The recent Harley-Davidson opinion from the Superior Court of California, County of San Diego is an alarming example of why it is important to apply the appropriate constitutional standard in state tax cases. In a Commerce Clause challenge, where the taxpayer argued a California statute discriminated against interstate commerce, both the California Appellate Court and the trial court applied Equal Protection standards in their Commerce Clause analyses. In doing so, the courts upheld an otherwise discriminatory tax scheme on the grounds that it furthered the state’s legitimate interests in generating revenue and ensuring income is fairly apportioned among the several states. Such a holding effectively guts the protections offered under the dormant Commerce Clause and highlights the analytical differences between discrimination under the Commerce Clause and discrimination under the Equal Protection Clause.
The bright-line physical presence nexus standard established by the US Supreme Court in Quill v. North Dakota, 504 U.S. 298 (1992) for sales and use tax purposes is under attack. Under this standard, a company must have a physical presence within a state in order for such state to constitutionally impose its sales or use tax upon that company. If such in-state physical presence does not exist, the imposition of tax is unconstitutional because it fails the “substantial nexus” requirement of the Commerce Clause. This has been the rule for the past 24 years, but now, in response to Justice Kennedy’s concurring opinion in Direct Marketing Association v. Brohl, Dkt. 13-1032 (U.S. 2015) advocating for a reconsideration of Quill, South Dakota and Alabama have enacted controversial sales and use tax nexus laws designed to directly conflict with the US Supreme Court’s holding in Quill. Both states have found companies willing to challenge them, including Newegg, Inc., a company that has been targeted by both states in their attempts to overturn Quill. For additional background on the events leading up to each state’s change, please refer to the prior Tax News and Developments article States on the Verge of a Nexus Showdown (Vol. 16, Issue 2, April 2016).
On December 31, 2015, the California Supreme Court issued its long-awaited opinion in Gillette Co., et al. v. Franchise Tax Board, 363 P.3d 94, addressing whether The Gillette Company and several other California corporate taxpayers (collectively, “Gillette”) were permitted to elect to use the Multistate Tax Compact’s evenly-weighted, three-factor apportionment formula comprised of property, payroll, and sales factors (“MTC Formula”) in lieu of the three-factor apportionment formula with a double-weighted sales factor (i.e., property, payroll, and double-weighted sales factors) subsequently enacted by the state (“Double-weighted Sales Formula”) in 1993. The California Supreme Court held that the California legislature not only had the power to override the Compact election contained in the California statutes, but that it also intentionally exercised that power when it statutorily mandated the use of the Double-weighted Sales Formula. This holding would result in a denial of the taxpayers’ refund claims of approximately $34 million, which were premised on the election and application of the MTC Formula to their franchise tax returns filed between 1993 and 2005.