Public Law 86-272 Reaches Its 60-Year Anniversary

This regular Tax Notes State column is called Moving Forward? The question mark is used because many state (and federal) tax laws remain outdated, and often proposals for change seem to better address the economy, society, environment, and technology of the 20th century (sometimes even of the 19th century) rather than the 21st century’s global marketplace and the rapidly advancing technology innovations that mark this time period as the fourth Industrial Revolution.¹ That P.L. 86-272 — intended as a stopgap measure — remains in its same form after 60 years is a good (and sad) example of not moving state tax systems forward into the modern era.

This article begins with the same words from my 2009 article discussing the 50th anniversary of P.L. 86-272, just changing 50 to 60.²

This article won’t repeat the background that led Congress to enact P.L. 86-272 in 1959, as that was covered in the 2009 article along with an explanation of the legislation. That article also noted the extensive analysis and proposals for multistate taxation reform by the Willis Commission, which was also created by the 1959 legislation; noted that many of the issues that led to P.L 86-272 remained in 2009; and discussed lessons learned and suggestions for moving forward.³

Major developments since writing about the 50th anniversary of P.L. 86-272 include the U.S. Supreme Court’s 2018 decision in Wayfair Inc. and the current work of the Multistate Tax Commission’s P.L. 86-272 Statement of Information Work Group.⁴

A third development is the long-standing and ongoing introduction in Congress of the Business Activity Tax Simplification Act (BATSA) to modify P.L. 86-272. This proposal aims to allow more businesses to apply the protections of P.L. 86-272 to avoid income (and perhaps other) taxes in more states. This article examines P.L. 86-272 in light of Wayfair; describes the MTC’s work in addressing modern issues of dealing with an outdated law; notes recent rulings from state tax agencies and one court; describes several issues that suggest the need to update or perhaps scrap the tangible-goods-focused P.L. 86-272; and finally, emphasizes the need to examine, clarify, and simplify not only nexus determinations but also related matters of sourcing and apportionment of multistate income.

I. P.L. 86-272 and the Wayfair Decision

No doubt, a significant event in the last 10 years occurred with the Supreme Court’s 2018 decision in Wayfair. Before this decision, the Quill case held that physical presence via tangible assets or people was necessary for a business to have sales and use tax collection obligations in a state.⁵ The significance of tangible property or people for a state’s taxing authority ended with Wayfair, which found Quill “unsound and incorrect.” Instead, the Court found a business’s “economic and virtual contacts” with a state sufficient for finding nexus for tax purposes. The Court wrote:

Wayfair is significant in today’s digital world in that having physical presence in the state is not necessary for a state or local government to impose tax collection obligations. Also significant is that the Court’s conclusion that economic nexus with a carveout for small businesses is sufficient for a state or local government to impose tax obligations was not limited to sales tax. Thus, unless a state or local government prefers physical presence as a standard, virtual presence that generates economic activity in the state can create tax obligations. Yet one more possible limit on the Court’s new economic nexus perspective is P.L. 86-272, which limits a state’s reach for income tax purposes if the statutory requirements are met. The Wayfair Court had no reason to address P.L. 86-272, as it was not before the Court. And arguably it could not find such a law unconstitutional given Congress’s commerce clause authority to regulate commerce among the states.

So P.L. 86-272 remains despite the Court’s recent finding that economic nexus can be sufficient for tax purposes. This reality is a reminder that Congress can enact legislation to limit Wayfair, and some proposals to do that have already been introduced, such as S. 128 — the Stop Taxing Our Potential Act of 2019 — which provides that a seller must have physical presence in a state for that state to impose tax collection obligations.

Barring any new federal legislation, the result after Wayfair is that an e-commerce seller of clothing with customers throughout the United States, no sales force outside State X, and a physical presence and domicile solely in State X will only have income tax obligations in State X, yet possibly have sales and use tax collection obligations in all states that impose that tax. While this vendor might have economic nexus in many states, for income tax purposes it appears to be shielded by P.L. 86-272 from having income tax obligations other than where it is physically located or domiciled.⁶

This result may seem odd for at least two reasons. First, why should the nexus standard be different for income versus other taxes? Are there sufficient reasons to justify this today in light of the Court overturning Quill and finding economic nexus sufficient for tax purposes?

Second, back when Quill was in effect, several courts found it acceptable for income tax nexus to be broader than sales tax nexus. For example, in the 2006 case Tax Commissioner of the State of West Virginia v. MBNA America Bank, the West Virginia court held that Quill only applied to sales and use taxes, and upheld the economic presence test the state used for income taxes based on the Court’s explanation in Quill and on differing compliance burdens for these taxes. The court wrote:

So, after Wayfair, we have an oddity that some vendors may have significant sales and use tax compliance obligations yet minimal income tax compliance ones. This situation highlights the inequities of P.L. 86-272 only applying to sellers of tangible personal property. If the vendor in the earlier example sold digital books rather than clothing, P.L. 86-272 would not apply and the vendor would have income tax obligations in any state where it meets that state’s economic nexus law for income tax purposes. However, its sales tax obligations would likely be reduced relative to the clothing vendor’s obligations, as some states, such as California, don’t tax sales of intangible products.

Many examples can be offered of types of sellers of tangible goods, intangible goods, services, or combinations of these revenue-generating items that will result in many variations of state tax obligations. These tax obligations can vary depending on the amount of sales in the state (in terms of dollar amount and number of transactions), the existence of employees and their salaries, and the existence, and perhaps basis, of real and tangible personal property in the state.

Can these differing tax obligations be rationalized? After Wayfair, are there reasons to justify P.L. 86-272 only applying to sellers of tangible personal property or even continuing to exist? Do sellers of services and intangibles obtain greater benefits from the states where customers are located, or have greater capacity to file in multiple states to justify possibly owing income tax when the seller of tangible personal property might not owe income tax in as many states?⁸ A question that makes sense today that was not realistic to consider in 1959 is why P.L. 86-272 protects a seller of tangible property using state roads to deliver products from owing income tax while a seller of goods and services delivered electronically can have income tax obligations. There are many questions involving equity, neutrality, economic efficiency, and transparency to be addressed. The Court’s discussion in Wayfair of the important economic and virtual contacts e-commerce vendors have with states seems to be an invitation to all stakeholders to discuss and rethink what actions, activities, and sales or other thresholds should trigger state and local tax obligations on businesses with customers in multiple states, including when physical presence in a state should be considered in the determination of nexus.⁹

II. The MTC’s P.L. 86-272 Statement of Information Work Group

In late 2018 the MTC formed a committee to update its 1986 “Statement of Information Concerning Practices of Multistate Commission and Signatory States Under Public Law 86-272,” last updated in 2001.¹⁰ The rationale for the project is to ensure the statement addresses changes in the economy and new ways business is conducted today to provide greater clarity and uniform application.¹¹

The statement primarily “reflects the signatory states’ current practices with regard to” whether particular activities are protected under P.L. 86-272. Repairing property, collecting delinquent accounts, and picking up or replacing damaged property are examples of unprotected activities. Protected activities include soliciting sales orders using any type of advertising, checking customer inventory levels without a charge, and training sales personnel. The statement explains that any unprotected activity during the year causes all sales to fall outside P.L. 86-272 protections.

The work group poses various scenarios with discussion and vote on whether they are protected or unprotected activities. A two-step analysis is used: (1) Does the activity constitute solicitation of orders for tangible personal property, and (2) if it is determined that the activity goes beyond solicitation of orders for tangible personal property, does the activity take place in the customer’s state?¹² Likely these discussions include another challenging issue in the e-commerce arena of what constitutes a de minimis activity that can be ignored as having only a trivial connection to the taxing state.

Scenarios discussed by the work group include:¹³

• ways customers may use the seller’s website, including sending messages, engaging in chat sessions, reading posted FAQs, watching videos, or offering credit card applications;

• sellers providing apps for customers’ smartphones that enable the user to order and pay for goods;

• sellers selling to third parties and obtaining customer data from orders placed online;

• sellers or third parties using the seller’s website such as for advertising and placing cookies on the customer’s computer;

• sellers using a marketplace facilitator, such as Amazon, to help sell products; and

• customers downloading and saving a movie to watch later or watching it via streaming.

The analysis involves the need to understand the technology involved, how it works, where it takes place, and if it is analogous to a 1959-type transaction such as a phone call. The analysis requires the need to understand interactive websites, cookies, apps, and other modern technologies. Scenarios that also raise difficult questions as to the nature of the activity and its location include those that occur without human intervention such as through smart contracts on a blockchain, information created through artificial intelligence programs, and interconnectivity of devices via embedded internet of things technology to allow devices to communicate on their own.¹⁴ Continued advances in technology will require revisiting of the MTC statement and its lists of protected and unprotected activities.

While the work group’s project focuses on updating the statement of information rather than addressing when businesses should be subject to state income tax obligations, the committee’s work provides helpful information on the complexities of interpreting and uniformly applying a law written 60 years ago before the internet and its capabilities aided sales and interactions with customers.

III. Congressional Proposals Since 2009

The BATSA has been regularly proposed in Congress to modify P.L. 86-272.¹⁵ H.R. 3063 is the version in the current 116th Congress and includes the following changes to P.L. 86-272:

• Expand coverage beyond net income taxes to include any business activity tax defined as “any tax in the nature of a net income tax or tax measured by the amount of, or economic results of, business or related activity conducted in the State.” Such tax does not include a sales or use tax, a similar transaction tax, or tax imposed on the privilege of doing business.

• Expand coverage beyond tangible personal property to include “all other forms of property, services, and other transactions, fulfilled or distributed from a point outside the State; and in the case of all other forms of property, services, and other transactions, fulfilled or distributed from a point outside the State.” It would also cover “the furnishing of information to customers or affiliates in such State, or the coverage of events or other gathering of information in such State by such person, or his representative, which information is used or disseminated from a point outside the State.” Sales or transactions of a digital good or service would be covered. A digital good includes software delivered or transferred electronically. Digital services are those provided electronically including data processing, cloud computing, and providing remote access to or use of a digital good.

• Provide that states may not impose a net income or other BAT for a person’s activities in interstate commerce unless during the tax period the person has a physical presence in the state or is domiciled there. Physical presence of less than 15 days during the tax year and presence “to conduct limited or transient business activity” does not constitute physical presence.

• Specify that for group returns, the numerator of any apportionment factor only includes “factors attributable to the State of only those persons that are themselves subject to taxation by the State pursuant to the provisions of this Act and subject to all other legal constraints on State taxation of interstate or foreign commerce.”

A few hearings have been held on BATSA bills. On February 26, 2014, the House Judiciary Committee’s Subcommittee on Regulatory Reform, Commercial, and Antitrust Law held a hearing with four witnesses testifying. Two witnesses were from businesses, one from the Tax Foundation, and the other from the National Governors Association.¹⁶ On April 13, 2011, a different subcommittee of the House Judiciary Committee held a hearing on H.R. 1439. Witnesses included members of Congress, industry, the International Franchise Association, the Federation of Tax Administrators, and the Tax Foundation.¹⁷

Support for BATSA typically includes the following arguments:¹⁸

• The law reduces uncertainty for businesses by having a common standard for nexus among the states. Such uncertainty also creates issues in financial statement disclosures.

• Physical presence provides greater certainty in determining if tax obligations exist in a state.

• It reduces compliance costs by reducing the number of return filings.

• For affiliated groups, taxation in the state is limited to the members or persons that meet the physical presence requirement.

• After Wayfair, states may expand their reach for BATs with increased taxes on economic activity.

Opposing arguments to BATSA often include the following:

• It shifts tax away from multistate businesses and more toward local businesses, even though the multistate businesses may have significant economic activity in the state. Thus, some businesses will not have to pay for benefits derived from the state.

• It can encourage tax sheltering activity such as using one entity to own assets in the states with another entity without physical presence handling the sales into the state.

• It reduces state tax revenues.

• It intrudes on state authority to tax and govern.

The two most recent BATSA iterations were introduced after the June 2018 ruling in Wayfair (H.R. 6978 in September 2018 and H.R. 3063 in June 2019). Neither version mentions why section 2 of the bill on “modernization of Public Law 86-272” does not address Wayfair’s conclusion that physical presence is not the appropriate standard for state tax nexus.¹⁹ Similarly, legislation introduced in response to Wayfair doesn’t address P.L. 86-272. Suggestions for addressing state tax nexus matters in light of Wayfair and modern ways of doing business are addressed in Section V.

IV. P.L. 86-272 Rulings of Recent Years

There have been few rulings interpreting P.L. 86-272 in recent years. This may mean that past rulings have provided clarity, issues are resolved at the examination level rather than in court, or issues such as those under discussion by the MTC work group have not yet been litigated or are not always raised. Three recent rulings are summarized here as examples of interpretation matters that states and businesses have recently addressed.

A. P.L. 86-272 Workarounds Unlikely to Work

Stanislaus Food Products Co. v. Director, Division of Taxation, a 2019 ruling from the New Jersey Tax Court, involved a California company protected from New Jersey’s corporation business tax (CBT) by P.L. 86-272.²⁰ However, the state imposed its alternative minimum assessment (AMA) on Stanislaus. The AMA’s base was gross receipts (or gross profits) and the tax only applied to entities protected by P.L. 86-272.

The state’s position was that the AMA could be applied to Stanislaus because P.L. 86-272 did not protect it from a tax that is not a net income tax. The taxpayer argued that “the AMA is merely an end-run around P.L. 86-272.” The decision provided history and constitutional lessons including how P.L. 86-272 was enacted, congressional commerce clause authority, and even the role New Jersey played in 1786 and 1787 in getting that clause into the U.S. Constitution. The court explained the dormant commerce clause and how it constrains states even when Congress has not imposed specific legislation on a matter involving interstate commerce.

The court then moved to what it identified as the key constitutional issue before it — application of the supremacy clause to determine if federal law preempts a state law. First the court must determine if the federal law is a valid exercise of congressional authority or whether the matter involves a power reserved to the states. The court found P.L. 86-272 a valid exercise of power by Congress under its commerce clause authority.

Next is determining whether the state law prevents the federal law from accomplishing its objective. This task required the court to review the history and rationale of the state’s enactment of the AMA. New Jersey enacted this tax in 2002 to “assure a fair measure of support of State services from firms that exploit the State’s marketplace, but are exempt from a tax like the CBT pursuant to federal Pub. L. 86-272.” The AMA was intended to “capture the value of the activities in New Jersey of out-of-state companies that currently pay no corporate income taxes in New Jersey.”

The AMA was repealed in 2018, but Stanislaus’s case involved tax years 2012 through 2014. During this period, the AMA was zero if a corporation exempt from the CBT under P.L. 86-272 agreed to pay the CBT anyway. If the corporation did not agree, it had to pay the AMA, which, not being a net income tax, applied to corporations even if otherwise protected by P.L. 86-272.

Based on the enacting rationale and the application of the AMA only to P.L. 86-272 taxpayers, the court stated: “Any claim the AMA does not target P.L. 86-272 taxpayers simply ignores both the plain reading of the statute as well as the legislative history.” It noted that for taxpayers facing an AMA liability greater than a CBT liability, “the AMA clearly operates as an end-run around P.L. 86-272, in that it coerces a taxpayer to consent and pay the CBT which is measured by net income. Thus, when the AMA is greater than the CBT, the AMA becomes a tax measured by net income since the taxpayer would be paying the CBT.”

What about situations in which the AMA is lower than the CBT? In such cases, only the gross receipts tax (AMA) is owed. The court found that this situation still posed a conflict under the supremacy clause because CBT calculation was necessary to make the determination. Thus, the AMA was found to be part of the CBT to generate tax from P.L. 86-272 protected corporations. This made the AMA “nothing more than a de facto CBT, albeit at a potentially lower rate in cases where the AMA is lower . . . in a transparent attempt to garner lost net income tax.” The court observed that the name given to a tax doesn’t matter if its “economic effects” indicate a different type of tax.

Thus, the court found that the AMA “effectively thwarted” Congress’s purpose in enacting P.L. 86-272 and was subject to preemption. The court did note, though, that if all corporations were subject to the AMA, it would be a permissible tax.

Twice, the court wrote that it may be appropriate for Congress to review the policy underlying P.L. 86-272 because it was intended to be temporary and it raises fairness questions today “especially with the shift in the economy from a manufacturing (that is, tangible goods) economy to a service economy.” But it pointed out that it was not the court’s role to address the policy aspects; that was something the New Jersey Legislature should explore with Congress.

B. Protected Versus Unprotected Activity

TAM 2018-03 issued by the California Franchise Tax Board answers whether delivery of tangible personal property in vehicles owned by the taxpayer is a protected activity under P.L. 86-272. It concluded that it is.

The FTB wrote, however, that “any activity that goes beyond the scope of delivery, such as backhauling, is not protected activity.”²¹ The rationale ties to Wrigley’s defining of “solicitation,” and that Congress did not “specify the mode of delivery” such as limiting it to common carrier, even though P.L. 86-272 protects filling orders “by shipment or delivery from a point outside the State.”²²

The FTB explained how Wrigley helps address the question, writing that in that opinion:

That text reminds us that it is not always clear what is considered “solicitation” as evidenced by the need for the FTB to issue this memorandum in 2018. The memorandum mentions litigation in Massachusetts and Virginia on this same delivery issue in which the courts reached the same conclusion as the memorandum.

C. Modern Economy Activities

A 2016 ruling from the Virginia Tax Department is a rare ruling to address cloud computing and the state’s corporate income tax.²³ Virginia applies the P.L. 86-272 solicitation test to sales of intangible property. Finding that the taxpayer does not solicit orders in the state, per the ruling, “the issue becomes whether the taxpayer performs any unprotected activities in Virginia that create more than a de minimis connection to Virginia.”

The taxpayer is a limited liability company that through an arrangement with a software developer may license, customize, and resell the developer’s software or sell subscriptions to it. The taxpayer purchases the license agreements through the developer’s reseller. All transfers between the developer and the taxpayer and between the taxpayer and its customers are made through cloud computing services without any exchange of tangible personal property. The developer owns the servers used to host the software. One of the data centers with servers is in Virginia. The taxpayer has no access to or control over any server.

Several terms of P.L. 86-272 are applicable to the ruling, including whether the developer is the taxpayer’s representative or an independent contractor. If the developer is a contractor, there is more leeway allowed by P.L. 86-272 as to what the developer may do in Virginia with the taxpayer remaining protected. The department wrote:

The department notes that the taxpayer did not provide enough information to determine if the developer is the taxpayer’s contractor. It concludes that if the developer is a contractor and all the taxpayer does is purchase cloud computing services from the developer, these services are not attributable to the taxpayer to create nexus. If not a contractor, the developer is providing services to the taxpayer’s customers on the taxpayer’s behalf — an unprotected activity.

This ruling illustrates the importance of understanding the definitions used in P.L. 86-272, including as applied to modern activities. It also accentuates questions raised by the MTC work group on the need to know how in-state customers are engaging with a potential taxpayer through technology.

V. Would P.L. 86-272 Be Written the Same Way Today?

If a federal law were to be written anew today to limit or protect a company from state income tax obligations, what would it provide and why? It seems unlikely such a law would be limited to protecting businesses that sell tangible personal property as that would not cover most of today’s businesses. Also, what justification is there to provide greater protection to a seller of tangible personal property that clearly needs state infrastructure to carry out the sale, but offer no protection to a seller who uses little or no state infrastructure to generate revenue? Who needs protection and from what?

If the purpose of protection is to avoid numerous income tax return filing obligations, an alternative is to simplify the filing process. For example, a uniform definition of taxable income among states could allow for a standard state income tax form with the multistate income allocated among the states in a logical and constitutional manner. States could have their own rate structure and could still provide tax credits should they want to encourage or subsidize some activities.

If the purpose of protection is to avoid multiple taxation of the same income, alternatives exist for this concern as well. The modern version of P.L. 86-272 could require a uniform measure of taxable income and uniform sourcing and apportionment rules. A uniform throwback rule would reduce nowhere income and could be drafted to except income earned in states without an income tax. A uniform law would include uniform definitions. And as suggested in the Willis Commission report, issues could be resolved by a federal agency such as Treasury and the U.S. Tax Court and would apply to all states.²⁴

If the protection is intended to reduce filing costs for small businesses, a de minimis standard that must be met before tax obligations exist in a state could solve this concern. Requiring a uniform definition of what constitutes de minimis among the states would provide simplification and greater certainty for taxpayers and state tax agencies.

A federal law written today to limit a state’s ability to tax would also have to consider Wayfair. Thus, economic presence with a de minimis rule would be the starting point. The de minimis rule could be the same among states and for all types of taxes. Of course, Congress can modify the holding under its commerce clause authority. Finally, the federal nexus law created today would ideally include a mechanism for regular review with broad input so that it could continue to cover future transactions and activities.

After 60 years of failed efforts to modernize P.L. 86-272 despite the detailed Willis Commission report and its recommendations, rulings, legislative proposals, congressional hearings, and many thoughtful experts with suggestions, we still have a law that violates several principles of good tax policy, including equity, neutrality, certainty, and transparency. Businesses of all sizes face uncertainty as to what is taxed and where and how new transactions fit within a law written without such activities in mind. Small businesses may limit the reach of their activities to reduce uncertainty and filing costs, but at the cost of reducing economic activity.

Despite Wayfair laying out a nexus standard for all types of taxes, legislative proposals of today are separated between income-based taxes and sales and use taxes. Also, the BATSA bills are basically the same before and after Wayfair, thereby bypassing an important discussion about nexus in the modern era.

While sales taxes tend to have a narrower base than do income taxes, a single de minimis rule could still cover all types of taxes. A uniform de minimis rule offers certainty and simplifies recordkeeping to monitor when this threshold is surpassed by a business. A de minimis rule should not be viewed as reducing aggregate tax collections because of backstops that exist. For example, where a small business doesn’t collect use tax, the buyer is obligated to remit it. Where a small business doesn’t owe income tax in a customer’s state, throwback or sourcing rules would tax it in the origin state.

Another weakness of today’s reform proposals, such as BATSA, is that they both continue and expand complexities. For example, H.R. 3063 requires a definition of physical presence and the need to track it by day. Also, the exception for “presence in a State to conduct limited or transient business activity” needs to be defined. In addition, terms such as “solicitation of orders” that would remain under BATSA would continue to pose challenges. Alternatively, the need for such terms should be avoided because of the inherent weakness in identifying or measuring activities using subjective terms. More objective terms and measures should be favored where possible and necessary.

The BATSA proposal will continue to raise questions regarding cloud computing and the treatment of transactions performed by software and machines but without ongoing human intervention.²⁵ A simpler approach would be to base any protections on items that are easy to measure, such as gross receipts. Of course, once gross receipts exceed a de minimis threshold, sourcing rules are needed. Uniform and simple sourcing rules should be in the modern legislation.

VI. Looking to the Future

Today, it is not only large businesses that generate income widely, but even small businesses, including sole proprietors. Taxes are a business reality and it should be assumed that all businesses want rules that are understandable, certain, equitable, and that allow for compliance with minimal costs.

Technology is significantly different between 1959 and today and continues to advance in many ways that can simplify compliance. For example, it is feasible to develop an algorithm that takes appropriate data from a company and determines where it is subject to income and other taxes. Software could also handle the e-filing and e-payment of taxes.

Modern state tax compliance and administration needs attention to be sure it can appropriately measure state tax bases including from activities involving the use of modern technologies and business practices. This exercise will help in understanding how modern technology can be used to simplify, streamline, and automate compliance and tax administration. While all of this involves challenging issues, they are merely difficult rather than impossible to address.