The State Tax Grab
By Steven Malanga
Revenue-hunting states have lately gone beyond raising their own taxes; now they’re trying to shake down firms and workers in other states.
Stretching the limits of the U.S. Constitution’s commerce clause to the breaking point, local revenue agents have seized out-of-state trucks simply passing through their jurisdiction, refusing to release them until the firms that dispatched them fork over corporate income taxes. Finance departments have slapped out-of-state businesses with bills for thousands of dollars in corporate back taxes, based on little more than a single worker visiting the state sometime during the year. And tax agents have targeted employees who work remotely for in-state firms, claiming that they owe personal income taxes, even when they’ve never stepped foot in the taxing state.
Technological change has unleashed some of this unprecedented aggression. In a world where businesses can offer products to customers thousands of miles away or sell sophisticated services, such as cloud computing, that seem to originate from nowhere, states that once levied business taxes only on physically present firms have been coming up with far broader definitions for what, and who, is taxable. At best, the states have inconsistently defined what falls under their tax jurisdiction; at worst, they’ve used the transforming technological landscape as an excuse to grab revenue from surprised, and outraged, new sources.
In a 2011 CFO magazine survey, finance officers at large companies judged five states — California, Massachusetts, New Jersey, New York and Michigan — as particularly assertive in going after out-of-state revenue.
“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,” the CEO of one out-of-state firm told Chief Executive recently. “We can’t afford for New York to become a tax nexus for us just because our employees participate in a conference in New York.”
The Supreme Court has invited Congress to clean up this mess, and a handful of bills are circulating in Washington that offer clearer standards on what constitutes “tax nexus” — the state authority to tax a firm or an individual located elsewhere. Yet for years, Congress has put off passing any remedy, causing confusion, bitterness and sometimes outright panic within the business community. As one corporate finance officer put it to CFO recently: “The states are in a pure money-grab mode and don’t care about policy, the law or fairness.”
The commerce clause gives Congress the power to regulate interstate trade. The Supreme Court has always interpreted the clause as limiting a state’s ability to tax the businesses of other states. Generally, the court required that an out-of-state business had to establish some physical presence in a second state — opening a branch office, say, staffed by several paid employees — before that state could impose a business tax on the firm. Even then, the court has ruled, the state could only tax a portion of the business’s income, commensurate with its activity there, not its entire profit.
Congress has occasionally passed laws that clarify the scope of interstate taxation. A good example was the 1959 Interstate Income Act, which banned states from applying corporate or other business activity taxes to a firm if its only activity there was to solicit orders.
As business practices have mutated, the Supreme Court has refined its definition of interstate taxation — but not enough to keep up with the myriad new ways that firms operate. In 1992, for instance, the court ruled that North Dakota could not require a Delaware-based catalog retailer, the Quill Corp., to collect sales or use taxes on goods ordered by North Dakotans from the firm and shipped into the state. Because Quill had no operations in North Dakota, the court reasoned, the state violated the commerce clause by trying to tax the firm’s transactions. The court added, however, that Congress could enact legislation defining how states could legitimately tax these kind of exchanges.
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