Nexus Prong of Complete Auto Test for Taxes on Interstate Commerce

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Article I, Section 8, Clause 3:

[The Congress shall have Power . . . ] To regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes; . . .

In Complete Auto Transit, Inc. v. Brady,1 the Court held that a state tax on interstate commerce will be sustained “when the tax is applied to an activity with a substantial nexus with the taxing State, is fairly apportioned, does not discriminate against interstate commerce, and is fairly related to the services provided by the State.” 2 The first prong of the Complete Auto test, which this essay concerns,3 asks whether the tax applies to an activity with a “substantial nexus” with the taxing state, which requires the taxpayer to “avail[ ] itself of the substantial privilege of carrying on business in that jurisdiction.” 4 This requirement runs parallel to the “minimum contacts” requirement under the Due Process Clause that a state must meet to exercise control over a person, that person’s property, or a transaction involving the person.5 Specifically, under the due process requirement, there must be “some definite link, some minimum connection between a state and the person, property, or transaction it seeks to tax.” 6 The “broad inquiry” under “both constitutional requirements” 7 is “whether the taxing power exerted by the state bears fiscal relation to protection, opportunities and benefits given by the state—” i.e., “whether the state has given anything for which it can ask return.” 8

Until the Court’s 2018 decision in South Dakota v. Wayfair,9 the Court imposed a relatively narrow interpretation of the minimum contacts test in two cases, which involved a state’s ability to require an out-of-state seller to collect and remit tax from a sale to a consumer within that state. First, in the 1967 case of National Bellas Hess, Inc. v. Department of Revenue, the Court held that unless a retailer maintained a physical presence with the state, the state lacked the power to require that retailer to collect a local use tax.10 A quarter of a century later, the Court reaffirmed Bellas Hess's physical presence rule under the Commerce Clause in Quill v. North Dakota.11

In South Dakota v. Wayfair, however, the Court overruled both cases, rejecting the rule that a retailer must have a physical presence within a state before the state may require the retailer to collect a local use tax.12 Several reasons undergirded the Wayfair Court’s rejection of the physical presence rule. First, the Court noted that the rule did not comport with modern Dormant Commerce Clause jurisprudence, which viewed the substantial nexus test as “closely related” to and having “significant parallels” with the due process minimum contacts analysis.13 Second, Justice Anthony Kennedy viewed the Quill rule as unmoored from the underlying purpose of the Commerce Clause: to prevent states from engaging in economic discrimination.14 Contrary to this purpose, the Quill rule created artificial market distortions that placed businesses with a physical presence in a state at a competitive disadvantage relative to remote sellers.15 Third, the Wayfair Court viewed the physical presence rule, in contrast with modern Commerce Clause jurisprudence, as overly formalistic.16 More broadly, the majority opinion criticized the Quill rule as ignoring the realities of modern e-commerce wherein a retailer may have “substantial virtual connections” to a state without having a physical presence.17

As the Court in Wayfair noted, the substantial nexus inquiry has tended to reject formal rules in favor of a more flexible inquiry.18 Thus, maintenance of one full-time employee within the state (plus occasional visits by non-resident engineers) to make possible the realization and continuance of contractual relations seemed to the Court to make almost frivolous a claim of lack of sufficient nexus.19 The application of a state business-and-occupation tax on the gross receipts from a large wholesale volume of pipe and drainage products in the state was sustained, even though the company maintained no office, owned no property, and had no employees in the state, its marketing activities being carried out by an in-state independent contractor.20 The Court also upheld a state’s application of a use tax to aviation fuel stored temporarily in the state prior to loading on aircraft for consumption in interstate flights.21

Providing guidance on what states may tax, the Court’s unitary business principle looks at whether the taxpayer’s intrastate and extra-state activities form a “single unitary business” or if the extra-state activities are unrelated to the instrastate activities and instead form a discrete business.22 In MeadWestvaco Corp. v. Illinois Department of Revenue, the Supreme Court stated:

When there is no dispute that the taxpayer has done some business in the taxing State, the inquiry shifts from whether the State may tax to what it may tax. To answer that question, [the Court has] developed the unitary business principle. Under that principle, a State need not isolate the intrastate income-producing activities from the rest of the business but may tax an apportioned sum of the corporation’s multistate business if the business is unitary. The court must determine whether intrastate and extrastate activities formed part of a single unitary business, or whether the out-of-state values that the State seeks to tax derive[d] from unrelated business activity which constitutes a discrete business enterprise. . . . If the value the State wishe[s] to tax derive[s] from a ‘unitary business’ operated within and without the State, the State [may] tax an apportioned share of the value of that business instead of isolating the value attributable to the operation of the business within the State. Conversely, if the value the State wished to tax derived from a discrete business enterprise, then the State could not tax even an apportioned share of that value.23

However, notwithstanding the existence of a unitary business, a “minimal connection” or “nexus” must still exist between the state and the taxpayer’s interstate activities to meet constitutional standards as well as a “rational relationship” between the amount taxed and the taxpayer’s intrastate activities.24 As the Court explained in Container Corp. v. Franchise Tax Board:

The Due Process and Commerce Clauses of the Constitution do not allow a State to tax income arising out of interstate activities—even on a proportional basis—unless there is a ‘minimal connection’ or ‘nexus’ between the interstate activities and the taxing State and ‘a rational relationship between the income attributed to the State and the intrastate values of the enterprise.'25

1: 430 U.S. 274 (1977).
2: Id. at 279. “In reviewing Commerce Clause challenges to state taxes, our goal has instead been to ‘establish a consistent and rational method of inquiry’ focusing on ‘the practical effect of a challenged tax.’” Commonwealth Edison Co. v. Montana, 453 U.S. 609, 615 (1981) (quoting Mobil Oil Corp. v. Comm’r of Taxes, 445 U.S. 425, 443 (1980)).
3: ArtI.S8.C3.7.11.5 Apportionment Prong of Complete Auto Test for Taxes on Interstate Commerce; ArtI.S8.C3.7.11.6 Discrimination Prong of Complete Auto Test for Taxes on Interstate Commerce; ArtI.S8.C3.7.11.7 Benefit Prong of Complete Auto Test for Taxes on Interstate Commerce.
4: See Polar Tankers, Inc. v. City of Valdez, 557 U.S. 1, 11 (2009) (internal citations and quotations omitted).
5: See MeadWestvaco Corp. v. Ill. Dep’t of Revenue, 553 U.S. 16, 24 (2008).
6: See Miller Bros. Co. v. Maryland, 347 U.S. 340, 344–45 (1954).
7: See MeadWestvaco Corp. 553 U.S. at 24 .
8: See Wisconsin v. J.C. Penney Co., 311 U.S. 435, 444 (1940).
9: South Dakota v. Wayfair, No. 17-494, slip op. at 22 (U.S. June 21, 2018).
10: 386 U.S. 753, 758 (1967).
11: See 504 U.S. 298 (1992).
12: See Wayfair, slip op at 22.
13: Id. at 10–12. The Court, citing Burger King Corp. v. Rudzewicz, 471 U.S. 462, 476 (1985), concluded that it is “settled law that a business need not have a physical presence in a State to satisfy the demands of due process.” See Wayfair, slip op. at 11.
14: See Wayfair, slip op. at 12 (noting that the purpose of the Commerce Clause was to prevent states from engaging in economic discrimination and not to “permit the Judiciary to create market distortions.” ) Id.
15: Id. at 12–13.
16: Id. at 14–15.
17: Id. at 15.
18: Id. at 14.
19: Standard Pressed Steel Co. v. Dep’t of Revenue, 419 U.S. 560 (1975). See also Gen. Motors Corp. v. Washington, 377 U.S. 436 (1964).
20: Tyler Pipe Indus. v. Dep’t of Revenue, 483 U.S. 232, 249–51 (1987). The Court agreed with the state court’s holding that “the crucial factor governing nexus is whether the activities performed in this state on behalf of the taxpayer are significantly associated with the taxpayer’s ability to establish and maintain a market in this state for the sales.” Id. at 250.
21: United Air Lines v. Mahin, 410 U.S. 623 (1973).
22: MeadWestvaco Corp. v. Ill. Dep’t of Revenue, 128 S. Ct. 1498, 1505–06 (2008).
23: Id. (citations and internal quotation marks omitted). The holding of this case was that the concept of “operational function,” which the Court had introduced in prior cases, was “not intended to modify the unitary business principle by adding a new ground for apportionment.” Id. at 1507–08. In other words, the Court declined to adopt a basis upon which a state could tax a non-unitary business.
24: Container Corp. of Am. v. Franchise Tax Bd., 463 U.S. 159, 165–66 (1983) .
25: Id. (internal quotation marks omitted). See also ASARCO Inc. v. Idaho State Tax Comm’n, 458 U.S. 307, 316–17 (1982); Hunt-Wesson, Inc. v. Franchise Tax Bd., 528 U.S. 458 (2000) (interest deduction not properly apportioned between unitary and non-unitary business).