nexus - States “clicking through” to new sources of tax revenue

Until a few years ago, the term "nexus" was rarely seen or heard outside the realm of tax practitioners. Recently, it has jumped into the pages of national newspapers and is being publicly debated in Congress as well as in state legislatures around the country. Nexus refers to the connection between a business and a state or locality that allows the state or locality to legally assert its powers of taxation.

Nexus encompasses not only income taxes but also retail sales taxes and many other state and local tax levies. The rules vary by tax type, industry, and state. In addition, traditional nexus concepts are being redefined by state courts and legislatures as states push the envelope looking to boost tax revenue. For these reasons, nexus has been described as a “quagmire" or a “briar patch" waiting to entangle unwary businesses. The consequences of being caught unawares include potentially large assessments for back taxes and interest, the imposition of late filing and negligence penalties, cash flow issues, and possibly, financial impairment.

However, "click-through" nexus is likely the most controversial of the new state approaches to taxing businesses and consumers. Also called “" nexus, click-through nexus has to do with state efforts to force Internet retailers to collect sales tax from customers in states where the sellers have no physical presence. By some estimates, state and local governments could increase their revenue by as much as $23 billion annually if they could collect sales tax on retail transactions made using the Internet.

Historically, remote sellers—e.g., those who sell via Internet, telephone, mail order—have been protected by the 1992 landmark sales tax case ruling in Quill Corp. v. North Dakota. That case addressed the question of sales tax nexus for an out-of-state mail order company with no physical presence in the taxing state. The US Supreme Court ruled the Commerce Clause requires a physical presence before a state can require an out-of-state seller conducting all transactions over the phone and through the mail to collect sales and use tax.

New York began a bold assault on the “physical presence" doctrine, challenging Quill in the enactment sales tax rules affecting Internet retailers. A number of large Internet retailers, most notably, and, have raised legal objections. Under its so-called rules, an out-of-state retailer that has a commission arrangement with a company for sales through its website is required to collect state sales tax if the website company has New York nexus. While certain safe harbors apply, New York is imposing its sales tax collection responsibilities on businesses with no in-state physical presence.

The list of states that have followed New York’s lead and enacting click-through sales tax nexus standards is growing. It includes Arkansas, Connecticut, Illinois, North Carolina, Pennsylvania, Rhode Island, and Vermont. Although there is some variation among these states, their click-through nexus standards share a number of characteristics. The template is as follows:

  • Nexus is established through a business relationship between a remote seller and one or more Internet affiliates with an in-state presence.
  • Sales are referred directly or indirectly to the remote seller via a link on the affiliate’s website.
  • In-state customers “click through" the affiliate links to purchase taxable goods or services from the seller.
  • The affiliates are compensated by the seller under a commission sales agreement or similar arrangement.
  • Nexus can be created through a contract with an aggregator, establishing and maintaining a retailer’s relationship with a network of Internet affiliates for a fee or commission.
  • There may also be a requirement that the seller actively solicit sales through the affiliates or otherwise (e.g., through target advertising or promotions).
  • In-state taxable sales must exceed a threshold such as, $10,000 during the previous 12 months, to trigger the sales tax registration requirement.

Pennsylvania, the latest addition to the “" states, implemented this standard without any enabling legislation. In Pennsylvania Sales Tax Bulletin 2011-01, 12/1/2011, The Department of Revenue announced that “a remote seller who regularly solicits orders from Pennsylvania customers via a website of an entity or individual physically located in Pennsylvania, such as via click-through technology" is consider to have a place of business in the state.

The department not only concluded that nexus exists but also that it has authority under Quill and the US Constitution to assert it without any changes to Pennsylvania’s sales tax laws. Retailers deemed to have nexus under the new Pennsylvania guidelines have been given until February 2012 to register for sales tax purposes. If they do, prior-year liabilities will be forgiven. Failure to register will open the remote sellers to back sales taxes, interest, and penalties.

Adding its weight to the click-through nexus idea, the Multistate Tax Commission (MTC) has been working on a model standard. It covers direct relationships between a remote seller and an Internet affiliate as well as indirect relationships through aggregators. Sales tax registration is required for an Internet retailer when in-state gross receipts referred from an affiliate vendor exceed $10,000 and total in-state sales exceed $500,000.

It is easy to see that a large number of Internet retailers, small and large, fit the click-through template. In spite of the publicity surrounding the issue and state pronouncements on their new laws, many of these retailers are unaware of the sales tax collection responsibilities asserted by state tax authorities. This is not surprising given the questionable legal basis for click-through nexus and the differences among states.

Internet retailers also face practical problems. For example, how will a remote seller know whether an affiliate has nexus in a state with a click-through statute like New York? An Internet retailer in Illinois might have a link on the website of Florida affiliate. However, the affiliate hosts its website on a server outside of its home state of Florida. In this example, the Illinois seller would likely only know the address to send its account payment to or of its headquarters’ location. If the affiliate has nexus in New York, Connecticut, or another click through state because its server is there or is visited by a marketing representative, the Illinois retailer must register and collect sales tax; assuming the other registration requirements are met.

This issue becomes even more troublesome when an aggregator or broker is used. Since the aggregator maintains that relationship with affiliates and accounts for the commissions, the retailer is even more isolated from the activities of the affiliates. Under the MTC version of click-through nexus, the activities or presence of an aggregator or broker could also create a sales tax filing requirement for our Illinois Internet retailer.

The movement ran into opposition in some states during 2001. Proposed click-through sales tax legislation failed in Arizona, Hawaii, Louisiana, Maine, Minnesota, Mississippi, Missouri, and New Mexico. Bills to repeal it were introduced in North Carolina and Rhode Island. After an intense lobbying campaign in California, was able to delay the implementation of click-through nexus until 2012 or 2013, depending on the enactment of federal legislation expanding state sales tax authority over remote sellers.

The fight over taxing Internet sales simmered for years in Congress. It intensified with the introduction of four bills to Congress in recent months. H.R. 2702, H.R. 3179, and S. 1452 authorize states to tax Internet sales. The Marketplace Equity Act (H.R. 3179) permits the collection of state sales tax on remote sales regardless of whether the retailers have a physical presence in the state. The act contains a small business exemption for online retailers with less than $100,000 of in-state revenue or less than $1 million of Internet revenue nationally. States have the option to raise the exemption. There is no requirement for states to join the Streamlined Sales & Use Tax Agreement in order to assert their taxing powers over online sales. The other bills are similar in nature to the Marketplace Equity Act.

The support for overturning Quill seems to be increasing. Perhaps Congress is sympathetic to the budget problems facing states which face a collective deficit estimated at $140 billion in the coming fiscal year. It is also influenced by what is perceived to be the unfair competitive advantage that Internet retailers enjoy over conventional "brick-and-mortar" retailers that must collect state and local sales tax.

Certain elements of the business community such as the Retailers Industry Leaders Association have endorsed the new federal initiatives. After bruising struggles with California, North Carolina, Tennessee, and Texas, even appears to have thrown in the towel. In testimony before the House Judiciary Committee, a company official stated “Congress should authorize the states to require collection, with the great objects of protecting states’ rights, addressing the states’ needs, and leveling the playing field for all sellers."

What should retailers that sell their wares over the Internet do, given the growing number of click-through nexus states? The first step is to map out their nexus footprint. It is important for them to know where their customers are and what their sales volume is in various states and localities. Once this is done, retailers can focus on the jurisdictions where their potential exposure for uncollected sales tax is high. They should catalog all of their activities in the states. Retailers could have a physical presence through employee visits, contracts with third-party sales representatives, or consigned inventory. Such activities create nexus regardless of state rules.

It may be advisable to consult with a state and local tax advisor during the nexus mapping process. The advisor can help businesses apply the requirements of each click-through nexus state to their facts. This is key in determining what the next steps are, which could include registration and filing sales tax returns on a go-forward basis; seeking a voluntary disclosure agreement to close off prior years and avoid penalties, and , restructuring the business to avoid states entirely. Retailers might also want to consider their options for compliance such as outsourcing or licensing sales tax software.

In any event, now is the time to start the sales tax planning process. It appears that click-through nexus is here to stay.