The physical presence standard is no more. In a 5-4 decision issued this morning, the U.S. Supreme Court reversed its own precedent that, for over fifty years, provided an in-state physical presence by a retailer was a prerequisite for the constitutional imposition of a state sales or use tax collection obligation. See South Dakota v. Wayfair, Inc., No. 17-494 (U.S. Jun. 21, 2018), rev’g Quill Corp. v. North Dakota, 504 U.S. 298 (1992) and National Bellas Hess Inc. v. Illinois, 386 U.S. 753 (1967).
The Supreme Court rejected the physical presence rule, which the Quill Court had acknowledged as being “artificial at its edges,” as being “artificial in its entirety,” and upheld the South Dakota statute that requires certain out-of-state retailers to collect and remit South Dakota sales tax, regardless of whether they had a physical presence in the state.
While we continue to digest and dissect the Court’s decision and evaluate its implications, some initial thoughts, reactions, and comments from Baker McKenzie’s State and Local Tax Team on this historic development are set forth below:
1. What Is the New Sales/Use Tax Nexus Standard Moving Forward?
One thing the Wayfair decision makes clear is that the historical “physical presence rule of Quill is unsound and incorrect . . . and . . . overruled.” What the decision leaves open for debate is the level of activity sufficient to create nexus. Here is what we do know: South Dakota’s tax system and nexus standards satisfy the Commerce Clause requirement for substantial nexus, at least as applied to the large, national companies with extensive virtual presence at issue in Wayfair.
In this regard, the Court called out several features of the South Dakota law “that appear designed to prevent discrimination against or undue burdens upon interstate commerce.” More specifically, the Court noted the following in support of its decision to uphold South Dakota’s law: (1) the $100,000 sales and 200 transaction “safe harbor” that could not be exceeded “unless the seller availed itself of the substantial privilege of carrying on a business in South Dakota;” (2) the law’s protection against retroactive application; and (3) South Dakota’s adoption of the Streamlined Sales and Use Tax Agreement. While these criteria serve as useful guide posts, many questions are left unanswered, e.g., is one or more of these criteria absolutely required, what “safe harbor” amounts are sufficient, etc. More importantly, the Court expressly acknowledges the potential for additional Commerce Clause challenges to South Dakota’s nexus standard “in the absence of Quill and Bellas Hess” on remand as well as additional case-by-case challenges by other businesses seeking relief.
One open question raised by the Court’s decision is how the repeal of the physical presence standard will impact small businesses or businesses with de minimis contacts in certain states. The Court acknowledges that the compliance burdens associated with nationwide sales tax collection in the absence of a physical presence standard “pose legitimate concerns in some instances, particularly for small businesses that make a small volume of sales to customers in many States.” However, the court declined to comment on whether a de minimis standard should apply and what any such de minimis standard should be, noting that “these issues are not before the Court in the instant case.” Interestingly, the Court seems to suggest that small businesses with de minimis contacts would have to seek relief from burdensome collection systems “under other theories.” However, prior Supreme Court case law would support an argument that, even in the absence of a physical presence standard, a de minimis presence (virtual or otherwise) should not give rise to substantial nexus. As the Court stated in Wisconsin Department of Revenue v. Wrigley, “the venerable maxim de minimis non curat lex (‘the law cares not for trifles’) is part of the established background of legal principles against which all enactments are adopted, and which all enactments (absent contrary indication) are deemed to accept.”
2. Will States Attempt to Impose Wayfair’s Sales/Use Tax Nexus Ruling Retroactively?
Retroactivity also remains an open question. As discussed above, part of the Court’s reasoning in upholding South Dakota’s law is that “the Act ensures that no obligation to remit sales tax may be applied retroactively.” Although this is true for South Dakota, other states may take a more aggressive approach. If a business never filed a sales tax return in a state where it had significant sales, historical liability could feasibly exist from the first year the business made significant sales in the state. The risk of retroactive application may be heightened in states that have broad “doing business” statutes or that define nexus to the extent constitutionally permissible because these statutes now just require enforcement (e.g., California defines “retailer engaged in business in this state” to include “any retailer that has substantial nexus with this state for purposes of the commerce clause of the United States Constitution . . . ”). However, the risk of retroactive application in a state is lower if the state does not currently have a law that requires, or could be interpreted to require, taxpayers without a physical presence to collect sales tax, noting that a state could enact a law consistent with Wayfair and attempt to apply such law retroactively.
Although the majority did not focus on retroactivity, the dissent picked up on this “troubling question” and suggested looking to Congress for resolution. As retroactivity remains an ongoing concern, we recommend businesses keep vigilant regarding states’ attempts to adopt or apply sales tax retroactively in order to potentially mitigate exposure. For instance, by coming forward through voluntary disclosure programs, most states will limit that lookback period to three or four years and waive certain penalties. Moreover, if a state does apply the Wayfair standard retroactively, we would expect such application to be challenged.
3. Will Congress Act or Remain Silent?
An apparent point of contention among the justices at oral argument was whether the Court, rather than Congress, is the appropriate body to reconsider Quill. Writing for the majority, Justice Kennedy answered that question in the affirmative, stating “[i]t is inconsistent with the Court’s proper role to ask Congress to address a false constitutional premise of this Court’s own creation,” and that “[c]ourts have acted as the front line of review in this limited sphere.” In doing so, the majority appears to suggest that departing from established precedent may be proper – perhaps even advisable – if it is to fix a “mistake” that the Court itself created, notwithstanding Congress’ ability to intervene. Chief Justice Roberts, writing for the dissent, acknowledged that Quill may have been wrongly decided, but would have exercised restraint and “let Congress decide whether to depart from the physical-presence rule that has governed . . . for half a century.” Congress, he stated, is better equipped to “directly consider the competing interests at stake,” and could have crafted a compromise between the stakeholders “beyond anything the Judiciary could match,” including providing “a nuanced answer to the troubling question whether any change will have retroactive effect.” In sum, the dissent recognized that the physical presence standard was one of many “established rules” that allowed the ecommerce industry to flourish over the past 25 years, and cautioned that “[a]ny alteration to those rules with the potential to disrupt the development of such a critical segment of the economy should be undertaken by Congress.”
As the Court in Quill noted, “[t]he underlying issue here is one that Congress may be better qualified to resolve and one that it has the ultimate power to resolve.” To this end, the dissent in Wayfair noted that “Congress has . . . been considering whether to alter the rule established in Bellas Hess for some time.” Indeed, the Marketplace Fairness Act of 2013 passed the Senate with bipartisan support, and the 2017 iteration of that bill, along with the Remote Transactions Parity Act of 2017 and the No Regulation Without Representation Act of 2017, are currently pending before Congress. However, now that Quill and Bellas Hess have been overruled, state lawmakers and tax administrators may have a diminished incentive to push Congressional leaders to act. It will be interesting to see whether and to what extent Congress pursues a legislative solution in light of the Court’s decision today.