Arizona Court Reversal: Online Retailer’s Use of In-State Fulfillment Company Created Nexus

By: Tracey Stewart, SALT Associate

At a glance

• The main takeaway: The Arizona Court of Appeals reversed a lower court ruling in the taxpayer’s favor and held that activities of third-party fulfillment centers created physical presence nexus. 
• Assess the impact: Businesses must be aware of the in-state activities done by independent contractors as they could trigger sales tax nexus and collection/filing obligations.   
• Take the next step: Unsure of your sales tax nexus footprint? Aprio’s State and Local Tax (SALT) team can help you understand your sales tax obligations.

Schedule a free consultation today to learn more!

The full story:

In our July 2023 SALT Newsletter, we wrote an article summarizing an Arizona Tax Court (Tax Court) ruling that an online auto parts distributor that contracted with six third-party fulfillment centers in Arizona did not have physical presence in the state. On April 2, 2024, the Arizona Court of Appeals (Court of Appeals) reversed that decision, concluding that the in-state presence of suppliers that fulfilled customer orders created physical presence for the taxpayer in Arizona.[1]

Background of the case

The taxpayer, RockAuto (or the Company) is an online auto-parts retailer based in Madison, Wisconsin, that disputed Arizona Department of Revenue’s (DOR) assessment of sales tax for the audit period from April 1, 2013 through April 30, 2019. Since Arizona’s economic nexus rules did not become effective until October 1, 2019, this case addressed whether RockAuto had physical presence nexus in Arizona.

The Company did not have any office or employees in Arizona. However, it contracted with at least six in-state suppliers (i.e., independent contractors) that fulfilled customer orders. When a customer ordered a part on the website, the customer is given the option to select “Choose for Me to Minimize Cost,” where different suppliers of the same auto part might be selected in a way to minimize total cost of the part plus shipping cost. As a result, 89% of orders that RockAuto placed with Arizona suppliers shipped to customers outside of Arizona, while 83% of RockAuto’s sales to Arizona customers came from suppliers outside Arizona.

Additional facts noted by the Court of Appeals that were not specifically mentioned and presumably not viewed as relevant by the Tax Court were:

• RockAuto made its suppliers use RockAuto’s branded tape and include a promotional magnet with each order shipped. 
• RockAuto employees visited Arizona four times to meet with and to strengthen relationships with suppliers. 

Unpacking the ruling

The Tax Court and the Court of Appeals applied the same nexus principle that looks at whether the independent contractor’s (i.e., the supplier’s) activities in the state are “significantly associated with the taxpayer’s ability to establish and maintain a market in this state for the sales.”[2] In ruling for RockAuto, the Tax Court was persuaded by the fact that the suppliers’ activities were not specifically directed towards Arizona customers, as evidenced by the low percentage of Arizona sales that were fulfilled by the in-state suppliers.

However, the Court of Appeals disagreed with the Tax Court’s analysis. The decision notes that “an activity need not produce business in order to create nexus.” In other words, it is the nature of the activity that is relevant, not whether the activity itself includes direct in-person contact with customers. For example, the Court of Appeals noted that the suppliers use branded tape and included a promotional magnet. 

In addition, the Court of Appeals also dismissed the Company’s claim that its suppliers did not aim to maintain an Arizona market because it chose which supplier would fulfill an order based on inventory and cost rather than location. In other words, it did not matter to the Court of Appeals that only about 10% of the sales fulfilled by Arizona suppliers were shipped to Arizona customers or that 83% of sales to Arizona customers were fulfilled by out-of-state suppliers. The Court of Appeals stated that a “representative’s in-state activities support concluding a taxpayer has a physical in-state presence, even when the representative is predominately focused on serving an out-of-state market.”[3]

The bottom line

Despite most of the sales tax nexus news focusing on the Wayfair case and state economic nexus rules, it is important to remember that physical presence nexus is alive and well. Businesses need to be aware of the activities done by their independent contractors, as those activities in a state may create a physical presence nexus and trigger sales tax obligations. Moreover, those activities may also create income tax nexus, thereby requiring the business and/or its owners to file income tax returns and pay income tax to the state. 

Aprio’s SALT team has experience helping companies understand their sales tax nexus footprint, both physical and economic. We will assist your business to determine its state tax compliance obligations so that you do not incur any unexpected tax liabilities and penalties. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

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[1] RockAuto, LLC v. Arizona Department of Revenue, No. 1 CA-TX 23-0002 (Az. Ct. App. Div. One, April 2, 2024).  RockAuto has appealed this decision to the Arizona Supreme Court, so this may not be the last word.

[2] Tyler Pipe v. Wash. Dep’t of Rev., 483 U.S. 232, 250 (1987).

[3] The Court also noted that in addition to the suppliers’ activities, the four employees visits further support the conclusion that RockAuto had physical presence in Arizona, although the Court did not address whether those trips alone would have been sufficient.