Years before the rise of online retailing, states tried to force out-of-state merchants who sold goods via catalogs to levy sales taxes on their residents. The Supreme Court, citing the principle that a state can require tax collection only from firms with a physical presence in their jurisdiction, struck down those efforts. But now South Dakota, encouraged by an opinion from Justice Anthony Kennedy, is urging the Court to allow it to collect sales taxes from online retailers. If the Court agrees in South Dakota v. Wayfair, many e-commerce firms could face unprecedented new burdens requiring them to track and file taxes in up to 45 states and potentially exposing them to audits in any of them. For some small firms, such changes could be fatal.

Even more troubling, though, is the role of the Trump administration’s Justice Department, which intervened with a brief in support of South Dakota, in which the Solicitor General argues that the Court should expand the definition of what constitutes tax “nexus”—that is, the authority to levy taxes—from physical presence in a state to virtual presence. The Justice Department brief is so vague and inexact on what “virtual” means that were the court to follow its advice, it might subject almost any enterprise that does business online—in other words, just about any business—not only to sales tax obligations but also, possibly, to corporate income taxes in places where these businesses don’t operate. It’s difficult to imagine a more unwise, uninformed approach to a complex issue.

The Supreme Court has interpreted the Constitution’s Commerce Clause—which gives the federal government the right to regulate interstate trade—as limiting the ability of states to tax businesses from other jurisdictions. A business must have a physical presence—a local sales office, a distribution facility, a warehouse—in a state to establish tax nexus. States have long tried to get around the court’s rulings, for instance by declaring that any firm trying to sell goods to in-state customers was automatically present in the state, even if the seller was located out of state. To clarify the issue, in 1959 Congress passed the Interstate Income Act, prohibiting states from applying their corporate taxes to firms if those businesses’ only activity was to solicit orders in a state.

As catalog retailing expanded, local governments also tried forcing out-of-state firms to collect sales tax. The court swatted these efforts down several times, most recently in 1992, when North Dakota claimed that Quill, an Illinois cataloger, had established a physical presence in the state when it sent floppy disks with product listings to in-state customers. The court ruled against North Dakota but noted that as technology changed the terms on which firms were doing business, Congress should intervene with new laws clarifying what constituted in-state presence.

Ironically, the Quill decision created an opening for states because it applied only to taxes that out-of-state firms might be required to pay on transactions—it said nothing about taxes on earnings or revenues, such as corporate income and gross-receipts levies. As technology evolved, states expanded the definition of what they considered “physical presence” for the purpose of grabbing corporate taxes from firms. Several dozen states now say that if a company’s website is hosted on a server in-state, even if the firm has no other presence there, then that constitutes enough nexus to levy income taxes on the firm. Similarly, because the Interstate Income Act applies only to tangible goods, states are trying to dun out-of-state businesses that sell intangible products, like software and cloud-computing services, to residents or businesses in their jurisdictions. In testimony before Congress, for instance, the owner of South Carolina firm ProHelp Systems described how New Jersey forced it to pay corporate income tax for licensing a software program to an in-state firm. The fee that the software firm earned was less than the minimum corporate income tax; when other states began doing the same thing, the small firm decided to go out of business.

Meanwhile, as e-commerce has exploded, states complain that they’re losing sales tax to remote sellers. Though Amazon and other big online retailers now collect and pay sales tax because they have physical operations in many places, states saw an opportunity to grab revenue from smaller firms after Justice Kennedy wrote in a 2015 opinion that the Court should reevaluate the Quill decision. President Trump’s selection of Neil Gorsuch to the Supreme Court also buoyed states because Gorsuch had expressed similar sentiments while serving on the Tenth Circuit Court of Appeals. Several states, including South Dakota, passed new laws requiring out-of-state e-commerce firms to collect taxes with the express purpose of generating a court challenge. The parties argued the case last week.

Settling this matter through the courts, however, is a recipe for trouble, because the justices can’t possibly deal with all the nuances of the issue, which require legislation. The chair of the House Judiciary Committee, Robert Goodlatte, along with other members of Congress, has urged the court in an amicus brief to deny South Dakota’s petition because it is Congress’s job to sort this out. Acknowledging that Congress has struggled to find an answer, Goodlatte nonetheless observes that “the Court should recognize that a lasting solution will require compromise, and respect and accommodate the ongoing, diligent efforts of Congress to find a fair solution consistent with Constitutional norms.” Of course, the White House would participate in any legislative negotiations, and the president would have to sign a new bill into law. Why, instead, the Justice Department seems willing to hand over to the court a responsibility that the Constitution gives to Congress and the executive branch is baffling.

Even worse, the administration’s brief urges the court to set a new definition for physical presence that could rewrite the rules of tax nexus dramatically. The brief begins by alleging that e-commerce firms create ubiquitous “virtual” existences online and then urges the court to use virtual presence as a way of defining whom a state can tax. “Internet retailers can establish a pervasive and continuous presence—including by maintaining virtual storefronts that seek to replicate the experience of shopping in a physical store, available to every state resident 24 hours a day—even in States where they have no employees or physical property,” the brief declares. But the Solicitor General never explains how Wayfair (an ecommerce retailer of home goods) might be specifically targeting South Dakota residents. It is merely the business’s general web presence, accessible to any American with a computer and online connection, that makes it vulnerable to the tax man. While the Solicitor General’s brief concerns itself only with the sales taxes at issue in this case, the notion of physical presence applies to a much broader range of taxes. The Trump administration’s argument, then, not only opens up small firms to assessing and collecting sales tax in dozens of states but also serves as an invitation to states to extend their hands into the pockets of distant firms via business levies like the corporate income tax or gross receipts tax. The bureaucratic burdens alone are daunting to imagine.

It’s not easy to understand what would prompt an administration that bills itself as business-friendly and anti-bureaucratic to take such a position on something as central as the federal government’s role in interstate commerce. One can only hope that cooler heads—Trump economic adviser Larry Kudlow, say, or Treasury Secretary Steven Mnuchin, or Treasury Under-Secretary David Malpass—will talk some sense into the Justice Department, if it isn’t already too late.

Photo: AndreyPopov/iStock


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