Also In This Issue:
- Hercules and Firstar: Nondomiciliary Taxpayers Successfully Defend Nonbusiness Income Treatment Before the Minnesota Supreme Court
- Once Again, South Carolina Breaks New Ground on Hotly Debated Nexus Issues
- California's Deduction for Dividends Received from Insurance Companies Held Unconstitutional
- California Business Property Tax: Reported Costs Are Not Necessarily Fair Market Value
Nexus continues to demand a disproportionate amount of attention at state tax conferences, in state tax publications, and in state tax planning by companies. There is good reason for this. Notwithstanding the United States Supreme Court's landmark nexus case in 1992, Quill Corp. v. North Dakota, 504 U.S. 298 (1992), and the South Carolina Supreme Court's surprising extension of nexus concepts in 1993, Geoffrey, Inc. v. South Carolina Tax Comm'n, 437 S.E.2d 13 (S.C. 1993), cert. den., 510 U.S. 992 (1993), there remains considerable uncertainty about the quantity and quality of contacts that are necessary for an actor or an activity to establish nexus with a taxing jurisdiction. For example, taxpayers still must wonder whether physical presence is necessary to establish nexus for income tax purposes. Likewise, the cases afford little practical guidance regarding whether particular in-state activities of independent contractors performed on behalf of an out-of-state company confer nexus on that company.
Recently, the South Carolina Court of Common Pleas (trial court) decided two cases that address some of the most hotly debated nexus issues with a level of sophistication that may seem surprising. The cases, which are now pending before the South Carolina Supreme Court, City of Charleston v. Government Employees Insurance Co. (GEICO), Ct. of Common Pleas, Case No. 93-CP-10-2567 (Sept. 15, 1997), and City of Charleston v. United Services Automobile Association, et al., Ct. of Common Pleas, Case No. 95-CP-10-1859 (Sept. 15, 1997), are substantially similar. We will focus this article on the highlights of the GEICO case.
GEICO's Facts
GEICO, an insurance company, waged a Commerce Clause challenge against a business license tax deficiency assessed by Charleston. GEICO was headquartered in Chevy Chase, Maryland, and maintained its closest regional office in Macon, Georgia. It had some policy holders in Charleston, and it dealt with them solely by mail and by telephone. GEICO had no offices, property, or agents in Charleston. All of its advertising was placed from out of state. Insureds made claims by mail or via an 800 number.
GEICO maintained, apparently as employees, two resident auto appraisers in the vicinity of Charleston County, but outside of the City. Occasionally these individuals traveled into the City to view a vehicle that was the subject of a claim. GEICO used the services of two independent appraisal firms, one located outside of Charleston and the other located in North Charleston. The adjusters of these companies only occasionally entered the City to view a vehicle, or to adjust other claims apparently of GEICO insureds. GEICO paid claims from Macon, through the mail. GEICO had no salespeople, whether employees or independent contractors, either in Charleston or in South Carolina.
The Commerce Clause Applies To The City
First, GEICO addressed whether, because the taxpayer was an insurance company, Charleston was immune from Commerce Clause requirements. It is well-settled that the McCarran-Ferguson Act, 15 U.S.C. §§ 1011, 1012, exempts state taxes on the "business of insurance" from Commerce Clause scrutiny. Congress believed that insurance regulation and taxation was a local activity that should be left to the states, and so it enacted McCarran-Ferguson to protect state regulation and taxation of the business of insurance. However, GEICO held that Congress did not intend to extend the Commerce Clause immunity to cities. In addition, this tax was not immune from Commerce Clause scrutiny because Charleston did not enact it pursuant to South Carolina's delegation of its authority to regulate and to tax insurance, and so the tax was not imposed on the business of insurance. Thus, Charleston's tax was subject to review under the Commerce Clause.
Interestingly, the decision does not address how, in light of the fact that the challenged tax was levied by a city, the court reached the conclusion that the interstate Commerce Clause applied. After all, the Commerce Clause affords Congress the power to regulate commerce among the states. The Commerce Clause generally does not apply to commerce engaged in between cities but confined within a state. However, much of GEICO's business in Charleston was conducted across state lines. Thus, it seems likely that GEICO assumes the Commerce Clause applied because most of the taxpayer's activity vis-à-vis Charleston crossed South Carolina state lines.
Application of Complete Auto Test
For many people, the most interesting issue in GEICO will be whether the tax withstands muster under the Commerce Clause. To make that determination, the court appropriately applied the four-pronged test of Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977). Complete Auto established that a tax on interstate commerce is valid only if (1) it is applied to an activity with a substantial nexus with the taxing state; (2) it is fairly apportioned; (3) it does not discriminate against interstate commerce; and (4) it is fairly related to the services provided by the state. As explained below, GEICO alleged that the tax failed all four prongs of the Complete Auto test. The court resoundingly agreed.
Substantial Nexus
Notwithstanding the South Carolina Supreme Court's decision in Geoffrey, GEICO concluded that physical presence is required to establish nexus for purposes of Charleston's tax. Acknowledging the arguable distinction that Quill involved use tax collection, the court nevertheless relied on it. According to GEICO, Quill implied that physical presence might be required to establish nexus for the purpose of other types of taxes, and, importantly, it noted that all of the cases relied upon by the lower court involved taxpayers with a physical presence in the state.
The court rejected the City's reliance on Geoffrey and particularly on the case's apparent holding that exploitation of the marketplace can, at least in the circumstances in Geoffrey, establish nexus. The court's treatment of Geoffrey is quite surprising in light of the fact that a South Carolina trial court should be bound by its own supreme court's decisions. The court relatively easily could have distinguished Geoffrey's facts from GEICO's because GEICO's intangible property in Charleston (insurance contracts) or its economic activity (solicitation of insurance) there did not approach the level of Geoffrey's intangible presence and economic activity in South Carolina. Most remarkably, the court did not even attempt to distinguish Geoffrey. Instead, the court discredited it by stating that the South Carolina Supreme Court had relied on only three cases in Geoffrey, two of which were Due Process not Commerce Clause cases, International Harvester Co. v. Wisconsin Dep't of Taxation, 322 U.S. 435 (1944), and Curry v. McCanless, 307 U.S. 357 (1939), and the third of which the GEICO court snubbed by implying that it was short of analysis in that it "merely noted that the Commerce Clause issue had been decided adversely to the taxpayer in prior cases." American Dairy Queen Corp. v. Taxation and Revenue Dep't, 605 P.2d 251 (N.M. Ct. App. 1979). Thus, GEICO implies that Geoffrey was constructed on quicksand and is unworthy of being addressed directly.
Moving to the question whether GEICO's physical presence in the City amounted to substantial nexus (the court discussed these sub-issues in a different order), the court held that there was "no ‘substantial nexus' between the GEICO activity being taxed and the City of Charleston." In the court's view, Charleston's tax was imposed on GEICO's underwriting of risks located in Charleston, as measured by the gross receipts or premiums collected by GEICO on such risks. However, the court observed that GEICO's only economic activity in the City was adjusting claims. Because no underwriting of risks or collection of premiums occurred in the City, and the adjustment of claims was not sufficiently related to the taxed activity, the City failed to establish substantial nexus over the activity that it intended to tax.
Next, the court rebuffed the City's claim that "the taxing incident or measure of taxation need not be related to the nexus activity." The City relied primarily on National Geographic Soc'y v. California Bd. of Equalization, 430 U.S. 551 (1977). In that case, the Court upheld California's imposition of a use tax collection requirement on a company that conducted all of its selling activity that generated the use tax from out-of-state. The GEICO court apparently agreed with the City that in National Geographic an unrelated in-state activity by the company established the state's nexus over the company for use tax purposes. Yet, the GEICO court observed, the Supreme Court had restricted its analysis to cases involving the imposition of a use tax collection requirement, as evidenced by its statement that "[h]owever fatal to a direct tax a ‘showing that the particular transactions are dissociated from the local business…,' such dissociation does not bar the imposition of the use-tax collection duty." National Geographic, at 560 (citations omitted). Thus, the GEICO court concluded, "a direct tax such as that at issue here, requires a showing that the local nexus is substantially related to the taxed activity."
While not explicitly discussed in GEICO, substantial nexus comprises two distinct nexus requirements: nexus over the actor and nexus over the taxed activity. Allied-Signal, Inc. v. Director, Division of Taxation, 504 U.S. 768, 778 (1992). In National Geographic, the parties agreed that the state had nexus over the taxed activity because that activity (use of the magazines) occurred in California. As for the disputed issue, nexus over the actor (i.e., the out-of-state company from which California sought to collect the use tax at issue), the Court indeed held that National Geographic's presence in California, unrelated to the taxed activity, conferred jurisdiction on California to tax the actor (the company that would collect the tax). Accordingly, we believe an appropriate refinement to the GEICO opinion is that nexus over the taxed activity, as opposed to nexus over the actor, must be established by a "local nexus [that is] substantially related to the taxed activity."
The City attempted to rebut the view that the nexus inquiry is more rigorous in direct tax cases than in use tax collection cases. Citing Tyler Pipe Indus., Inc. v. Washington State Dep't of Rev., 483 U.S. 232 (1987), Standard Pressed Steel Co. v. Dep't of Rev. of Washington, 419 U.S. 560 (1975), and General Motors Corp. v. Washington, 377 U.S. 436 (1964), the City argued that in these cases the "nexus was not the taxed activity," i.e., the in-state activity was not related to the taxed activity. The Court flatly disagreed. In Tyler Pipe, the tax was imposed on the sales of an out-of-state manufacturer, and an in-state independent contractor helped the taxpayer to establish and to maintain the very transactions that formed the basis of the tax. In Standard Pressed Steel, the taxpayer maintained an employee in-state whose primary function was to service the taxpayer's principal customer which accounted for the taxed sales. And, in General Motors, in-state employees performed substantial services in relation to the taxpayer's establishment and maintenance of sales, the incident upon which the tax was measured. Finally, disavowing a "slightest physical presence" standard, the court concluded that even if any activity by GEICO in Charleston could establish nexus, the taxpayer still had an insufficient physical presence in the City because the only in-city activity, i.e., claims adjustment, only occurred in the event of a loss and therefore was "sporadic at best."
Lurking within this analysis is a controversial nexus question, namely the significance for nexus purposes of employees and independent contractors in the state. Taxpayers and their representatives, it seems, generally assume that the permanent presence of one or more employees in-state establishes nexus. In addition, taxpayers and their representatives place significant weight on the notion that an independent contractor may establish nexus for an out-of-state company, if the independent contractor's activities are directed towards establishing and maintaining a market for the out-of-state company in the taxing state, regardless of the type of tax that is at issue. However, GEICO may well refine these conclusions.
First, as GEICO implicitly makes evident, the "establish and maintain a market" standard arose in a situation where the taxed activity was selling or was substantially related to selling. See, e.g., Tyler Pipe. Because selling fundamentally is establishing and maintaining a market, it seems sensible that the Court used the phrase "establish and maintain a market" to describe the in-state activity that would be sufficiently connected to the taxed activity (selling) to establish nexus. GEICO suggests that the in-state activity that would be sufficiently connected to the taxed activity to establish nexus might be something different from establishing and maintaining a market if the taxed activity were something different from selling. Indeed, it is difficult to give meaning to establishing and maintaining a market outside of selling. For example, suppose a company is engaged in manufacturing (in state A) and selling (in state B), and then drops its manufacturing operations into a wholly-owned subsidiary. Applying an "establish and maintain a market" standard to determine whether the wholly-owned subsidiary creates nexus for its parent in state A seems inappropriate because the subsidiary is engaged in manufacturing, not selling. Thus, focusing on the taxed activity and determining whether the activities in the jurisdiction are sufficiently connected to the taxed activity to establish nexus in state A may be more meaningful than attempting to fit the subsidiary's activities and the taxed activities into the inflexible mold of an "establish and maintain a market" standard.
GEICO suggests that the Court in Tyler Pipe did not mean for the "establish and maintain a market" standard to be a litmus test for nexus generally, but rather intended it to be used only where the taxed activity is selling. In an income tax context, the taxed activity may be described as all activities that contribute to producing business income. To determine whether in-state activities of an independent contractor establish nexus over an out-of-state company, rather than applying an "establish and maintain a market" standard, it may be more appropriate to evaluate whether the in-state actors are doing their own business on their own behalf (e.g., a lawyer hired by a company to defeat a state tax assessment on the grounds of lack of nexus) or whether the in-state actors are doing the business of the out-of-state company (a subsidiary established by a contribution to capital of the parent's manufacturing facilities). By articulating this dichotomy, we do not mean to imply that characterization in the former category avoids nexus while characterization in the latter category inevitably establishes nexus. Rather, we mean only to continue the dialogue regarding factors that may be considered in evaluating states' claims of nexus for income tax purposes. A recent case that grappled with these proposed factors is JS&A Group, Inc. v. State Board of Equalization, California Court of Appeal No. A075021 (Feb. 10, 1997), which we discussed at length in State & Local Tax Insights, March 1997.
Second, where a company maintains permanent employees in the state, it has generally been accepted that the company will have income tax nexus. And, indeed, we have difficulty imagining circumstances in which permanent employees would not confer nexus on a company that is otherwise out of state. It seems likely that, as employees, the in-state individuals are not doing their own business on their own behalf, but rather are doing the business of the out-of-state company. By contrast, GEICO suggests that taxpayers with one or more in-state employees, whose business otherwise is conducted wholly out-of-state, should not concede nexus too quickly in the context of taxes on specific activities. That is, if the in-state employees' activities are not sufficiently related to the taxed activity, the in-state employees may not create nexus for the out-of-state company.
Fair Apportionment
Applying the second prong of the Complete Auto Transit test, the GEICO court determined that Charleston's tax was not fairly apportioned. First, the court concluded that the tax failed the internal consistency test, though it seems that the court may have misapplied the test. The court relates that, prior to 1994, the tax was imposed on premiums collected within the City, regardless of where the risk was located, and on premiums on risks located within the City, regardless of where the premiums were collected. (After 1994, the tax was imposed on particular premiums only if the insured risk was located in the City.) Under South Carolina law, due to a preference to the municipality in which the risk was located, if the premium was collected in one jurisdiction and the risk was located in another, only the jurisdiction in which the risk was located could claim the tax. To the court, "it [was] clear that if other states were to impose an identical tax, GEICO would be subject to multiple taxation based upon the collection of premiums or the location of risks in other states." The court stated, "it cannot guarantee" that other states would follow the preference for the location of the risk; rather "other states [might] impose a similar tax on some other aspect of the taxed transaction, such as the collection of premiums."
To apply the internal consistency test properly, one must assume that the same tax, in all respects, is applied in all jurisdictions. Assuming the preference for the location of risks applied in all jurisdictions (including in other states), the tax would seem to satisfy internal consistency. That is, if premiums were collected in a jurisdiction different from the place where the risk was located, only the latter jurisdiction would impose its tax. If the premiums were collected and the risk were located in the same jurisdiction, again only one level of tax would apply. Thus, the burdens on interstate and intrastate commerce would seem to be the same.
In any event, in the court's view, the tax would still fail the fair apportionment requirement because the tax was not externally consistent. The court observed again that the taxed activity was underwriting of insurance risks for which premiums are collected. However, the only local activity was adjustment of claims, "a service that is distinguishable from and merely incidental to GEICO's underwriting the risk." To the court, "Charleston's taxation of the underwriting process, as measured by premiums collected, which can and does occur in different states, is disproportionate to the discrete activity that occurs in Charleston." The court continued, suggesting that the tax would be saved from its external consistency failure if the City allowed a credit for taxes paid to other states (or, presumably, the local jurisdictions of other states).
The court's holding that the tax violates external consistency is worthy of extra attention because only a handful of reported decisions have considered whether a tax fails external consistency. See City of Winchester v. American Woodmark Corp., 471 S.E.2d 495 (Va. 1996). The holding would appear to miss the mark to the extent that it implies that the tax would not have violated external consistency if the City had allowed a credit. A credit may solve an internal consistency problem, but in general it does not solve an external consistency problem. Internal consistency is concerned with avoiding multiple taxation, and a credit satisfies internal consistency because normally it eliminates multiple taxation. By contrast, external consistency is concerned with avoiding extraterritorial taxation. A credit does not satisfy external consistency because a jurisdiction with nexus over certain premiums might choose not to tax those premiums, so the taxpayer would not receive any credit attributable to those premiums. The fact that the other jurisdiction could have taxed the premiums, but chose not to, does not expand Charleston's jurisdiction to tax those premiums. Charleston's attempt to tax those premiums constitutes extraterritorial taxation. The only remedy for an external consistency failure is apportionment, assuming it is feasible. See Walter Hellerstein, Is "Internal Consistency" Foolish?: Reflections on an Emerging Commerce Clause Restraint on State Taxation, 87 Mich. L. Rev. 138, 186 (1987) ("[w]holly apart from its role in preventing multiple taxation, the fair apportionment requirement serves to limit the territorial reach of state power by requiring that the state's tax base corresponds to the taxpayer's in-state presence").
Burden on Interstate Commerce and Relationship to Services Provided By the City
The court's analyses of the final two prongs of the Complete Auto Transit test are less interesting than the nexus and apportionment issues, so we will discuss them briefly. The court held that the tax violated the third prong because the tax disproportionately burdened interstate commerce, and it violated the fourth prong because the tax was not fairly related to the services provided to the taxpayer by the City. By this point in the opinion, the court had so displayed its distaste for the City's tax that these holdings seemed to follow naturally.
Nevertheless, the manner in which the court reached the conclusion that the tax was not fairly related to the services by the state or the city is curious. First, the court rejected the City's argument that the tax was fairly related to the services (e.g., fire and police protection) provided to the insureds in the City. Then, the court determined that the tax could be related to services provided by the City if the taxpayer received services itself, or if an affiliate of the taxpayer received services from the City. In GEICO, because neither the taxpayer nor any corporate affiliate was present in the City in any meaningful way, the tax failed the fourth prong of the Complete Auto Transit test.
In our view, on one hand, the court's approach is too narrow in rejecting the City's view that services provided to the insureds are sufficient to satisfy the fourth prong of the Complete Auto Transit test. It is at least arguable that the services provided to insureds facilitated a market for the taxpayer in GEICO and thus provided a constitutionally significant benefit to the taxpayer, though we note that this logic should not be extended so far as to justify any market state taxing an out-of-state company. On the other hand, the court's approach is remarkably broad in implying that services provided to a corporate affiliate would be sufficient to meet the test. Assuming it were appropriate to disregard services provided to insureds, and to focus only on services provided to the taxpayer, it would seem to be particularly inappropriate to consider services provided to a corporate affiliate. An affiliate is a different corporate entity and must be respected as such. See, e.g., Current, Inc. v. State Board of Equalization, 24 Cal. App. 4th 382 (1994) (holding California's affiliate nexus statute unconstitutional). Curiously, with regard to this issue, the GEICO court agreed with, and relied on, Geoffrey.
What Does the Future Hold?
We find particularly interesting the breadth of nexus issues GEICO raises as well as its provocative analysis of many of these issues. Of course, for many people, the most pressing nexus issue is whether Geoffrey was correct in its apparent holding that in some circumstances exploitation of the marketplace, without physical presence, can establish nexus. A South Carolina Supreme Court decision in GEICO is not certain to address Geoffrey head on.
We are aware of a number of other nexus cases pending around the country (in Florida, Maryland, New Jersey, North Carolina, and Tennessee, to name a few) with facts more similar to Geoffrey. Together with GEICO, these cases potentially will answer a number of nexus questions that have been troubling taxpayers and impeding their ability to engage in planning. Moreover, without firm nexus rules, taxing authorities may tend to take the most aggressive nexus positions both because they can and because they believe they need to protect their revenue base. Judicial decisions that establish firm nexus rules may well limit this practice, too. We will follow these cases closely and report on important nexus developments in this newsletter.
This newsletter addresses recent state and local tax developments. Because of its generality, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.