State Tax Return. How Low Can You Go? New York Court Holds Instant Messaging to In-State Person Sufficient for In-State Jurisdiction

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1 October 2006 Volume 13 Number 10 State Tax Return How Low Can You Go? New York Court Holds Instant Messaging to In-State Person Sufficient for In-State Jurisdiction Michelle Brunsvold Thomas Molins Chicago Chicago (312) (312) The Court of Appeals of New York recently held, in Deutsche Bank Securities, Inc. v. Montana Board of Investments, 1 that New York could extend long-arm jurisdiction over an out-of-state entity simply because it had communicated through an instant messaging system with an investment banking firm in New York. Although the case does not involve taxes, we wondered whether it had potential tax implications. If an outof-state entity has personal jurisdiction with a state by virtue of an instant messaging exchange, might states argue instant messaging is sufficient to create nexus for tax purposes? Background Deutsche Bank Securities involves an abandoned bond transaction between Deutsche Bank Securities, Inc. and the Montana Board of Investments ( MBOI ), a state agency that manages an investment program for public funds. In the thirteen months prior to the transaction at issue, Deutsche Bank and MBOI had engaged in eight other bond transactions with a face value totaling over $100 million. These transactions were negotiated between Stephen Williams for Deutsche Bank and Robert Bugni for MBOI. On March 25, 2002, Williams contacted Bugni from New York to ask if MBOI was interested in a bond transaction. Williams communicated with Bugni through the Bloomberg Messaging System, an instant messaging system provided to Bloomberg subscribers. Bugni declined, and the exchange ended with a simple THX (thanks). Approximately 10 minutes later, however, Bugni sent Williams a new instant message inquiring as to price and particulars. After several exchanges, the parties agreed that Deutsche Bank would pay $15 million in cash for MBOI s Pennzoil bonds, with a settlement date later in the month. Hours after the agreement was made, Shell Oil publicly announced that it had agreed to acquire Pennzoil-Quaker State Company, an announcement that would potentially increase the value of the bonds. The following day, MBOI notified Deutsche Bank that it 1 Deutsche Bank Sec., Inc. v. Mont. Bd. of Invs., 7 N.Y.3d 65 (N.Y. 2006).

2 would break the trade because it believed Deutsche Bank had inside information and the trade was illegal. Deutsche Bank purchased the bonds elsewhere, paying an additional $1.6 million. Deutsche Bank commenced an action in New York alleging breach of contract, and after limited discovery, MBOI moved for dismissal of the action based on its affirmative defense of lack of personal jurisdiction, among other defenses. The trial court dismissed for lack of personal jurisdiction. The appellate court reversed the trial court s decision, and New York s highest court affirmed the appellate court. The Court Does Not Focus on the Means of Communication Although the Deutsche Bank decision is perhaps notable because the means of communication was an instant messaging service, the court instead focused on the fact that MBOI, a sophisticated institutional trader that had negotiated several substantial transactions in the thirteen months prior to the abandoned transaction, should have expected to defend its actions in New York. First, the Court of Appeals noted that New York s long-arm statute is a single act statute, under which proof of one transaction in New York is sufficient to invoke jurisdiction, even without physical presence, so long as the defendant s activities were purposeful and there is a substantial relationship between the transaction and the claim asserted. 2 Because a party can transact enormous volumes of business within a state without physically entering it, New York recognizes long-arm jurisdiction where the party avails itself of the forum, has sufficient minimum contacts with it, and should reasonably expect to defend its actions there. 3 New York in the past has recognized long-arm jurisdiction over commercial actors and investors using electronic and telephonic means to project themselves into New York to conduct business transactions. 4 The court implicitly concluded that, for personal jurisdictional purposes, there is no difference between an instant messaging system and a telephone. In fact, other than a brief mention in the factual background portion of the decision, the court does not mention that the means of communication was instant messaging. Instead, the court simply stated that MBOI had entered New York to transact business here by knowingly initiating and pursuing a negotiation with a [Deutsche Bank] employee in New York that culminated in the sale of $15 million in bonds. 5 Because negotiating substantial transactions is part of MBOI s mission and because MBOI had engaged in eight other bond transactions in the prior thirteen months, the court held, the requirements of due process were met, and MBOI could be subject to personal jurisdiction in New York. 2 Kreutter v. McFadden Oil Corp., 71 N.Y.2d 460, 467 (N.Y. 1988). New York s long-arm statute provides that a court may exercise personal jurisdiction over any non-domiciliary... who in person or through an agent... transacts any business within the state or contracts anywhere to supply goods or services in the state. N.Y. C.P.L.R. 302 (a)(1) (2006). 3 Id. 4 Parke-Bernet Galleries v. Franklyn, 26 N.Y.2d 13 (N.Y. 1970); Ehrlich-Bober & Co. v. Univ. of Houston, 49 N.Y.2d 574 (N.Y. 1980). 5 Deutsche Bank Sec., Inc., 7 N.Y.3d at

3 Tax Implications of the Deutsche Bank Decision The U. S. Supreme Court has held that in order to impose taxes on an out-of-state corporation, the constitutional requirements of both the Due Process Clause and the Commerce Clause must be met. 6 Each constitutional provision requires a sufficient nexus between the state and the out-of-state individual or business it seeks to tax. Since the 1992 Quill decision, Supreme Court caselaw makes it clear that the nexus required by the Due Process Clause is a relatively low barrier to state taxation. By contrast, the substantial nexus required by the Commerce clause imposes a far more significant limitation on state taxation. Due Process Nexus The Due Process Clause requires minimum contacts with a state before the state can impose its jurisdiction. The U.S. Supreme Court in Quill reasoned that a taxpayer who had utilized a number and mailed catalogs to in-state residents (along with the resulting contracts with in-state residents) would be subject to tax jurisdiction if the Due Process Clause alone were the standard for tax nexus. The U.S. Supreme Court also reasoned that the Due Process Clause standard for personal jurisdiction is the Due Process Clause standard for tax jurisdiction. Under Deutsche Bank, an out-of-state corporation using an instant messaging system to communicate with a New York person would be considered to have tax jurisdiction with New York for Due Process purposes. Commerce Clause Nexus The U. S. Supreme Court in Complete Auto 7 set forth a four-part test to determine whether a tax will withstand Commerce Clause scrutiny. A state may impose a tax only if the tax (1) applies to an activity with a substantial nexus with the taxing State, (2) is fairly apportioned, (3) does not discriminate against interstate commerce, and (4) is fairly related to the services provided by the State. 8 With respect to the Commerce Clause, the Supreme Court in Quill held that physical presence is required to create substantial nexus at least for use tax collection purposes. In Quill, the U.S. Supreme Court held that North Dakota could not require an out-of-state vendor to collect and remit use tax because the corporation had no physical presence, and therefore no substantial nexus with, North Dakota. 9 Regarding the duty to collect sales tax, the New York Court of Appeals followed Quill and concluded that substantial nexus requires physical presence of an interstate vendor 6 See Quill Corp. v. North Dakota, 504 U.S. 298, 305 (1992). 7 Complete Auto Transit, Inc. v. Brady, 430 U. S. 274 (1977). 8 Complete Auto, 430 U.S. at Quill, 504 U.S. at It is less clear whether physical presence is the test for substantial nexus for income taxes. 3

4 in the taxing state. 10 In New York, physical presence need not be substantial, but must be demonstrably more than a slight presence. 11 Nexus may be manifested by the presence in the taxing State of a vendor s property or the conduct of economic activities in the taxing State performed by a vendor s personnel or on its behalf. 12 Quill s physical presence test likely applies to New York franchise and income taxes as well. Even though she concluded that a gas company was not doing business within the state, a New York administrative law judge in Wascana Energy Marketing U.S., Inc. went on to examine the constitutionality of New York s (now repealed) franchise tax on gas suppliers under the physical presence test. 13 In doing so, the judge noted that, [t]he Quill opinion seems to suggest that the nexus standard as applied to the duty to collect sale and use taxes may be different from the standard as it applies to a tax measured by income.... However, the holding in Quill relies on and reaffirms the vitality of the substantial nexus requirement expressed in Complete Auto, which is applicable to franchise and income taxes. 14 Conclusion Without some other indicium of physical presence, communication by way of an instant messaging service with a New York person, in and of itself, is not sufficient to satisfy the substantial nexus test for Commerce Clause purposes. If, however, the New York party to the instant message exchange also performs services in New York on the out-ofstate corporation s behalf (e.g., as its agent), the out-of-state corporation may have substantial nexus for Commerce Clause purposes based on those services and could therefore be subject to New York tax. While an out-of-state person can be sued in New York court on the basis of an instant message exchange with a New Yorker, that instant message exchange will not, in and of itself, create tax nexus for an out-of-state corporation. 10 Orvis Co. v. Tax Appeals Tribunal, 654 N.E.2d 954 (N.Y. 1995). 11 Orvis, 654 N.E.2d at Id. at ). 13 DTA No , 2002 WL (N.Y. Div. of Tax Appeals (Advisory Opinion) Aug. 8, 14 Id. at *17 n.6. 4

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