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Physical Presence and the Corporate Income Tax: What’s Wayfair Got to Do With It?

Posted on Feb. 22, 2021
Roxanne Bland
Roxanne Bland

Roxanne Bland is Tax Notes State’s contributing editor. Before joining Tax Analysts, Bland spent 17 years with the Multistate Tax Commission, where she worked with state revenue agency representatives to draft model legislation pertaining to sales and use taxation and corporate income, analyzed and reported on proposed federal legislative initiatives affecting state taxation, worked with legislative consultants and representatives from other state organizations on international issues affecting states, and assisted member state representatives in federal lobbying efforts. Before that, she was an attorney with the Federation of Tax Administrators for over seven years.

In this installment of The SALT Box, Bland examines Apex Laboratories International Inc. v. City of Detroit and whether Wayfair’s result can be applied to a physical presence requirement regarding the corporate income tax.

The U.S. Supreme Court has been far more lenient with constitutional nexus standards for corporate income tax than for sales and use tax. One need to look back no further than 1993, when the Court denied certiorari in Geoffrey,1 declining to review a decision from the Supreme Court of South Carolina that held that the physical presence nexus standard for sales and use tax of Quill2 did not apply to the state’s corporate income tax. In subsequent years, several state supreme courts followed suit;3 other states have enshrined the economic nexus standard in statutory or regulatory law, or through administrative interpretation.4 Although denial of certiorari does not carry the weight of a decision on the merits, it is nevertheless indicative of the Court’s thinking. While it is unlikely the Court would agree to hear such a case should one come before it, the fact remains that the economic nexus standard for corporate income tax has not received its blessing.

Since South Dakota v. Wayfair Inc.,5 there has been speculation on what the demise of the physical presence rule for sales and use tax means for the physical presence rule as applied to income tax. Although the general trend in the states clearly points toward an economic nexus standard for corporate income tax, not all have chosen to follow along. Michigan is one, and the question of the physical presence nexus standard’s continued vitality in the context of the corporate income tax has been raised.

Michigan’s income tax statute provides that, with enumerated exceptions, a taxpayer is subject to tax if he has physical presence in Michigan for more than one day during the tax year. Physical presence is defined as “any activity conducted by the taxpayer or on behalf of the taxpayer by the taxpayer’s employee, agent, or independent contractor acting in a representative capacity. Physical presence does not include the activities of professionals providing services in a professional capacity or other service providers if the activity is not significantly associated with the taxpayer’s ability to establish and maintain a market in this state.”6

In Apex,7 the would-be taxpayer challenged Detroit’s attempt to impose its income tax on Apex’s activities within the city’s jurisdiction.8 Apex was a Delaware passive holding company, created by a private equity firm for the sole purpose of holding the stock purchased by the firm in a Canadian company. Apex paid the city’s income tax on dividends paid during the years it held the stock, and finally, on the gain realized when the stock was sold. A few years later, the city determined Apex had nexus, and assessed additional tax, penalties, and interest.9 Apex filed for a refund, which the city denied, and subsequently filed an appeal with the Michigan Tax Tribunal.

The tribunal found that Apex was subject to the city’s income tax because, although its activity was minimal, it met the state’s statutory definition of doing business.10 However, it further determined that Apex was not taxable because it did not meet the state’s statutory definition of physical presence. The tribunal found that Apex did not have physical presence because (a) the presence of officers and directors in the city does not create nexus; and (b) Apex’s officers and directors were employed by the private equity firm, and acted at the firm’s direction, not that of Apex. Thus, the tribunal concluded, the officers and directors qualified as professional consultants. Moreover, actions taken by the officers and directors were incidental to Apex’s activity in the city, which was to hold the shares and debt of the Canadian company. Finally, Apex was not engaged in the sale of goods or services, and, as a passive holding company, was not engaged in an active trade or business in the city. The income Apex received was attributable to the activities of the Canadian company, which had no connection with the city. Thus, Apex did not have the physical presence in the city required to subject it to an income tax liability.

The city appealed to the Michigan Court of Appeals, which upheld the tribunal’s ruling. The twist is that roughly a month after the appellate court’s affirmance, and while the city’s appeal was pending at the Michigan Supreme Court, the U.S. Supreme Court released its Wayfair opinion.11 The state supreme court then remanded the case to the appellate court for reconsideration in light of Wayfair, which in turn remanded to the tribunal.

The Past Is Prologue

The question is whether Wayfair should have any impact on the tribunal’s holding. If the U.S. Supreme Court’s 1993 response to Geoffrey is any indication, the answer is no. Every state high court that addressed whether Quill’s physical presence standard applied in the income tax context held that it does not, save one. In J.C. Penney,12 the Tennessee Supreme Court ruled that, under Quill’s physical presence rule, the state could not assess franchise and excise taxes against an out-of-state bank with no physical presence in Tennessee. After an exhaustive analysis of the Court’s due process and commerce clause precedent concerning the limits of state taxing jurisdiction over out-of-state entities, the state court reasoned the only issue was whether there was any reason the Quill rule should not apply outside the sales and use tax arena. The court claimed that it could discern no basis for treating the two types of taxes differently, pointing out that the state did not provide any authority as to why the analysis should be different (although in fairness, the bank provided no authority as to why the analysis should be the same). The crucial point is that while the state court acknowledged the Quill Court’s reservations on whether it would have decided Bellas Hess13 differently today, it ignored the Court’s observation that it never applied the physical presence rule outside the sales and use tax context, an observation that all other state courts recognized.

The reasoning and result reached by the Geoffrey court and all other subsequent state courts is equally applicable here. In dispensing with the physical presence rule for sales and use tax, nowhere did the Wayfair Court say it was dispensing with the rule as it applied to other types of taxes, too. Indeed, Justice Anthony Kennedy’s announcement was emphatic: “For these reasons, the Court concludes that the physical presence rule of Quill is unsound and incorrect. The Court’s decisions in Quill Corp. v. North Dakota and National Bellas Hess, Inc. v. Illinois Department of Revenue should be, and now are, overruled.” (Citations omitted.)

The only conclusion to be drawn from the Court’s pronouncement is that the physical presence standard pertains solely to sales and use tax. No, the Court does not explicitly say that its overturning of the physical presence standard applies only to the sales and use tax, thereby leaving the standard intact for other taxes, but that is because as the Quill Court noted, the rule has only been applied to the sales and use tax. Thus, Wayfair has no impact on Michigan’s physical presence requirement for income tax purposes, and the tribunal has no choice but to reaffirm its holding that Apex’s lack of physical presence in the city precludes it from imposing an income tax liability on Apex.

Conclusion

Since the Supreme Court’s Wayfair decision overturning the physical presence standard for a state to require an out-of-state merchant to collect sales and use tax on purchases by in-state residents, there has been speculation that the standard’s demise may have implications for laws providing that a corporation incurs income tax liability only if it has physical presence in a state. The Court’s 1993 denial of certiorari in Geoffrey indicates, although not directly, that physical presence is not required. All state supreme courts that have considered the issue, except one, have taken the hint. However, for those states that have chosen to retain a physical presence requirement for corporate income tax liability, an analysis of Wayfair shows that the decision has no effect on those states’ laws. Because the physical presence standard was never applied outside the sales and use tax context, Wayfair’s result cannot be applied to a physical presence requirement for corporate income taxation. For Michigan, whose tax tribunal is facing this issue, the state should rest easy that the status quo will remain undisturbed. For the taxpayer, it can breathe a sigh of relief that the corporate income taxes it paid to Detroit must be refunded.

FOOTNOTES

1 Geoffrey Inc. v. South Carolina Tax Commission, 437 S.E.2d 13 (S.C. 1993), cert. denied 510 U.S. 992 (1993).

2 Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

3 E.g., Commissioner v. MBNA America Bank N.A., 640 S.E.2d 226 (W. Va. 2006).

4 E.g., Haw. Rev. Stat. ch. 235; 830 Mass. Code Regs. 63.39.1; Pennsylvania Department of Revenue, Corporate Tax Bulletin 2019-04 (Sept. 30, 2019).

5 South Dakota v. Wayfair Inc., 585 U.S. ___ (2018).

6 Mich. Comp. Laws section 206.621 (2011).

7 Apex Laboratories International Inc. v. City of Detroit, No. 16-000724 (May 2, 2017). Note that Detroit’s income tax is incorporated into the state income tax statute, Mich. Comp. Laws section 141.501 et. seq.

8 The state’s definition of physical presence applies to the city’s income tax statute.

9 From the tribunal’s statement of the facts, it is unclear why Apex paid the city’s tax in the first place.

10 Mich. Comp. Laws section 141.605 (2011).

11 Wayfair, 585 U.S. ___ (2018).

12 J.C. Penney National Bank v. Johnson, 19 S.W.3d 831 (Tenn. 1999).

END FOOTNOTES

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