State Tax Return. i. The Alabama Supreme Court has since denied the Department s petition for review.

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1 July 2007 Volume 14 Number 7 State Tax Return NEXUS: UPDATE ON RECENT DEVELOPMENTS Maryann B. Gall Laura A. Kulwicki Columbus Columbus (614) (330) We keep track of nexus developments on a regular basis - legislation, administrative interpretations, the passage of rules and regulations, and court cases. This issue of our newsletter updates important nexus developments during the Second Quarter, It is organized by the kind of activity that tends to give out-of-state entities nexus planning and litigation difficulties, such as temporary in-state presence, in-state independent contractors and sales reps, fulfillment center safe harbors, incidental ownership of property and affiliate nexus. We hope you find it helpful in your planning and compliance work. I. SUBSTANTIAL NEXUS LITIGATION IN THE STATE COURTS A. NON-RESIDENT LIMITED PARTNER This case dealt with a Georgia resident who owned a 62.5% limited partnership interest in an Alabama family investment partnership. The general partners, all Alabama residents, managed the partnership's investments and did all other work. The assessee stipulated that he had only a passive limited partnership interest in the partnership and took no part in its management. After a convoluted set of hearings and appeals, the Alabama appellate court held that Alabama could not tax the nonresident taxpayer's income from the Alabama partnership. The limited partner did not have a commercial domicile in Alabama. The limited partner, who was a Georgia resident, had no contacts with Alabama other than this partnership interest. This is a very sensible result. 1. ALABAMA a. Lanzi v. Dep t of Revenue, No , 2006 Ala. Civ. App. LEXIS 406 (Ala. Civ. App. June 30, 2006), cert. denied, (Ala. Apr. 13, 2007). i. The Alabama Supreme Court has since denied the Department s petition for review. B. Independent Contractors, Sales Representatives, And Manufacturing Representatives

2 Although many people can't believe it, the rule is that even one employee or sales representative in a state will establish excise tax and income tax nexus. Here is another ruling that reiterates this rule. 1. VIRGINIA a. Ruling of Commissioner, P.D , 2007 Va. Lexis 52 (Dep t of Taxation, Apr. 26, 2007) i. Taxpayer provided a commission-based sales service that employed one sales representative who resided in Virginia and solicited sales of tangible personal property on behalf of the Taxpayer s third-party clients. The Taxpayer did not have an office in Virginia, did not lease or own any real or tangible personal property in Virginia, and did not advertise or maintain bank accounts in Virginia. Taxpayer sought a ruling that it was not subject to Virginia s corporate income tax because the salesperson s activities were exempted as solicitations of sales under P.L ii. The Commissioner held that P.L did not exempt the salesperson s activities in Virginia, and thus the Taxpayer was required to pay the corporate income tax. The Commissioner ruled that the salesperson was selling tangible personal property on behalf of third-party clients, not for the Taxpayer. Thus, the salesperson s activities were business services and not the solicitation of sales exempted under P.L C. Fulfillment Centers: Safe Harbor When considering "outsourcing" any core operational activities, a taxpayer should always review state law to determine if there are any "safe harbors" preventing the establishment of nexus. Many states have specific statutory "carve outs" for printing plants, call centers, distribution centers, and other activities. If not found in the law, always look for rulings and interpretations like the one issued by the Virginia Commissioner below. 1. VIRGINIA a. Ruling of Commissioner, P.D , 2007 Va. Tax Lexis 32 (Dep t of Taxation, Mar. 27, 2007) i. Taxpayer operates retail websites that offer products for sale. The property sold on the websites is handled by the Taxpayer s various retailing entities, one of which was at issue here ( the Retailer ). The Retailer has no retail stores in Virginia, but has entered into arms-length contracts with Distribution Centers, who actually purchase the items that the Retailer needs to fulfill the Internet orders. When a customer places an Internet order, the Retailer purchases the product from a Distribution Center, which maintains title to the product and ships it to the customer via common carrier. The title passes to the customer when the product is delivered by the Distribution Center to the carrier. ii. The Retailer is considering the addition of a Distribution Center located in Virginia and sought a ruling as to whether the addition of a Virginia Distribution Center would create

3 nexus in Virginia such that the Retailer would be liable for corporate income or sales and use tax. iii. With respect to corporate income tax, the Commissioner ruled that the Retailer would be exempt under P.L The Retailer s activities do not go beyond the mere solicitation of orders for sales of tangible personal property and the Retailer owns no inventory in Virginia other than when it is in the process of being shipped by the Distribution Center. The Distribution Center would also not be an affiliated representative or an independent contractor acting on behalf of the Retailer. All activities in Virginia will be performed at the Distribution Center s direction because those activities occur prior to the Retailer taking title to the property. iv. The Commissioner likewise ruled that the Retailer would not be liable for sales and use tax. The Commissioner analyzed the proposed relationship between the Retailer and the Virginia Distribution Center to determine if an agency relationship existed such that the Retailer might meet the definition of a dealer required to pay sales and use tax. The Retailer, although benefiting from the Distribution Center s work, did not control the work to be done or the manner in which it was to be done. Therefore, no agency relationship existed, and the Retailer would not have to pay sales and use tax based on the Virginia Distribution Center. The Commissioner specifically noted that she presumed that the Distribution Center would not be a subsidiary of the Retailer. D. Incidental Ownership Of Property This is the conclusion of this important case in which the appellate court affirmed the determination that leased railcars did not create tax nexus in Alabama for a Chicago lessor of railcars. Even if you are not in the leasing business, this is a very sensible and clear decision that should be reviewed for many purposes. 1. ALABAMA a. Dept. of Rev. v. Union Tank Car Co., No , CCH (Ala. Ct. Civ. App. April 13, 2007). i. The taxpayer, a manufacturer and lessor of specialty rail cars, was incorporated in Delaware, had its headquarters in Illinois, manufactured its cars in Illinois and Texas, and executed all of its leases in Illinois. It did not maintain any office, repair center, or service center in Alabama. It did, however, lease to an Alabama-based company. The Alabama Department of Revenue determined that the taxpayer s railcars had been used by lessees to haul materials within and outside Alabama during certain tax years. ii. The Department ruled that the lease income was subject to Alabama income tax under (a)(2) and (a)(3) and assessed the taxpayer accordingly. An ALJ within the Department ruled that the assessment was void, and this ruling was adopted by a state trial court. The Department challenged the ALJ and trial court s ruling before the Alabama Court of Civil Appeals.

4 iii. The Court of Civil Appeals affirmed, denying the Department s claims. First, the Department argued that the taxpayer was required to pay income tax because the taxpayer was licensed or qualified to transact business in Alabama, as revealed by the taxpayer s payment of license tax in earlier tax years. See Ala. Code , The Court disagreed, pointing out that payment of the license tax does not itself license a corporation to transact business in Alabama and that the taxpayer withdrew its qualification to do business just before the tax years in question. iv. The Department also argued that the tax was justified under (a)(3), which imposes an income tax on [e]very corporation doing business in Alabama or deriving income from sources within Alabama, including income from property located in Alabama. The Court again disagreed. Although the railcars had been located in Alabama, the Court reviewed a number of state-tax cases and held that the taxpayer derived income from the lease transactions in Illinois, not from sources in Alabama [i.e., the rail cars]. v. Because the Court resolved the issue of taxation on statutory grounds, it did not address the various constitutional questions raised by the parties. vi. The Department has since sought review by the Alabama Supreme Court. E. Affiliate Nexus Since at least 1986, state tax departments have been asserting that two channel retailers (in-state stores and catalogs) and three channel retailers (stores, catalog businesses and Internet sales) have "affiliate nexus. Generally, the states have lost but they still keep trying. The following is a report of a new appeal to the Kansas Board of Tax Appeals by Cabela's which was just filed in December, KANSAS a. In re Cabela s Promotions, Inc., Cabela s Catalog, Inc., & Cabela s Internet, Inc., Written Final Determination, Nos , -0132, -0133, WFD-P , (Dep t of Revenue, November 27, 2006). i. Cabela s Inc. is the parent company of a number of subsidiaries that together make up the country s largest retailer of hunting, fishing, camping, and related outdoor merchandise. Among the subsidiaries are Cabela s Catalog, Cabela s Internet, and Cabela s Promotions (collectively, the Taxpayers ). Another subsidiary, Cabela s Retail, Inc., operates a retail store in Kansas. On January 5, 2006, the Kansas Department of Revenue assessed against the Taxpayers $392,905 in unpaid compensating (i.e., use) tax, penalty, and interest. None of the taxpayers had a physical presence in the state of Kansas, and they protested. ii. The Department upheld its determination. It determined that the material issue was whether Cabela s entities were retailers doing business in this state and concluded that Catalog, Internet, and Promotions each satisfied this definition. Although no Taxpayer had any physical presence in Kansas, the Department stated that [a]s a

5 practical matter, Retail serves as the Taxpayers in-state representative for purposes of taking orders and selling, delivering, and soliciting sales. iii. The Department pointed to the following facts: Cabela s Retail bought and placed catalogs from Cabela s Catalog in its stores. Retail employees assisted customers in placing and obtaining orders through the catalogs. Each subsidiary sold gift cards that could be used with Cabela s Retail, Catalog, or Internet. The retail stores would accept returns or exchanges of items purchased from the other subsidiaries. The catalogs made reference to retail employees. Also, the Department repeatedly pointed to language in Cabela s SEC filings that described its integrated, synergistic business model. iv. The Department acknowledged that one of the regulations in play (K.A.R (a)(3)) was arguably inconsistent with Quill. That regulation defines doing business in this state to include soliciting orders within this state through catalogues or other advertising media. The Department concluded that Cabela s situation was clearly distinguishable because the use of catalogues and other media is but one of a variety of ways in which Cabela s and the Taxpayers have successfully established and maintained a market for their products in Kansas. v. This ruling represented a reversal of course for the Department. In 2001, the Department had issued a private letter ruling opining that the operations of Cabela s Retail would not be deemed to create nexus for any of the three Taxpayers. This ruling was later revoked by operation of law upon the enactment of new legislation amending the definition of retailer doing business in this state. The Department, however, did abate any taxes assessed before the amending legislation came into effect. vi. The Taxpayers have appealed this determination to the Board of Tax Appeals. Among other things, they argue that they do not have nexus, a place of business or a physical presence in Kansas, that they do not have any ownership interest in Retail so that they [should] not [be] deemed to be doing business in Kansas, and that the assessment violates the Commerce, Due Process and Equal Protection Clauses of the U.S. and Kansas Constitutions. They also complain that they cannot determine the amount of the partial abatement resulting from the revoked private letter ruling. F. In-State Advertising/Solicitation 1. IDAHO a. Effective March 30, 2007, Idaho amended its tax regulations to clarify that compliance with Public Law (a federal law prohibiting the imposition of income tax on persons if the person s only business activity comprises solicitation of orders of sales of tangible personal property) relieves corporations of a number of obligations: i. Idaho Admin. Code clarifies that [a] corporation whose Idaho business activities fall under the protection of Public Law is exempt from the taxes imposed by Sections [on corporate income] and A [an alternative-to-income-tax excise tax], Idaho Code, including the minimum tax.

6 ii. Idaho Admin. Code states that [a] taxpayer whose Idaho business activities fall under the protection of Public Law is not required to file an Idaho income tax return since the taxpayer is exempt from the tax imposed under the Idaho Income Tax Act. If a taxpayer is a member of a unitary group, however, it shall be included in the combined report although it is exempt from the income tax. iii. Idaho Admin. Code states that [t]he permanent building fund tax shall not apply to a taxpayer whose Idaho business activities fall under the protection of Public Law , since the taxpayer is exempt from the tax imposed under the Idaho Income Tax Act and is not required to file an income tax return. G. Michigan Single Business Tax Even though the SBT is being phased out, there are still important Michigan decisions in this area. The taxpayer, Fluor Enterprises, was a California corporation that provided engineering, construction, and technical services. It also performed architectural and engineering services at its out-of-state offices for real estate improvement projects constructed in Michigan. Fluor filed SBT returns, but did not report the receipts from the services performed out-of-state as Michigan receipts. Upon audit, the Michigan Department issued assessments. Fluor appealed, arguing that imposition of SBT on the receipts violated the Commerce Clause because the receipts were for engineering and architectural services rendered outside Michigan. On appeal, the appellate court agreed with Fluor and held that the assessment violated the internal consistency requirement set forth in Complete Auto Transit v. Brady, 430 U.S. 274 (1977). Unfortunately, Fluor lost in the Michigan Supreme Court as explained below. 1. Fluor Enterprises, Inc. v. Rev. Div., Dept. of Treasury, 730 N.W.2d 722, 2007 WL (Mich. May 2, 2007). a. The Department appealed. On review, the Michigan Supreme Court affirmed the Court of Appeals statutory interpretation, but reversed its holding that the tax violated the internal consistency requirement. b. The Court agreed with the lower court s interpretation of (c). That section taxed services performed in support of construction activities within [Michigan], no matter where those services were performed. c. The Court also upheld the lower court s ruling that nexus existed. Because the receipts at issue were for services that [Fluor] provided for construction projects in Michigan,... the incidence of the tax as well its measure [were] tied to the earning which the State has made possible. This constituted substantial nexus. d. Regarding the fair-apportionment question, the Court reversed. The Court of Appeals had reasoned that if Michigan and California had the same apportionment formula, double taxation would result. In the lower court s view, Michigan would tax the services performed in California under its version of 53(c), while California would tax the same

7 services under its version of 53(a). That section taxes business activity within [the] state, and the term business activity would cover the services rendered by Fluor. e. The Michigan Supreme Court disagreed. Although 53(a), read by itself, would cover any services performed in state, 53(c) applies a special rule to planning, design, or construction activities that carves out an exception from 53(a). Services performed for construction activity may only be taxed if the construction activity occurs in the taxing state. f. The Court reasoned that California, contrary to the conclusion of the lower court, would not apply 53(a) to services performed for construction activity but would look to the specifically applicable 53(c). Further, it would not tax the services because the construction activity occurred in Michigan, not California. Because no double tax would occur, the Supreme Court concluded that the tax passed the fair-apportionment test. H. Doing Business In The State This case has a little bit of just about every kind of nexus using a facility in California, having an agency relationship, and storing manufactured product in California. Not surprisingly, the taxpayer lost. 1. CALIFORNIA a. In the Matter of the Petition for Redetermination under the Sales and Use Tax Law of Robert L. Reynolds and Donald R. Reynolds, Memorandum Opinion (Cal. Bd. of Equalization, May 31, 2007), available at legalbusop07.htm. i. The taxpayer was a partnership in the business of manufacturing fruit bins. Some of these bins were manufactured in Oregon and shipped unassembled to a separate company in California (RN Nails, also owned by the Reynolds) to be assembled and delivered to customers in California. The taxpayer also held a California seller s permit. For the tax years in question, the company did not collect use tax, believing that it was not engaged in business in this state. ii. The Board of Equalization disagreed, finding three independent bases that justified collection of the use tax. First, it held that the taxpayer maintained a storage place in California. Under Revenue and Tax Code 6203(c)(1), a person is engaged in business in California if they maintain, occupy, or use, among other places, a warehouse or storage place, or other place of business. The Board found that RN Nails upon assembling the taxpayer s goods, held [the] finished goods until the sale could be completed. This constituted use of a storage place for its stock of goods held on its behalf by its agent and hence a place of business in California. iii. Second, the Board held that the taxpayer hired an agent in California. Under 6203(c)(2), if a retailer has any representative [or] agent... operating in the state under the authority of the retailer, it is engaged in business in California. The Board noted that the act of hiring an agent to assemble goods in California and then ship them out of California would not constitute engaging in business in the state. In this case,

8 however, the Board found that RN Nails assembled the bins and then (1) contacted the taxpayer, (2) held them until an authorized person arrived to take possession, and (3) transferred them on the taxpayer s behalf to the authorized person. The Board concluded that RN Nails acted under the authority of the taxpayer and that the taxpayer thus engaged in business in the state. In the course of its discussion, the Board observed in a footnote that it was difficult to fathom a circumstance where a business that shares common ownership with another would perform acts on the other s behalf without being authorized in some manner by its relative to do so. iv. Finally, the Board pointed out that the taxpayer held a seller s permit. [A] retailer who properly holds a California seller s permit will always have a business location in this state and thus be engaged in business within the state. The Board indicated that the seller s permit may have been improperly issued (it appears the taxpayer should have received a Certificate of Registration Use Tax), but nevertheless stated that we conclude that so long as such a retailer holds a seller s permit, it is required to comply with the requirements imposed on all holders of seller s permits, including the collecting and remitting of any applicable California use tax. v. Although the Board did not purport to answer whether the contacts established constitutional nexus, it observed in a footnote that any retailer who is engaged in business in California under section 6203 has constitutional nexus with this state for purposes of use tax collection. (Emphasis in original.) Given the Board s conclusion that the taxpayer was engaged in business, the facts outlined above would also establish constitutional nexus, at least in the view of the Board. 2. MISSOURI Here the Missouri Department of Revenue correctly determined that customers located outside the state did not establish Missouri corporate franchise or income tax nexus by using data processing services provided from a location in Missouri. a. Letter Ruling No. LR3819, CCH (Mo. Dept. of Rev., April 11, 2007). i. The Applicant provided the following services at a location in Missouri to its customers located outside Missouri: data storage, manipulation, and processing, as well as the assembly of products for delivery outside Missouri. The applicant sought guidance on whether the non-missouri customers establish nexus by using these services. ii. Using Missouri data services would not establish nexus. [A] customer solely using Applicant s services of data storage, data manipulation, or data processing would not have sufficient contacts with Missouri to establish nexus for the imposition of the corporation franchise tax or the corporate income tax. iii. On the other hand, Applicant s assembly of customer s products in Missouri for delivery outside of Missouri would establish nexus for its customers. The Department assume[d] that the assembly of products requires a customer s property to be in Missouri for Applicant to provide the contracted for [sic] assembly. Based on this

9 assumption, because the customers have property in Missouri, sufficient contacts would exist to establish nexus. 3. NEW YORK a. Advisory Opinion, Petition No. C070313B, 2007 N.Y. Tax LEXIS 45 (N.Y. Dep t. Tax & Fin., May 16, 2007) i. The taxpayer was an S Corporation organized under Connecticut law and located in that state. The taxpayer did not employ capital or salespeople, own or lease property, or maintain an office within New York State. The majority of the taxpayer s business occurred within Connecticut; however, the taxpayer did sell some equipment to customers in New York State. The typical sale for the taxpayer involved shipping equipment from its Connecticut warehouse using a common carrier delivery service. On some occasions, the taxpayer s truck would leave its Connecticut warehouse and enter New York State to deliver equipment to a customer. This was the taxpayer s only activity in New York State. The taxpayer requested an opinion as to whether it was subject to the New York franchise tax. ii. The Tax Commissioner held that the taxpayer was not subject to the franchise tax. Pursuant to Section of the tax code and Sections 1-3.2(b), (c), (d), and (e) of the Article 9-A regulations, a corporation organized outside of New York State is subject to the franchise tax if the corporation is doing business, employing capital, owning or leasing property, or maintaining an office in New York State. The taxpayer s only activity in New York State, however, was the delivery of equipment to its customers. Based on those activities, the taxpayer was not doing business, employing capital, owning or leasing property, or maintaining an office in New York State. Thus, the taxpayer was not subject to the franchise tax. 4. VIRGINIA This ruling is a good explanation of the differences between a limited partner having state income tax nexus as opposed to a general partner. The ruling concluded that the non-resident limited partners were not subject to Virginia income tax but that the general partner was. a. Ruling of Commissioner, P.D , 2007 Va. Tax LEXIS 81 (Va. Dep t of Taxation, May 18, 2007) i. The taxpayer was a limited partnership organized under Delaware law. The limited partners were not Virginia residents; however, the general partner was. The taxpayer s sole assets consisted of securities traded on the major stock exchanges, which were held in a Virginia brokerage account located in Virginia. The taxpayer had no employees and no real or tangible property in Virginia. The taxpayer sought the opinion of the State Tax Commission as to the obligations of the taxpayer and its partners for Virginia income tax.

10 ii. The taxpayer was not required to file an informational tax return. The Commission reiterated its position that pass-through entities, like partnerships, that are established solely to invest in intangible personal property and that have no employees and no real or tangible property, are not considered to be carrying on a trade or business. Therefore, income from intangible property held by an investment pass-through entity like the taxpayer was not income from a Virginia source, and the taxpayer was not required to file an informational return. According to the facts provided by the taxpayer, the taxpayer was not carrying on a trade or business in Virginia and did not have income from Virginia sources. Thus, the taxpayer was not required to file a return. iii. The non-resident limited partners were not liable for Virginia income tax. The Commissioner held that the taxpayer s income from intangible property can be taxable to the non-resident limited partners only if the taxpayer is engaged in a trade or business in Virginia. Because the Commissioner had already ruled that the taxpayer was not engaged in a trade or business in Virginia, the non-resident limited partners were not liable for Virginia income tax. iv. The general partner was subject to Virginia income tax for the income it received from the taxpayer. The Commissioner held that the Virginia partner was liable for the tax by virtue of the general partner s residence in Virginia.

11 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/ or gfwhelan@jonesday.com) in Jones Day s Dallas Office, 2727 N. Harwood, Dallas, Texas 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.