State Tax Return. Nexus And Web-Related Activities: How The New York "Grinch" Tried To Ruin The Holiday Spirit

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1 December 2007 Volume 14 Number 11 State Tax Return Nexus And Web-Related Activities: How The New York "Grinch" Tried To Ruin The Holiday Spirit Maryann B. Gall Columbus (614) Carolyn Joy Lee New York (212) Laura A. Kulwicki Columbus (330) As a general rule, since the Supreme Court of the United States decided Quill Corp. v. North Dakota, 504 U.S. 298 (1992), state tax departments have respected the interstate commerce exemption for internet retailers. The exemption has been respected where the retailer itself has no physical facilities in the state, even if the retailer has certain affiliation advertising arrangements with in-state retailers and other entities, like schools and other organizations, as well as certain "affiliation" arrangements with instate retailers and other entities, like schools and other organizations. However, in early November, 2007, the New York State Department of Taxation & Finance took a different position which is discussed below. Below is a summary of various state positions on this important issue. 1. INTERSTATE COMMERCE COMMUNICATION DOES NOT CREATE NEXUS IF THE OUT-OF-STATE VENDOR HAS NO PHYSICAL PRESENCE IN THE STATE (a) GENERAL RULE (ii) (iii) For over 60 years, the United States Supreme Court has declared that interstate commerce communication, including various forms of advertising, direct mail, and mail order catalogs, does not create nexus for sales and use tax purposes if the out-of-state vendor has no physical presence in the state. In the "computer age," as noted below, most states have held by statute, regulation, or interpretation, that various forms of advertising on the internet do not create tax nexus. For example, in Section 4 below, discussing website linking arrangements, Illinois, Missouri, New Mexico, North Carolina, Texas and Virginia uniformly held that linking arrangements, sometimes called "affiliation agreements," did not create nexus for an out-of-state internet vendor. New York's tax law expressly provided that an out-of-state vendor was not subject to tax if its only connection to the Empire State was

2 advertising stored on a server located in New York or if its advertising was disseminated or displayed on the internet by an entity subject to tax in New York. See Section 4(d). (iv) However, for less than a week, the New York State Department of Taxation & Finance took a different position. In TSB-M-07(6)S, issued November 9, 2007, New York attempted to treat affiliation arrangements between an out-of-state internet vendor and a New York "agent" as sufficient to create sales tax nexus. In less than a week, the New York Department pulled the new memorandum off its website. However, the broader implications of this position remain unclear, especially since the November 9, 2007, memorandum noted that it was intended "to clarify current policy and does not reflect any change in requirements for vendors doing business in New York State." 2. MAINTAINING A WEBSITE ON A COMPUTER SERVER IN THE STATE (a) California Cal. Code Regs. tit. 18, Under California law, an out-of-state retailer whose only contact with California is the use of a computer server on the Internet to create or maintain a web site does not have substantial nexus with the state. No Internet service provider, on-line provider or other similar provider of Internet access services or World Wide Web hosting services shall be deemed the agent or representative of any out-of-state retailer solely as the result of the service provider maintaining a web site on a computer server that is physically located in the state. In summary, agency nexus is not created when an out-of-state company uses an in-state computer server to either host its web site or transact e- commerce. (b) Maryland Responses to CCH Internet/Electronic Commerce Survey indicate that having a web page on a computer server in Maryland by itself does not create nexus. (c) New Jersey Responses to CCH Internet/Electronic Commerce Survey, CCH (N.J. Div. of Tax Sept. 22, 1999).

3 In the Department s response to the CCH Internet Survey, the Department stated that the maintenance of a web page on a computer server located in New Jersey does not give rise to sales/use tax collection responsibility for an out-ofstate vendor with respect to sales of products delivered into New Jersey. For income tax nexus purposes, the Department concluded that nexus will be created if the taxpayer also has some physical presence in New Jersey connected with the construction, maintenance or operation of the website. According to the Department, the computer server and the technicians that kept it functioning are located in New Jersey, and the web page is accessible in New Jersey by downloading it into computers located in New Jersey. As such, the out-of-state vendor is considered to have the intention to exploit the market in New Jersey and consequently, would be considered doing business in New Jersey. In addition, the vendor is considered to be employing or maintaining tangible personal property in the state which also would give rise to nexus. N.J.A.C. 18:71.6(a).2.v. See also Response to CCH Internet/Electronic Commerce Survey, CCH (Sept. 12, 2000). (d) New York Maintaining a web page on a server located in New York does not, by itself, create nexus for an out-of-state retailer with respect to sales of products delivered in New York. (ii) N.Y. Tax Law 12 (2003). New York s tax statutes expressly provide that an out-ofstate company is not subject to income tax, and will not be required to collect sales tax, if its only connection is advertising stored on a server located in-state, or if its advertising is disseminated or displayed on the Internet by an individual or entity subject to tax in New York State. (e) Oklahoma Ok. Admin. Code 710: The use of an on-line service or the establishment of a website, whether the server on which the website is maintained is located inside or outside Oklahoma, is not a sufficient physical presence in Oklahoma, absent any other

4 connection, to require the website owner to register as a business and to collect Oklahoma sales tax on sales of tangible personal property or service to consumers located in Oklahoma or on sales of goods sold for use in Oklahoma. (f) Texas (ii) Maintaining a web page on a third-party server in Texas does not create nexus for an out-of-state seller unless the seller owns, leases or rents the server. Hearing No. 44,127, CCH (Tex. Cmptr. Pub. Accts. Nov. 22, 2005). The Texas Department stated that the location of the server will be disregarded for determining the vendor s situs or for nexus unless the Texas server is owned, leased, or rented by the vendor. See also Rul. No L and Rul. No L (an out-of-state seller of taxable items who owns, leases, or rents a server in Texas has nexus with Texas, but an out-of-state seller who sells products on a website stored on a Texas server that is owned or maintained by a third party does not have nexus in Texas). (g) Vermont Vt. Stat. Ann. Tit. 32, 5811(15)(C)(ii), 9701(9)(H)(2003). Vermont will not tax an out-of-state company if its activities are limited to using in-state computer servers for e- commerce or maintaining a web site including owning the server. Accordingly, ownership of server by an out-of-state company in Vermont, by itself, does not establish substantial nexus over the company for Vermont sales and use tax, income and franchise tax purposes. (h) Virginia P.D , 2000 Va. Tax LEXIS 75 (Va. Dep't of Taxation Apr. 14, 2000). Facts: Taxpayer was an out-of-state company with no physical presence in Virginia engaged in the sale of auto parts. Taxpayer had websites that allowed customers to view and order products. If an order was placed, the product was shipped from inventory located outside of Virginia. Taxpayer was contemplating doing business with web hosting companies located in Virginia. One alternative was a

5 managed hosting service, whereby the web hosting company would provide power and bandwidth connections, other web hosting services, and Internet servers dedicated exclusively to Taxpayer s websites. These servers were owned by and remain the property of the web hosting company. A second alternative was a co-locating hosting service. Under this alternative, the web hosting company would provide the power and bandwidth connections and other web hosting services to servers which were owned or leased by Taxpayer. Taxpayer s servers would be located in Virginia at the web hosting service s facility. Taxpayer s servers would be dedicated exclusively to Taxpayer s websites. Held: The Department held that no nexus would be created under both alternatives and thus Taxpayer would not be subject to Virginia sales and use taxes. The Department held that Taxpayer met the definition of a dealer but did not find nexus because the use of servers, by itself, did not constitute physical presence sufficient under the Commerce Clause. Based on this ruling, nexus will not be established for out-of-state vendors whose only presence is the use of computer servers provided to them under a Virginia managed hosting service. Nor will nexus be established for out-of-state vendors whose only presence is the use of computer servers owned by them in connection with a Virginia co-location hosting service. Washington Wash. Rev. Code Washington does not tax web site hosting or e-commerce conducted on an in-state computer server for an out-of-state company as long as the company, or an affiliate, does not own the server. 3. MAINTAINING WEBSITES ACCESSIBLE BY IN-STATE RESIDENTS (a) South Carolina Rev. Rul. #98-3 (S.C. Dep t of Revenue April 30, 1998). Facts: An Ohio company has a web site server in North Carolina. The web site can be accessed in South Carolina through a South Carolina or out-of-state third party Internet service provider.

6 Held: The Department held that the Ohio company did not have nexus with South Carolina for income tax purposes. According to the Department, a website which is accessible in, but not located in, South Carolina is viewed as the equivalent of an 800 telephone number. Soliciting through electronic mail is viewed as the equivalent of soliciting by letter. (b) Tennessee Letter Ruling No , 1999 Tenn. Rev. Rul. LEXIS 4 (Mar. 17, 1999). Facts: Taxpayer operated retail stores and sales offices located through the country, including Tennessee. Beside employing direct salespeople who solicited sales, Taxpayer also sold its products via mail order and solicited mail order sales through catalogs, other promotional material and its web site. Held: The Department concluded that maintaining web sites accessible by Tennessee residents is no different than any other mail order business and would also, absent all other indicators, fail to rise to the level of nexus. 4. WEBSITE LINKING ARRANGEMENTS (a) Illinois Priv. Ltr. Rul. No. ST GIL, 2006 Ill. PLR LEXIS 81 (Ill. Dept. of Rev. Apr. 19, 2006). Facts: Taxpayer sold footwear over the Internet. It had no traditional physical presence in Illinois and it did not maintain its website or server in Illinois. Although most of the footwear it sold was acquired from unrelated third-party vendors, Taxpayer also sold private label shoes that were designed, manufactured, marketed and sold by sister companies through affiliated brick and mortar retail stores (some of which were in Illinois) and via the Internet on their own separately-branded websites. Taxpayer planned to pay its sister companies to send out s directing their customers to Taxpayer s website. In addition, Taxpayer will pay an arm s-length price to have its link appear on the sister companies separate websites.

7 Held: The Illinois Department of Revenue held that the link on the Sister Companies website to the [Taxpayer s] website will not create nexus for sales and use tax purposes in Illinois, primarily because all solicitation was done via the Internet. Key to the Department s determination was that all technology infrastructure for Taxpayer and the sister companies was located entirely outside Illinois, and that there was no local element or solicitation whatsoever in this link. The Department also noted that tax collection obligations based on website linking activities run afoul of the Internet Tax Freedom Act by discriminating against electronic commerce. Because the ruling expressly noted that the companies at issue had no technology infrastructure in Illinois, it is possible that the Department could reach a different result if the sister companies had conducted its website operations from within Illinois or maintained its Internet shopping mall on a server located in Illinois. (ii) Priv. Ltr. Rul. No. ST GIL, 2005 Ill. PLR LEXIS 11 (Ill. Dept. of Rev. Jan. 11, 2005). Facts: Taxpayer was an out-of-state corporation engaged in the sale of nutritional supplements via a website. Taxpayer s website was maintained on an out-of-state server. All design, implementation, support, maintenance, and administrative services associated with Taxpayer s website were performed outside Illinois. Taxpayer planned to enter into an Affiliate Agreement with various retailers (some of them had physical presence in Illinois) who themselves maintained websites accessible through the Internet. Under this Agreement, the affiliate partner s website contained an Internet link to the Taxpayer s website. Held: The Department declined to make any nexus determination but set out the applicable principles of law as guidance. Authority cited by the Department included Quill and Brown s Furniture. (b) Missouri Ltr. Rul. No. LR2257, 2004 Mo. Tax Ltr. Rul. LEXIS 82 (Mo. Dept. of Rev. Dec. 17, 2004).

8 Facts: Taxpayer was an Internet seller that had no physical presence in Missouri. Taxpayer planned to enter into agreements with various retailers who maintained websites on servers located within Missouri. Under the proposed agreement, a link to Taxpayer s website would be placed on the retailer s websites. Taxpayer would pay a commission to each retailer for purchasers routed to Taxpayer via the retailer s website. Held: The Department held that Taxpayer did not have nexus for sales tax, income tax, and franchise tax in Missouri due to its web link on the retailer s website (even when the retailer had nexus with Missouri). (c) New Mexico Ruling , CCH (N.M. Taxation and Rev. Dept. May 18, 2005). Facts: Taxpayer was a Nevada corporation engaged in the sale of tangible personal property via a web site accessible through the Internet. Taxpayer had no sales force and no employees or property in New Mexico. The server for Taxpayer s website was located in Ohio. Taxpayer planned to enter into agreements with other Internet retailers ( affiliate partners ), some of whom had websites maintained on servers in New Mexico. Under these agreements, the affiliate partners agree to carry a linked advertisement on their websites. If a customer browsing that web page clicks on the advertising and links to Taxpayer s web page, Taxpayer will pay the affiliated partner a commission on any resulting sales. Taxpayer and the affiliate partners do not have any connection or affiliation beyond the web link capability. Held: The Department held the website advertising link and commission arrangements with the affiliate partners would not create nexus for Taxpayer for New Mexico gross receipts and compensating use tax purposes. Specifically, the Department relied upon a statutory safe harbor for computer websites. Under New Mexico law, engaging in business for gross receipts and compensating use tax purposes does not include having a worldwide web site as a third party content provider on a computer physically located in New Mexico but owned by another nonaffiliated person. N.M. Stat. Ann

9 (d) New York N.Y. Tax Law 12 (2003). New York s tax statutes expressly provide that an out-ofstate company is not subject to tax if its only connection is advertising stored on a server located in-state, or if its advertising is disseminated or displayed on the Internet by an individual or entity subject to tax in New York State. (ii) TSB-M-07(6)S (Withdrawn) This short-lived Technical Services bureau Memorandum addressed the sales tax nexus of internet vendors who use independent contractors, agents or other representatives within New York State to solicit sales or to make or maintain a market for their products or services. The Memorandum provided three examples of the situations it sought to cover: A vendor of skis contracted with a New York ski club to maintain on the ski club s website links to the vendor s website. The ski club then solicited its members and the local community to purchase the vendor s products through those links, and earned commissions the vendor paid on sales originating through the ski club s website. Instead of having a link on its website, the ski club encouraged its members and the community to purchase from the vendor s website using a code number. Through that code the vendor associated the sales with the ski club, and paid commissions accordingly. (C) An individual authored a book that was sold on a retail e- commerce website. He traveled throughout New York promoting his book, referring purchasers to the vendor s website. He was paid commissions on sales originating from the link he maintained, on his own website, to the vendor s website. In each case, the Department concluded that the vendor had nexus to New York. Specifically, the vendors were soliciting business in New York through the representatives, and thus satisfied the physical presence necessary for sales tax nexus. As noted above, the Memorandum explicitly described this as a clarification, and not any change in policy. Nevertheless, the Memorandum provided an amnesty of sorts for vendors with contacts like those described in the Memorandum, provided they registered and began collecting

10 sales tax by December 7, 2007 (a mere thirty days after the Memorandum was issued). Following adverse press coverage, which characterized the Memorandum as an Amazon tax and a pre-holiday tax grab suitable of the Grinch, the Memorandum was withdrawn. Query, however, whether the genie still fits in the bottle. The Memorandum was described by Department officials as based on Scripto, longstanding authority for the proposition that in-state solicitation by independent contractors is sufficient contact to establish sales tax nexus. 362 U.S. 207 (1960). And as compared with the fact pattern described in the Illinois ruling (4(a), above), the representatives in the Memorandum were regularly soliciting sales through activities carried on in New York. Thus, whether the Department s position is really withdrawn, or instead might resurface in audits or as prospective, revenue-raising legislation, remains to be seen. (e) North Carolina CCH Survey on the Sales and Use Taxation of E-Commerce, CCH (N.C. Dept of Rev. July 11, 2000). The North Carolina Department of Revenue provided some nexus guidance in its informal responses to general questions regarding sales and use tax nexus, including questions related to web malls and website advertising. This non-binding response indicated that the state would find nexus if an Internet seller pays for banner exchanges, perclick commission on a third-party web page displayed in North Carolina. However, no nexus is created if the seller pays for advertising only on such web page. With specific regard to web malls, the Department concluded that nexus does not exist if the seller has a webbased mall arrangement (a web site comprised of several other commercial web sites) with a mall in your state under which the mall provides services for the seller such as design, advertising or order processing. (f) Texas Letter No L (Tex. Cmptr. of Pub. Accts. Jan. 5, 1998). Facts: Taxpayer had no physical presence in Texas and received its website orders through a server located outside Texas. Taxpayer s only connection with Texas was that it

11 had a link to its website on an unrelated third party s website that was located on a Texas server. Held: The Comptroller held that such website linking arrangement did not create nexus for Taxpayer in Texas for sales tax purposes. (g) Virginia Rul. No , 2005 Va. Tax LEXIS 145 (Va. Dept. of Tax Aug. 2, 2005). Facts: Taxpayer was an Internet seller located outside Virginia. Taxpayer was seeking to enter into website linking arrangements with various retail partners. Pursuant to the agreement, an Internet link would be placed on the retail partners website that would establish a direct link to Taxpayer s website. The link also would contain technology provided by Taxpayer that allowed Taxpayer to track sales to individuals who made purchases from Taxpayer while linked through the retail partners website. The retail partners owned or used computer servers within Virginia, but had no other physical presence nexus in Virginia. The ruling did not indicate whether or not the taxpayer paid a commission to its retail partners. Held: The Department concluded that Taxpayer s use of an Internet link on these facts did not create nexus in Virginia for sales and use tax purposes. The Department similarly concluded that nexus did not exist for income tax purposes. The Department found that the retail partners were independent contractors acting on behalf of Taxpayer, and also reasoned that permission to include Taxpayer s link and sales tracking technology on a website by a retail partner did not exceed the protection afforded by P.L As such, Taxpayer would not be subject to either the sales and use tax or the corporate income tax based on its relationship with its Virginia partners. 5. OTHERS (a) New York Advisory Opinion, No. S990421A, TSB-A-99(49)S (N.Y. Dept. of Tax and Finance Nov. 17, 1999). Facts: Sothebys (Taxpayer) established and maintained an Internet website on which dealers offered property for sale

12 by auction. It was not known whether the server will be located in New York state. Held: The Department held that Sothebys activities in connection with the website constituted a combination of the provision of Internet advertising services and fulfillment services. These activities were insufficient to make Sothebys a vendor of the auctioned items. (b) Texas Ruling 9609L1438G12 (Tex. Cmptr. Pub. Accts. Sept. 18, 1996). Facts: A California company ( MallCo ) provided support, maintenance, and administration of an electronic mall accessible through the Internet. The mall was maintained on a server outside of Texas. MallCo performed the following services for its Texas clients: (1) website design and set up; (ii) website maintenance and support; (iii) receive, record, and take payment for sales made through the mall; and (iv) send the client its share of mall sales. MallCo received a commission on all mall sales, but its clients were solely responsible for filling any order generated through the mall. Held: The Department held that MallCo did not have nexus with Texas for sales tax purposes. According to the Department, even if MallCo was acting as an agent for Texas clients under the terms of its contracts with such clients, such agency relationship itself is not sufficient to constitute nexus in Texas sufficient to subject MallCo s own sales of tangible personal property to sales tax. MallCo, however, as agent for the retailers located in Texas, would be responsible for the collection of sales tax due on sales transacted with the retailers customers in Texas. In addition, the Department held that retailers located outside Texas would not acquire nexus solely based on their relationship with MallCo. This article is reprinted from the State Tax Return, a Jones Day monthly newsletter reporting on recent developments in state and local tax. Requests for a subscription to the State Tax Return or permission to reproduce this publication, in whole or in part, or comments and suggestions should be sent to Gail Whelan (214/ )1 in Jones Day s Dallas Office, 2727 N. Harwood, Dallas, Texas or StateTaxReturn@jonesday.com. Jones Day All Rights Reserved. No portion of the article may be reproduced or used without express permission. Because of its generality, the information contained herein should not be construed as legal advice on any specific facts and circumstances. The contents are intended for general information purposes only.