The Out-of-State-Business Tax Grab

As states struggle to boost their revenues, one strategy has become increasingly popular regardless of political party: taxing out-of-state businesses.

The latest example is Tennessee, whose Republican Gov. Bill Haslam proposed a “Revenue Modernization Act” last month. It would require firms selling $500,000 or more to residents to pay the state’s corporate-franchise tax—a 0.25% levy on a company’s local net worth—even if these firms have no physical presence in the state. If the measure passes, Tennessee would join more than three-dozen states (according to a Bloomberg BNA Survey) that have changed the rules for when they impose income or other business taxes on a company not located in-state.

California, New York, New Jersey, Michigan and Massachusetts are among the most aggressive, according to CFO magazine. But Pete Vegas, CEO of Los Angeles-based Sage V Foods, which sells ingredients to food-processing companies, might add Washington to that list.

Testifying before a House subcommittee in February 2014, Mr. Vegas explained that one of his trucks on a delivery run was stopped at a Washington state weigh station in 2010. Shortly after, the company got a request for information from the state’s tax authorities. Because the firm admitted that its employees visit the state once a year, it was hit with a bill for $180,266.95 in back taxes, penalties and interest—though Sage V has no operations in Washington. The company is now assessed $20,000 annually by Washington’s Business and Occupation Tax, though, as Mr. Vegas told Congress, he already pays taxes on Sage V’s income in four states where the company has actual operations.

Exercising its constitutional authority to regulate commerce among the states, Congress has long sought to limit a state’s ability to collect taxes from businesses not based within its borders. The 1959 Interstate Income Act prohibits states from imposing an income tax on a business with no physical presence in a state merely because the firm solicited orders in-state.

In 1967 the Supreme Court ruled (National Bellas Hess v. Illinois) that Illinois could not require that a Missouri mail-order company collect sales tax on its goods shipped into the state. But North Dakota tried again in the early 1990s, claiming it could force an out-of-state catalog retailer named Quill to collect sales tax on goods it shipped into the state. Its “presence”? The company provided North Dakota customers with software on floppy disks to make their orders.

The Supreme Court rejected that argument in 1992 (Quill Corp. v. North Dakota), but it acknowledged that in a rapidly changing technological landscape states might need new clarification from Congress about how to determine when a company has a “substantial nexus” in a state for tax purposes.

Unfortunately, Congress has failed to clarify this issue, and states have slowly taken matters into their own hands. For example, 33 states, including Michigan, Rhode Island and Florida, have focused on gobbling up more in corporate-income taxes from out-of-state firms that derive profits from non-tangible products like software, or services like cloud computing, that are not explicitly protected by the 1959 Interstate Income Act.

“Physical presence” has been stretched to absurdity. In a 2014 survey by Bloomberg BNA, 27 states said that if a company hosted its website on a leased Web server located in their state they would consider that sufficient to declare the business owed income taxes to them. Twenty-one states said an out-of-state firm that sent an employee to attend a job fair or otherwise recruit in their state would trigger a tax nexus. An executive told CEO Magazine in 2013 that “given New York’s onerous tax regulations, we are seriously going to consider whether we allow employees to travel to or participate in events in that state. We can’t afford for N.Y. to become a tax nexus for us.”

Trade groups and multistate businesses argue that states should not collect income tax on a business that receives no significant local government services. They support legislation to extend the Interstate Income Act to the sale of goods like software and online services. The legislation, known as the Business Activity Tax Simplification Act, has been introduced several times in Congress, most recently in 2013 by Rep. James Sensenbrenner Jr. (R., Wis.). It has gone nowhere.

Meanwhile, states continue pressing Congress to pass the Marketplace Fairness Act, which was reintroduced in the Senate earlier this month and would force online, out-of-state retailers to collect sales tax. In the meantime, Justice Anthony Kennedy observed earlier this month (Direct Marketing Association v. Brohl) that because technological changes have deprived states of sales-tax revenues from online transactions, the court should reconsider its previous rulings. He all but invited states to challenge the Quill precedent.

But as Justice Kennedy and members of Congress ponder when it is fair to collect sales taxes, they ought to also consider the ways states are exploiting technological changes to squeeze more income-tax revenues out of often unwary businesses. Updating tax fairness in a technological age should be a two-way affair.

This piece originally appeared in Wall Street Journal

This piece originally appeared in The Wall Street Journal