Originally published November 22, 2006

In a decision issued on November 21, 2006, the Supreme Court of Appeals of West Virginia, the state’s highest court, held that West Virginia could impose its business franchise tax and corporation net income tax on a non-physically present corporation. Tax Comm’r of the State of W. Va. v. MBNA America Bank N.A., Docket No. 33049 (W.Va. November 21, 2006). The decision affirms a 2005 West Virginia Circuit Court decision and, following on the heels of the New Jersey Supreme Court’s recent decision in Lanco, continues the trend of state courts rejecting the application of Quill’s Commerce Clause "bright-line" physical presence nexus standard to corporate income tax.1

Background

MBNA America Bank N.A. ("MBNA"), a Delaware-based bank, had no real or tangible personal property or employees located in West Virginia. MBNA’s principal business was issuing and servicing VISA and MASTERCARD credit cards, and promoting its business in West Virginia via mail and telephone solicitation only. MBNA filed returns and paid West Virginia Business Franchise Tax and Corporation Net Income Tax and subsequently filed refund claims with the State Tax Commissioner, on the basis that West Virginia lacked jurisdiction over MBNA. The Commissioner denied the refunds.

Initially, the Office of Tax Appeals ("OTA") ruled in favor of MBNA and authorized refunds of the taxes. The OTA reasoned that "substantial nexus" is required for taxation of an out-of-state corporation under the Commerce Clause, and that standard required a finding of physical presence. On appeal, the Circuit Court of Kanawha County reversed the OTA’s decision, holding that physical presence was not a necessary predicate to establishing substantial nexus for income tax purposes. Instead, the circuit court found that MBNA’s business activity in

the state, as described above, was sufficient to meet the Commerce Clause substantial nexus standard. MBNA appealed this decision to the Supreme Court of Appeals of West Virginia ("West Virginia Supreme Court").

West Virginia Supreme Court Decision Toes the Line Drawn in Other States

The single issue raised in the appeal was whether application of West Virginia’s franchise and net income taxes to MBNA, a business with no physical presence in the state, violated the Commerce Clause of the U.S. Constitution.2 The court held that the U.S. Supreme Court’s decision in Quill (i.e., an entity’s physical presence in a state is required to meet the "substantial nexus" prong of the dormant Commerce Clause) applies only to state sales and use taxes, and not to corporate franchise and net income taxes.

The West Virginia court acknowledged the distinction drawn by the U.S. Supreme Court in Quill between the nexus requirements of the Due Process and Commerce Clauses, and noted that the Due Process Clause merely requires "some definite link, some minimum contacts, between a state and the person, property, or transaction it seeks to tax." Minimum contacts are satisfied when the business is engaged in continuous and widespread solicitation within a state giving the business fair warning that it may be subject to the jurisdiction of the foreign state. The West Virginia court conceded that the nexus requirement under the Commerce Clause is, by contrast, concerned with the effects of state regulation on the national economy, and the "substantial nexus" requirement serves to limit state burdens on interstate commerce; nevertheless, it rejected the application of a bright-line physical presence requirement outside the context of sales and use taxes, on four distinct grounds.

  • Stare Decisis Limits Impact of Quill: The court found that a "close reading" of Quill indicates that its reaffirmation of the Bellas Hess physical-presence standard was based primarily on stare decisis (i.e., the principle of following prior rulings on the same legal issue in the absence of changed facts or other substantial justification). The benefits of reliance interests and the stability of jurisprudence associated with consistent application of physical presence to sales and use taxes was viewed by the court as not applicable to franchise and corporate net income taxes.
  • Quill Limited by Its Own Language: The court found that the U.S. Supreme Court expressly limited Quill’s scope to sales and use taxes. However, the U.S. Supreme Court language relied on by the MBNA court merely noted (in language not central to its holding) that it had not required a physical presence "concerning other types of taxes." Thus, the MBNA court found the U.S. Supreme Court’s Quill decision "clearly implies" that physical presence nexus is limited to sales and use taxes.
  • Differential Burdens Imposed by Income/Franchise Taxes: The court found that the application of the physical presence test in Bellas Hess and Quill turned on the substantial compliance burdens associated with collecting and remitting use taxes on behalf of numerous state and local jurisdictions (over 2,300 localities at the time of Bellas Hess and over 6,000 at the time of Quill) at varying tax rates demanded knowledge of a multitude of administrative regulations, deductions, and tax rates. In contrast, the West Virgina court found that the franchise and income taxes do not impose the same administrative and compliance burdens on taxpayers (e.g., income and franchise taxes are remitted less frequently, through annual returns and quarterly estimated payments). Many corporate income and franchise taxpayers will disagree with the MBNA court’s observation that "the franchise and income taxes at issue in this case do not appear to cause the same degree of compliance burdens" as sales and use taxes.
  • New Facts Make New Law: The court found that the Bellas Hess/Quill physical presence nexus standard "makes little sense in today’s world," where the electronic commerce allows an entity to have significant economic presence in a state without having any physical presence.

New Commerce Clause Nexus Standard Announced: "Significant Economic Presence"

The court prefaced its articulation of a new Commerce Clause substantial nexus standard with the statement that "the mechanical application of a physical-presence standard to franchise and income taxes is a poor measuring stick of an entity’s true nexus with a state." The court announced that a taxpayer’s "significant economic presence" would demonstrate Commerce Clause "substantial nexus" for purposes of income and franchise taxes. This test incorporates the Due Process notion of "purposeful direction" of economic activity toward a state, but also requires examination of the degree to which a company has in fact exploited a local market by reference to the "frequency, quantity and systematic nature of a taxpayer’s economic contacts with a state." In other words, the "significant economic presence" test involves an examination of both the quality and quantity of the company’s economic presence. Pursuant to this standard, the court found MBNA’s systematic and continuous business activity with West Virginia produced significant gross receipts and therefore, established the significant economic presence required for the state to constitutionally impose its business franchise and corporation net income taxes.

Sutherland Observation: The substitution of the physical presence nexus standard with a "significant economic presence" standard, if adopted in multiple jurisdictions or by the U.S. Supreme Court, results in a subjective analysis. Consequently, the standard might be applied differently and/or yield different conclusions as to an entity’s nexus, from jurisdiction to jurisdiction. The decision comes at a time in which many companies are grappling with compliance with FIN 48. This decision, and the "significant economic presence" test will create additional nexus uncertainty and additional FIN 48 compliance issues

MBNA’s Objections to Significant Economic Presence Standard

The court summarily addressed and rejected MBNA’s enumerated objections to the application of any nexus standard other than physical presence. Perhaps the most compelling argument raised by MBNA was that the adoption of a substantial nexus requirement that is not premised upon the taxpayer’s physical presence violates the specific holding in Quill that the applicable nexus standards are different under the Due Process and Commerce Clauses. MBNA argued to meet the "substantial nexus" requirement under the Commerce Clause, an entity’s exploitation of the market must be greater than under the Due Process Clause. Therefore, logic dictates that something "greater in degree" than Due Process minimum contacts must be required for purposes of every type of tax. Nevertheless, the court disagreed with MBNA’s contention, stating that the substantial economic presence standard, although more elastic and less demanding than a bright-line physical presence test, does impose a higher nexus threshold, when properly applied, than the Due Process minimum contacts standard.

Sutherland Observation: Observers might question whether the West Virginia court would have found that an intangible holding company (IHC), similar to the taxpayers in Geoffrey (SC and OK) or Lanco (NJ), would also satisfy the "significant economic presence" standard. On the one hand, an IHC arguably maintains less systematic and continuous business contacts with the state (though the end-result – generation of income from in-state sources – is the same) than the credit card company in this case. Note, however, that the court in footnote 11 of its opinion specifically addressed the numerous income tax nexus cases dealing with IHCs, and distinguished those cases because the intangibles (i.e., trademarks) themselves "provide a sufficient nexus for income tax purposes" under the Commerce Clause; in other words, the court indicated that there was an additional basis to find nexus over an IHC.

Footnotes

1 The New Jersey Supreme Court held on October 12, 2006 that New Jersey could impose its Corporation Business Tax on an out-of-state corporation without a physical presence in a state. Lanco, Inc. v. Director, Div. of Taxation, 908 A.2d 176 (N.J. 2006). See Sutherland’s Legal Alert dated October 12, 2006 for a discussion of the Lanco decision.

2 MBNA originally raised an assignment of error concerning fair apportionment of the taxes in this case, but subsequently abandoned this assignment of error.

© 2006 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.