Factor Presence Nexus Rules Challenged in Ohio

A determination of nexus based solely on sales made to customers in another state, without any other connection to that state, may violate the Commerce Clause of the Constitution.

It often comes as a surprise to taxpayers at year-end that they must file and pay taxes to the state of Ohio when they have never set foot in the state. Starting with 2005, Ohio began to restructure its corporate tax regime, shifting from a traditional income and franchise tax to a tax based solely on gross receipts earned from Ohio customers. As part of this change, nexus rules were broadened to include the concept of factor presence nexus, a type of economic nexus, whereby a business is deemed to have created sufficient contact with the state to be taxed solely by meeting a certain threshold of sales, property or payroll in the state during the tax year. [1]

Ohio’s factor presence rules, identified as “bright-line presence” in the tax statutes, require an out-of-state taxpayer to file and pay Ohio Commercial Activity Tax (CAT) when the business has at least $500,000 in taxable gross receipts, property valued at $50,000 or payroll of $50,000 in Ohio during the tax year. [2] Further, the factor presence test is met if the Ohio portion of any one of these three factors represents at least 25 percent of the taxpayer’s total receipts, property, or payroll for the year. Under these rules, a business can be deemed to have tax filing requirement when their only Ohio activity is making sales to customers located in the state. [3]

A determination of nexus based solely on sales made to customers in another state, without any other connection to that state, may violate the Commerce Clause of the Constitution. The U.S. Supreme Court previously established in National Bellas Hess v. Illinois, 386 U.S. 753 (1967) and Quill v. North Dakota, 504 U.S. 298 (1992) that substantial nexus under the commerce clause requires a physical presence for sales and use tax purposes. Since Quill, the U.S. Supreme Court has declined to hear related nexus cases. [4] Since Quill addressed nexus for sales and use taxes, many states have enacted laws or otherwise taken an administrative position that the physical presence requirement established in that case does not extend to other types of taxes, such as gross receipts taxes like the CAT. [5] The enduring issue is whether merely making sales to customers located within a state, without any other contact with the state, satisfies the substantial nexus requirement under the Commerce Clause for taxes other than sales and use taxes.

Two legal challenges are currently proceeding through Ohio’s court system under which the constitutionality of the factor presence rules may ultimately be determined: Crutchfield v. Testa and Newegg v. Testa. Both plaintiffs are online retailers with no physical presence in Ohio and argue that nexus based on sales factor presence alone violates the Commerce Clause by assessing state tax without substantial nexus.

The Ohio Board of Tax Appeals ruled earlier this year that it does not have jurisdiction to rule on the constitutionality of Ohio’s factor presence law and that the plaintiffs have nexus under the factor presence rules as they exist under Ohio law. Both plaintiffs have now filed appeals with the Ohio Supreme Court regarding the constitutionality, a path that may ultimately lead to the U.S. Supreme Court.

Decisions on these two Ohio cases should be instructive for the Ohio CAT and may end up providing guidance for other states as well, since several other states have implemented similar factor presence nexus laws. [6] HA&W’s SALT group will continue to monitor these cases and will provide any updates in future issues of the newsletter.

Jeff Glickman, partner-in-charge of HA&W’s SALT practice, at jeff.glickman@aprio.com for more information.

[1] Under the Constitution as interpreted by the Supreme Court, states may only require those taxpayers with substantial nexus to file tax returns and pay taxes. State rules may differ on what level of activity constitutes substantial nexus, and these issues are often the subject of state tax disputes and litigation.

[2] Ohio Rev. Code Ann. § 5751.01(H)(3).

[3] No in-state solicitation, travel, contractors or other physical presence is necessary. The sales to Ohio customers alone are deemed to create substantial nexus when they exceed $500,000 or 25 percent of total sales annually.

[4] The Quill opinion indicates the court would prefer legislative resolution by Congress.

[5] Others argue that the physical presence nexus standard set forth in Quill should apply regardless of the type of tax involved.

[6] States with factor presence rules include California, Colorado, Connecticut, Michigan, Ohio, New York, Tennessee (effective for tax years beginning on or after Jan. 1, 2016 – see the Legislative Update article in this newsletter for more information) and Washington.

[7] Texas Admin Code Section 3.286(b)(2).

[8] 40 TexReg 3183 (May 29, 2015).

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