U.S. Supreme Court Reverses Long Standing Law On Collection Of Sales Taxes
On June 21, 2018, in the landmark case of South Dakota v. Wayfair, Inc., the U.S. Supreme Court overturned cases from 1967 and 1992 that formed the basis for a long held advantage that the ecommerce industry held over traditional commerce. These cases held that an out-of-state seller’s liability to collect and remit the tax to the consumer’s State depended on whether the seller had a physical presence in that State. Many ecommerce retailers were permitted to avoid collecting sales tax and therefor have an advantage over local brick and mortar retailers.
Wayfair arose when South Dakota enacted a law requiring out-of-state retailers to collect and remit sales tax ‘as if the seller had a physical presence in the State.’ The law only applied to retailers that made at least 200 sales or sales totaling at least $100,000 in the State and required them to collect and remit a 4.5% sales tax. South Dakota subsequently sued several online retailers with no employees or real estate in the State. The State sought a declaration that the sales tax was valid and applicable to the retailers, along with an injunction requiring the retailers to register for licenses to collect and remit the tax. A trial court dismissed the case before trial, and the State Supreme Court affirmed, citing its obligation to follow U.S. Supreme Court precedent – Quill Corp. v North Dakota – which created the physical presence standard.
Forty-one States, two Territories, and the District of Columbia asked the Court to reject Quill’s test. The Court articulated that helping Wayfair’s customers evade a lawful tax unfairly shifts an increased share of the taxes to those consumers who buy from competitors with a physical presence in the State. The Court further stated that it is essential to public confidence in the tax system that the Court avoid creating inequitable exceptions. The Court went on to state:
By giving some online retailers an arbitrary advantage over their competitors who collect state sales taxes, Quill’s physical presence rule has limited States’ ability to seek long-term prosperity and has prevented market participants from competing on an even playing field.
The Wayfair court based its decision on the Court’s Commerce Clause principles and their application. The Court articulated the boundaries of a state’s authority, saying: (a) state regulations may not discriminate against interstate commerce; and (b) states may not impose undue burdens on interstate commerce. Under these principles, state taxes will be permitted so long as they:
apply to an activity with a substantial nexus with the taxing State,
are fairly apportioned,
do not discriminate against interstate commerce, and
are fairly related to the services the State provides.
Prior Supreme Court decisions held that a ‘seller whose only connection with customers in the state is by common carrier or…mail’ lacked the requisite minimum contacts with the State required by the Constitution.
The Court rejected its prior decision in Quill. It based its rejection on three key principles. First, the Court recognized how the physical presence rule has long been criticized as giving out-of-state sellers an advantage. The Court stated that each year, it becomes further removed from economic reality and results in significant revenue losses to the States. Second, the Court found that Quill creates market distortions – the Court calling it a judicially created tax shelter for businesses that limit physical presence. Finally, the Court said that Quill imposes an arbitrary, formalistic distinction that the Court’s modern precedents disavow. The Court said that the Quill decision treats economically identical actors differently for arbitrary reasons.
Franchisors that are not ecommerce sellers should not be substantially affected by this decision initially. The decision clears the way for states to enact laws that require remote sellers or facilitators (e.g., Ebay and Etsy) to collect and remit sales or use tax regardless of whether they have a physical presence in the taxing jurisdiction. It also allows for future challenges to new laws that take an aggressive position on economic nexus – challenging state laws that fail the ‘substantial nexus’ test.
Franchisors will need to monitor state developments to determine where the new state economic nexus thresholds are met, and be mindful of state law changes that may look to tax royalties.