CPAs’ Biggest Tax Myths

A state can tax the income of businesses having no physical presence there.

October 11, 2007
by John Karayan, JD/PhD

Sherlock Holmes solved the "Silver Blaze" case by observing something which did not happen: The dog did not bark, and thus it was logical that the criminal had to be someone the dog knew well. Similarly, by choosing not to review similar cases from the highest court in two states, last month the U.S. Supreme Court may have signaled a sea change in state and local tax planning. These cases allowed two different states to impose income taxes on businesses having no physical presence in the state. Although both cases involve intangibles, and thus could be read as merely following the U.S. Supreme Court’s 1993 Geoffrey decision, the language used clearly allows state income taxes on any out-of-state businesses where the only connection with the jurisdiction is “substantial gross receipts.”

With ironic but limited exceptions (e.g., dealers of illegal drugs have a Constitutional right to deduct their costs of goods sold), tax planners generally can ignore the font of U.S. law: The U.S. Constitution. The only area where the U.S. Supreme Court has consistently ruled legislated tax laws unconstitutional has been in state and local taxation of interstate businesses. Even this has been limited: States have long been allowed to estimate the business income they can tax based on formula apportionment (e.g., taxing total income multiplied by an average of the firm’s property, payroll, and sales sourced to the state). The Court primarily has acted where states tried to tax out-of-state businesses selling into the state purely through interstate commerce (e.g., through the mail, over the telephone, or via the Web). Last month, the Roberts’ Court may have signaled its reluctance to continue its “judicial activism” in this area, and instead leave it up to Congress to decide what Federal limits should be imposed on state and local taxation.

On June 18, 2007, the U.S. Supreme Court denied petitions for certiorari appealing similar decisions by the highest state courts in New Jersey (Lanco Inc. v. Director, New Jersey Division of Taxation, Dkt. 06-1236) and West Virginia (FIA Card Services sub nom MBNA America Bank v. Tax Commissioner of the State of West Virginia, Dkt. 06-1228). Both cases upheld state income taxes on taxpayers whose only contact with the state was intangible. In neither case did the taxpayer have any physical presence in the taxing state. In Lanco, 908 A. 2d 176 (New Jersey S. Ct., 2006), the New Jersey Supreme Court upheld state income taxes on a firm whose only contact with the state was collecting licensing fees from the use in the state of the firm’s intangible assets by unrelated parties. In MBNA America Bank, N.A., 640 S.E.2d 226 (West Virginia S. Ct., 2006), the West Virginia Supreme Court upheld state income taxes on a bank whose only contact with the state was collecting fees from the use of its funds in the state by unrelated parties.

Planning Opportunities

This decision suggests that mere “economic presence” now allows the imposition of state and local non-sales taxes. This may very well expand tax compliance costs for two main reasons. First, there may be an increase in the number of jurisdictions in which multi-state businesses must file tax returns. This might be complicated beyond the usual need to delve into the Byzantine complexities caused by non-conformity among state and local jurisdictions, because tax statues of limitation rarely apply if returns have not actually been filed. It has been common practice for multi-state businesses to simply not file returns in jurisdictions where the firm lacked physical presence. At a minimum, firms concerned with GAAP reporting may need to reevaluate their provisions for deferred state and local taxes.

Second, firms which have attempted to limit nexus by licensing intangibles out of a parent “holding company” may now be whip-sawed by inconsistencies among states For example, the income of the holding might be taxed by jurisdictions where the intangibles are being used, yet also taxed. This may be worse than it seems because of the general lack of a “foreign income tax credit”: Many states do not allow a in-state tax credit for income taxed in another state.

However, there is a silver lining to this cloud. Most states estimate the business income they can tax based on formula apportionment (e.g., taxing total income multiplied by an average of the firm’s property, payroll and sales sourced to the state). Thus, total state income and franchise taxes often can be reduced if a firm generates more of these factors sourced in lower tax jurisdiction. For example, in deciding where to locate new facilities, or where to closed old one down, firms have tax incentives to locate in states like Texas and Nevada, which do not impose income taxes. Under an “economic presence” test, firms may have the delightful surprise of finding that more of their factors, particularly “sales”, can be sourced to lower tax states.

This is particularly the case for jurisdictions that have a “throwback” rule for sales. Often these are high tax states such as California. Under formula apportionment, sales generally are sourced to the jurisdiction where the customer is located. This happens even if the jurisdiction chooses not to impose an income tax. Thus, sales into non-taxing states where the firm has a physical presence usually lowers a firm’s total state income tax liability. However, under throwback rules, sales into states which cannot impose a tax are instead sourced to where the sale originated. Thus, under prior law a business which only has a physical presence (such as employees and fixed assets) in California could have all of its U.S. sales sourced to California. However, under an “economic presence” test, firms may have the delightful surprise of finding that they have taxable nexus with more states, and thus more of their factors, particularly “sales,” may be sourced to lower tax states.

Furthermore, it should be noted that even though the effect of denying cert. in Lanco and FIA Card Services is to uphold state court rulings applying an economic presence test, the U.S. Supreme Court has yet to directly rule on the issue. This is particularly important with these cases, because in is short life the Robert’s Court has shown a proclivity to not rule except where necessary. Further, the Robert’s Court may merely prefer that weighing the pros and cons of economic policy decisions like multi-state taxation is best done by logrolling elected politicians.

In addition, the history of Supreme Court decisions suggests a narrow reading: that is, that the “economic presence” test only applies to net business income from the use of intangibles in a jurisdiction.


The U.S. Constitution has long been read as limiting state and local taxation of interstate commerce. Originally, the Court barred all State taxes. After the Great Depression, this “free trade” view gradually was replaced with a “nondiscrimination” doctrine: taxes could be imposed on interstate commerce, unless there was a risk of multiple taxation, and such risk was not borne by local commerce. Freeman v. Hewit, 329 U.S. 249 (1946).

In Northwestern States Portland Cement Co. v. Minnesota, 358 U.S. 450 (1959), the Court shifted to a “substantial nexus” approach. A nondiscriminatory tax, based on the apportionment of the firm’s net income to the state determined under a formula, could be imposed on out-of-state businesses, but only if there was sufficient minimum connection (“nexus”) with the jurisdiction. That is, the tax must be reasonably attributable to business activities within the State, which in this case was merely the physical presence of traveling salesmen.) Uncharacteristically, Congress responded swiftly. On Sept. 14, 1959, Public Law 86-272 was enacted. Now codified (outside the Internal Revenue Code) as 15 USCS § 381, it prohibits any state and local “net income tax on the income derived … from interstate commerce if the only business activities within such State … are the solicitation of orders … for sales of tangible personal property.”

This approach has been dutifully followed in sales and use tax cases (e.g., National Bellas Hess, Inc. v. Illinois, 386 U.S. 753 (1967). Further, in Complete Auto Transit Inc. v. Brady, 430 U.S. 274 (1977), the Court noted that state and local taxes on interstate businesses must be fairly related to services provided by the taxing jurisdiction. However, in Quill Corp. v. North Dakota, 504 U.S. 298 (1992) the Court suggested that the standards of nexus might differ based on the type of tax involved. The Court categorically referred to the tremendous growth in the mail-order industry “from a relatively inconsequential market niche” to a “goliath,” also specifically noted that this was an area where Congress alone had the power regulate such transactions.

In response to Quill, various legislation has been introduced in Congress (e.g., “The Consumer and Main Street Protection Act of 1995”), none of which has been. Similarly, state courts in New Jersey, New Mexico, North Carolina, Ohio, Oklahoma, South Carolina, Washington and West Virginia have limited the physical presence standard to the sales and use taxes, while courts in Michigan, Tennessee, and Texas have not. The seminal state case applying an “economic presence” test is Geoffrey Inc. v. South Carolina Tax Commission, 437 S.E. 2d 13 (South Carolina S. Ct., 1993), cert. denied, 114 S. Ct. 50 (1993).

There, the South Carolina Supreme Court upheld an income tax on a Delaware holding company whose sole connection to South Carolina was licensing “Toys ‘R Us” trademarks for use in the state. The court reasoned that the company had purposefully directed its activities at the state’s economic forum and that it had sufficient connection with the state through its intangibles and accounts receivables in the state. The court refused to accept that the physical presence requirement under Quill was necessary for its state income tax to attach to the taxpayer. Similarly, in A & F Trademark, Inc. v. Tolson, 167 N.C.App. 150 (N.C. App. 2004), cert. denied, 126 S. Ct. 353 (2005) the North Carolina Court of Appeals upheld corporate franchise and income taxes assessed against nine "trademark holding companies," each of which is a wholly-owned, non-domiciliary subsidiary corporation of the Limited, Inc., an Ohio corporation.

A number of states now impose income taxes in the use of intangibles in the state. For example, Arkansas now requires that holding companies receiving royalty income from an Arkansas business file an Arkansas corporate income tax return. Some of the other states that have adopted the Geoffrey approach are Florida, Hawaii, Iowa, New Mexico, Tennessee, Texas and Wisconsin. There are other states that are considering adopting this approach. Some states have actually incorporated economic nexus standards in their statutes, especially with regard to the income taxation of financial institutions (e.g., Massachusetts).


“Economic presence” may now be the touchstone for taxable nexus allowing state and local jurisdictions to impose tax liabilities on multi-state firms engaged purely in interstate commerce. This can be both a negative and a positive development. One thing is for certain: tax planners need to think about these cases when advising multi-state organizations.

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John E. Karayan, JD, PhD was formerly Director of Taxes of a leading software concern. He is currently a Chair and Professor of Accounting at Woodbury University, and a testifying Expert Witness on accounting and tax issues.