On June 21, the U.S. Supreme Court ruled on a case that has far-reaching consequences for internet commerce, including buyers, states and most especially sellers.
In South Dakota v. Wayfair Inc., reversing 50 years of tax policy, the court decided 5-4 that the physical presence standard for sales tax collection is no longer the law of the land. So, retailers across the nation must prepare for a profound increase in sales tax collection responsibilities as states adapt their laws to this new judicial standard.
Rhode Island announced as of July 2, it would begin requiring companies to collect and remit taxes on sales to state residents and businesses.
The physical presence standard has been the cornerstone of sales tax policy in the United States for the last half century. The standard was first imposed by the Supreme Court in 1967 in National Bellas Hess Inc. v. Department of Revenue of Illinois. In 1992, the Supreme Court in Quill Corp. v. North Dakota confirmed the applicability of the physical presence standard. The physical presence standard in simple terms requires a retailer to have physical presence in a state before that state can impose sales tax collection requirements on the retailer’s in-state sales.
The Quill decision is an interpretation of the “substantial nexus” standard that existed under the broader Constitutional criteria for taxation in the U.S., first enunciated in Complete Auto Transit Inc. v. Brady, which stated that a tax must:
• Apply to an activity with a substantial nexus with the taxing state.
• Be fairly apportioned.
• Not discriminate against interstate commerce.
• Be fairly related to the services that state provides.
The proliferation of online retail business since the Quill decision allows a vast number of merchants without physical presence in a state to sell goods or services that are “free” of sales tax. Consumers are required in these circumstances to remit use tax on their purchases; however, compliance under this self-assessment system is notoriously low. The court in Wayfair noted states lose between $8 billion and $33 billion every year as a consequence of this framework.
Justice Anthony M. Kennedy delivered the majority opinion in Wayfair, in which the court notes “the physical presence rule, both as first formulated and as applied today, is an incorrect interpretation of the Commerce Clause.” The court then provided three reasons to support its decision to overturn Quill:
• The physical presence rule “is not a necessary interpretation” of the requirement that an activity must have a substantial nexus with the taxing state.
• The physical presence rule “creates rather than resolves market distortions.”
• The physical presence rule is an “arbitrary, formalistic distinction” disavowed by modern precedents to the Commerce Clause.
In bolstering its rationale to overturn Quill, the Supreme Court in Wayfair frequently cites injustices associated with sales tax policy that has been applied to online businesses and their “brick-and-mortar” counterparts. According to the Supreme Court, Quill puts both local businesses and many interstate businesses with physical presence at a competitive disadvantage relative to remote sellers. Remote sellers can avoid the regulatory burdens of tax collection and can offer de facto lower prices caused by the widespread failure of consumers to pay the tax on their own.
This “guarantees a competitive benefit to certain firms simply because of the organizational form they choose” while the rest of the court’s jurisprudence “is all about preventing discrimination between firms.” In effect, Quill has come to serve as a judicially created tax shelter for businesses that decide to limit their physical presence and still sell their goods and services to a state’s consumers – something that has become easier and more prevalent as technology advanced.
Tarra Curran is a managing director at CBIZ & MHM New England, with offices in Providence and Boston.