The California Department of Tax and Revenue, formerly the State Board of Equalization, can now require the collection of sales tax for out of state online retailers who have no in-state property or employees. In South Dakota v. Wayfair, Inc. (2018) 2018 WL 3058015, ____ U.S. ____, the U.S. Supreme Court upheld a South Dakota law requiring out-of-state retailers to collect and remit sales tax, even without having a physical presence within the State. The law suit initially arose when the State of South Dakota sought a declaratory judgment against online retailers Wayfair, Inc., Overstock.com, Inc., and Newegg.
Farewell To The Physical Presence Rule
Upending 51 years of precedent, Wayfair overruled the Court’s physical presence rule as articulated in National Bellas Hess, Inc. v. Department of Revenue of State of Ill. (1967) 386 U.S. 753 and affirmed in Quill Corp. v. North Dakota (1992) 504 U.S. The physical presence rule prohibited states from requiring out-of-state retailers to collect and remit sales tax if the out-of-state retailer did not have a physical presence within the state. As such, the physical presence rule has long been the target of criticism for giving out-of-state businesses an advantage over in-state businesses and resulting in significant revenue losses to the states.
The Court found that the physical presence rule is “flawed on its own terms” for three reasons. First, the physical presence rule is not a necessary interpretation of the requirement that a state tax “must be applied to an activity with a substantial nexus with the taxing state.” Second, it creates, rather than resolves, market distortions thus placing local businesses and many interstate businesses with a physical presence at a competitive disadvantage to remote sellers. It also creates an incentive to avoid developing a physical presence in multiple states even when doing so might be efficient or desirable.
Third, the Wayfair Court found the physical presence rule treats economically identical actors differently, and for arbitrary reasons. As an example the Court compared two businesses that sell furniture online. One of these businesses maintained a small warehouse in-state, while the other maintained a major warehouse just across the state’s border. The Court found it arbitrary that only one of these businesses must collect and remit sales tax, although both are selling the same product to the same in-state market. Furthermore, the Court reasoned that the physical presence rule makes even less sense today considering the mass expansion of e-commerce since Quill was decided.
What Remains?
In order to pass constitutional muster, the Court made clear that a state tax must still satisfy all four prongs of the test established in Complete Auto Transit, Inc. v. Brady (1977) 430 U.S. 274, 279. Complete Auto provides that a tax will be sustained so long as it (1) applies to an activity with a substantial nexus with the taxing state, (2) is fairly apportioned, (3) does not discriminate against interstate commerce, and (4) is fairly related to the services the state provides. In the absence of the physical presence rule, the Court explained that the substantial nexus prong “is established when the taxpayer [or collector”] ‘avails itself of the substantial privilege of carrying on business’ in that jurisdiction.”
The Court ultimately found that the online retailers challenging the South Dakota tax law satisfied the substantial nexus prong “based on both the economic and virtual contacts [they] have with the State.” The law only applied to sellers that deliver more than $100,000 of goods or services into South Dakota or engage in 200 or more separate transactions for the delivery of goods and services into the State on an annual basis. Accordingly, the Court found that the challenging online retailers could not have incurred such a quantity of business without availing themselves of the substantial privilege of carrying on business in South Dakota. Finally, the Court found that the challenging online retailers undoubtedly maintain an extensive virtual presence within the South Dakota market. For these reasons, the Court found that the substantial nexus prong was satisfied.
Although the Court remanded the case to determine whether some other principle might invalidate the South Dakota tax law, it suggested that the law is likely to be constitutional based on three features of its design, namely that the law: (1) provides a safe harbor to those who transact only limited business in South Dakota; (2) is not retroactive; and (3) does not unfairly discriminate against out of state retailers.
What About California’s Sales Tax?
Under California’s sales tax law, online retailers are required to collect state sales tax. (Rev. & Tax. Code, § 6203.) An online retailer is said to be engaged in business in the state if they have anyone operating in California on their behalf for the purpose of selling, delivering, installing, assembling, or the taking of orders for any tangible personal property, or otherwise establishing or maintaining a market for their products. (Cal. Code Regs., tit. 18, § 1684(c)(1)(D); Rev. & Tax. Code, § 6203(c)(2) .) An online retailer is also considered to be engaged in business in the state if they have (1) an agreement with anyone in California to pay for customer referrals obtained via an Internet-based link or website, (2) total cumulative sales to purchasers in California, pursuant to such an agreement, exceeding $10,000 during the preceding 12 months, and (3) total cumulative sales to purchasers in California exceeding $1,000,000 during the preceding 12 months. (Cal. Code Regs., tit. 18, § 1684(c)(3); Rev. & Tax. Code, § 6203(c)(5).)
It was debatable whether these California sales tax laws, the so-called “Amazon” laws, would pass constitutional muster under Quill. Any such debate, however, has abated in light of the Wayfair decision. Without the physical presence rule, the California laws easily satisfy the substantial nexus prong articulated in Complete Auto because, like the laws upheld in Wayfair, they only apply to online retailers which have incurred a requisite quantity of business or are otherwise present in the taxing state. In addition, they also satisfy the remaining requirements from Complete Auto, as they are fairly apportioned, do not discriminate against interstate commerce, and are fairly related to services California provides. Accordingly, it is highly likely that California sales tax laws should survive any constitutional challenges under Wayfair.
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