In March 2001, Arkansas enacted a sales tax law specifically targeting out-of-state Internet, facsimile and telephone-based retailers ("e-retailers") that have no connection with the state other than an ownership affiliation with a business with a physical presence (a "brick and mortar" business) operating in the state. Last year, the California legislature passed a similar law, but the Governor of California vetoed that law.
Under the Arkansas law, effective as of January 1, 2002, out-of-state e-retailers that sell tangible personal property into Arkansas by electronic means (for example, the Internet, facsimile, or telephone) or non-electronic means (for example, mail order) will be required to collect Arkansas’ 5.125% tax on those sales if the following two conditions are satisfied.
- The e-retailer must have a substantial interest in a brick and mortar business that operates in Arkansas. For this purpose, an e-retailer will be considered to have a substantial interest in a brick and mortar business if it owns or is owned, directly or indirectly, by the brick and mortar business or that business’ parent company.
- The e-retailer must be selling products similar to those sold by the brick and mortar business under a similar business name, or the facilities of the brick and mortar business must be used to advertise or promote sales of the e-retailer.
The Arkansas law is apparently intended to deal with the perceived phenomenon of brick and mortar businesses creating Internet subsidiaries in order to sell products over the Internet without the obligation to collect the sales taxes that would otherwise apply if the brick and mortar businesses sold the products directly.
Constitutional challenges to the law are expected. The U.S. Supreme Court has held that the Constitution requires a business to have a physical presence, or "nexus," within a state before the state can require the business to collect sales or use taxes on sales into the state. The mere sale of goods into the state, without also establishing a physical presence in the state (for example, by opening an office), is not itself sufficient to create nexus for this purpose.
In light of this constitutional restriction, many states have attempted to supply an in-state physical presence for out-of-state businesses by attributing to them the in-state presence of a related business. These attempts have been premised on at least one of three theories: (i) an agency theory; (ii) an alter-ego theory; and/or (iii) a unitary theory. Under the agency theory, the presence in the taxing state of an agent for an out-of-state business may be attributed to the out-of-state business. Under the alter-ego theory, where an out-of-state business is completely dominated by or completely dominates a business operating in the taxing state, the taxing state may attempt to treat the two as alter-egos of one another and thereby impose its taxing jurisdiction over the out-of-state business. Finally, under the unitary theory, an out-of-state business may be subject to a state’s taxing jurisdiction based on some legal relationship other than agency or alter-ego (typically a mere affiliation) with a business operating in the state.
The new Arkansas law is apparently based on the unitary theory, and it almost certainly will be attacked as such. Although states, in limited circumstances, have been able to deflect court challenges to their collection of sales and use taxes based on the agency and alter-ego theories, states have so far had no success with the unitary theory, which has been discredited by the few courts that have considered it.
For example, a California law based on the unitary theory was found unconstitutional by the California Court of Appeals in 1994 and was subsequently repealed. In Current, Inc. v. State Board of Equalization, 24 Cal. App. 4 th 382 (1994), the Court concluded that, in light of the physical presence test established by the U.S. Supreme Court, the mere affiliation with a parent corporation that was engaged in business in California was not sufficient to establish nexus for an out-of-state subsidiary engaged in a mail-order business.
Perhaps in recognition of the uncertainty surrounding attributional nexus, recently proposed federal legislation would require states to follow the agency theory of attributional nexus and preclude them from asserting the more expansive unitary theory. Under the bill, a state could only require a business to collect its sales taxes if that business had a substantial physical presence in the state. For this purpose, neither the use of the Internet to sell into the state nor an affiliation with a business operating in the state would be sufficient to create nexus. However, an agency relationship with a business operating in the state would be sufficient to create nexus for the out-of-state business.
Previously, Congress did address the issue of Internet taxation when it passed the Internet Tax Freedom Act of 1998, which we discussed in our August 1, 1999 Internet Alert. That statute created a three year moratorium on: (i) new taxes on Internet access; (ii) multiple taxes on e-commerce; and (iii) discriminatory taxes on e-commerce. It is unclear, however, whether the Internet Tax Freedom Act is broad enough to preclude the enactment of state legislation such as the new Arkansas law.
In any event, at least three things are clear. First, the new Arkansas law almost certainly will be challenged. Second, other states may follow the example now set by Arkansas. Third, businesses will now have to be even more cautious in establishing Internet sales companies.
C. Kenneth Strachan