Yesterday the United States Supreme Court overruled decades of legal precedent governing taxation for online purchases. The decision, South Dakota v. Wayfair, Inc., No. 17-494 (June 21, 2018) changes the national standard on when an online business must collect and remit taxes under the states’ respective tax laws. Specifically, the Court ruled that an out-of-state seller’s “physical presence” is not necessary for the state to compel the company to collect and remit its sales tax, overruling prior cases on the matter (Quill Corp. v. North Dakota By and Through Heitkamp and National Bellas Hess, Inc. v. Department of Revenue of State of Ill.)
In a typical retail transaction, states tax the retail sale of goods and services within their state. The sellers are generally required to collect and remit the sales tax to the state, but when they do not, the in-state customers must pay a “use tax” at the same rate (consumer compliance rates are “notoriously low” which can cause states to lose billions). This model did not previously apply to businesses operated entirely out-of-state, without any physical presence, such as an office, warehouse, or any employees.
The state of South Dakota sought to challenge the present taxing standard by passing a legislative measure in 2016, entitled “An Act to provide for the collection of sales tax from certain remote sellers . . . and to declare an emergency.” The Act did not apply to all remote sellers, but those who deliver more than $100,000 of goods or services into the state annually or engage in 200 or more separate transactions for the delivery of goods or services into the state.
To test its new statute, South Dakota filed a declaratory judgment suit against Wayfair, Inc., Overstock.com, Inc., and Newegg, Inc., leading online retailers with billion dollar revenues, who have no employees or real estate in South Dakota (and who did not collect and remit state sales tax). Each company shipped goods to South Dakota purchasers and met the Act’s minimum revenue or transactions requirement.
The trial court granted summary judgment for Defendants under the Quill physical presence test. The Supreme Court affirmed, noting that Quill remained the controlling precedent on interstate collection and use taxes.
The Supreme Court granted certiorari to re-examine under the Commerce Clause when an out-of-state seller can be required to collect and remit a sales tax for a consumer’s purchase of goods or services within the state. Justice Kennedy first conveyed a long history lesson on the development of case law under the Commerce Clause, calling out two guiding principles: 1) state regulations may not discriminate against interstate commerce and 2) states may not impose undue burdens on interstate commerce. In a 5-4 decision, the Court returned to the test set forth in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), finding that a tax should be sustained if it “(1) applies to an activity with a substantial nexus with the taxing State, (2) is fairly apportioned, (3) does not discriminate against interstate commerce, and (4) is fairly related to the services the State provides.”
In setting forth the new (and less restrictive) standard, the Court noted that “[e]ach year, the physical presence rule becomes further removed from economic reality and results in significant revenue losses to the States.” The Court referenced that, in the context of jurisdictional disputes, businesses need not have a physical presence to satisfy due process and be subject to a state’s laws.
The Court held that the modern economic realities do not comport with the current model developed in 1992, when less than 2 percent of Americans had Internet access. Now, e-commerce retail sales are estimated at half a trillion dollars, noting that last year, e-commerce grew at four times the rate of traditional retail. In turn, the Court noted that states are estimated to lose from $8 to $33 billion through the inability to collect such taxes. Moreover, the Court concluded that the physical presence rule is practically unworkable; for example, Massachusetts proposed a law defining physical presence to include having mobile apps available for download by residents and placing cookies on the in-state residents’ web browsers. The Court balked at how many “technical and arbitrary” disputes such statutes would attract.
Ultimately, under the Complete Auto standard, the Court found that South Dakota’s tax statute satisfied the “substantial nexus” requirement for imposing a duty on online retailers to collect and remit sales tax.
Why it matters?:
The Supreme Court’s holding in Wayfair is extremely significant because it levels the competitive “playing field” between brick-and-mortar shops and online-only businesses. (The ruling actually caused shares of certain Internet retailers like Amazon Inc., Wayfair, Inc. EBay, Inc. and Etsy, Inc. to drop.) Some retailers, like Amazon, already charge a sales tax to consumers in states that impose one, but only when selling its own inventory, not acting as a platform for third-party merchants. This model will may need to be reevaluated under this ruling. The decision also adds potential hurdles for small, online-only businesses, as they will need to navigate states’ tax laws or engage software or services to assist. States have long criticized the prior standard and will be quick to take advantage of the new revenue stream (12 states have already developed such laws in advance of the court’s decision).