In a decision that may foretell the future of business privilege tax nexus, the Washington Supreme Court in November upheld the imposition of the state’s business & occupation (B&O) tax on an out-of-state distributor with respect to sales that were not generated by the distributor’s in-state office. In Avnet Inc. v. Dep’t of Rev., Dkt. No. 92080-0 (Wash. 2016), the Court effectively killed any notion that transactional nexus is required to impose the B&O tax—a tax on the privilege of doing business in Washington.  This case, coupled with the Ohio Supreme Court’s decision in Crutchfield v. Testa, which was decided one week before Avnet and involved Ohio’s similar Commercial Activity Tax (CAT), continue the trend of aggressively pursuing nexus in the business privilege tax context.

Avnet, a large distributor of electronic items, was headquartered in Arizona and shipped all of its products from distribution centers outside Washington. Avnet also had an office in Washington, but this local office and its employees were not involved with the Washington sales at issue in the case, which the taxpayer referred to as its “national sales.”  The taxpayer also disputed the taxability of its drop shipments, i.e., sales of goods that were shipped directly to the taxpayer’s customers’ customers in Washington, and the court ultimately concluded that those sales were subject to the B&O tax.  With respect to its national sales, the taxpayer argued that its Washington activities were sufficiently dissociated from those sales such that, under relevant U.S. Supreme Court precedent, citing Norton Co. v. Dep’t of Rev., 340 U.S. 534 (1951), it did not have substantial nexus with the state and could not be subject to the B&O tax with respect to the specific national sales at issue.  In Norton, the U.S. Supreme Court addressed whether the dormant commerce clause prohibited Illinois from imposing its business privilege tax on out-of-state sales that were not facilitated or fulfilled by the taxpayer’s Illinois branch.  The Court held that a taxpayer with a physical presence in the taxing state may not be subject to tax on certain revenue streams if it can show that the particular revenue generating activities at issue are “dissociated from the local business and interstate in nature.” Id. at 357.  Several Washington and U.S. Supreme Court cases post-Norton have recognized and applied the dissociation doctrine, which is also known as the principle of transactional nexus—thus, courts have recognized that there must be nexus with the specific transaction generating the revenue stream at issue, rather than just nexus over the taxpayer generally, for the B&O tax to be imposed.

Although commentators (see Hellerstein, State Taxation ¶19.02)  have questioned the continuing viability of Norton in the wake of cases like Complete Auto Transit v. Brady (which set forth the famous four-pronged Commerce Clause taxability test), the Washington Supreme Court explicitly stated that Norton “unquestionably remains good law[.]”  However, it went on to conclude that, in the 60 years since Norton, the Supreme Court’s interpretation of how a company must demonstrate dissociation has significantly changed.  According to the court, to establish dissociation, a taxpayer must show a “complete absence of any connection between the local office and the underlying sales in order to meet its burden.”  (emphasis added).  Such a standard may prove extremely difficult for taxpayers to meet.

While the dissociation doctrine arose in the context of a gross receipts tax, it may be that the Washington Supreme Court (and others) are of the view that transactional nexus, conceptually, is not necessarily required to impose a B&O-type tax because such a tax—although measured by “receipts” similar to a sales tax—is imposed upon the privilege of doing business within the state rather than upon a specific transaction, as a sales tax is. Furthermore, the unitary business concept—which exists uniquely in the income/business activity tax context—may be thought of as an additional safeguard against taxing revenue streams that do not have a sufficient connection with the state.  In other words, where the in-state business is unitary with the out-of-state business, it may seem less offensive to tax the out-of-state business’s revenues even if they are dissociated from the in-state business activities.  However, we must remember that the unitary business principle is an apportionment concept—it is not a substitute for nexus.  Furthermore, the first prong of the Complete Auto test is that the tax is “applied to an activity with a substantial nexus with the taxing State[.]” Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977) (emphasis added).  Thus, the question of whether a state has substantial nexus with the particular transaction (or, activity) it seeks to tax should remain a viable concern in the income and business privilege tax areas.  Additionally, it should be noted that had Avnet separated its national sales business into a separate out-of-state legal entity, the case could have been decided very differently, assuming, for example, that the in-state entity did not conduct activities that would establish and maintain the market for the out-of-state entity’s sales.

As discussed above, Avnet was decided one week after the Ohio Supreme Court issued its own business privilege tax decision in Crutchfield. (See our previous post, Ohio Supreme Court Physical Presence Not Required for Commercial Activity Tax.)  While not addressing transactional nexus, Crutchfield also furthers the reach of business privilege taxes by eliminating the physical presence requirement in the CAT context.  These two cases taken together demonstrate a marked expansion of nexus principles and may very well be an indication of a growing trend with respect to business privilege taxes.

Contact the Authors: Maria Eberle, Nicole Ford