected internet-based activities (California Franchise Tax Board, Technical Advice Memorandum No. 2022-01 (Feb. 14, 2022)). California is enforcing its position on a retroactive basis for open periods, as evidenced by its issuing information document requests asking businesses about these internet-based activities.

Even though California’s guidance will now subject previously protected out-of-state businesses to its income tax, the guidance reminds taxpayers that P.L. 86-272 may also determine when a person is “taxable in another state” for purposes of California’s sales factor throwback rule. For affected taxpayers, throwback may be eliminated or reduced, which could lower Californiasource sales and therefore lower California apportionment. The tax benefit may depend on whether a California taxpayer is in a net income or net loss position. Elimination of throwback will reduce California-source losses, while taxpayers in a net income position will benefit from reduced California-source taxable income. Amended returns may need to be filed, and refunds may be available. Additionally, this is typically a favorable result for limited liability companies (LLCs) paying the California LLC fee because the fee is based on California-source gross receipts.

New York is currently in the process of adopting the MTC’s revised interpretation by promulgating the Statement into its regulations. New York has released its draft regulations, making them available for public comment. During 2022, New Jersey and Oregon both indicated that they also intend to amend their regulations to adopt the MTC’s Statement, but they have yet to release the drafts for public comment (see also Jones, “States’ Reactions to MTC’s Application of P.L. 86-272 to Internet Sales,” 53 The Tax Adviser 44 (December 2022)).

On Aug. 19, 2022, the American Catalog Mailers Association brought the first lawsuit challenging California’s new interpretation of P.L. 86-272. Trade organizations will likely file similar suits in other states that adopt the MTC’s revised interpretation. But it could be some time before taxpayers in California or other jurisdictions have a state court opinion to rely upon. And it could be even longer, if ever, until the U.S. Supreme Court weighs in on the Statement. So, what should taxpayers do in the meantime?

Taxpayer action steps

Will other states adopt the MTC’s revised interpretation by issuing administrative guidance or promulgating regulations? And if states do adopt the Statement, will they do so retroactively or prospectively? One of the most challenging aspects for taxpayers is that, since P.L. 86-272 is a federal law, states are under no obligation to provide guidance on how they apply it. As a result, states could apply the revised interpretation upon audit, catching taxpayers off guard.

It is always a best practice for a business to periodically review its business activities, particularly those conducted over the internet and protected under P.L. 86-272, for all open periods, including an analysis of whether they remain within those protections. They should consult with their tax advisers to determine whether a state is properly applying the protections afforded by P.L. 86-272. These uncertain tax positions could have financial statement implications that need to be accounted for under FASB Accounting Standards Codification Topic 740, Income Taxes.

State filing options

Taxpayers should also review whether a state’s application of the revised interpretation of P.L. 86-272 puts them in a favorable or unfavorable tax position. Taxpayers should calculate the tax impact of the new interpretation for any state, such as California, that has a throwback rule for sales factor apportionment purposes. A business could reduce its tax liability for goods shipped from an origin state with a throwback rule by claiming that it is taxable in the destination state because of the unprotected activities performed by its website. But it is important to note that if a taxpayer is taking a position that it does not have to throw back sales into its origin-based state, then it might have a filing obligation and tax liability in the destination state.

States that require unitary combined reporting may include sales into the state of a non-nexus member of the group in the group’s sales factor numerator (the approach in Appeal of Finnigan Corp., No. 88-SBE-022 (Cal. St. Bd. of Equal. 8/25/88)) or may require that selling member to have stand-alone nexus with the state (the approach in Appeal of Joyce, Inc., No. 66-SBE-070 (Cal. St. Bd. of Equal. 11/23/66)). The MTC’s interpretation could significantly affect unitary groups filing in either of these types of states. For example, in Joyce states (e.g., New Jersey), taxpayers should also determine whether a member of a unitary business group has nexus and is subject to tax when applying the MTC’s revised interpretation of P.L. 86-272. As with California, applying the revised interpretation to states with a throwback rule or to Joyce states could result in amended returns and refund claims.

In states that have elections to file a nexus consolidated return or a nexus combined return, taxpayers should calculate the impact of including a corporation in a group return that would now have nexus and be subject to tax by virtue of its unprotected internet-based activities. The benefit may depend on whether the affiliate being included in the group return is in a net income or a net loss position and whether that affiliate’s position can help offset the group’s overall income or loss position.

Key takeaways

The application of P.L. 86-272 presents many challenges for states and taxpayers alike. The law already provided narrow protection with limited application. The MTC’s Statement seeks to limit its protection even more, perhaps making it inoperable altogether. Taxpayers need to consider whether the MTC’s revised interpretation applies and, if so, what effect it would have on their tax obligations. Proactive reviews and proper planning can help taxpayers avoid unknown tax liabilities.

Editor notes

Kevin Anderson, CPA, J.D., is a managing director, National Tax Office, with BDO USA LLP in Washington, D.C.Contributors are members of or associated with BDO USA LLP. For additional information about these items, contact Anderson at 202-644-5413 or kdanderson@bdo.com.