United States: Hawaii Department Of Taxation Finds Internet Retailer Has General Excise Tax Nexus

On July 10, the Hawaii Department of Taxation issued a letter ruling determining that an out-of-state Internet retailer was subject to the Hawaii General Excise Tax (GET) and the Honolulu County GET surcharge by virtue of its relationship with an affiliate that had a number of store locations in Hawaii and at least one store location in Honolulu County.¹ In particular, since the affiliate accepted returns on behalf of the Internet retailer at its stores and also participated in a loyalty points program that allowed customers to accrue and redeem points interchangeably at either its stores or the Internet retailer's Web site, the affiliate was acting as an "agent" of the Internet retailer and established nexus for the Internet retailer.

Background

The taxpayer, an Internet retailer of fragrances and specialty items that was headquartered outside Hawaii, did not have any employees, solicitors, or real or tangible property located in the state. Moreover, shipments of its products were made via common carrier from out-of-state centralized warehouses or distribution centers.

While the taxpayer itself lacked a physical presence in Hawaii, the taxpayer's affiliate operated eight retail stores in the state. Beginning on or about September 1, 2011, the taxpayer and the affiliate began to operate a loyalty points program through which a customer could earn points for purchases made either from the taxpayer's Web site or the affiliate's retail stores. After a customer reached a certain amount of purchases, he or she received a fixed-price redeemable gift certificate for use at either a store location or the taxpayer's Web site. Also beginning on or about September 1, 2011, the taxpayer's customers were permitted to return items purchased via its Web site to affiliate store locations.

The substantive issue presented to the Department was whether the activities of the taxpayer's affiliate created GET nexus for the taxpayer at the state and county (Honolulu County) level.

GET Nexus Created by Affiliate Relationship

The Department initially addressed the relevant statutory and regulatory authorities in its letter ruling. The Hawaii Revised Statutes imposes a privilege tax on "persons on account of their business and other activities in the State measured by the application of rates against values of products, gross proceeds of sales, or gross income" in accordance with the U.S. Constitution and Congressional acts.² The Department's regulation interprets the GET nexus standard to allow imposition of the GET only if both of the following elements are present: "(1) a place of delivery within Hawaii by the purchaser, or its agent; and (2) the seller must have nexus for the general excise tax to apply to the particular sale."³ Since the taxpayer's items were being delivered to customers residing in Hawaii, the Department stated that the first element was present. Therefore, the sole question was whether the taxpayer had "nexus" for GET purposes.

In examining that question, the Department again resorted to its regulation, which defined the term "nexus" as the "activity carried on by a seller in Hawaii which is sufficiently connected with the seller's ability to establish or maintain a market for its products in Hawaii," and also cited to U.S. constitutional standards.⁴ The Department explained that the Due Process Clause of the U.S. Constitution "â€Ürequires some definite link, some minimum connection between a state and the person, property, or transaction" in order to establish "nexus,"⁵ and the U.S. Supreme Court has consistently held that one way to establish nexus is through the "in-state physical presence" of a representative who conducts regular or systematic activities to further a seller's business and to create a market for the seller's products.⁶ The Department found that an in-state physical presence was established by the affiliate's brick-and-mortar retail store locations in Hawaii, because the affiliate acted as the taxpayer's representative by participating in the mutual merchandise exchange and loyalty points programs.

In reaching this conclusion, the Department also pointed to the Multistate Tax Commission's Nexus Program Bulletin.⁷ The Bulletin stated that where independent contractors perform warranty repairs for customers on behalf of an out-of-state entity, the independent contractors create and maintain an in-state market for the out-of-state entity and as a result, nexus is established for that entity. The Department analogized the present taxpayer to this scenario, asserting that the affiliate's acceptance of returns and participation in the loyalty points program aided the taxpayer in establishing and maintaining a market in Hawaii.

In addition to its interpretation of constitutional standards and MTC guidance, the Department cited to Borders Online, a California Court of Appeal case, which found nexus where an affiliated in-state book store accepted returns on behalf of an out-of-state Internet bookseller.⁸ Therefore, the Department concluded that the affiliate was deemed an in-state representative creating nexus for the taxpayer, and that the taxpayer's gross receipts from sales to Hawaii customers were subject to the GET.

Honolulu County Surcharge

After determining that the taxpayer was subject to the state GET, the Department discussed the applicability of the Honolulu County surcharge to the taxpayer's overall GET liability. While the GET rate is 4.0 percent statewide, Honolulu County imposes a 0.5 percent surcharge for businesses that have nexus with Honolulu County. Based on the Department's research, the affiliate had at least one retail store in Honolulu County and as such, the affiliate was acting as an agent of the taxpayer, establishing nexus in the County.⁹ Thus, for sales destined for Honolulu County, both the 4.0 percent GET rate and the 0.5 percent surcharge would apply. For sales destined to any other County, the 4.0 percent GET rate would apply. The Department noted that the GET could be passed to the consumer at slightly higher rates than the total GET rates.¹⁰

Commentary

The Department's ruling comported with California's treatment of out-of-state Internet retailers with in-state affiliates that accept returns of online purchases. However, the Department's analysis in its ruling was not as thorough or in-depth as the California Court of Appeal's consideration. The California decision addressed the intricacies of agency law as well as the Commerce Clause of the U.S. Constitution as they relate to the nexus issue.¹¹ The Department, on the other hand, summarily reached its conclusion based on the assertion that the affiliates were acting as "representatives" of the online retailer. In addition to California and Hawaii, the New Mexico Court of Appeals recently addressed a similar fact pattern and ultimately reached the same conclusion of nexus.¹² The New Mexico Court of Appeals focused on the in-state affiliates' creation of goodwill for a shared trademark with the out-of-state online retailer. This fact led to the determination that the online retailer had nexus. The in-state affiliates' activities (i.e. the return policies) alone did not create nexus.

It should not be surprising that state tax authorities are continuing to challenge taxpayers on nexus issues by using several innovative arguments. The developments in New Mexico, California, and now Hawaii highlight the recent trend of expanding the nexus landscape as states continue to face budget challenges. While the letter ruling released by the Department is just that, and not a proclamation handed down by a court, the Department did not shy away from a constitutional analysis that would be normally found in a judicial opinion. As such, the taxpayer may need to resort to litigation to determine whether the Department's conception of constitutional law is correct or mistaken.

Footnotes

1 Letter Ruling No. 2012-10, Hawaii Department of Taxation, July 10, 2012.

2 HAW. REV. STAT. § 237-13.

3 HAW. ADMIN. RULE § 18-237-13-02.01(b)(3).

4 HAW. ADMIN. RULE § 18-237-13-02.01(a).

5 Pursuant to Miller Bros. Co. v. State of Maryland, 347 U.S. 340, 344-345 (1954).

6 See Scripto, Inc. v. Carson, 362 U.S. 207 (1960); General Trading Co. v. Iowa, 322 U.S. 335 (1944); and Felt & Tarrant Manufacturing Co. v. Gallagher, 306 U.S. 62 (1939).

7 See MTC Nexus Program Bulletin No. 95-1 and Tax Information Release No. 96-1.

8 See Borders Online, LLC v. State Board of Equalization, California Court of Appeal (First District), 29 Cal. Rptr. 3d 176, May 31, 2005.

9 As stated previously, the Department took the position that the affiliate was acting as an agent of the taxpayer by participating in the merchandise exchange and loyalty points programs.

10 Where the rate is 4.0 percent, the seller is entitled to pass a maximum rate of 4.166 percent on to the consumer and in Honolulu County, where the combined rate is 4.5 percent, the seller is entitled to pass a maximum rate of 4.712 percent on to the consumer. The collection of the tax at higher rates compensates the taxpayers for their GET expenses.

11 Borders Online, LLC v. State Board of Equalization, California Court of Appeal (First District), 29 Cal. Rptr. 3d 176, May 31, 2005.

12 In re Barnesandnoble.com LLC, New Mexico Court of Appeals, No. 31,231, April 18, 2012.

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