Overview -- Congress Must Act to Clarify the Nexus Standard for State Business Activity Taxes

The Traditional Physical Presence Nexus Rule Provides Certainty and Fosters Economic Growth

The longstanding rule governing state taxation provides that state and local governments may impose taxes on an out-of-state company only if that company or its representative has a physical presence in the taxing state. See, e.g., Quill Corp. v. North Dakota, 504 U.S. 298 (1992); National Bellas Hess, Inc. v. Department of Revenue, 386 U.S. 754 (1967). In fact, although the U.S. Supreme Court has not ruled directly on the issue of the appropriate nexus standard for state assessment of corporate income taxes, it has never upheld any kind of state tax on an out-of-state company unless that company had a physical presence in the taxing state.

This traditional physical presence nexus rule recognizes a practical compromise between state authority to tax and the need to protect an open, accessible and unfettered national market. Thus, the rule fosters the fundamental purposes of the Commerce Clause, preventing undue burdens on the free flow of interstate commerce, limiting the risk that the same income will be taxed multiple times and generally forestalling the “welter of complicated obligations” that the Commerce Clause was designed to avoid. Bellas Hess, 386 U.S. at 760.

The physical presence nexus rule is a bright-line standard that provides businesses and states with adequate understanding of when and where companies will be subject to tax. The rule is equitable, simple to comprehend and easy to enforce. As a result, the rule promotes economic growth: a business that reports and pays taxes in fewer states spends less money complying with tax laws and litigating their application, and thus has more money to invest in labor and capital. Additionally, the standard permits a business to determine with confidence, before entering a particular state, whether it will be subject to taxation there and whether it is willing to incur the associated costs (such as the likely need to keep multiple records, meet multiple filing requirements and engage in multiple interactions with regulators). Settled expectations foster investment, so the national economy benefits from the stability of a bright-line rule.

Recent Efforts by Some States to Enforce New “Economic Nexus” Theories Will Result in Chaos


More recently, some state and local governments have aggressively sought to increase their tax revenues by asserting the power to tax the corporate income of out-of-state businesses that have no physical presence in the taxing state based on the taxpayer’s “economic nexus” to the taxing jurisdiction. These states have adopted a variety of ill-defined alternative nexus standards through judicial, legislative and administrative action. Economic nexus theories eliminate virtually any limit on the states’ authority to impose extraterritorial taxation. Thus, such theories conflict with Supreme Court interpretations of the states’ taxing authority under the Commerce Clause and subject interstate commerce to severe burdens. Economic nexus actions have included attempts by state and local governments to tax out of state businesses for licensing software, licensing the use of intellectual property, franchising and providing credit to customers.

Because out-of-state businesses provide an attractive target for state legislatures seeking to raise additional revenue, the economic nexus standard is spreading to other states. Political processes within the taxing state do not easily restrain the taxation of non-residents, and a state has every incentive to export its tax burden and interpret its laws aggressively to reach as many out-of-state taxpayers as possible.

State efforts to tax out-of-state companies beyond the scope authorized by the Commerce Clause are sure to increase dramatically in light of the U.S. Supreme Court’s refusal over the past few years to review several cases that challenged the constitutionality of such efforts. See, e.g., Capital One Bank v. Commissioner of Revenue, 899 N.E.2d 76 (Mass. 2009), cert. denied 2009 WL 733877 (2009); FIA Card Services NA (fka MBNA America) v. West Virginia Tax Commissioner, 640 S.E.2d 226 (2006), cert. denied, No. 06-1228 (June 18, 2007); Lanco, Inc. v. Director, N.J. Division of Taxation, 908 A.2d 176 (N.J. 2006), cert. denied, No. 06-1236 (June 18, 2007). State legislatures and tax administrators seeking to expand their tax nexus authority likely will interpret the Court's denial of certiorari as an affirmation of their positions on economic nexus. This gives those states an ideal opportunity to raise revenues from out-of-state corporations on the theory that since the Court will not review their nexus standards and Congress has not acted, they are free to enact whatever nexus legislation or policies affecting interstate commerce are beneficial to their particular state revenue needs, regardless of the national impact. By way of example, following the Court’s denial of certiorari in the FIA Card Services and Lanco cases, the New Hampshire legislature added economic nexus language as a legislative amendment to the state budget on June 21, 2007, just two days after the Supreme Court declined to review those two cases. The New Hampshire Department of Revenue will aggressively apply this legislation to tax credit card banks and other financial institutions whose customers reside in the state even if the bank does not have a physical presence in the state. Inevitably, other states will follow suit.

Economic Nexus Impairs Economic Growth

Economic nexus theories have resulted in a number of serious problems sure to intensify as states are emboldened to act more aggressively:

  • Economic nexus is not a fair test. Businesses that have no physical presence in a state do not receive meaningful benefits or protections from the state – such as police and fire protection, transportation infrastructure, government-sponsored employee training programs, economic development grants, and so on – and, therefore, they should not be required to pay taxes to support state and local government programs.
  • Economic nexus theories increase companies’ compliance costs, and such costs will be passed on to consumers in the form of higher prices. Companies with customers scattered across several states are faced with the task of complying with an expanding patchwork of state statutes and regulations that frequently set vague and unpredictable criteria for establishing when an entity is deemed to have an “economic” nexus in a state. Multi-state businesses face the prospect of taxation not only in 50 states, but also in thousands of localities authorized to impose business activity taxes. A recent Ernst & Young survey found that state and local governments impose over 3,300 business activity taxes. An additional 9,300 U.S. jurisdictions have the power under state law to impose such business taxes but do not currently do so. In the absence of a physical presence rule, multi-state businesses will face significant costs in trying to determine the jurisdictions in which they face potential tax liabilities and the applicable rules of those jurisdictions. Some may be unable to ascertain accurately their tax liabilities at all. Furthermore, the current uncertainty over state extraterritorial taxing authority is itself generating enormous – and enormously wasteful – litigation costs.
  • Economic nexus hampers reliable strategic business planning. A business seeking to predict the tax liability arising from particular business activities cannot be sure what exactly will subject it to taxation in a given jurisdiction. Because the extent of states’ tax authority is still being litigated, even the current basis for liability in many states is uncertain. And, absent clear guidance by Congress, there is no reliable way for businesses to predict how far jurisdictions will assert taxation authority in the future, and whether such assertions will be upheld in court. This all combines to render long-term strategic decisions, including decisions about where to invest, difficult.
  • Economic nexus does not lend itself to a bright-line rule. For example, some states may choose to adopt a definition that is sensitive to the size of a company or the volume of a company’s in-state sales. Other states may set the bar very low and consider even a relatively small amount of sales to be significant. Already some states choose to apply economic nexus only to specific industries or business structures. As a result, companies have no reliable means of determining which, if any, of these diverse interpretations will be applied in various taxing jurisdictions, and will have no reliable means of determining whether they are subject to tax.
  • Economic nexus violates the U.S. Constitution. State court analyses adopting an economic nexus approach are fundamentally flawed because they improperly co-mingle the U.S. Supreme Court’s due process clause minimum contacts test and its Commerce Clause test. The jurisdictional question for Commerce Clause purposes is not simply whether exposing an out-of-state business to a state’s taxing power would be unfair. Instead, the question is whether the business activity in question has a sufficient connection with the state so that the imposition of a tax by the state would not unduly burden interstate trade. The economic nexus standard merely reaches the due process inquiry and goes no further.
  • The labyrinth of economic nexus rules places businesses at risk of duplicative over-taxation. Because business activity taxes actually impose payment obligations on the taxpayer, abandoning traditional physical presence nexus rules exacerbates the risk that taxpayers will be taxed multiple times on the same revenue.
  • Economic nexus threatens the continued development of electronic commerce. At a time when the Internet has enabled start-up businesses and hometown companies to access a national marketplace and to realize the benefits of a single, unified economy, a crazy quilt of state and local tax compliance obligations will effectively erect a barricade across the electronic highway. Proliferation of economic nexus theories also will limit the ability of consumers, including those living in rural and remote areas of the country, to purchase products that might not otherwise be available to them.
  • Economic nexus permits aggressive states to, in effect, steal from states that are in full compliance with Commerce Clause requirements. Those states that continue to apply the physical presence nexus rule may be forgoing revenue. States that are aggressively asserting extraterritorial taxing power may be inappropriately interfering with the revenue base and commercial conditions of other states.
  • Economic nexus stymies accounting reporting rules for publicly traded companies. The Financial Accounting Standards Board recently prescribed FIN 48, a comprehensive model for the recognition, measurement and disclosure of a company’s income tax uncertainties. The divergence of legal opinions and the swirl of litigation surrounding the increased use of economic nexus theories by states have stymied such attempts to achieve consistent reporting treatment.
  • Economic nexus is inconsistent with the nexus standards agreed to in U.S. income tax treaties. Among the network of international tax treaties that have developed, including all tax treaties to which the U.S. is a party, a universal requirement for imposing income taxes on a nonresident is physical presence in the taxing jurisdiction. Utilization of economic nexus theories contravenes that norm. If states tax the income of corporations of other nations based on such nebulous minimal nexus theories, the expectations of international businesses that engage in commerce with the U.S. will be disrupted. Also, allowing states to depart from the settled norm of physical presence will encourage aggressive extraterritorial tax measures by foreign countries against U.S. businesses.

Economic Nexus Theories Have a Disproportionately Adverse Impact on Smaller Companies


The impact of economic nexus theories on small and mid-sized businesses is severe. While the tremendous problems associated with multiple versions of an economic presence standard make compliance with varying business activity tax laws burdensome for larger companies, the impact on small and medium-sized businesses is especially onerous.

The Direct Marketing Association estimates that there are more than 479,500 businesses in the U.S. with annual revenue of ten million dollars or less that engage in remote marketing in one or more states in which they have no physical presence. This group of small businesses collectively had estimated combined annual revenue of $299.4 billion dollars in 2006, and employed an estimated total of 1.13 million people.

Smaller businesses will be hardest hit by widespread use of the economic nexus standard. Smaller businesses do not have the resources or capability to comply with the multitude of state and local tax laws that are triggered by the economic nexus standard. Moreover, the prospect of challenging an incorrect assessment in a remote jurisdiction is daunting and expensive, thus many smaller businesses faced with improper tax assessments are left with no choice but to pay the tax and forget their objections.

Congress Must Act to Protect Interstate Commerce

Congress has an obligation to act to resolve the myriad of problems caused by state efforts to expand their taxing authority beyond the confines of the Commerce Clause. A general sweeping-aside of all restraints on state taxing authority over non-resident companies by state taxing administrators and courts does not serve the interests of the national economy but only the parochial revenue interests of individual state governments. Economic nexus presents an uncertain standard with no refinements regarding its scope and implementation. A bright-line physical presence rule applicable to all state taxes settles expectations, fosters investment and promotes interstate commerce.

State sovereignty can only be respected when state territorial boundaries retain their integrity. States’ physical bounds are effectively erased by out-of-state taxation that is justified on the basis of an economic presence. Because virtually every business that sells services to out-of-state consumers arguably has such a presence in the states where its customers reside, an economic nexus standard would make such companies fair game for income taxation without any reference to the state boundaries within which they operate, thereby rendering geographic borders meaningless as limitations on state power. If one state can expand the territorial reach of its taxing authority, by definition it is regulating activity that is occurring within the territory of another state.

One of the main foundations of our federalist system of government is that the power to regulate beyond individual states’ borders rests not with those states, but with Congress. An economic nexus standard violates perhaps the most fundamental principle of our Constitution. In contrast, physical presence nexus promotes respect for geographic borders by limiting the exercise of state authority over out-of-state businesses to those entities that engage in activity, through some form of physical presence within the states’ bounds.