Massachusetts is looking to join a growing list of states asserting that internet vendors that lack traditional “physical presence” in a state must still collect sales tax if they have sufficient economic contacts. But unlike states that have passed “Kill Quill” statutes that challenge Quill directly, Massachusetts takes a more nuanced approach that potentially presents a more difficult challenge for internet vendors. Rather than attacking Quill directly, Massachusetts argues that the nature of almost any major internet vendor’s business requires them to have sufficient “physical presence” with the state to satisfy Quill. The Massachusetts approach argues that the nature of these businesses is different than those of the catalog companies in Quill, and when combined with sufficient economic presence, results in sufficient presence in Massachusetts to permit the state to require the internet vendor to collect sales and use tax.
For example, the Department argues that the ownership or use of “cookie” can constitute sufficient in-state presences to create a sales tax obligation for an internet vendor. The Department’s theory is currently part of a draft regulation and a public hearing regarding the regulation is scheduled for August 24 in Boston.
Massachusetts initially attempted to enforce its nexus theory through Directive 17-1. However, in light of litigation challenging that Directive and Massachusetts’ authority to implement this change in position through a Directive, the Department revoked Directive 17-1 shortly before it was to go into effect. See Directive 17-2 (June 28, 2017). Then, on July 28, the Massachusetts Department of Revenue (the “Department”) issued Proposed Regulation 64H.1.7 (the “proposed regulation”) that, if adopted, would require “internet vendors” to collect and remit sales tax on sales to customers in Massachusetts.
Killing Quill or Within its Scope?
Instead of attacking Quill head-on, the Department asserts the proposed regulation does not violate Quill’s physical presence rule. Rather, the Department asserts the proposed regulation falls within the scope of Quill, arguing that internet vendors are physically present in Massachusetts because they typically:
- Own or use software and “cookies” located on customer computers in Massachusetts;
- Have contracts or relationships with content distribution networks that use in-state servers or otherwise provide services in Massachusetts; and/or
- Make sales through marketplace facilitators or sales involving delivery companies that provide payment processing or fulfillment services.
When these contacts are considered, it appears that the Department’s nexus theory derives, at least in part, from the United States Supreme Court decision in Tyler Pipe Industries v. Washington Department of Revenue, 483 U.S. 232 (1987). Under Tyler Pipe, an out-of-state taxpayer can have nexus in a state if it hires a third party to engage in activities in the state that “establish or maintain a market” for the taxpayer’s sales in the state. Id. at 250.
Tax Imposed on Internet Vendors
If vendors have any of the in-state activities described above, the vendor then has an obligation under the draft regulation to collect tax if it meets certain economic thresholds. Specifically, the proposed regulation requires an “internet vendor” with sufficient in-state contacts to collect and remit Massachusetts sales tax for its sales to Massachusetts customers if two conditions are satisfied during the prior calendar year:
- The internet vendor made $500,000 or more in sales to Massachusetts customers completed over the internet; and
- The internet vendor completed 100 or more transactions that were delivered to Massachusetts.
“Internet vendor” is broadly defined to include vendors making sales to Massachusetts customers over the internet, regardless of whether the sales were made through the vendor’s website or through the website of a third party, such as a “marketplace facilitator.” A “marketplace facilitator” “facilitates sales . . . through a physical or electronic marketplace” it operates. Earlier this year, both Minnesota and Washington enacted legislation imposing sales tax obligations on online marketplaces. Most recently, one chamber of the Pennsylvania Legislature passed legislation that would also impose sales tax obligations on online marketplaces.
Broader Reach than Directive 17-1?
The proposed regulation appears have a slightly broader scope than Directive 17-1. The Directive asserted that “ownership and use” of software in Massachusetts constituted physical presence in Massachusetts. In contrast, the proposed regulation seems to go further by asserting that a vendor could have Massachusetts nexus based merely on having a “property interest” or “use” of software in Massachusetts. Thus, even if an internet vendor does not actually own or have a property interest in software (including cookies) located on a computer in Massachusetts, it could still have nexus as a result of the use of software owned by others on a computer located in Massachusetts.
The Internet Tax Freedom Act
In addition to addressing the Commerce Clause issues implicated by the proposed regulation, the Department asserts that the proposed regulation does not violate the Internet Tax Freedom Act (“ITFA”). P.L. 105-277 (1998). ITFA prohibits the states from enacting “discriminatory” taxes on internet commerce. A “discriminatory tax” is defined in several ways, including as a tax on transactions consummated in e-commerce that is not imposed on equivalent transactions consummated through traditional commerce. The Department asserts the proposed regulation does not violate ITFA because the same transactions would be subject to tax regardless of whether they were consummated through e-commerce or traditional commerce. It seems likely that the Department included the discussion of the application of the standards set forth in the proposed regulation to traditional commerce in response to the declaratory action filed against Directive 17-1, which asserted that the Directive violated ITFA. In any event, the Department has made an ITFA challenge to the proposed regulations more difficult by expressly finding that the nexus standard set forth in the proposed regulation applies to non-internet vendors. However, there are very few cases (both at the state and federal level) adjudicating claims under ITFA, thus making it difficult to predict how a court would apply ITFA to the proposed regulation.
The Department’s proposed regulation is markedly different from the “kill-Quill” legislation, and regulations adopted in other states, like South Dakota and Alabama. Whereas the laws and regulations adopted by other states have been premised on Quill’s physical presence rule supposedly being outdated, the Department has taken a different approach by asserting that the proposed regulation is permissible because most large internet vendors have an in-state presence that satisfies Quill’s physical presence rule. We expect other states may consider following the same approach as Massachusetts in justifying new legislation or regulation aimed at taxing internet vendors. In addition, with the rise of laws and regulations addressing online marketplaces, we expect future litigation to address restrictions on state taxing authority beyond the Commerce Clause, including ITFA and the Due Process Clause of the United States Constitution.