I remember several years ago working with a fellow who had made several trips to almost every state in the U.S. to visit clients, install equipment and provide other services to his customers. I told him, quite sadly, that he had nexus all over the place. He looked at his arms with a horrified expression and asked if could be cured? We both almost fell off our chairs laughing at his joke, but the underlying question was a very good one.
What is nexus, is it a good thing or a bad thing, and what can be done about it?
Nexus from Tax Perspective
Nexus is a concept developed by the various states in the U.S. to determine whether a taxpayer is, a taxpayer. It is loosely similar to the federal concept of permanent establishment. Where the comparison ends is in the definition of the two terms. Permanent establishment is fairly well defined in treaties and the Internal Revenue Code. There are some very important concepts in tax that are very poorly defined. The definition of income for tax purposes is “income from whatever source”. The definition of nexus is more nebulous in that this concept has been defined mostly by jurisprudence.
In short, nexus is a closeness or connection between the taxing jurisdiction and the person that the jurisdiction is seeking to impose its tax obligations upon. Not helpful, but it’s a start.
Nexus has different thresholds that depend upon the type of tax, the state and sometimes even the industry under consideration.
Generally, both the Due Process Clause of the United States Constitution and the Commerce Clause require that a taxpayer have some minimum connection with, or presence in the state before taxes can be imposed.
Minimum standard
The Supreme Court ruled in Millar Brothers Co. v. Maryland that the Due Process Clause requires some “definite link, some minimum connection, between a state and the person, property, or transaction it seeks to tax.” Generally a residence within the state, the doing of business or the hiring of employees within the state, or the owning of property within the state would all qualify as such a connection.
The Court further ruled in Quill Corporation v. North Dakota that while the Due Process Clause required some minimal connection the Commerce Clause imposed a different and higher standard. In this instance, Quill had some minimal amount of property present in North Dakota, however, the Court determined that, “… contrary to the State’s argument, a mail-order house may have the “minimum contacts” with a taxing State as required by the Due Process Clause and yet lack the “substantial nexus” with the State required by the Commerce Clause. These requirements are not identical and are animated by different constitutional concerns and policies. Due process concerns the fundamental fairness of governmental activity, and the touchstone of due process nexus analysis is often identified as “notice” or “fair warning.” In contrast, the Commerce Clause and its nexus requirement are informed by structural concerns about the effects of state regulation on the national economy.”
In other words, while a company may have enough presence to satisfy the Due Process Clause, the Commerce Clause, and in particular, the Dormant Commerce Clause requires that the presence is substantial before sales or use tax nexus is found.
Many states, when looking at other types of taxes are quick to remind that Quill and its supporting cases are applicable only to sales tax and not to other tax types.
The Income Tax Approach
The Supreme Court’s found in the Northwestern States Portland Cement case, that an out of state seller could be required to pay income tax for having employees solicit orders for sales and maintaining a leased office in the state. The Court wasn’t clear whether nexus was created by the presence of a leased office, the activity of the employees or some combination of the two. In response to the questions raised, Congress acted to assist business by passing Public Law 86-272 (PL 86-272) in 1959. This federal law allowed that, no state or political subdivision thereof, shall have the power to impose a net income tax on the income derived by such person from interstate commerce if the only business activities of such person are the solicitation of orders for the sale of tangible personal property, which orders are sent outside the State for approval or rejection, and if approved, are filled by shipment or delivery from a point outside the State.”
There are a few terms of art in the legislation that warrant further scrutiny. The law is clear that it only applies to net income based taxes. Therefore, taxes on capital, gross receipts or other tax bases that are not net income are not covered by this law. Accordingly, Ohio’s Commercial Activity Tax and Washington’s Business and Occupation Tax are not restricted by PL 86-272.
The law is also very clear that it applies only to orders for the sale of tangible personal property. Taxpayers making sales of intangible property or services, whether in addition to sales of tangible personal property or not, are not covered by this law. In recent years, legislation has been introduced in both Congress and the Senate to extend the protection of PL 86-272 to intangible property and services, however, none of the efforts to date to expand the law have been successful.
Another point is that the law specifically applies, by its terms, to interstate commerce and not necessarily to foreign commerce. Interstate commerce is generally thought of to include business done between the 50 states and the Commonwealth of Puerto Rico. Therefore, shipments originating outside of the United States may not be included as “in furtherance of interstate commerce”, and the activity of soliciting orders for those sales is not a protected activity pursuant to PL 86-272. California is one of the more predominant states to hold the position that companies who fill orders by shipment from a point outside the U.S. (e.g. direct shipment from an offshore factory) are acting in furtherance of international commerce and are outside the protections of the law.
Is Nexus a Bad Thing?
Having nexus in a state is not necessarily a bad thing. In the U.S., state income and franchise taxes generally require taxpayers to apportion their tax base among the several states where they are doing business. Underlying the apportionment principle is that you must be doing business, or have nexus, in more than one state to have the right to apportion some amount of income to that state. If you only have nexus in one place, it is hard to argue that your income should be apportioned to other locations.
Having nexus in a state will create a filing requirement in that state which will increase the compliance and administrative burden on taxpayers. This is generally the first thought when looking at whether expanded nexus is good or bad and since the expansion means an increase in burden and associated costs, nexus is often viewed as a bad thing.
If, however, by creating nexus in another state, you can apportion income from your current state to another state that has a lower tax rate state, then nexus may not be a bad thing. The analysis will depend upon the incremental costs of operating in, and complying with that second state’s rules compared to the incremental benefits gained. Those benefits can be cost savings and can also be intangible benefits such as better presence in a local market or other rights that residence in a state ma confer.
You should work with your U.S. tax advisor to determine whether you have created nexus in a state, whether you want to create nexus in a state, or whether you want to structure your business in that state to take advantage of the protections offered or other methods for not creating nexus in a state.
AG TAX LLP Can Help
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