Tax Bulletins usually clarify the application of existing laws and regulations to new or disputed circumstances, but for the second time in as many years, Pennsylvania’s Department of Revenue arguably went further, adopting new nexus standards for corporate income tax purposes in a bulletin. The action has left some policymakers and practitioners perplexed about both what the bulletin accomplishes and whether the action was within the power of the Department. It’s a complex issue, so a questions-and-answers approach may be the best way to distill the issue.
What does the new Tax Bulletin purport to do?
The Bulletin changes the nexus standard for Pennsylvania’s Corporate Net Income Tax (CNIT) from physical presence to factor presence. The federal courts have held that a company must have “substantial nexus” (contact) with a state before it can be subject to the state’s tax. Until now, Pennsylvania’s own nexus rules have been limited to companies with a physical presence in the Commonwealth. Under the new rules, which take effect in January 2020, a company has nexus with Pennsylvania if it does business in the state, with a presumption that any business that has more than $500,000 in sales in the Commonwealth has taxable nexus even if it has no physical presence in Pennsylvania.
So in the past, Pennsylvania could only tax companies that were located in the Commonwealth?
Not quite. Physical presence seems like a simple bright-line rule, but in practice it is highly complex and varies from state to state. Having any property in Pennsylvania was enough for nexus to attach, and employees traveling into the state can establish nexus as well under certain conditions, except when their activities are protected by federal law (but more about that later).
Is Pennsylvania’s planned new approach unusual?
Not entirely. Pennsylvania is currently in the very small minority of states which require physical presence, with Alaska, Delaware, and Texas. Other states tend to have economic presence standards, a facts-and-circumstances approach under which a company’s activity in the state is evaluated to determine if it is sufficient to legally justify taxation. A small but growing number employ a variant called factor presence, in which nexus is established when one or more of the factors traditionally used for apportionment purposes (property, payroll, or sales) exceeds a given amount in the state. Functionally, the factor that matters is the sales factor since in most cases, companies with payroll and property in a state are already taxable.
Why is the Department of Revenue doing this now?
Pennsylvania has historically interpreted the Quill Corp. v. North Dakota (1992) case broadly, concluding that the physical presence requirement it imposed as a condition of substantial nexus for sales tax purposes applied to other taxes as well, including corporate income taxes. Although this had long been an open question, most states operated on the assumption that Quill only applied to sales taxes, and that substantial nexus—which is constitutionally necessary for imposing a tax—could be achieved without physical presence with other taxes, like the corporate income tax. Since the physical presence requirement from Quill has been struck down (in South Dakota v. Wayfair), the question is largely moot, so the Department is moving forward with new standards.
Does that mean the Department has the inherent authority to set these new rules?
That’s unclear. Existing state law establishes that the CNIT is imposed on corporations (1) doing business, (2) carrying on activities, (3) employing capital or properties, or (4) owning property in the Commonwealth. That’s an expansive list that captures just about everything a company could do in Pennsylvania with or without a physical presence, and one impediment—Pennsylvania’s application of a physical presence standard through Quill—has now been lifted, presumably meaning that nexus standards become broader just through application of existing law.
However, that’s not the end of the story. There are several remaining constraints on Pennsylvania’s authority to impose its tax on companies not domiciled in the state (we’ll get to those shortly), and the approach the Department took, establishing a rebuttable presumption at $500,000 in sales, looks a lot like factor presence, which is not mentioned in the statute. The Department’s best argument is probably that technically all of these activities are taxed unless there’s a legal reason why they can’t be, but if a company has more than $500,000 in sales into the state, they will begin with the assumption that they are taxable, and act accordingly. To the degree that $500,000 comes to act as a nexus threshold, that could create problems, as the Department has no statutory basis for establishing a factor approach.
Where did the $500,000 threshold come from?
It’s lifted from the state’s post-Wayfair safe harbor for remote sales tax collection and remittance obligations. Pennsylvania is the second state, after Hawaii (which adopted legislation), to create factor presence that follows remote sales tax provisions. This is not necessarily a problem, but it must be noted that nothing in the Wayfair decision expands corporate nexus. Using a threshold like those used for online sales taxes does not relieve Pennsylvania of the obligation to recognize other limitations on nexus. The Bulletin at times seems to lean on Wayfair for justification, which seems neither appropriate nor necessary.
Does Pennsylvania’s constitution allow such a threshold?
That’s uncertain, though state courts have granted significant latitude in the past. Pennsylvania has a robust uniformity clause in its constitution, applying to all taxes and requiring that they be “uniform, upon the same class of subjects, within the territorial limits of the authority levying the tax,” and collected under general law. Although the Bulletin indicates that all doing business in the Commonwealth are potentially taxable (an economic presence standard), enforcement would appear to be on a factor presence basis, with a $500,000 threshold. This raises questions given the constitutional provision, though state courts have permitted a homestead exemption and other thresholds in the past despite the uniformity clause.
What outside constraints are there on nexus?
First and foremost, nexus standards must be consistent with both the Due Process and Dormant Commerce Clauses of the U.S. Constitution. The Commerce Clause requirement has been interpreted as requiring “substantial nexus” for a state to impose a tax on an individual or corporation. It is not always clear what “substantial” means, but the contacts must be more than trivial.
Secondly, and significantly, a federal law sometimes called the Interstate Income Act of 1959 (P.L. 86-272) stipulates that a company can “solicit orders” of tangible property in a state without establishing nexus for income tax purposes. States have adopted long lists describing which economic actions are and aren’t protected by P.L. 86-272, guided by several court cases, but a simple version is that nexus is not established if a company simply has salespeople, but no offices, in a state, and they send orders back to an office in another state for processing and fulfillment. Business functions that are undertaken solely in pursuit of this order solicitation are also protected, but there is often a very fine line between these and unprotected activities. The law, moreover, only applies to solicitation of orders for the sale of tangible property, not sales of intangible property (including services) or rentals or leases.
Given P.L. 86-272, what would Pennsylvania’s forthcoming nexus standards accomplish?
At the very least, the Bulletin would establish nexus between many out-of-state service providers and the Commonwealth that lack a physical presence in the state. It may also capture some companies selling tangible personal property with activities that fell short of the state’s standards for physical presence but are not protected by P.L. 86-272. Going to an economic or factor presence standard broadens the scope of taxable companies.
Does this mean Pennsylvania can tax all the income of out-of-state companies?
No. Multistate businesses have their income apportioned, so Pennsylvania can only tax the share of it that is associated with the Commonwealth. How that’s done is complicated and not always equitable, but that’s a topic for another day.