Business Activity Taxes: The States Reach Out

As states seek to maintain or expand both their tax base and collections, we’ve noted increasing and novel attempts to tax interstate transactions.  No less than the U.S. Supreme Court, however, has held that the predicate that for a state to tax a non-resident individual or business, the individual or business must have a real physical presence in the state.  Commonly, physical presence has been interpreted as having an office or place of business in the state, or employing workers that operate within the state.

Of course the rationale for the physical nexus requirement is that it is principally unfair for a state to require a business to collect sales and use taxes when that business has no physical presence in the taxing state.  Yet, while physical nexus continues to be the law of the land with respect to sales and use tax collections, some states are now seeking to ignore this requirement for other forms of taxation – asserting that an “economic nexus” is sufficient.  Under the economic nexus theory, some states have attempted to tax any transaction that touches the state, whether or not the parties are physically located in the state.  This is a bad tax policy which will result in unmanageable tax and compliance problems for all businesses.

Imposition of business activity taxes under the economic nexus theory imposes a particularly burdensome regime on the IT industry.  Consider the following example:  A VAR located in State A is engaged by a customer in State B to solve a software issue.  The VAR has no place of business in State B and without ever entering State B, the VAR connects to the customer’s computer via the Internet, the computer is repaired and the customer is billed for this service.  Under the economic nexus theory, State B could assert that income earned by the VAR is subject to income and franchise taxes in State B.  Also, because the VAR is a resident and is physically present in State A, State A could likewise seek to tax these earnings.  This sets up a tug of war for tax revenue, with the business caught in the middle.

From this example, it is easy to see how adoption of the economic nexus standard will usher in a burdensome and complex multiplicity of tax regimes for all businesses.  This would be most devastating for small businesses which have neither the expertise to learn the taxing requirements of all states, nor the money to pay a professional to monitor and comply with dozens, hundreds or thousands of taxing authorities.

This is not just a theoretical problem.  Recently, a small VAR IT business located in New Hampshire recounted a situation in which the state of Maine demanded that this business file a Maine tax return.  The Maine tax authority noted that the VAR had a few customers in Maine (as well as a couple of employees who lived in Maine at their personal choice and not for work).  After great time and expense on the part of the VAR, the Maine tax authority eventually withdrew its demand.  This was only after the VAR was required to prove that its business dealings within Maine were “de minimis” and did not warrant a tax return.  Of course, we agree with this outcome, but we do not agree with the process that required this small business to spend enormous and needless time, effort and expense in order to contest this overreaching approach to interstate taxation.  To avoid this in the future, clear and consistent criteria must be established to determine whether a business has a sufficient physical presence in a state to allow that state to impose business activity taxes.

Before more states move to collect unfair taxes from small out-of-state businesses, CompTIA has urged Congress to require distinct physical presence requirements as a prerequisite for the taxation of interstate business activities; this position is embodied in H.R.1083, Business Activity Tax Simplification Act of 2009.  Introduced on February 13, 2009, it has languished in the jurisdiction of the Subcommittee on Commercial and Administrative Law (under the House Judiciary Committee).  The subcommittee held a hearing on February 4, 2010 (for which CompTIA submitted testimony supporting the legislation), but little activity has occurred since then.

However, just before the House recessed for its election break last week, the majority of members of the House Judiciary Committee signed a letter urging the Chair, Rep. Conyers, and the Chair of the Judiciary Subcommittee on Commercial and Administrative Law to set a date for mark-up of this legislation; this is an encouraging event (although it might be a bit late in the current session of Congress).  Even so, as we gear up for the lame duck session, we will be speaking to House offices in support of this legislation.  However, action on H.R. 1083 during the lame duck session is quite uncertain, because the issue of most interest (and urgency) will certainly be the expiring tax cuts.