Does the Commerce Clause Protect Commerce or State Coffers?
December 12, 2006
Apparently it’s the latter, according to the West Virginia Supreme Court Court of Appeals.
In the case of Tax Commissioner v. MBNA America Bank, the West Virginia Supreme Court of Appeals ruled that the state could force MBNA to pay corporate tax even though MBNA was a Delaware-based corporation with no property or employees in West Virginia. MBNA did have numerous customers in West Virginia who held MBNA credit cards and it drew over $10 million in gross receipts per year from its West Virginia customers. MBNA challenged the tax assessment, claiming that the Commerce Clause required a physical presence (which it did not have) before a state could require it to pay tax.
The MBNA case is the latest in a long list of cases where state courts have decided what types of presence are required for a state to assert nexus to tax under the Commerce Clause. There are two competing views of nexus:
• Physical presence: a state can assert nexus if a company has a real, tangible investment in a state (such as a plant, office, equipment, or employees)
• Economic presence: a state can assert nexus if a company has customers in a state from which the company derives income
The Supreme Court of the United States affirmed the physical presence rule in the sales tax context (first articulated by the Court in 1967) in the 1992 Quill case, but there is debate over whether physical presence applies to state corporate taxes. States courts are divided on the question but the latest cases (including MBNA) are breaking in the direction of economic presence.
What is most troubling about the MBNA case is the court’s reasoning. At one point, the court defends its adoption of economic presence by noting that:
“we believe that the…physical-presence test, articulated in 1967, makes little sense in today’s world. In the previous almost forty years, business practices have changed dramatically. When Bellas Hess was decided, it was generally necessary that an entity have a physical presence of some sort, such as a warehouse, office, or salesperson, in a state in order to generate substantial business in that state. This is no longer true. The development and proliferation of communication technology exhibited, for example, by the growth of electronic commerce now makes it possible for an entity to have a significant economic presence in a state absent any physical presence there. For this reason, we believe that the mechanical application of a physical-presence standard to franchise and income taxes is a poor measuring stick of an entity’s true nexus with a state.”
To summarize: the West Virginia Supreme Court of Appeals thinks that the physical presence test is defective because it was articulated at a time when goods were produced and sold more locally, and since our modern economy features truly global production and sales the test is now an inappropriate way to measure business activity.
Of course, this reasoning begs an important question: why should the Commerce Clause test for nexus change merely because business practices have changed? The Commerce Clause, after all, was designed to protect interstate commerce from state intrusion and regulation.
Indeed, the Founders would not have included the Commerce Clause in the Constitution if businesses at the time were not engaged in interstate commerce and trade. Yet the West Virginia court remarkably says that the Founders “lived in a world that is impossible for people living today to imagine”—as if they lived in world without interstate commerce. State Tax Notes legal editors Jennifer Carr and Cara Griffith rightly take the court to task for this sloppy history in the closing paragraphs of their analysis of the MBNA decision.
And so the chief problem with economic nexus is that it seems designed to protect (or enhance) state coffers rather than commerce. It does so because it significantly expands the number of states that can lay claim to tax a company’s income—and multiplies the number of accountants and lawyers a firm must employ to comply with multiple state tax systems. It is a good deal for states (particularly market states without a lot of labor and capital) but not the businesses who ply their trade in interstate commerce.
We’ve written on these themes in several studies (here, here, and here). Doug Lindholm, president of the Council on State Taxation, also wrote an excellent piece (called ‘Old Economy’ Tax Systems on a ‘New Economy’ Stage: The Continuing Vitality of the ‘Physical Presence’ Nexus Requirement) explaining why the new economy actually strengthens—not weakens—the case for physical presence.