United States: Supreme Court Of Ohio Hears Oral Argument In Crucial Case For Factor-Presence Nexus

The Supreme Court of Ohio heard oral argument in a case involving the Ohio Commercial Activity Tax (the "CAT")—which provides that taxpayers have nexus with Ohio and are subject to tax if they have at least $500,000 of annual sales to Ohio. The focal point of oral argument concerned whether the Commerce Clause requires physical presence for nexus or whether Ohio's $500,000 requirement is constitutionally permissible. Taxpayers with sales to Ohio should closely follow the outcome of this case.

Today, the Supreme Court of Ohio heard oral argument in three consolidated cases1 concerning a question of first impression: whether Ohio's nexus standard for its Commercial Activity Tax (the "CAT")—a gross receipts tax—violates the Commerce Clause. Specifically, under the CAT statute, tax is imposed on taxpayers with at least $500,000 of annual sales to Ohio, regardless of whether the taxpayer is physically present in the state. The cases involve three out-of-state sellers with no physical presence in Ohio: Crutchfield, Inc., Newegg, Inc., and Mason Companies, Inc. (collectively, the "Taxpayers").

History of the CAT The CAT's factor-presence nexus standard has its origins in a 2002 Multistate Tax Commission ("MTC") project to create a model statute for business activity taxes. The MTC adopted a model statute, Factor Presence Nexus Standard for Business Activity Taxes, which found that "substantial nexus" exists for out-of-state retailers if one of four criteria are met, including $500,000 of sales to Ohio.

In enacting the CAT in 2005, Ohio adopted a variation on the substantial nexus requirement in the MTC's model factor-presence statute. A driving force behind Ohio's change was the advent of the national online marketplace and its effect on state economies. Indeed, in today's argument, the court suggested that a primary purpose of the CAT was to level the playing field for Ohio merchants competing with online retailers. Thus, because of the effect of the online marketplace on its economy, which contributed to a projected one-billion-dollar budget shortfall, Ohio chose to phase out its franchise tax and instead implement the CAT.

With the move away from traditional nexus standards, Ohio opened the door for taxpayers to challenge the validity of the CAT. The most significant challenge–Ohio Grocers Assoc. v. Levin2–involved an as-applied challenge from food retailers who argued that the CAT violated state constitutional prohibitions against certain sales or excise taxes on food.3 In finding that the CAT did not violate those provisions, the Supreme Court of Ohio distinguished the CAT from a sales and use tax, holding that the CAT is a tax on the "privilege of doing business" in Ohio.4 This distinction matters because if deemed a sales tax, the CAT would be subject to the physical-presence standard announced in National Bellas Hess v. Department of Revenue5 and Quill Corp. v. North Dakota.6

In today's argument, the court heard its first challenge to the CAT on the basis of the Commerce Clause, and must determine what nexus standard applies to Ohio's tax on gross receipts. The Taxpayers are appealing a decision by the Board of Tax Appeals (the "BTA"), which ruled that it did not have the authority to address the constitutional questions presented in the cases. Specifically, the BTA noted that although the parties "have set forth their respective positions regarding the constitutional validity of the commissioner's application of the statutory provisions in question . . . we find such arguments may only be addressed on appeal by a court which has the authority to resolve constitutional challenges."7

Arguments Raised by the Taxpayers The Taxpayers argue that Ohio's Tax Commissioner cannot assess them on the basis of their sales volume alone. In support of that argument, Taxpayers assert that the U.S. Supreme Court has always required physical presence for gross receipts taxes to meet the constitutional mandate of having a substantial nexus between the state and the taxpayer announced in Complete Auto Transit v. Brady.8 As a result, Taxpayers argue that the CAT violates the Commerce Clause on its face because nexus through sales in excess of a statutory threshold alone, without a physical presence in Ohio, subverts the protections afforded taxpayers by the Commerce Clause.

In today's oral argument, the court got right to the point and asked the Taxpayers to "start with nexus." The court's first question focused on whether the U.S. Supreme Court has decided a case involving similar issues with taxpayers selling into a state where they are not physically present. Justice Pfeifer also asked the Taxpayers whether the U.S. Supreme Court had addressed "e commerce as it is evolving" in the context of the Commerce Clause. Taxpayers responded by noting that the U.S. Supreme Court had addressed the early stages of e-commerce in 1992 with its decision in Quill. But the court seemed to be looking for more, as Justice Pfeifer called Quill "ancient by today's standards."

The Taxpayers focused on the U.S. Supreme Court's decision in Tyler Pipe v. Washington State Department of Revenue9 and noted that the only way they could be subject to the CAT was through physical presence, either its own or by third parties "establishing or maintaining its market" within Ohio. The taxpayers conceded as much when Justice French asked whether they would be subject to the CAT if the "guts of their operations" were in Ohio, i.e., computer servers in Ohio, warehouses in Ohio, and other activities in Ohio. While acknowledging that they would have nexus with Ohio under those facts, the Taxpayers argued they did not have a physical presence in Ohio.

As a result, the Taxpayers argued that they did not have nexus with Ohio, and that ruling in favor of the state would "blaze a new trail" for nexus. In the Taxpayers' view, the only body with authority to expand nexus is Congress.

Arguments Raised by the State The state's brief raises numerous arguments against the Taxpayers' challenge of the CAT. First, the state asserts that the physical presence requirement for a state to impose transaction taxes—as announced in Bellas Hess and reaffirmed in Quill—does not apply to the CAT. Because the CAT is levied "on each person with taxable gross receipts for the privilege of doing business in [Ohio]" and not intended to be "a tax imposed directly on the purchaser," the tax is not a transaction tax subject to Quill's physical-presence rule.10 At oral argument, when questioned whether the Supreme Court of Ohio would need to deviate from existing U.S. Supreme Court precedent—Quill—the state responded: "you don't need to touch Quill."

Because Quill does not apply, the state argued it only needs to demonstrate that the Taxpayers' activities directed toward Ohio create an "economic nexus" between the Taxpayers and the state. When pressed by the court to identify its strongest U.S. Supreme Court case in its favor, the state offered Tyler Pipe v. Washington State Department of Revenue.11 In this case, also involving a gross receipts tax, the U.S. Supreme Court considered whether the taxpayer's in-state representatives were significantly associated with the taxpayer's ability to "establish and maintain a market" in Washington. The state urged the Supreme Court of Ohio to ask this same question: do the Taxpayers' activities establish or maintain a market for sales in Ohio? Importantly, the Taxpayers argue that this question misses the point of Tyler Pipe, which determined whether the activities performed in-state by third parties helped establish or maintain a market. By removing the in-state aspect of Tyler Pipe, the Taxpayers assert that the state is misapplying Tyler Pipe.

Nevertheless, the state—applying Tyler Pipe without the requirement of an in-state representative or other in-state physical presence—alleges that "[f]oremost among [Taxpayers'] business activities in Ohio is the harvesting of consumer data from online users."12 By using tracking devices such as "cookies" on Ohio customers' computers, Taxpayers can "grow and maintain its Ohio market." The cookies harvest data in the form of names, addresses, phone numbers, and email addresses of Ohio customers in order to improve online marketing capabilities.

In addition to the use of cookies, the state alleges that Crutchfield "aggressively marketed online and offline to grow and develop" its market in Ohio. Importantly, if the CAT is appropriately deemed a transaction tax such that Quill applied, its marketing activities in Ohio engaged from outside Ohio would not suffice to give Taxpayers a physical presence in Ohio. However, because the state alleges that the CAT is not subject to Quill, it asserts that these marketing activities do not preclude the state from asserting nexus over Ohio. These marketing activities include "display ads" that appear on customers' web browsers; "paid search" ads to target visitors' search trends; and the use of shopping comparison sites to represent its products when searches contain certain keywords by the users.13

Finally, the state argues that the $500,000 sales threshold "is a proxy for the high level of activity required to generate those amounts of receipts in the state and correlates to the benefits and protections offered by Ohio."14 This "bright-line" reflects the "modern trend among states recognizing that nexus may exist over a party that conducts significant business in the forum state, without regard to whether that entity is physically present."15 If physical presence is not required, then the $500,000 threshold exists to determine when a retailer's activities are substantial enough such that Ohio can assert its taxing authority over an out-of-state retailer.

What's Next? Taxpayers with substantial sales to Ohio customers should pay close attention to these cases. If the decision by the BTA is upheld, taxpayers making at least $500,000 in Ohio sales are subject to the CAT, which is imposed at a rate of 0.26% of Ohio taxable gross receipts. Taxpayers should prepare to comply with the CAT in the event the Supreme Court of Ohio finds the tax constitutional.

Regardless of the outcome, the decision may be appealed to the U.S. Supreme Court. Although the Court denies cert in the overwhelming majority of cases appealed, these cases could be candidates for review. The cases raise issues on the Court's radar in the wake of Direct Marketing Association v. Brohl;16 namely, whether the physical-presence standard announced in Bellas Hess and reaffirmed in Quill is still a legitimate test to determine whether a taxpayer has a substantial nexus with a state.

While the Taxpayers are seeking resolution through the courts, relief is also being sought by federal legislation. The Business Activity Tax Simplification Agreement ("BATSA") has been introduced in Congress numerous times over the past decade, and most recently in the House of Representative on June 1, 2015.17 This legislation would prohibit states like Ohio from imposing business activity taxes on taxpayers without a physical presence in the taxing state. BATSA was addressed at today's argument: the Taxpayers argued that Congress, and Congress alone, has the ability to regulate interstate commerce. BATSA—or any other legislation passed by Congress—would resolve this issue for the nation as a whole. The state's response was that, as a separate sovereign, "the state is free to impose any tax it desires."

For more information on these cases and their impact on your business, contact the authors of this alert or the Reed Smith state tax attorney with whom you regularly work.


1 Crutchfield Corp. v. Testa, Case No. 2015-368 (Ohio Mar. 6, 2015); Newegg, Inc. v. Testa, Case No. 2015-483 (Ohio Mar. 25, 2015); Mason Cos., Inc. v. Testa, Case No. 2015-794 (Ohio May 19, 2015). The cases were consolidated by the Ohio Supreme Court for purposes of oral argument.

2 See Ohio Grocers Assoc. v. Levin, 916 NE.2d 446 (Ohio 2009).

3 Ohio Const. art. XII, § 13.

4 See Ohio Grocers Assoc., 916 NE.2d at 455.

5 386 U.S. 753 (1967).

6 504 U.S. 298 (1992).

7See, e.g., Newegg, Inc. v. Testa, BTA decision, Case No. 2012-234 (February 26, 2015).

8 430 U.S. 274 (1977).

9 483 U.S. 232 (1987).

10 See Appellee Tax Commissioner's Merit Brief, Crutchfield, Corp. v. Testa, No. 2015-368 (Ohio October. 20, 2015).

11 483 U.S. 232 (1987).

12 See Appellee's Brief, Crutchfield, Corp. v. Testa, No. 2015-368 (Ohio October. 20, 2015).

13 Id.

14 Id.

15 Id.

16 575 U.S. __ (2015).

17 H.R. 2584 (June 1, 2015)

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

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