[Editor's Note: While I try to post exclusively on Federal Income Taxation matters, the New York Court of Appeal's Decision on the facial validity of the New York Internet Sales Tax is most noteworthy. The Commerce Clause and Due Process Clause challenges ultimately will have to be resolved by the U.S. Supreme Court.]
On March 28, 2013, the Court of Appeals for New York rejected the arguments made by Amazon.com. and Overstock.com. that New York's sales tax on certain internet transactions, N.Y. Tax Law §1101(b)(8)(vi) was unconstitutional. The argument supporting that the Internet Tax should be struck down was that it violated the Commerce Clause or the Due Process Clause of the U.S. Constitution. Overstock com. v. New York State Department of Taxation and Finance, N.Y. Ct. App. Dkt. No. 33 (3/28/13) and Amazon. Com. V. New York State Department and Finance, N.Y. Ct. App. Dkt. No. 34 (3/28/13).
In a 4-1 decision, the Court of Appeals, in a majority opinion written by Chief Judge Jonathan Lippman, held that the Internet Tax does not violate the Commerce Clause or the Due Process Clause of the U.S. Constitution. The Court accordingly rejected the arguments advanced by the plaintiffs that the Internet Sales (and Use) Taxes imposed a tax on online retailers which did not have a physical presence in New York thereby violating the Commerce Clause or did not violate the Due Process clause by creating an irrational, irrebuttable presumption of solicitation of business within the State.
Amazon.com. is organized as a Delaware limited liability company or LLC. Amazon Services LLC is also an LLC formed in Nevada, which the Court collectively referred to as "Amazon".
Its principal corporate offices are located in the State of Washington. Amazon is strictly an online retailer and sells merchandise solely through the Internet and represents that it does not maintain any offices or property in New York.
Amazon offers an "Associates Program". This program allows third parties to place links on their own websites that, when clicked, become direct users to Amazon's website. The Associates are compensated on a commission basis based on a percentage of revenue when a customer clicks on the Associate's link and completes a purchase from the Amazon site. The operating agreement governing the Associates Program recites that the Associates are independent contractors and that there is no employment relationship between the parties. Thousands of entities that enrolled in the Associates Program provided a New York address in connection with their applications.
The other plaintiff in the proceeding, Overstock.com is a Delaware corporation with its principal place of business in Utah. Overstock likewise sells its merchandise solely through the Internet and does not maintain any office, employees or property in New York. Similar to Amazon, Overstock had an "Affiliates" program through which third parties would place links for Overstock.com on their own websites. When a customer clicked on the link, he was immediately directed to Overstock.com, and if the customer completed a purchase, the Affiliate received a commission. As with the Associates Program conducted by Amazon, the Court also noted that the Affliates were independent contractors without the authority to obligate or bind Overstock.
In April 2008, the New York legislature amended the Tax Law to include the subdivision at issue here. In connection with the statutory definition of "vendor," the Internet tax provides that:
"a person making sales of tangible personal property or services taxable under this article ('seller') shall be presumed to be soliciting business through an independent contractor or other representative if the seller enters into an agreement with a resident of this state under which the resident, for a commission or other consideration, directly or indirectly refers potential customers, whether by a link on an internet website or otherwise, to the seller, if the cumulative gross receipts from sales by the seller to customers in the state who are referred to the seller by all residents with this type of an agreement with the seller is in excess of ten thousand dollars during the preceding four quarterly periods". NYS Tax Law §1101[b][vi].
The statutory presumption of soliciting business through an independent contractor or other representative in New York may be rebutted by proof that the resident with whom the seller has an agreement did not engage in any solicitation in the state on behalf of the seller that would satisfy the nexus requirement of the United States constitution during the four quarterly periods in question.
Guidance on the Internet Tax was issued shortly after its adoption by the Department of Taxation and Finance. Its memorandum clarified that advertising alone would not invoke the statutory presumption, but further observed that, for purposes of this statute, the placement of a link to the seller's website where the resident was compensated on the basis of completed sales deriving from that link would not be considered mere advertising (see NY St Dept of Taxation & Fin Memorandum No. TSB-M-08S). The memorandum also explained that the statutory presumption could be rebutted through proof that the residents' only activity in New York on behalf of the seller was to provide a link to the seller's website and that the residents did not engage in any in-state solicitation directed toward potential. New York customers (see NY St Dept of Taxation & Fin Memorandum No. TSB-M-08S).
A second memorandum was issued by the Department of Taxation and Finance providing further details on how sellers could rebut the statutory presumption. The presumption would be deemed successfully rebutted if the seller satisfied two conditions: (i) where the parties' contract prohibited the resident representative from engaging in any solicitation activities in New York State on behalf of the seller, and (ii) where each resident representative submitted an annual, signed certification stating that the resident had not engaged in any of the proscribed solicitation (see NY St Dept of Taxation & Fin Memorandum No. TSB-M-08[3.1]S).
Amazon filed an action against the DTF on April 25, 2008 and Overstock commenced its action on May 30, 2008, and further sought injunctive relief. The New York Supreme Court, in separate decisions, granted DTF's motions to dismiss the complaints for failure to state a cause of action and denied plaintiffs' cross motions for summary judgment as moot, rejecting all of plaintiffs' challenges to the constitutionality of the statute (Amazon.com LLC v. New York State Dept.of Taxation & Fin., 23 Misc 3d 418 [Sup Ct, NY County 2009]).
The Appellate Division affirmed the portions of the orders that dismissed challenges to the Commerce and Due Process Clauses and declared the Internet Tax constitutional on its face (81 AD3d 183 [1st Dept 2010]). However, the Court modified by reinstating the as-applied challenges, finding that further discovery was required before those claims could be determined. Plaintiffs then entered into stipulations of discontinuance withdrawing their as-applied constitutional challenges with prejudice, which were deemed the final judgments. Then they filed appeals pursuant to CPLR 5601 (b)(1) and CPLR 5601 (d), bringing up for review the prior nonfinal Appellate Division order.
Court of Appeals Decides in Favor of the NY Department of Taxation and Finance
The plaintiffs then decided to bypass their as-applied challenges and sought a reversal from the Court of Appeals by meeting its burden to prove that the Internet Tax is unconstitutional on its face. Chief Judge Lippman noted that "It is well settled that facial constitutional challenges are disfavored".
"Legislative enactments enjoy a strong presumption of constitutionality... [and] parties challenging a duly enacted statute face the initial burden of demonstrating the statute's invalidity 'beyond a reasonable doubt.' Moreover, courts must avoid, if possible, interpreting a presumptively valid statute in a way that will needlessly render it unconstitutional" (LaValle v. Hayden, 98 NY2d 155, 161  [citations omitted]).
While the Court of Appeals noted that there is a dispute as to the proper standard for evaluating a facial (invalidity) challenge under the Commerce Clause, the Court stated that under either standard, i.e., the "no set of circumstances" under which the tax would be valid or the stricter test of "whether the statute has a plainly legitimate sweep", the Internet Tax is constitutional on its face.
The Commerce Clause has been interpreted by certain courts to prohibit states from imposing an undue tax burden on interstate commerce. Matter of Orvis Co. v. Tax Appeals Trib. of State of N.Y., 86 NY2d 165, 170-171 ). However, in the absence of an improper burden, entities participating in interstate commerce will not be excused from the obligation to pay their fair share of state taxes. More specifically, a state tax impacting the Commerce Clause will be upheld
"' when the tax is applied to an activity with a substantial nexus with the taxing State,  is fairly apportioned,  does not discriminate against interstate commerce, and  is fairly related to the services provided by the State'" Moran Towing, 99 NY2d at 449; Complete Auto Transit, Inc. v. Brady, 430 US 274, 279 ). The parties agree that the only prong at issue here is whether the statute satisfies the "substantial nexus" test.
In National Bellas Hess, Inc. v. Department of Revenue of Illinois, 386 US 753 1967, the United States Supreme Court held that a use tax could not be imposed on an out-of-state mail-order business that did not have offices, property or sales representatives in Illinois. The Supreme Court observed that, if Illinois were permitted to impose that type of tax burden, every other taxing jurisdiction in the country could do the same, which would result in a morass of obligations to local governments.
The Supreme Court confronted a similar issue involving a mail-order business in Quill Corp. v. North Dakota, 504 US 298, 314, 1992 and considered whether the emphasis in Bellas Hess on physical presence within the state had been rendered obsolete by the Court's shift toward "more flexible balancing analysis" under the Commerce Clause. While allowing that the result might have been different if the issue was being considered for the first time, the Court retained the bright line presence requirement articulated in Bellas Hess, recognizing the benefits provided by a clear rule that established the limits of State taxing authority.
Questioning the Physical Presence Test as Outdated: Defer to U.S. Supreme Court
The Court of Appeals then observed that the "world has changed dramatically in the last two decades, and it may be that the physical presence test is outdated." An entity may now have a profound impact upon a foreign jurisdiction solely through its virtual projection via the Internet. But Chief Judge Lippman noted that "That question, however, would be for the United States Supreme Court to consider. We are bound, and adjudicate this controversy, under the binding precedents of that Court, the ultimate arbiter of the meaning of the Commerce Clause."
Subsequent to Quill, supra, the Court of Appeals for New York required that an in-state physical presence is necessary, it need not be substantial. Rather, it must be demonstrably more than a slightest presence. The presence requirement will be satisfied if economic activities are performed in New York by the seller's employees or on its behalf .
The Court acknowledged that there are clearly parallels between a mail-order business and an online retailer –- both are able to conduct their operations without maintaining a physical presence in a particular state. Indeed, physical presence is not typically associated with the Internet in that many websites are designed to reach a national or even a global audience from a single server whose location is of minimal import. However, through this statute, the legislature has attached significance to the physical presence of a resident website owner. The decision to do so recognizes that, even in the Internet world, many websites are geared toward predominantly local audiences — including, for instance, radio stations, religious institutions and schools -– such that the physical presence of the website owner becomes relevant to Commerce Clause analysis. Indeed, the Appellate Division record in this case contains examples of such websites urging their local constituents to support them by making purchases through their Amazon links. Essentially, through these types of affiliation agreements, a vendor is deemed to have established an in-state sales force.
Viewed in this manner the Court of Appeals held that New York's Internet Tax sales tax statute plainly satisfies the substantial nexus requirement. Active, in-state solicitation that produces a significant amount of revenue qualifies as "demonstrably more than a 'slightest presence'" under the Orvis standard. While not controlling per se, it also merits notice that vendors are not required to pay these taxes out-of-pocket. Rather, they are collecting taxes that are unquestionably due, which are exceedingly difficult to collect from the individual purchasers themselves, and as to which there is no risk of multiple taxation. The majority decision based its conclusion that "if a vendor is paying New York residents to actively solicit business in this State, there is no reason why that vendor should not shoulder the appropriate tax burden. We will not strain to invalidate this statute where plaintiffs have not met their burden of establishing that it is facially invalid."
The Court next addressed the admittedly closely related challenge based on the Due Process Clause, which, as with the dormant Commerce Clause, limits the taxing powers of the states. Unlike the bright line presented by the Commerce Clause, physical presence is not required in order to satisfy due process test. Instead, the focus is on whether a party has purposefully directed its activities toward the forum state and whether it is reasonable, based on the extent of a party's contacts with that state and the benefits derived from such access, to require it to collect taxes for that state. Citing Quill, supra. Indeed, an entity "that is engaged in continuous and widespread solicitation of business within a State... clearly has fair warning that [its] activity may subject [it] to the jurisdiction of a foreign sovereign," even in the absence of physical presence (Quill, 504 US at 308 [internal quotation marks and citation omitted]). In this respect, the Court of Appeals opined that "a brigade of affiliated websites compensated by commission" are the equivalent of "a deluge of catalogs" and "a phalanx of drummers" .
Plaintiffs argued that the Internet tax violates due process because the statutory presumption is irrational and essentially irrebuttable. In order for the presumption to be constitutionally valid, there must be "a rational connection between the Facts proven and the fact presumed, and... a fair opportunity for the opposing party to make [a] defense". Matter of Casse v. New York State Racing & Wagering Bd., 70 NY2d 589, 595 (1987).
Under the facts of both Associates Programs involved, residents of New York are compensated for referrals that result in purchases. The fact presumed is that at least some of those residents will actively solicit other New Yorkers in order to increase their referrals and, consequently, their compensation. The Court held that it is "plainly rational to presume that, given the direct correlation between referrals and compensation, it is likely that residents will seek to increase their referrals by soliciting customers. More specifically, it is not unreasonable to presume that affiliated website owners residing in New York State will reach out to their New York friends, relatives and other local individuals in order to accomplish this purpose." The presumption would be less rational if it were applied to those who receive some types of "other consideration" i.e., those whose compensation is unrelated to actual sales.
Plaintiffs also claim that the presumption is irrebuttable because it will be extremely difficult, if not impossible, to prove that none of their New York affiliates is soliciting customers on the retailers' behalf. However, as noted above, DTF has set forth a method (contractual prohibition and annual certification) through which the retailers will be deemed to have rebutted the presumption. Obtaining the necessary information may impose a burden on the retailers, but inconvenience does not render the presumption irrebuttable. In addition, while not determinative, it is notable that the presumption sensibly places the burden on the retailers to provide information about the activities of their own affiliates –- information that DTF would have significant difficulty uncovering on its own . Lavine v. Milne, 424 US 577, 585 (1976).
The Court of Appeals therefore found that the New York Internet Tax is facially unconstitutional under either the Commerce or the Due Process Clause and affirmed the orders of the Appellate Division below.
Dissenting Opinion by Justice Robert S. Smith
In registering the lone dissent, Justice Smith starts off his analysis by noting that the majority opinion correctly summarizes the law by saying that "if New York residents were merely engaged to post passive advertisements on their websites" no tax could be collected, but that a vendor who "is paying New York residents to actively solicit business in this State" may be required to remit tax. In his view, the issue for the court was whether certain New York-based websites — Overstock's "Affiliates" and Amazon's "Associates" — are the equivalent of sales agents, soliciting business for Overstock and Amazon, or are only media in which Overstock and Amazon advertise their products. Justice Smith thought there was insufficient nexus based on the facts and that the tax was applied in an unconstitutional manner.
The Overstock and Amazon links that appear on websites owned by New York proprietors serve essentially the same function as advertising that a more traditional out-of-state retailer might place in local newspapers. The websites are not soliciting customers for Overstock and Amazon in the fashion of a local sales agent. Of course the website owners solicit business for themselves; they encourage people to visit their websites, just as a newspaper owner would seek to boost circulation. But there is no basis for inferring that they are actively soliciting for the out-of-state retailers. Justice Smith made further comment distinguishing the in-state website owners as not being the same as a direct commission agent.
The statute at issue here tries to turn advertising media into an in-state sales force through a presumption. The statute says that a seller "shall be presumed to be soliciting business through an independent contractor or other representative" if it enters an agreement under which a New York resident "for a commission or other consideration, directly or indirectly refers potential customers, whether by a link on an internet website or otherwise". But of course a statutory presumption cannot by itself permit a state to do what the United States Constitution forbids. To presume that every website that has an agreement under which it carries an Overstock or Amazon link is a sales agent for Overstock or Amazon would be to nullify the rule that advertising in in-state media is not the equivalent of physical presence.
According to Justice Smith, the scope of the Internet Tax suffers from overbreadth, i.e., the statute would reach essentially all internet advertising that links to a seller's website: it includes any agreement for referral of customers, by a link or otherwise, "for a commission or other consideration." Since this literal reading would unquestionably render the statute unconstitutional, the Department of Taxation and Finance has adopted a narrowing construction, largely ignoring the words "or other consideration," and applying the presumption only where the website receives a commission or similar compensation — i.e., where "the consideration for placing the link on the Web site is based on the volume of completed sales generated by the link" (NY St Dept of Taxation and Fin Memorandum No. TSB-M-08S at 2). The narrowing construction, in Judge Smith's view, does not save the statute. The Internet Tax is invalid under the Commerce Clause.
It has been mentioned that the case will be appealed to the United States Supreme Court. It would be hoped that the Supreme Court will grant certioari and hear the dispute and determine if the New York Internet Tax will require companies like Amazon.com and Overstock.com to collect and remit New York sales tax on internet sales sourced from websites having a New York address, etc.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.