In this Ropes & Gray podcast, Brittany Cvetanovich, an associate in the tax group, is joined by Kat Gregor, tax partner and co-founder of the tax controversy group, to discuss a notable Supreme Court decision, South Dakota v. Wayfair. On June 21, 2018, the Supreme Court ruled in Wayfair that the State of South Dakota may constitutionally require large online retailers without actual physical presence in the state to collect and remit sales tax.
Brittany Cvetanovich: Hello, and thank you for joining us today on this Ropes & Gray podcast. I'm Brittany Cvetanovich, an associate in the tax and tax controversy groups. Joining me today is Kat Gregor, a partner in the tax group and co-founder of the firm's tax controversy group. In today's podcast, we're going to discuss the Supreme Court's June 21, 2018 decision in South Dakota v. Wayfair. The Supreme Court granted certiorari in Wayfair to reconsider two prior cases in which it had restricted states from imposing sales tax on businesses unless those businesses had an actual physical presence in the state. Those cases were Quill v. North Dakota, from 1992, and National Bellas Hess, Inc. v. Department of Revenue of Illinois, from 1967.
These decisions all implicate the states' power to impose restrictions on interstate commerce under the negative Commerce Clause. On its face, the Commerce Clause vests power in Congress to regulate interstate commerce. However, courts have long ruled that the Commerce Clause also restricts state action, prohibiting states from imposing undue burdens on interstate commerce. The Supreme Court has held that a tax that either discriminates against or is imposed on transactions that cross state borders must meet four criteria to pass the undue burden test: first, the tax must apply to an activity that has a substantial nexus with the taxing state; second, the tax must be fairly apportioned to the taxing state; third, the tax may not discriminate against interstate commerce, and fourth, the tax must be fairly related to the services the taxing state provides. This test is often called the "Complete Auto" test because it's from the Supreme Court case Complete Auto Transit, Inc. v. Brady.
In 1967, the Court held in Bellas Hess that states could not require an out-of-state retailer to collect the state's sales tax unless the retailer had a "physical presence," such as an employee or a building in the state. The Court doubled down on the physical presence rule in South Dakota v. Quill in 1992. Since then, and with increasing intensity as ecommerce has grown, the states have sought to circumvent or overturn this physical presence requirement. In 2016, South Dakota passed a law that explicitly violated Quill and then sued major online retailers for a declaratory injunction that the law was valid.
Now that I've set the stage, Kat, could you describe the holding in Wayfair?
Kat Gregor: Sure, Brittany. South Dakota's new sales tax law requires out-of-state sellers to collect tax if they make at least 200 separate sales or $100,000 worth of sales in the state, regardless of whether they have a physical presence. The Supreme Court ruled 5-4 that this law does not violate the Commerce Clause. In particular, the Court concluded that physical presence is not necessary to meet that first factor of the Complete Auto test, since a company can have a substantial nexus with a state even without a physical presence.
The majority explained that the purpose of the Commerce Clause was to avoid market distortions and provide an even playing field for interstate commerce in the United States. They criticized Quill for establishing a standard that creates market distortions rather than correcting them. In particular, they noted that Quill gave out-of-state sellers a competitive advantage because their products appeared to have lower prices because they did not include sales tax. They also reasoned that Quill provided an incentive for out-of-state sellers to limit their physical presence by not establishing brick-and-mortar stores, distribution centers, or other facilities in the state, and these are decisions not based on any business-related concerns other than avoiding paying sales tax. In fact, the Court had some pretty harsh language for Quill, calling it a "judicially created tax shelter."
Brittany Cvetanovich: Wow, those sound like some strong words. Were you surprised by this decision?
Kat Gregor: Well, I think overall, most people were expecting the Supreme Court to overturn Quill. After all, in 2015, the Supreme Court had unanimously ruled that the State of Colorado could require out-of-state sellers to submit information regarding their customers and their purchases and sales tax liability to the state. And in that decision, Justice Kennedy wrote a concurring opinion in which he basically said he was ready to overturn Quill in light of the growth of the internet and the economic and societal changes that came with it. After that, South Dakota and a large number of other states began to pass legislation with the hopes of bringing the issue before the Supreme Court again so that Quill could be overturned.
The Wayfair opinion explained how technology and internet sales have changed since Quill. The Court said e-commerce sales had grown to 8.9% of total retail sales, amounting to $453.5 billion per year. It also quoted estimates that the physical presence test caused states to lose from $8 to $33 billion per year in sales tax revenue—roughly 10 times more than the estimate of lost sales tax revenue from remote sales at the time of Quill. Additionally, the number of Americans with internet access grew from 2% to 89% since Quill. But despite this discussion, one surprising thing was that the Supreme Court didn't just overturn Quill in light of intervening technological change, it said that Quill was wrong from the outset. The Supreme Court basically said that Quill imposed "the sort of arbitrary, formalistic distinction" disfavored by its other dormant Commerce Clause precedents.
Brittany Cvetanovich: So, I can understand how the Court thought that the physical presence rule was formalistic, but that rule did provide a very clear standard that companies could easily understand and follow. Overturning it disrupted settled expectations about how sellers could set up e-commerce operations without being required to collect and remit sales tax. Without the physical presence rule, what should companies do?
Kat Gregor: Well, the problem is that Wayfair didn't set a new standard to replace Quill. The Court's holding was limited to answering the following question: is physical presence necessary for substantial nexus. Wayfair didn't eliminate the substantial nexus requirement—substantial nexus is still required. So the holding is fairly limited. The question of what substantial nexus means post-Wayfair is less clear. But the Court offered a few hints about what factors may be relevant in future litigation by highlighting specific aspects of the South Dakota law that set a threshold of sales activity below which the State would not require retailers to collect tax.
Brittany Cvetanovich: I thought another interesting aspect of the case was South Dakota's participation in the Streamlined Sales and Use Tax Agreement, which I'll call "SSUTA," which has now been adopted by more than 24 states. As some of you may know, the SSUTA resulted from a cooperative effort between the states to simplify sales tax reporting and collection for companies working across state lines. States that adopt the agreement impose sales taxes on a uniform tax base and reporting system, though they may impose unique rates. The Supreme Court suggested that South Dakota's decision to join SSUTA substantially reduced the burdens of its state sale tax. But as you suggested, this was not part of the court's holding. Future decisions will be necessary to determine if other aspects of state laws impose an undue burden on interstate commerce. ]
Kat Gregor: Yes, and there's the possibility that Congress could legislate in the area. Quill had reasoned that Congress was "better qualified" than the courts to make rules in the area of economic policy. In fact, the dissenting opinion in Wayfair, written by Chief Justice Roberts and joined by Justices Breyer, Sotomayor, and Kagan, would have upheld Quill and left the issue to Congress to resolve. The dissent reasoned that there was no urgency to overturn Quill, as Congress has long been considering passing legislation in the area. The dissent disagreed that the changes in the internet justified overturning Quill. After all, sales taxes have only become more complicated in the intervening years. The dissent noted that "over 10,000 jurisdictions levy sales taxes" and thus the majority's decisions could impose heavy costs and burdens on out-of-state sellers and many small businesses, having adverse effects on the national economy. Some companies and organizations are calling for Congress to act in light of the Wayfair ruling and it could certainly provide some helpful guidance in this area, but I think Congress is very unlikely to restore the physical presence requirement.
Brittany Cvetanovich: Absent any action by Congress, what does Wayfair mean for sales tax collection in other states?
Kat Gregor: Currently, there are 21 states that have economic nexus models similar to South Dakota's law. Several states' laws have already gone into effect. And we expect that many of the remaining states that have not yet passed similar legislation will engage in efforts to do so within the next year.
Other states have been developing somewhat more conservative "click-through" or "cookie" nexus laws that have a minimum threshold for sales, but also require other particular indicia of nexus, such as in-state apps, cookies or other data storage. For example, Massachusetts just passed a cookie nexus regulation along these lines last year, and California and New York both have click-through tax laws. Under the logic of Wayfair, there seems to be a good chance that these laws will be upheld, because they impose even more limits on state tax than the South Dakota law.
One of the central unanswered questions from the Wayfair decision is "How important was South Dakota's participation in SSUTA to the Court's undue burden holding?" Half of the states, including Massachusetts, are not members of SSUTA. That may leave their sales tax laws vulnerable, or we may see states rush to join SSUTA. Another unanswered question is the minimum nexus for state tax since a few states' sales tax rules, such as Pennsylvania and Washington, apply to out-of-state sellers who only make $10,000 in sales. It's unclear if that will be sufficient for nexus purposes, particularly if that only amounts to a couple sales for a particular out-of-state seller. Finally, Wayfair also didn't rule on whether states could retroactively apply sales tax, though the majority noted with approval South Dakota's application of its new law was on a prospective basis. So states will have to determine if it's worth the certainty of future litigation, or if they should just collect sales tax prospectively.
Brittany Cvetanovich: So, what steps should online retailers take now that Quill's physical presence test has been abandoned?
Kat Gregor: Businesses should look at the states in which they do business to determine whether they should begin collecting and remitting sales and use tax, and consult their tax advisors about their obligations. This is an area that's going to be changing fast, so they should make sure they are keeping up to date on changes in state law. Smaller businesses should start planning in terms of compliance cost strategy and how they will manage with the new laws.
Brittany Cvetanovich: Kat, I know Justice Kennedy's retirement so quickly after the Wayfair decision has gotten a lot of attention. Do you think Justice Kennedy's retirement will affect future litigation in this area?
Kat Gregor: It's hard to say. Wayfair was a 5-4 decision, but it did not split on traditional lines between the justices. And the prior decision in Direct Marketing was unanimous. So, these kinds of things are hard to predict. As always, companies interested in pursuing litigation will have to weigh the pros and cons, including the chances of success before deciding to proceed. It's a long way to the Supreme Court so the most important factors to look at are the particular facts and circumstances, including the nexus the company has to the state at hand and the amount of burden it would be to comply with the law.
Brittany Cvetanovich: Kat, thanks for joining me in this fascinating discussion. We'll be back in October to discuss the next case of the quarter. In the meantime, please visit the Tax Controversy Newsletter webpage at www.disputingtax.com, or of course, www.ropesgray.com for additional news and commentary about other notable tax developments as they arise. Thanks for listening.
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