Ohio can impose its commercial-activity tax (CAT) on out-of-state companies that sell products and services to Ohioans, but have no physical presence in the state, the Ohio Supreme Court ruled today.

In a 5-2 decision, the Supreme Court determined the U.S. Constitution’s commerce clause does not prevent a state from imposing a “privilege to do business” tax, such as the CAT, on online retailers. Writing for the Court majority, Justice William M. O’Neill determined that while a physical presence in a state may be required to impose the obligation to collect sales taxes and use taxes on an out-of-state seller, that requirement does not apply to a business tax on an interstate company. Ohio’s $500,000 in annual sales threshold for the CAT to apply meets the commerce clause requirement, he concluded.

In a dissenting opinion, Justice Sharon L. Kennedy wrote the U.S. Supreme Court issued the last word on taxing out-of-state companies in 1992, in Quill Corp. v. North Dakota when it ruled that a physical presence is required. She asserted that only Congress or the U.S. Supreme Court can change the current state of the law on taxing interstate commerce.

The Court’s opinion affirms a Board of Tax Appeals (BTA) decision upholding the Ohio tax commissioner’s imposition of the CAT on Virginia-based Crutchfield Corporation. The Court today also decided two companion cases involving Newegg Inc., which the Court noted is the nation’s second largest online retailer, and Wisconsin-based Mason Companies. Earlier this year, the Court consolidated the three cases for oral arguments because the online retailers essentially made the same claims when appealing the BTA ruling.

State Tax Overhaul Applies to Out-of-State Retailers
As part of a sweeping overhaul of Ohio’ state tax system in 2005, the General Assembly adopted the CAT. Under R.C. 5751.02(A) the CAT is imposed on every person with taxable gross receipts for the privilege of doing business in the state. The tax commissioner determined that orders of goods initiated by Ohio consumers on their computers and transported into Ohio by an out-of-state company make the company’s sales “taxable gross receipts.”

U.S. Supreme Court rulings have indicated that under the commerce clause, an out-of-state company’s transactions must have a “substantial nexus” with a state in order to be taxed. Crutchfield argued that the U.S. Supreme Court has ruled a company must have a physical presence in the state to fulfill the substantial nexus test. The Ohio tax commissioner has countered that a physical presence is not required, and that the General Assembly applies the CAT only if a business earns $500,000 or more in annual gross sales in Ohio. The $500,000 level was termed a “bright-line presence,” and the commissioner maintained it meets the requirement of a substantial nexus for companies that have no physical presence in the state.

Company Refused to Pay CAT
The tax commissioner audited Crutchfield from July 2005, when the CAT was first imposed, until 2010, and assessed the company nearly $66,000 for refusing to pay the tax. With interest and penalties, the commissioner concluded the company owed $106,000. The commissioner continued to audit and assess Crutchfield through mid-2012, and the final determinations were nearly identical, stating that Crutchfield is a direct marketer selling consumer electronics through the Internet from locations entirely outside of Ohio. The commissioner rejected Crutchfield’s argument that it does not have a substantial nexus with the state as defined by R.C. 5751.01(H).

Crutchfield appealed the commissioner’s finding to the BTA, which found that, under the bright-line $500,000 threshold in the law, Crutchfield was obligated to pay the tax. The BTA noted it does not rule on challenges based on constitutional grounds, such as the commerce clause, which may only be considered by the Court on appeal. The company appealed, and the Court was required by statute to hear the case.

Court Interprets Commerce Clause
Justice O’Neill wrote the Court examined the “before and after” view of the U.S. Supreme Court from its case law regarding state taxing power under the “dormant Commerce Clause.” The pivotal case, he noted, was 1977’s Complete Auto Transit Inc. v. Brady. Article 1, Section 8, Clause 3 of the U.S. Constitution is known as the commerce clause and gives Congress the power “to regulate commerce with foreign nations, and among the several states, and with the Indian tribes.” The “dormant Commerce Clause” comes from the implication that since Congress has the power to regulate interstate commerce, states do not have the right to pass laws that discriminate or impose excessive burdens on companies engaged in interstate commerce.

Justice O’Neill explained the Complete Auto decision rejected the notion that interstate commerce is immune from state taxation, and applied a new four-part test that allows a state to tax a company with a substantial nexus to the state. The main flaw in Crutchfield’s argument is that it relies on the “since-discarded theory of interstate-commerce immunity from state taxation,” he wrote. Even if interstate commerce is not immune, Crutchfield argued that a substantial nexus is required and that the U.S. Supreme Court’s 1992 Quill Corp. v. North Dakota decision confirmed that a physical presence in the state is required to meet the substantial nexus rule.

Justice O’Neill distinguished the Quill case because it dealt with the state’s legal requirement that out-of-state sellers act as agents of the state by charging, collecting, and remitting sales or use taxes when in-state buyers order items for delivery. In Quill, the state was imposing an “administrative obligation” on the company for regularly marketing its product and selling to North Dakota residents. Physical presence was required for imposing the tax on companies, asserting that those with retail outlets, property, or agents working in the state should pay while those merely interacting with consumers by mail and package delivery should not. The justification, Justice O’Neill maintained, was to limit the burden on companies from numerous state use taxes that have differing rates, exemptions, and record-keeping requirements.

Unlike the obligation to collect use tax, which imposes the burden of tax administration on the out-of-state seller, a business-privilege tax does not, Justice O’Neill wrote. And while a physical presence can be one way to determine if a company has a substantial nexus with the state, it is not a requirement for a privilege tax like the CAT. The CAT need only be imposed with an adequate standard that ensures the taxpayer’s connection to the state is substantial, and the $500,000 minimum meets the test, he concluded.

“We hold that the $500,000 sales-receipts threshold complies with the substantial-nexus requirement of the Complete Auto test,” he wrote.

Justice O’Neill added that a “quantitative standard,” such as the $500,000 minimum, is necessary to apply the CAT to out-of-state sellers, and that the amount of required sales is high enough to meet the federal constitutional requirement that a tax on interstate commerce be even-handedly applied to in-state and out-of-state companies and that it not impose an excessive burden on commerce.

“Were the state to tax all receipts without any regard for the volume of Ohio sales, the CAT could become clearly excessive as to a business with a very small amount of such receipts. The General Assembly has sensibly attempted to foreclose that possibility by setting a minimum sales-receipts threshold,” he wrote.

Justice O’Neill noted that in addition to arguing the CAT did not require a physical presence, the tax commissioner also maintained that Crutchfield did have a physical presence because some of its contractors and their equipment that facilitate Internet use were located in Ohio. Because the Court found a physical presence was not required, it declined to address the question of whether the company had a physical presence through the equipment use.

Newegg and Mason Addressed
The Court issued brief separate opinions for Newegg and Mason, adding some specifics about each company’s appeal. The tax commissioner conducted six assessments of Newegg, which shipped products from California and New Jersey, from the onset of the CAT through 2009. The commissioner concluded Newegg had more than $272 million in Ohio sales for that time and had Ohio sales of nearly $20 million per quarter through 2011. The commissioner assessed Mason 24 times from July 2005 until late 2011 for business it did by phone, mail, and online. Without stating a specific sales estimate for Mason, the Court concluded the company met the $500,000 minimum and was subject to the tax.

Chief Justice Maureen O’Connor and Justices Paul E. Pfeifer, Terrence O’Donnell, and Judith L. French joined Justice O’Neill’s opinions in the three cases.

Dissent Would Require Physical Presence
In her dissent, Justice Kennedy wrote this case is not about the wisdom of imposing a business-privilege tax or the constitutionality of the CAT, in general, but rather whether online purchases made by Ohio residents create a substantial nexus between the state and an out-of-state business. She asserts the U.S. Supreme Court’s decisions require an out-of-state company to have a physical presence in a taxing state in order for the state to tax the out-of-state company.

She recognized allowing out-of-state businesses to avoid paying the CAT might seem unfair to some, but she stated, “While I am sympathetic to all Ohio-based businesses that must pay a business-privilege tax such as the CAT, this court nevertheless should follow the law as it exists today.”

Justice Kennedy noted the commerce clause’s implicit limit on states’ power to burden interstate commerce by taxing out-of-state businesses has been affirmed by the U.S. Supreme Court as far back as 1825 (Gibbons v. Ogden) and as recently as 2015 (Comptroller of the Treasury of Maryland v. Wynne). She pointed out that the commerce clause grants Congress, not individual states, the power to regulate the instrumentalities of interstate commerce, and federal courts have determined that the Internet is an instrumentality of interstate commerce. She wrote that the Quill decision was the last word from the federal Supreme Court on the physical presence requirement, and while some members of the U.S. Supreme Court have indicated that technological advancements might make them reconsider their position, they have not ruled on the matter.

Justice Kennedy asserted that she sees no evidence that gross-receipts taxes are meaningfully different than use taxes for the substantial nexus requirement. She cited the 1987 Taylor Pipe Industries, Inc. v. Washington State Dept. of Revenue, in which the U.S. Supreme Court affirmed the use of a physical presence test for a gross-receipts tax, which she found to be similar to a business-privilege tax like the CAT. The Court relied on the Quill decision to decide Taylor Pipe, she noted.

She reasoned the limit on taxing out-of-state companies is in line with “common sense” because companies should not be forced to comply with Ohio’s law solely because Ohioans choose to buy products from them.

“Under the CAT as construed by the majority, a business could be forced to pay Ohio taxes if just one Ohioan spent more than $500,000 on its products. It is easy to imagine an Ohio manufacturing business ordering one machine from an out-of-state business, and that would trigger a requirement for that business to comply with the CAT,” she wrote. “The business could have no other connection with the state, but Ohio could drag it into Ohio’s taxing scheme based on one act of interstate commerce.”

In addition to the U.S. Supreme Court changing its view on physical presence and overruling Quill, Justice Kennedy noted Congress is considering legislation to require online retailers collect sales taxes, and while bills are pending, Ohio is asking residents to voluntarily report and pay sales tax on out-of-state purchases made over the Internet. She emphasized that “Congress could also authorize the states to impose taxes on out-of-state retailers like Crutchfield.”

She concluded it is not the role of the Ohio Supreme Court to affirm the state’s attempt to regulate interstate commerce just because Congress has been silent on the issue. She would remand the case to the BTA to determine if Crutchfield’s computerized connections to Ohio are enough to meet the physical presence test.

Justice Judith Ann Lanzinger joined Justice Kennedy’s dissent in the three cases.

2016-0386. Crutchfield Corp. v. Testa, Slip Opinion No. 2016-Ohio-7760.

View oral argument video of this case.

2015-0483. Newegg Inc. v. Testa, Slip Opinion No. 2016-Ohio-7762.

2015-0794. Mason Cos., Inc. v. Testa, Slip Opinion No. 2016-Ohio-7768.

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