• Breaking News:  Ohio's First CAT Nexus "Test Case" Finally on Track
  • October 12, 2010 | Author: Laura A. Kulwicki
  • Law Firm: Jones Day - Columbus Office
  • When Ohio first adopted a controversial "bright-line presence" nexus standard for its new commercial activity tax ("CAT") back in 2005, few taxpayers would have guessed that more than five years later, the constitutional questions surrounding the aggressive new standard would still remain unresolved. But until just a few weeks ago, no clear "test case" was on track to challenge the statute and address these issues. All of this changed on August 10, 2010, when the Ohio Department of Taxation (the "Department") issued its first public-record decision on CAT nexus to L.L. Bean, Inc., affirming assessments issued to a retailer that has significant sales to Ohio customers but no physical presence within Ohio.

    L.L. Bean is a traditional catalog and internet seller based in Maine. While it has retail stores in several other states, it has no stores or other physical presence in Ohio. L.L. Bean's annual sales to customers in Ohio exceeded $500,000 during each of the periods at issue. When L.L. Bean failed to register for the CAT, the Department assessed it; L.L. Bean responded by filing a petition for reassessment to administratively challenge the tax.

    Because L.L. Bean met the statutory "bright-line presence" test (which defines nexus solely on the basis of annual sales to Ohio residents in excess of $500,000), it is not surprising that the Department concluded that L.L. Bean was subject to tax. The Department's final determination in In re L.L. Bean, Inc. thus squarely tees up the nexus question for resolution by Ohio courts. While still in the very early stages of the appeals process, the issue presented in L.L. Bean is a fairly straightforward one: Must a taxpayer have some physical presence in Ohio before it can be constitutionally required to pay the CAT, or is the statutory requirement of economic presence alone enough?

    Resolution of the question will turn on whether the United States Supreme Court's longstanding "physical presence" requirement applies to the Ohio CAT. At the heart of the issue is the application of the Supreme Court's decision in Quill Corp. v. North Dakota, 504 U.S. 298 (1992). There, the Court unequivocally held that a mail-order seller lacked substantial nexus under the Commerce Clause—and therefore could not be constitutionally required to collect and remit sales and use tax—because it had no physical presence in the taxing state. Since Quill, state courts have differed in their views as to whether Quill's physical-presence nexus test is limited solely to sales and use taxes. Despite a split of authority among the states, the U.S. Supreme Court has not agreed to review the issue, and the Ohio Supreme Court has not squarely resolved it either. At its core, therefore, the L.L. Bean case will ultimately force the Ohio Supreme Court to determine whether Quill applies to the CAT. If the Department prevails in its view that it does not, L.L. Bean (and countless other out-of-state businesses) will face the curious result of being forced to pay a direct tax measured by the gross amount of sales to its Ohio customers (the CAT), while at the same time being constitutionally protected from any obligation to collect and remit sales tax on those same sales.

    The Ohio CAT Nexus Standard and Its Conflict With Quill

    The CAT has been in effect since July 1, 2005, when the State of Ohio imposed this broad-based gross receipts tax "on each person with taxable gross receipts for the privilege of doing business in this state." R.C. 5751.02. Under the terms of the statute, any business with "substantial nexus"—defined to include companies that merely have "taxable gross receipts" from sources in Ohio totaling at least $500,000—is required to register and pay the CAT. R.C. 5751.02(A), 5751.01(H), (I).[1] The statute calls this "bright-line presence."

    On the basis of this statutory standard alone, many companies traditionally immune from state taxation meet the threshold standards sufficient to trigger CAT obligations. However, the obligation to register, file tax returns, and pay state taxes is not defined solely by the applicable state tax statute. Indeed, the Commerce Clause of the U.S. Constitution (U.S. Const. art. I, § 8, cl. 3) prohibits a state from imposing tax registration, filing, and collection obligations unless the person has "substantial nexus" with the taxing state. See, e.g., Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977).

    More than 40 years of U.S. Supreme Court precedent supports L.L. Bean's view that nexus requires a physical presence. For example, in National Bellas Hess, Inc. v. Illinois Dept. of Revenue, 386 U.S. 753 (1967), the Supreme Court considered the issue of tax nexus in the context of an out-of-state mail-order seller that, like L.L. Bean, sold merchandise to customers in the state exclusively through interstate commerce. There, the Court created a bright-line substantial nexus test by drawing a "sharp distinction" between those mail-order sellers that "do no more than communicate with customers in the State by mail or common carrier as part of a general interstate business" and those that have an actual physical presence in the state by maintaining property, stores, or employees there. Bellas Hess, 386 U.S. at 758. Twenty-five years later, the Supreme Court reaffirmed this physical-presence rule in Quill, declaring that a "bright-line, physical presence requirement" remains the proper measure of whether a vendor has "substantial nexus" with the taxing state. Quill, 504 U.S. at 311, 314-15.

    The "bright-line presence" standard for nexus under the CAT defines nexus solely on the basis of economic connections, without regard for physical presence. When measured against Quill's physical-presence test, therefore, the CAT is unconstitutional as applied to a business that is not physically present in Ohio.

    Round 1: The L.L. Bean Final Determination

    L.L. Bean maintained that it is not constitutionally subject to tax—irrespective of whether or not it meets the statutory definition of "bright-line presence" in Ohio—because it lacks "substantial nexus" as required by the Commerce Clause. The Department disagreed. First, it upheld the assessments simply because L.L. Bean, by conceding that its annual sales to Ohio were in excess of the $500,000 statutory thresholds, met the definition of "bright-line presence" in R.C. 5751.01(I)(3) and thus was squarely subject to the tax. Second, the Department also relied on a statutory "catchall" condition in R.C. 5751.01(H)(4), which defines CAT nexus to include a person that "[o]therwise has nexus with this state to an extent that the person can be required to remit the tax imposed under this chapter under the Constitution of the United States."

    While the Department has no jurisdiction to decide the constitutional objections raised by L.L. Bean, it did reject L.L. Bean's claim that Quill applied and thus prevented the Department from subjecting it to CAT liabilities. The Department—like that of many other states—takes the position that Quill applies only to sales and use taxes, leaving the Department free to ignore the physical-presence rule when other types of taxes are at issue. Focusing on catalog mailings and L.L. Bean's more than $100 million in sales to Ohio residents during the period at issue, the Department concluded that L.L. Bean's "continuous, systematic, and significant solicitation and exploitation of the economic marketplace in Ohio is sufficient" to create substantial nexus under the Commerce Clause. Since R.C. 5751.01(H)(4) requires the CAT to be imposed to the fullest extent permissible under the Constitution, the Department relied on both "bright-line presence" and the statutory catchall provision to conclude that L.L. Bean was properly subject to tax.

    While the case focuses on whether economic ties alone are enough to create CAT liability, the Department has nevertheless hedged its bets and specifically reserved its right to make a case to establish CAT nexus for L.L. Bean on traditional physical-presence-nexus grounds. Footnote 1 in the final determination notes the following:

    Given the bright-line nexus standard set forth in R.C. 5751.01(H)(3) and R.C. 5739.01(I)(3), and the "economic presence" nexus encompassed within the scope of R.C. 5751.01(H)(4), the Tax Commissioner has not investigated nor issued findings concerning the petitioner's assertion that it lacked a "physical presence" in this state during any of the assessed periods. In the event, however, that the Commissioner's final determination is appealed and, on appeal the reviewing tribunal or court does not ultimately sustain the Commissioner's final determination on either of these grounds, the Commissioner hereby reserves ruling on the petitioner's assertion that it lacked a "physical presence" within the state during any of the assessment periods. In such event, the Tax Commissioner would render findings on the "physical presence" issue upon remand of any such adverse ruling.

    Thus, the Department has kept open the possibility of sustaining the assessments against L.L. Bean on more traditional grounds if the Department's view on economic nexus is not ultimately shared by the courts.

    Round 2: An Appeal to the Ohio Board of Tax Appeals

    To challenge the final determination, L.L. Bean must next file an appeal to the Ohio Board of Tax Appeals (the "BTA") within 60 days. The BTA is a quasi-judicial body empowered to hear and determine appeals from final determinations of the Tax Commissioner. See R.C. 5703.02. It serves as the independent trial-level tribunal for all Ohio tax matters. Further review is by direct appeal to the Ohio Supreme Court, where jurisdiction and review are mandatory rather than discretionary.

    While the next level in the appeal process for L.L. Bean is the Ohio BTA, the BTA has no authority to rule on the ultimate constitutional question. As a creature of statute, the BTA has no power to determine the constitutionality of a statute or to grant equitable relief. Instead, the BTA's role is to receive evidence and rule on factual issues. It is this factual record that will serve as the basis for the Ohio Supreme Court's resolution of the constitutional question.

    Indeed, the BTA's role in a constitutional case of this kind is well defined. In MCI Telecommunications Corp. v. Limbach, 68 Ohio St. 3d 195 (1994), for example, the Ohio Supreme Court explained that the BTA must receive the evidence that the court needs to make its constitutional findings and rule on the constitutional issue:

    The question of whether a tax statute is unconstitutional when applied to a particular state of facts must be raised in the notice of appeal to the Board of Tax Appeals, and the Board of Tax Appeals must receive evidence concerning this question if presented, even though the Board of Tax Appeals may not declare the statute unconstitutional.

    See also Cleveland Gear Co. v. Limbach, 35 Ohio St. 3d 229 (1988); Bd. of Edn. of South-Western City Schools v. Kinney, 24 Ohio St. 3d 184 (1986). While the BTA has no power to rule on the constitutional question, it is a necessary step in the appeal process. The court has explicitly rejected a "constitutional issue" exception to the general rule that all matters must first be raised and tried before the BTA.


    The Department's recent ruling in L.L. Bean is the first step toward determining whether the Ohio CAT nexus standard is constitutional. However, it will still be quite some time before taxpayers have clear guidance on this issue. The BTA has no power to rule on the constitutional issue, and there are significant case backlogs at the BTA that could limit the parties' ability to complete the BTA process in a speedy fashion before moving on to the Ohio Supreme Court.

    Stay tuned in Ohio . . . .

    [1] "Substantial nexus" for CAT purposes exists if the taxpayer: (1) owns or uses part or all of its capital in Ohio; (2) holds a certificate of compliance authorizing it to do business in the state; (3) has "bright-line presence" in the state; or (4) otherwise has nexus under the U.S. Constitution. R.C. 5751.01(H). The taxpayer has "bright-line presence" if: 1) it has at least $50,000 of property in Ohio; (2) its payroll in Ohio totals at least $50,000; (3) its annual taxable gross receipts total at least $500,000; (4) at least 25 percent of its total property, payroll, or gross receipts is in Ohio; or (5) it is domiciled in Ohio. R.C. 5751.01(I).