48 Forces Companies to Wrestle with Uncertain State Nexus Standards
Michael S. Schadewald
MAY 2008 - In
June 2006, FASB issued Interpretation 48, Accounting for Uncertainty
in Income Taxes—An Interpretation of FASB Statement No. 109.
The purpose of FIN 48 is to increase the comparability of how companies
report the risk that a taxing authority will audit a filed tax return
and assess additional taxes by providing guidance on how to account
for uncertain tax positions. FIN 48 applies only to income taxes,
and is effective for fiscal years beginning after December 15, 2006
(December 15, 2007, in the case of certain nonpublic enterprises).
48, a corporation may recognize the benefit of an uncertain tax
position only if there is a more than 50% likelihood that the
tax position will be sustained upon examination. In making this
determination, it is assumed that the tax position will be audited
and that the taxing authority has full knowledge of all relevant
information. Thus, the determination of whether a tax position
will be sustained is based solely on the technical merits of the
position, including the applicable tax laws and the relevant facts
and circumstances. If the past administrative practices and precedents
of the taxing authority are widely understood, they should be
taken into account as well.
Nonfiling Positions Pose Unique Challenges
states and the District of Columbia impose corporate income taxes.
It is clear that a corporation must file an income tax return
in a state in which it has a regular physical presence, such as
an office or other fixed place of business. It is not always clear,
however, whether a corporation must file an income tax return
in a state in which it has customers but no physical presence.
Nexus is the concept used to describe the threshold level of in-state
business activity that gives a state jurisdiction to impose a
tax on an out-of-state corporation.
face two dilemmas when applying FIN 48 to a position that a business
is not required to file an income tax return in a particular state.
First, there is a substantial controversy over whether a corporation
must file returns and pay income tax in a state in which it derives
a significant amount of income but has no physical presence. Because
nexus is a gray area of the law, it may be difficult to conclude
that there is a more than 50% likelihood that a nonfiling position
will be sustained in such states. Second, if this more-likely-than-not
recognition threshold is not met, FIN 48 requires a corporation
to record a liability for the full amount of the potential unpaid
state income taxes, including interest and any penalties. Recording
this contingent liability is problematic—if a return is
not filed in a state, the statute of limitations never closes
and the liability may remain on the corporation’s balance
of the problem is highlighted by a January 8, 2007, comment letter
to FASB (FASB File Reference 1215-U01) from the Council on State
Taxation, a leading trade association devoted to state tax issues.
According to the letter, “the problem with FIN 48 and nexus
is so great that at least one accounting firm has publicly suggested
that businesses should consider filing and paying taxes in jurisdictions
where they may not have nexus because the alternative under FIN
48 (indefinite reserves, interest, and penalties) is too large
a dollar figure for the financial statement to bear.”
Protections Against State Taxation
attempt to impose income taxes on out-of-state corporations to
the fullest extent permissible under the U.S. Constitution. Therefore,
a corporation generally must file an income tax return in any
state in which its in-state business activity creates a “constitutional
nexus.” The only other federal restriction on state tax
jurisdiction is the limited protection provided by Public Law
86-272 (1959), which prohibits a state from imposing a net income
tax on an out-of-state corporation that strictly limits its in-state
business activity to representatives soliciting orders for sales
has constitutional nexus in any state in which the requirements
of both the Due Process Clause and the Commerce Clause are satisfied.
The Due Process Clause provides that no state shall “deprive
any person of life, liberty or property, without due process of
law.” To satisfy this requirement, there must be a “minimum
connection” between the state and the corporation it seeks
to tax [Miller Bros. Co. v. Maryland, 347 U.S. 340 (1954)].
The Commerce Clause gives Congress the power to regulate interstate
commerce, and prohibits states from imposing taxes that unduly
burden interstate commerce. Among other things, this means a state
may tax a corporation only if its activities have a “substantial
nexus” with the state [Complete Auto Transit, Inc. v.
Brady, 430 U.S. 274 (1977)].
the Supreme Court established the principle that constitutional
nexus requires an in-state physical presence [National Bellas
Hess, Inc. v. Dept. of Revenue, 386 U.S. 753 (1967)]. Bellas
Hess was a mail-order vendor based in Missouri. It solicited orders
for merchandise through the mail, and made deliveries by mail
or common carrier. The Court ruled that Illinois could not force
Bellas Hess to collect sales tax on sales to Illinois residents
because Bellas Hess had no offices, outlets, tangible property,
salespersons, or any other type of physical presence in Illinois.
The Court reasoned that a mail-order vendor “whose only
connection with customers in the State is by common carrier or
the United States mail” should not be required to collect
sales tax because this could entangle the interstate business
in a “welter of complicated obligations.”
the Supreme Court reaffirmed the Bellas Hess physical-presence
test in another mail-order/sales tax case [Quill Corp. v.
North Dakota, 504 U.S. 298 (1992)]. Quill was a mail-order
vendor of office supplies that had no physical presence in North
Dakota. The Court concluded that an in-state physical presence
was required to satisfy the “substantial nexus” test
under the Commerce Clause, and therefore North Dakota could not
force Quill to collect sales tax on sales within the state. Notably,
however, the decision did not specifically address the issue of
whether the physical-presence test also applied to income tax
Supreme Court’s ruling in Quill, a major controversy
has been whether the Bellas Hess physical-presence test
for constitutional nexus applies to income taxes. Many states
assert that a physical presence is not required for income tax
nexus, and that a significant economic presence (i.e., deriving
a substantial amount of income from sources within the state)
is sufficient to create income tax nexus. This “economic
nexus” concept has been the subject of extensive litigation,
and state courts have issued conflicting rulings. The highest
courts in several states have ruled that the Bellas Hess physical-presence
test does not apply to income taxes, whereas appellate courts
in several other states have come to the opposite conclusion.
This controversy makes it difficult for a corporation to conclude
that FIN 48’s more-likely-than-not recognition threshold
is met with respect to a nonfiling position in a state where the
corporation derives significant income but has no physical presence.
the theory of economic nexus has been a tool that states have
used to combat the use of trademark holding companies (also known
as intangible property companies or passive investment subsidiaries).
In a nutshell, this tax-avoidance strategy involves the transfer
of valuable trademarks to a Delaware holding company, which then
licenses the use of the trademarks to related operating companies.
The royalty payments are potentially deductible by the operating
affiliates, but the royalty income of a trademark holding company
is not taxed by Delaware. In an attempt to tax the royalties paid
to the out-of-state holding company, many states assert that the
licensing of intangibles for use in a state is sufficient to create
income tax nexus.
Ruling that Physical Presence Is Not Required
state supreme court to rule that an out-of-state corporation “need
not have a tangible, physical presence in a state for income to
be taxable there” was South Carolina, in Geoffrey, Inc.
v. South Carolina Tax Commission [437 S.E.2d 13 (S.C. 1993)].
Geoffrey, Inc., was the Delaware trademark holding company of
the toy retailer, Toys “R” Us. Geoffrey licensed the
use of its intangibles to affiliates operating stores in South
Carolina, but did not have a physical presence in the state. The
South Carolina Supreme Court concluded that “by licensing
intangibles for use in this State and deriving income from their
use here, Geoffrey has a ‘substantial nexus’ with
South Carolina,” as required by the Commerce Clause.
motivated numerous states to enact statutes or promulgate regulations
which asserted that the licensing of intangibles for use in the
state is sufficient to create income tax nexus. Appellate courts
in several states have upheld these laws, ruling that the Bellas
Hess physical-presence test does not apply to income taxes
[see Kmart Properties, Inc. v. Taxation and Revenue Dept.
of New Mexico, 131 P.3d 27 (N.M. Ct. App. 2001), writ quashed,
131 P.3d 22 (N.M. 2005); A&F Trademark, Inc. v. Tolson,
605 S.E.2d 187 (N.C. 2004), cert. denied, 611 S.E.2d 168 (N.C.
2005), cert. denied, 126 S.Ct. 353 (2005); Geoffrey, Inc.
v. Oklahoma Tax Commission, 132 P.3d 632 (Okla. Civ. App.
2005; and Bridges v. Geoffrey, Inc, La. Ct. App., No.
2007 CA 1063 (Feb. 8, 2008)]. Each case involved a Delaware trademark
holding company licensing the use of its intangibles to affiliates
operating retail stores. For example, the A&F Trademark
case involved the clothing retailer Abercrombie & Fitch.
recent high-profile economic nexus case dealing with trademark
holding companies is Lanco, Inc. v. Division of Taxation [908
A.2d 176 (N.J. 2006); cert. denied, U.S. Sup. Ct., 06-1236, June
18, 2007]. The New Jersey Supreme Court ruled that the Delaware
trademark holding company of the clothing retailer Lane Bryant
had income tax nexus in New Jersey, even though it had no physical
presence in the state. The court concluded that “the better
interpretation of Quill is the one adopted by those states
that limit the Supreme Court’s holding to sales and use
taxes.” The court also stated that “we do not believe
that the Supreme Court intended to create a universal physical-presence
requirement for state taxation under the Commerce Clause.”
decision by the West Virginia Supreme Court of Appeals makes it
clear that the economic nexus issue is not limited to licensing
intangibles for use in a state. In Tax Commissioner v. MBNA
America Bank, N.A. [640 S.E.2d 226 (W. Va. 2006); cert. denied,
U.S. Sup. Ct., 06-1228, June 18, 2007], the taxpayer was a Delaware
bank that issued credit cards, extended unsecured credit, and
serviced the credit card accounts of customers nationwide. Although
MBNA did not have a physical presence in West Virginia, during
one of the tax years in question, it derived more than $10 million
of gross receipts from customers in the state. The West Virginia
Supreme Court of Appeals concluded that the Bellas Hess
physical-presence test “applies only to state sales and
use taxes and not to state business franchise and corporation
net income taxes,” and that MBNA had “a significant
economic presence sufficient to meet the substantial nexus”
test under the Commerce Clause. The court also made the following
that the Bellas Hess physical-presence test, articulated
in 1967, makes little sense in today’s world. In the previous
almost forty years, business practices have changed dramatically.
When Bellas Hess was decided, it was generally necessary
that an entity have a physical presence of some sort, such as
a warehouse, office, or salesperson, in a state in order to
generate substantial business in that state. This is no longer
true. The development and proliferation of communication technology
exhibited, for example, by the growth of electronic commerce
now makes it possible for an entity to have a significant economic
presence in a state absent any physical presence there. For
this reason, we believe 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
Ruling that a Physical Presence Is Required
Penney National Bank v. Johnson [19 S.W.3d 831 (Tenn. Ct.
App. 1999), aff’d, No. M1998-00497-SC-R11-CV (Tenn. 2000),
cert. denied, 531 U.S. 927 (2000)], the Tennessee Court of Appeals
ruled that a Delaware bank’s credit card activities did
not create income tax nexus because the bank did not have a physical
presence in the state. The court reasoned that “[w]hile
it is true that the Bellas Hess and Quill decisions
focused on [sales and] use taxes, we find no basis for concluding
that the analysis should be different in the present case.”
in Rylander v. Bandag Licensing Corp. [18 S.W.3d 296
(Tex. App. 2000), review denied, No. 00-0646 (Tex. 2001)], the
Texas Court of Appeals concluded that: “While the decisions
in Quill Corp. and Bellas Hess involved sales
and use taxes, we see no principled distinction when the basic
issue remains whether the state can tax the corporation at all
under the Commerce Clause.” In Guardian Industries Corp.
v. Dept. of Treasury [499 N.W.2d 349 (Mich. Ct. App. 1993),
appeal denied, 512 N.W.2d 846 (Mich. 1994)], the Michigan Court
of Appeals concluded that “after Quill, it is abundantly
clear that [a taxpayer] must show a physical presence within a
target state to establish a substantial nexus to it.” Finally,
in ACME Royalty Co. and Brick Investment Co. v. Department
of Revenue [96 S.W.3d 72 (Mo. 2002)], the Missouri Supreme
Court ruled that, based on the applicable state statutes, licensing
intangibles for use in Missouri was not sufficient to create income
tax nexus; the opinion did not, however, discuss the Bellas
Hess physical- presence test.
for Federal Intervention
Supreme Court has the ability to resolve the economic nexus controversy,
and the issuance of FIN 48 provides the Court with an additional
motivation for doing so. One option would be to clarify that the
Bellas Hess physical-presence test applies to income
tax nexus. This would make it easier to conclude that FIN 48’s
more-likely-than-not recognition threshold is satisfied with respect
to a nonfiling position in a state from which the corporation
derives significant income but has no physical presence. The Supreme
Court’s other option would be to clarify that a significant
economic presence is sufficient to create income tax nexus. A
key issue under this option would be the types or amounts of in-state
income that would justify taxation. The Multistate Tax Commission,
an intergovernmental state tax agency based in Washington, D.C.,
has proposed that an appropriate nexus standard is annual in-state
sales of more than $500,000 [“Factor Presence Nexus Standard
for Business Activity Taxes,” released October 17, 2002].
In both the
Lanco and MBNA America Bank cases, the taxpayer
filed petitions for a writ of certiorari with the U.S. Supreme
Court. On June 18, 2007, the Court denied both petitions, which
suggests that it does not want to address the economic nexus issue
at this time. In the near term, then, it may be up to Congress
to resolve the issue.
has the authority under the Commerce Clause to enact federal legislation
to define the threshold level of business activity that creates
income tax nexus. During the 109th Congress, bills were introduced
in the House and the Senate to create physical presence standards
for income tax nexus [H.B. 1956, introduced April 28, 2005, and
S.B. 2721, introduced May 4, 2006]. Neither bill was enacted into
law. The Business Activity Tax Simplification Act [H.B. 1956]
generally would have prohibited a state from imposing an income
tax unless a corporation had a physical presence in the state
on more than 21 days during a tax year. Similar legislation has
been introduced in the 110th Congress [H.R. 5267, introduced Feb.
7, 2008]. In light of the Supreme Court’s refusal to grant
certiorari in Lanco and MBNA America Bank, there
may be increased pressure on Congress to enact nexus legislation.
resolution of the issue at the federal level, state courts will
remain split as to whether the Commerce Clause permits a state
to impose an income tax on a corporation that has a significant
economic presence in a state but no physical presence. This gray
area of the law often makes it difficult for a corporation to
conclude that FIN 48’s more-likely-than-not recognition
threshold is satisfied with respect to a nonfiling position in
a state where the corporation derives a significant amount of
income but has no physical presence. FIN 48 makes the state tax
nexus controversy an important financial reporting issue, with
potential consequences for corporate shareholders and the financial
S. Schadewald, PhD, CPA, is an associate professor of taxation
in the school of business administration at the University of Wisconsin–Milwaukee.