California dreamin’: a modern nexus concept for
international taxation
Master’s Thesis Tax Law
Name: Max Velthoven
Supervisor: Maarten de Wilde Student Number: 10833692
Master track: Tax Law - International and European Tax Law Total EC’s: 12
3 Contents Abbreviations ... 5 1. Acknowledgements ... 7 2. Introduction ... 9 2.1. Research motivation... 9
2.2. Introduction of the subject ... 9
2.3. Problem statement ... 10
2.4. Formulary apportionment... 11
2.5. Framework ... 11
2.6. Legal comparative framework ... 12
2.7. American law ... 13
2.8. Research structure ... 13
3. The concept of permanent establishment ... 15
3.1. Historical context ... 15
3.2. Current definition ... 16
3.3. Agency-PE ... 18
4. The current issues with the permanent establishment in international taxation ... 21
4.1. Digital economy ... 21
4.2. Discussion Draft ... 22
4.3. Proposed solutions ... 25
4.4. Considerations ... 26
4.5. PE and the market ... 27
5. The determination of taxable income after a permanent establishment is constituted ... 31
5.1. Guiding principles ... 31
5.2. Separate entity and arm’s length principles ... 32
5.3. Considerations ... 34
6. The constitutional framework for nexus in state taxation in the United States ... 35
6.1. Due Process Clause and Commerce Clause ... 35
6.2. Public Law 86-272 ... 36
6.3. Dormant Commerce Clause ... 37
6.4. Miller Bros. v. Maryland ... 38
6.5. National Bellas Hess, Inc. v. Department of Revenue ... 41
6.6. Complete Auto Transit, Inc. v. Brady ... 43
6.7. Quill Corp. v. North Dakota ... 44
6.8. Geoffrey, Inc. v. South Carolina Tax Commission ... 46
4
7. Nexus for state corporate income tax under the MTC Nexus Standard... 49
7.1. MTC Nexus Program ... 49
7.2. Factors ... 50
7.3. Group approach ... 51
7.4. Nexus in California ... 52
7.5. Considerations ... 53
8. The determination of taxable income after nexus has been established under the MTC Nexus Standard ... 55
8.1. Unit Rule ... 55
8.2. Different formulae ... 56
8.3. Throwback ... 57
8.4. Considerations ... 58
9. A quantitative nexus concept work for the CCCTB ... 59
9.1. CCCTB proposals ... 59
9.2. The PE in the CCCTB ... 61
9.3. Avoidance concerns ... 62
9.4. A quantitative nexus concept for the CCCTB ... 64
9.5. Need for nexus? ... 67
9.6. Sales factor and VAT ... 68
9.7. Goods ... 68
9.8. Services ... 69
9.9. Administrative framework ... 70
9.10. Taxable presence in the CCCTB using the MTC Nexus Standard ... 71
9.11. Efficiency, equity, and simplicity ... 72
10. Conclusion ... 75 11. Literature ... 79 11.1. Books ... 79 11.2. Articles ... 79 11.3. Internet ... 82 12. Case Law ... 83
12.1. United States Supreme Court ... 83
5 Abbreviations
BEPS Base Erosion and Profit Shifting
CCCTB Common Consolidated Corporate Tax Base
Commentary Commentary to the OECD Model Convention
Compact Multistate Tax Compact
Constitution United States Constitution
EU European Union
MTC Multi State Tax Commission
MTC Nexus Standard Factor Presence Nexus Standard for Business Activity Taxes developed by the MTC
OECD The Organization for Economic Co-operation and
Development
PE Permanent Establishment
Supreme Court Supreme Court of the United States
TP Guidelines OECD Transfer Pricing Guidelines
7 1. Acknowledgements
Some kind words are in order to address the people who have enabled me to write this thesis. I would like to start by thanking my thesis supervisor Maarten de Wilde who has helped me to further develop my insights in this topic. I have thoroughly enjoyed our brainstorm sessions and have learned a lot. My previous supervisor Sebastiaan Wolvers has been helpful in getting me to focus on the more conceptual aspects of my topic instead of the more national framework with which I started.
It takes help to fiscally cross the pond, for which I thank Thomas Shimkin (MTC), William Kolarik (EY), and all the people at ATR but especially Ryan Ellis. Thanks for constructive criticism and cozy coffees go to my fellow students, especially to Milou Bonnema, Larissa Praat, and Martijn Vroom. Thanks to my family for their support during my years of study.
9 2. Introduction
California dreamin’: a modern nexus concept for international taxation
In this introduction I will firstly present the motivation for my research. Next I will continue with an introduction of the subject and my problem statement. Lastly I will set the structure of my research and the legal comparative framework.
2.1. Research motivation
In the spring of 2014 I interned in Washington D.C. at Americans for Tax Reform’s State Tax Team. During this internship I have learned and written a lot about American tax law, on both the federal and state level.1 I also noticed that I like comparing taxation of the Netherlands and the United States.2 Whilst interning at Americans for Tax Reform I attended a conference, U.S. State Tax Considerations for International Tax Reform, hosted by Taxanalysts. The topic of this conference was the developments in international tax law from an American state tax law perspective.3 It occurred that there were numerous parallels between the fiscal challenges of the American states and the current issues in international tax law. Furthermore, there were interesting similarities between the U.S. and the increasingly federalizing European Union.
2.2. Introduction of the subject
Lately the nexus concept of permanent establishment (hereafter: PE) has been under pressure because it would no longer suffice in the modern economy.4 In international taxation, nexus determines the right of a state to tax the profits of a company of another state. Since its introduction the PE concept has been focusing on physical reference points, whilst physical presence is very often not a requirement for profitable business nowadays.5 In the OECD
1 http://dailycaller.com/2014/06/04/north-carolina-should-repeal-the-fridge-tax/. 2 In this article I compare the Dutch Box 3 tax with the American Capital Gains Tax:
http://www.forbes.com/sites/theapothecary/2014/05/23/can-a-financial-assets-tax-be-a-pro-growth-replacement-for-the-capital-gains-tax/.
3 Taxanalysts, U.S. State Tax Considerations for International Tax Reform, 2014.
4 A. Skaar, Permanent Establishment – Erosion of a Tax Treaty Principle, Ad Notam Forlag, 1994, p. 19;
OECD BEPS Action Point 7; Y.Brauner, ‘Prevent the Artificial Avoidance of PE status’, Taxanalysts - U.S.
State Tax Considerations For International Tax Reform, 2014, p. 121.
5 OECD Action Plan on Base Erosion and Profit Shifting, p. 19; Offermans and Bal, ‘Internationale
belastingheffing van cloud’, Maandblad Belasting Beschouwingen 2014/07/08; Y.Brauner, ‘Prevent the Artificial Avoidance of PE status’, Taxanalysts - U.S. State Tax Considerations For International Tax Reform, 2014, p. 121.
10 Model Convention the PE is defined as ‘’a fixed place of business through which the business of an enterprise is wholly or partly carried on.’’6
In the Action Plan Base Erosion and Profit Shifting (hereafter: BEPS) published by the OECD, the prevention of the artificial avoidance of the PE status is one of the key points under Action Point 7.7 It is also a concern under the Action Points 1 and 6.8 It seems inevitable that the PE concept will undergo changes in the coming years or may even disappear.9 Therefore it is useful to look abroad for sources of inspiration for a new nexus concept for international taxation.10
2.3. Problem statement
The PE concept seems insufficiently prepared for the challenges of the modern economy. In the United States there is model legislation for state taxation which concerns the establishment of nexus for non-resident companies. This model legislation is called the Factor Presence Nexus Standard for Business Activity Taxes (hereafter: MTC Nexus Standard) developed by the Multi State Tax Commission (hereafter: MTC). This nexus standard has been implemented in several states. The concept of the MTC Nexus Standard differs considerably from the term permanent establishment as defined by the OECD. It determines nexus for taxation by making use of quantitative thresholds, instead of the qualitative PE criteria. The main research question is:
‘’Should the permanent establishment be replaced by a quantitative factor presence nexus test for the determination of nexus in international taxation?’’
I will also go into more detail on the determining of taxable income if nexus is present under the MTC Nexus Standard. Since the MTC Nexus Standard is a fundamentally different
6 Article 5 paragraph 1 OECD Model Convention.
7 Action Plan on Base Erosion and Profit Shifting, p. 19; P.Kavelaars, ‘Fiscaal digitaal geworstel’, NTFR
2014-2096; Y.Brauner, ‘Prevent the Artificial Avoidance of PE status’, Taxanalysts - U.S. State Tax Considerations
For International Tax Reform, 2014, p. 121.
8 OECD BEPS Action Points 1 and 6.
9 Action Plan on Base Erosion and Profit Shifting, p. 19; P.Kavelaars, ‘Fiscaal digitaal geworstel’, NTFR
2014-2096; Y.Brauner, ‘Prevent the Artificial Avoidance of PE status’, Taxanalysts - U.S. State Tax Considerations
For International Tax Reform, 2014, p. 121
10 D. Bucks, ‘Can Nations Find Answers in the States?’, Taxanalysts - U.S. State Tax Considerations For
International Tax Reform, 2014, p. 7; D. Ernick, H. Bissoondial, J. Kramer, ‘You Look Familiar – the OECD
Looks to U.S. State Tax Policy for BEPS Solutions’, Taxanalysts - U.S. State Tax Considerations For
11 concept than the PE it would also require another way of determining taxable income. PE attribution regimes, which revolve around the idea that the PE is a distinct and independent company, would not work if used in combination with a quantitative nexus concept.
2.4. Formulary apportionment
A quantitative nexus concept could however be combinable with a formulary apportionment system as is currently in place in state taxation in the United States. Another example of formulary apportionment the tax base is the proposed European Common Consolidated Corporate Tax Base (hereafter: CCCTB). I will discuss the possibility of implementing a nexus standard in the CCCTB and will argue that this is better than using the current PE-definition by the OECD to determine nexus under the CCCTB.
Apportionment systems rely heavily on (worldwide) unitary reporting.11 Unitary reporting requires a business group (or better: unitary group) to combine its tax reports, thereby eliminating all inter-company results from the tax base. Bucks and Hellerstein strongly favor the combination of apportionment and combined reporting.12 Although the application of an apportionment system requires or at least implies the use of some form of combined reporting, this thesis will not go deeper into this topic.
2.5. Framework
This research limits itself as much as possible to the OECD Model Convention, national corporate income taxation in Europe, the proposed CCCTB and corporate income taxation in the United States. These taxes are all on corporate income and the revenues benefit only the taxing state. It must be noted however that there are also considerable differences between these taxes. The taxable base for American state income taxes is usually determined by the federal tax base.13 The European national corporate income taxes on the other hand mainly determine the tax base on a national level, in the absence of a CCCTB. The best reference
11 W. Hellerstein, ‘Designing the Limits of Formulary Income Attribution Regimes’, Taxanalysts - U.S. State
Tax Considerations For International Tax Reform, 2014, p. 36; D. Bucks, ‘Can Nations Find Answers in the
States?’, Taxanalysts - U.S. State Tax Considerations For International Tax Reform, 2014, p. 7; M. de Wilde, ‘‘Sharing the pie’; taxing multinationals in a global market’, 2015, p. 374.
12 D. Bucks, ‘Can Nations Find Answers in the States?’, Taxanalysts - U.S. State Tax Considerations For
International Tax Reform, 2014, p. 7; W. Hellerstein, ‘Designing the Limits of Formulary Income Attribution
Regimes’, Taxanalysts - U.S. State Tax Considerations For International Tax Reform, 2014, p. 36.
13 An exception to this is California. California determines taxable income by implementing federal tax law,
which effectively creates the same result. See: note 320 of W. Kolarik and Wlodychak, ‘The Economic Substance Doctrine in Federal and State Taxation’, The Tax Lawyer – the State and Local Tax Edition, Vol. 67, NO. 4, 2014.
12 material for this research is the nexus standard as used by California, which is identical to the MTC Nexus Standard. If needed, this research will also go into the tax laws of other American states as well as into federal American tax laws.
2.6. Legal comparative framework
It is important to maintain a clear framework when doing a legal comparative research. Pintens distinguishes two schools within comparative law.14 The micro-comparative analysis is the most appropriate for this research, since this research aims to compare two legal systems with regard to a concrete legal question: the determination nexus for tax subjectivity of companies.15 Pintens states that a functional approach is advised for a micro-comparative analysis and that one needs to place the researched laws in their legal and social context.16
Besides that it is important to realize that the Dutch legal system has continental civil law roots, while the American law is clearly a common law legal system.17 Pintens suggests that the research question has to be formulated as an instrument to improve the own legal system.18 This is an approach which he calls the functional method and which suits the needs of this research.19
The aim of this research is not norm-based but problem-based: can we improve our own current nexus concept, looking at the MTC Nexus Standard? Regarding the specialist field of comparative taxation, this research clearly falls under the functional approach to comparative tax studies.20 The functional approach presumes that:
“the legal system of every society faces essentially the same problems, and solves these problems by quite different means, though very often with similar results.”21
Comparative taxation can be done best by considering the three economic principles of taxation: efficiency, equity, and simplicity.22
14 Pintens, Inleiding tot de rechtsvergelijking, Universitaire Pers Leuven, 2011, p. 60. 15 Ibid., p. 64. 16 Ibid., p. 64. 17 Ibid., p. 70. 18 Ibid., p. 85. 19 Ibid., p. 85.
20 N. Sartori and O. Marian, Global Perspectives on Income Taxation Law, New York: Oxford University Press,
2011, p. 5.
13 2.7. American law
The United States form a federation of states of which the legal system was originally based on the English common law-system.23 An important source of American law is the Constitution, which every judge can review laws with.24 For this research the Commerce Clause of the American and the Due Process Clause Constitution are relevant.25 Besides that there are relevant federal, state and local laws and the tax treaties entered into by the United States. The highest court in the United States is the Supreme Court which has done many relevant rulings on taxation in general and nexus in particular. Different levels of federal and state case law will be researched, as well as the federally operating Internal Revenue Service and state revenue departments.
2.8. Research structure
This research is divided in one main research question and a number of sub-questions. The main research question is:
‘’Should the permanent establishment be replaced by a quantitative factor presence nexus test for the determination of nexus in international taxation?’’
The sub-questions, divided in different chapters, are: 1. What is the concept of permanent establishment?
2. What are the current issues with the permanent establishment in international taxation?
3. How is taxable income determined after a permanent establishment is constituted? 4. What is the constitutional framework for nexus in state taxation in the United States? 5. How is nexus for state corporate income tax determined under the MTC Nexus
Standard?
6. How is taxable income per state determined after nexus has been established under the MTC Nexus Standard?
7. How would a quantitative nexus concept work for the CCCTB?
22
Ibid., p. 9.
23 http://education-portal.com/academy/lesson/american-law-history-origins-from-english-common-law.html. 24 http://www.lawnix.com/cases/marbury-madison.html.
25 http://www.law.cornell.edu/wex/commerce_clause; Rick Handel, ‘A Conceptual Analysis of Nexus in State
and Local Taxation’, The Tax Lawyer, American Bar Association, 2010; W. Kolarik, ‘Untangling Substantial Nexus’, The Tax Lawyer, Vol. 64 Issue NO. 4, 2010.
15 3. The concept of permanent establishment
The concept of permanent establishment (hereafter: PE) has been playing a prominent role in international tax law for a long time.26 Deriving from German commercial law (known in German as Bestriebsstätte), it was used in what is regarded as the world’s first tax treaty, the tax treaty of 1899 between Prussia and Austria-Hungary.27 It is one of the key concepts of tax treaties and therefore also of the taxation of international business. According to the OECD Model Convention and its Commentary (hereafter: Commentary) the main use of the concept is to determine the right of a Contracting State to tax the profits of a company of the other Contracting State.28 In both Dutch national tax law as well as in tax treaties, the PE is decisive in determining if non-resident corporations may be taxed.29
In Article 7 paragraph 1 of the Model Convention it is determined that:
‘’The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein.’’30
The PE is the nexus, the connection with a state which legitimizes that state to tax the profits of a non-resident company from another state.31 It is therefore a concept which relies on a combination of both residence and source based taxation.32
3.1. Historical context
During the first appearance of the concept, around 1900, profit taxation for corporations was usually solely based on residency.33 As a result, profits made in a source country often remained untaxed therein and went to the residence state. In his standard work on the PE, Skaar argues that an important factor in the development of the concept of PE was the fact that, at the end of the nineteenth century, transportation became much more efficient, which
26 A. Skaar, Permanent Establishment – Erosion of a Tax Treaty Principle, Ad Notam Forlag, 1994, p. 1. 27 Ibid., p. 19; http://www.bna.com/germany-revolution-pe-n17179877479/.
28 OECD Model Convention Commentary on Article 5. 29
OECD Model Convention Article 7 paragraph 1.; P.G.H.Albert, ‘Thema 2.Vaste Inrichting: Begrip’, WFR 1995/1442.
30 OECD Model Convention Article 7 paragraph 1. 31 Nexus is Greek for connection.
32
A. Skaar, Permanent Establishment – Erosion of a Tax Treaty Principle, Ad Notam Forlag, 1994, p. 24.
16 enabled more and faster international trade.34 However, labor and material production factors (capital) were still very immobile. This meant that the engaging in profit making activities of a company required a certain degree of permanent physical presence in a country, which made this permanency a logical factor in determining if the profits of a non-resident company could be taxed.
3.2. Current definition
The current definition of PE is stated in Article 5 paragraph 1 of the OECD Model Convention as:
‘’a fixed place of business through which the business of an enterprise is wholly or partly carried on.’’35
This definition contains three criteria: a place of business, which is fixed, through which the business of an enterprise is wholly or partly carried on. Article 5 defines three different kinds of PE’s: the physical-PE in paragraph 2, the project-PE in paragraph 3 and the agency-PE in paragraph 5.36 There have been proposals for a fourth kind in the form of a services-PE.37 The OECD Model Convention does not have a services-PE included but a draft of it can be found in the commentary under point 42.11 of the Commentary.
According to the Commentary, ‘’place of business’’
‘’covers all premises, facilities or installations used for carrying on the business of the enterprise whether or not they are used exclusively for that purpose.’’38
This place of business has to be at the disposal of the company. No formal right to use that space is required, just the fact that it is at the disposal of the company is enough.39
34 Ibid., p. 66. 35
Article 5 paragraph 1 OECD Model Convention.
36 C.van Raad, Cursus Belastingrecht, Studenteneditie 2013-2014: Internationaal Belastingrecht, Kluwer 2013,
p. 216.
37 Ibid., p. 216. 38
OECD Treaty Commentary Article 5 under 42.11.
17 The Commentary states that the words ‘’through which’’ have to be given a wide meaning.40 The given example here is an enterprise paving a road, which would lead to the carrying on of a business through a fixed place.41 The term ‘’fixed’’ indicates that there has to be a certain geographical link between the business and territory of the state. Since it has to be fixed, it can only exist if it is in some way permanent.42 It does not have to be actually fixed to the soil, as long as it remains on a particular site.43 The activity itself does not have to be productive.
The Commentary states that a PE exists as soon as the three criteria are met and ends when not all the three criteria are met, unless this interruption is only temporary. However, if a place of business is used for short temporary periods which are often interrupted, but this usage is for a longer period, this is still of sufficiently permanent nature.44 Paragraph 2 lists examples of the permanent establishment. These are a place of management, a branch, an office, a factory, a workshop, a mine, oil or gas well, a quarry or any place for the extraction of natural resources. This however does not mean that one of these examples automatically constitutes a PE, since paragraph 1 still has to apply. So for example, a temporary office which lasts only two weeks is very likely not a PE.
Paragraph 3 states that a building site or construction or installation project can only constitute a PE if it lasts more than twelve months. This enables short term construction work to be done without constituting a PE, which makes it easier for construction work to be done transnationally without immediately facing tax compliance costs and uncertainty about accidentally establishing a taxable presence. Without paragraph 3, construction work would very easily constitute a PE since it is by its very nature physically connected to the country of which the enterprise is not a resident and companies engaging in construction work obviously strive to carry on their business with these activities.
In paragraph 4, the so-called special activity exemptions to the PE concept are listed. The use of facilities or the maintenance of a stock of goods solely for the purpose of storage, display or delivery of goods or merchandise does not constitute a permanent establishment. The 40 Ibid. 41 Ibid. 42 Ibid. 43 Ibid. 44 Ibid.
18 maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information is also exempted. Paragraph 4 under e exempts all activities or a preparatory of auxiliary character and under f it states that any combination of paragraph 4-activities does not constitute a PE as long as the overall activity of this combination is of a preparatory or auxiliary character.
The thought behind the special activity exemptions is that auxiliary or preparatory activities by themselves can never lead to profit making. Skaar explains these exemptions by the fact that in the time of the introduction of the concept, all the activities listed in paragraph 4 were relatively insignificant parts of the economy and could not lead to much profit making.45 Also they were usually integrated in the line of business of one company: a car company would for example buy its materials (like steel) abroad, provide its own shipping and deliver it back to its home state were it would be used to build cars. Nowadays however most parts of the production process are done by specialized companies, all whose activities sometimes fall under the special activity exemptions.
3.3. Agency-PE
The paragraphs 5 and 6 list the conditions under which a permanent agent can constitute a PE. An agent who acts on behalf of a foreign corporation may heavily engage in profit-making business, but may not need a ‘’fixed place’’ through which that business is done. Skaar argues that the agency-PE is also a form of anti-abuse: without this PE, it would be easy to circumvent the establishment of a PE by merely using agencies.46 Paragraph 5 determines that a person who is acting on behalf of an enterprise and has, and habitually exercises, in a state the authority to conclude contracts in the name of a non-resident enterprise, constitutes a PE. An exception is made for an agent whose activities are limited to the activities listed in paragraph 4.
Paragraph 6 exempts business done through a broker, general commission agent or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business, from constituting a PE.47 This is often referred to as an independent agent. Paragraph 7 states that the fact that a company controls a company in another state does not
45 A. Skaar, Permanent Establishment – Erosion of a Tax Treaty Principle, Ad Notam Forlag, 1994, p. 69. 46
Ibid., p. 463.
19 of itself constitute a permanent establishment. This is usually an application of the agency-PE, since the controlled company may conclude contracts and so on behalf of the parent company.48 The fact that the controlling of a company does not of itself constitute a PE suggests that it could however contribute to constituting a PE.
In this chapter I have introduced PE and its role in international taxation as well as the way it is currently defined in the OECD Model Convention. In the next chapter I will discuss the issues with the concept as the nexus concept in this time.
21 4. The current issues with the permanent establishment in international taxation
Already in his standard work in 1994, Skaar foresaw issues with the concept of PE in combination with the digital economy.49 The PE definition of 1994 (and the definition of today) was focused on permanency and physical location. Skaar argued that the rise of modern, mobile international enterprises would give tension between the PE-definition and reality, since profit making would no longer always require permanency. This led him to state that:
‘’The PE principle ‘’…’’ may no longer be an appropriate instrument for taxation of international business profits.’’50
An interesting divide in the PE-debate is that between residence and source countries.51 Residence countries are traditionally the old industrialized nations, such as the United States and the member states European Union such as Great Britain, France, and Germany. They traditionally harbor multinational enterprises which engage in business around the globe. This creates an incentive for them to keep a high threshold for source-based taxation such as the PE, since they are usually the residency state of multinationals.52 On the other side are the source countries. These are upcoming economies such as China and India which see a lot of the profits (or at least: added value) which is created in their jurisdiction shifted towards the developed world.53 One cause of this is the high threshold of the PE, which makes it difficult for them to tax non-resident corporations.
4.1. Digital economy
Lately the PE-regime has been under pressure because it would no longer suffice in the current global, digital economy.54 From the introduction of the term on the PE has been focusing on physical reference points, whilst physical presence is often no longer a
49
A. Skaar, Permanent Establishment – Erosion of a Tax Treaty Principle, Ad Notam Forlag, 1994, p. 70.
50 Ibid.p. 557.
51 Y.Brauner, ‘Prevent the Artificial Avoidance of PE status’, Taxanalysts - U.S. State Tax Considerations For
International Tax Reform, 2014, p. 121.
52
L. Sheppard, ‘The Digital Economy and Permanent Establishment’, Taxanalysts Tax Notes, 2013.
53 Ibid.
54 OECD Action Plan on Base Erosion and Profit Shifting Y.Brauner, ‘Prevent the Artificial Avoidance of PE
status’, Taxanalysts - U.S. State Tax Considerations For International Tax Reform, 2014, p. 121; E.C.C.M.Kemmeren, ‘E-business en vaste inrichtingen: paniekvoetbal’, 2003; L. Sheppard, ‘The Digital Economy and Permanent Establishment’, Taxanalysts Tax Notes , 2013.
22 requirement for profitable business in the digital age.55 Brauner argues that although the concept of PE has a strong appeal, changes in the global marketplace have reduced the necessity of having physical presence for international business.56 Sheppard thinks that the PE is not the right nexus concept for the digital economy.57 Kavelaars states that the current system of international taxation has difficulty coping with the modern economy.58 It seems inevitable that the concept of PE will undergo changes in the coming years or may even disappear.59 In BEPS, the prevention of the artificial avoidance of the PE status is one of the key points, under Action Point 7.60
4.2. Discussion Draft
In the BEPS Discussion Draft On Action Point 7 of 31 October 2014 (hereafter: Discussion Draft), five main concerns on the avoidance of PE status are listed.61 During the writing of this thesis a revised discussion draft was released on 15 May 2015.62 Although the proposed solutions for the concerns are altered (or removed), the five main concerns remain the same as in the original discussion draft.63
The first one (A) is the artificial avoidance of PE status through commissionaire arrangements.64 A commissionaire arrangement is an arrangement through which a person sells products in a state in its own name but on a behalf of a foreign enterprise which owns the product.65 A person who is acting on behalf of an enterprise, and has, and habitually exercises, in a State an authority to conclude contracts in the name of the enterprise, can constitute a PE according to paragraph 5 of Article 5 of the Model Convention.
55 OECD Action Plan on Base Erosion and Profit Shifting; Offermans and Bal, ‘Internationale belastingheffing
van cloud’, Maandblad Belasting Beschouwingen 2014/07/08.
56
Y.Brauner, ‘Prevent the Artificial Avoidance of PE status’, Taxanalysts - U.S. State Tax Considerations For
International Tax Reform, 2014, p. 121.
57 L. Sheppard, ‘The Digital Economy and Permanent Establishment’, Taxanalysts Tax Notes, 2013. 58 P.Kavelaars, ´Fiscaal digitaal geworstel´, NTFR 2014-2096.
59
P.Kavelaars, ´Fiscaal digitaal geworstel´, NTFR 2014-2096; Action Plan on Base Erosion and Profit Shifting.
60 Action Plan on Base Erosion and Profit Shifting, p. 9; P.Kavelaars, ´Fiscaal digitaal geworstel´, NTFR
2014-2096.; L. Sheppard, ‘The Digital Economy and Permanent Establishment’, Taxanalysts Tax Notes, 2013; Y.Brauner, ‘Prevent the Artificial Avoidance of PE status’, Taxanalysts - U.S. State Tax Considerations For
International Tax Reform, 2014, p. 121.
61 Revised discussion draft BEPS Action 7: Preventing the Artificial Avoidance of PE Status. 62 Ibid.
63 Ibid. 64
Discussion draft BEPS Action 7: Preventing the Artificial Avoidance of PE Status, p. 10.
23 Two exceptions to this are made. The first one is that a PE is not present when the activities of this person are limited to the exemptions in paragraph 4. Paragraph 6 lists another exception: an enterprise is not deemed to have a PE merely because it carries on business in that State through a broker, general commission agent or any other agent of independent status, provided that such persons are acting in the ordinary course of their business. The OECD states that in many cases these commissionaire agreements are put in place in order to erode the tax base in the state where sales took place, since no PE is constituted.66 This leads to base erosion in that state.
The example given is that of medical company X, resident of State X, which sells medical products.67 Y, resident of State Y, which belongs to the same multinational groups, sells medical products to customers in State Y. Y is taxed in State Y on the profits it realizes with the sales in that state. However, in order to erode the tax base in State Y, X and Y conclude a commissionaire contract. This means that Y will transfer its fixed assets, stock and customer base to X and will sell X’s products in its own name, but on the account, name, and risk, of X.68 Such a commissionaire cannot constitute nexus and therefore the taxable profits in Y are reduced to the fees the commissionaire Y receives.
The second concern (B) is the abuse of the special activity exemption listed in paragraph 4.69 Four main issues are listed which enable the avoidance of the PE status through the special activity exemptions. Firstly, the exceptions in the four subparagraphs a to d do not require their activities to be of a preparatory or auxiliary character. This means that in the current situation no PE is established if one of those activities is the only activity carried out at a fixed place of business.70 The question is whether this is in line with the original meaning of paragraph 4, since many think it was meant as a provision that would enable companies to do business which at the time of the making of the provision was not considered to be profitable.71
66
Ibid., p. 11.
67 Revised discussion draft BEPS Action 7: Preventing the Artificial Avoidance of PE Status, p. 10. 68 Revised discussion draft BEPS Action 7: Preventing the Artificial Avoidance of PE Status, p. 10. 69 Ibid., p. 15.
70
Ibid., p. 15.
24 Second is the delivery-exemption in subparagraphs a and b. This exempts a distribution warehouse belonging to an online retailer from PE status, regardless of its size.72 The third concern is subparagraph d, which states that a PE does not include the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or collecting information for the enterprise. The original view behind this was that such activities could not be profitable by themselves, which is not true anymore today.73 The Action Plan suggests that this exemption is not justifiable anymore and is not in line with the arm’s length principle.74 The arm’s length principle means that transactions between associated enterprises and PE’s for fiscal purposes have to be reviewed as if they were done by unrelated, independent parties at a price which is determined by market forces.
The fourth and last concern on the special activity exemptions is the fragmentation of activities between related parties in order to avoid PE status.75 This is possible because the overall-activity test of subparagraph f does not function when there are multiple fixed places of business of the same group in a country, since it only views at one fixed place at the time. Thus, this fixed place on its own will likely be considered to be of an auxiliary or preparatory character, whilst the all the fixed places combined would certainly constitute a PE.
The third concern (C) is the splitting-up of contracts in order to avoid PE status.76 Paragraph 3 states that a building site or construction or installation project constitutes a PE only if it lasts more than twelve months. The OECD states that this exemption is often abused by artificially splitting up contracts in several parts in order to make sure none of the separate contracts exceeds the twelve month-period, whilst as a whole these contracts would span a longer time and thus constitute a PE.
The fourth issue (D) mentioned in the Discussion Draft is more of a symptom than a cause itself: because of the exemptions for commissionaires and special activities, a lot of insurance business can be done in a state without constituting a PE.77
72 Ibid., p. 16. 73 Ibid., p. 15. 74 Ibid., p. 15. 75 Ibid., p. 16. 76 Ibid., p. 21. 77 Ibid., p. 25.
25 The last issue (E) mentioned in the Discussion Draft is the profit attribution to PE’s and the interaction with the other BEPS Action Points such as Action Point 4, on base erosion through interest deductions, Action Point 8 on Intangibles and Action Point 9 on risks and capital.78
4.3. Proposed solutions
The revised Discussion Draft amends the solutions proposed in the original Discussion Draft based on comments received by stakeholders.79 I will briefly discuss the proposed changes which are meant to address the issue of the Artificial Avoidance of PE Status under A,B,C,D, and E.
To address issue A the Working Group proposes to add a reference in paragraph 5 that would refer to contracts for the provision of property or services by an enterprise. It would also seek to combat the artificial avoidance of PE status by broadening the scope of the ‘’conclude contracts’’ description in paragraph 5 to
“concludes contracts, or negotiates the material elements of contracts.’’80
It would also strengthen the requirements to qualify as an independent agent under paragraph 6.
To combat the issues listed under B, The Working Group proposes to amend the special activity exemptions listed in paragraph 4, making them all subject to a preparatory or
auxiliary-condition.81 This would mean that the previously mentioned example of a
warehouse which would generate profits but would fall under the delivery-exemption would be tackled since this warehouse would clearly fulfill more than a preparatory or auxiliary function for the enterprise.
The splitting-up of contracts under C is addressed by altering the Commentary: from now on, the purpose behind the splitting of a contract has to be taken into account to see if, for
78 Ibid., p. 26.
79 Revised Discussion draft BEPS Action 7: Preventing the Artificial Avoidance of PE Status, p. 2. 80
Revised Discussion draft BEPS Action 7: Preventing the Artificial Avoidance of PE Status, p. 13.
26 example, the time limit for construction work listed in paragraph 3 applies.82 It also seeks to separate contracts from a broader perspective: are the contracts related, for example because they are concluded by the same or related people or businesses. Would they have split the contract absent tax considerations?
The Working Group concluded that at this time no specific action would be undertaken for the concerns under D and E, at least not under Action Plan 7.83
4.4. Considerations
Considering all this, it seems that there are legitimate concerns whether the PE as it is currently defined in the Model Convention, or maybe even as a concept, is still sufficiently prepared for the central role which it currently has in international tax law. Even at fundamental level, one could wonder if in the contemporary fast paced economy, taxation between nations should be determined by the usage of a concept which relies on the words permanent and establishment.84 The economic giants of today, such as Google and Facebook, of their very nature are very dynamic, intangible and certainly not permanent in a physical sense. But even enterprises which are not digital by their nature, such as retailers, do more and more of their business online. This means that also for them, a permanent physical presence will often no longer be required to engage in profitable business.
In my opinion the issues with the PE concept can be brought down to two categories: the issues concerning the current OECD definition of PE and the issues concerning the concept, the principle, of PE itself. The first one, the definition, is formal and is discussed intensively in for example the previously mentioned OECD BEPS Action Point 7. This revolves around the exact wording of what can constitute PE, the examples, exact time thresholds and the exemptions. Problems with the definition include for example abovementioned the abuse of the special activity exemptions or the splitting up of contracts between group members. The BEPS Action Plan seeks to tackle these issues.
82 Ibid., p. 34. 83
Ibid., p. 36.
84 E. Dayle Siu, ‘Lessons From U.S. State Corporate Taxation In a Regional Transition to Unitary Taxation’,
Taxanalysts - U.S. State Tax Considerations For International Tax Reform, 2014, p. 96; OECD BEPS Action
Point 1: Address the Tax Challenges of the Digital Economy; M. de Wilde, ‘‘Sharing the pie’; taxing multinationals in a global market’, 2015, p. 316; L. Sheppard, ‘The Digital Economy and Permanent Establishment’, Taxanalysts Tax Notes, 2013.
27 The concept of PE itself however a point of discussion in BEPS. This would mean asking questions like: is the PE as a concept still fitted for the challenges of taxation in the modern economy? Is it not time to start thinking about a new way of determining nexus? It can be argued that the concept of PE mainly revolves around the supply side of the economy: capital and labor. The demand side, the market, is not by itself taken into account.85 The only way the market can provide for the establishment of a PE is because of capital and labor which are necessary to enter in and act on this market.
I will explain this with the example of Company A from State A, whose business consists of selling books. In order to sell books in State B, Company A rents a building and hires staff in State B. This book shop will very likely constitute a PE in State B, since it is a fixed place of business through which the business of the enterprise is carried on. Assuming the Tax Treaty between State A and State B is in line with the OECD Model Convention, State B will be able to tax the profits Company A makes in State B.
4.5. PE and the market
However, what constitutes the PE here is not so much the business e.g. market activity (book sales) but the capital (the shop) and the labor (the staff). Without those, for example if Company A were to sell its books online and ship them by mail, the business of Company A is carried on in State B but not through a fixed place of business. The profits Company A makes with those sales will remain untaxed in State B. The given example of the sizeable warehouse distributing online sales which does not qualify for PE as discussed in the OECD Action Plan 7 shows this.86
Even if the special activity exemptions all would be eliminated the conceptual shortcomings of PE would still allow Company A to keep its profits untaxed in State B by selling its books online and delivering them by the use of a mail company. The Commentary clearly states that entry on a market solely through digital means such as a web site does not constitute a PE.87 This may be otherwise if the company also has a server in the State B, but since web hosting can also be done without having a server in the state this can easily be avoided. And what if
85 M. de Wilde, ‘‘Sharing the pie’; taxing multinationals in a global market’, 2015, p. 303. 86 Discussion draft BEPS Action 7: Preventing the Artificial Avoidance of PE Status, p. 15. 87
OECD Commentary Article 5 paragraph 42; L. Sheppard, The Digital Economy and Permanent
28 Company A starts selling e-books to customers in State B through a website hosted in State A?
Another example of the failure of the current PE concept to take the market in account is the tax base erosion in market countries through the use of commissionaire structures.88 This allows multinationals to avoid having a taxable base in a market country by working with a commissionaire, an arrangement by which a person in the market country sells under his own name but on behalf of the multinational.89 The only profits taxable in the market country are the fees the commissionaire receives from the multinational as remuneration for its activities. The following slide made by Taxanalysts shows the place this commissionaire arrangement has in international tax planning. Combined with a so-called Limited Risk Distributor this allows a multinational to erode its taxable base in market countries.90
91
The focus that the PE concept has on the supply side (labor, capital) of the economy is highlighted in the second paragraph of Article 5 of the Model Convention. The examples of PE’s given are: a place of management (labor, and a bit capital), a branch (labor and capital),
88 Revised Discussion draft BEPS Action 7: Preventing the Artificial Avoidance of PE Status, p. 4; L. Sheppard,
‘Is transfer pricing worth salvaging?’, Taxanalysts - U.S. State Tax Considerations For International Tax
Reform, 2014, p. 75.
89 Revised Discussion draft BEPS Action 7: Preventing the Artificial Avoidance of PE Status, p. 10.
90 Revised Discussion draft BEPS Action 7: Preventing the Artificial Avoidance of PE Status, p. 4; L. Sheppard,
‘Is transfer pricing worth salvaging?’, Taxanalysts - U.S. State Tax Considerations For International Tax
Reform, 2014, p. 75.
29 and office (labor and capital), a factory (usually a lot of capital and labor), a work shop (same), a mine oil or gas well, a quarry of any place of extraction of natural resources (usually a lot of capital and labor). All the examples mentioned do not (necessarily) have any direct interaction with the market side of the economy: a mine can solely be used to extract natural resources which then are disturbed to associated enterprises.
Updating the OECD PE-definition by, for example, deleting all the special activity exemptions listed in Paragraph 4 or broadening the scope of the Agency-PE will only do away with the worst consequences of the shortcomings of the current PE definition. This will however not remove the conceptual shortcomings which derive from the fact that a PE is only constituted when sufficient supply side of the economy in the form of capital and labor is present.92 This is a major shortcoming in the current digital economy in which mainly the capital and labor are more dynamical than ever.93
In this chapter I have highlighted the current issues with the PE, both with the current definition in the OECD Model Convention and at a conceptual level. I have also discussed the concerns with the PE in combination with the digital economy. In the next chapter I will discuss how taxable income attributable to a PE is determined after a PE has been constituted in a state.
92 E. Dayle Siu, ‘Lessons From U.S. State Corporate Taxation In a Regional Transition to Unitary Taxation’,
Taxanalysts - U.S. State Tax Considerations For International Tax Reform, 2014, p. 96; OECD BEPS Action
Point 1: Address the Tax Challenges of the Digital Economy.
93 De Wilde, ‘Sharing the pie’; taxing multinationals in a global market, 2015, p. 316; L. Sheppard, ‘The Digital
Economy and Permanent Establishment’, Taxanalysts Tax Notes, 2013; Y. Brauner, ‘Prevent the Artificial Avoidance of PE status’, Taxanalysts - U.S. State Tax Considerations For International Tax Reform, 2014, p. 121.
31 5. The determination of taxable income after a permanent establishment is
constituted
Once sufficient nexus is present in a state it is necessary to determine the taxable income attributable to that presence. Article 7 of the OECD Model Convention deals with the determining of the taxing rights of states to business profits. Profits of an enterprise of a state are taxable in that state, unless that enterprise carries on business in another state through a PE.94 This is the principle of residency-taxation, which can only be overridden by a PE. Paragraph 1 of Article 7 limits the taxing rights of a state to tax the profits of an enterprise of another state to the profits which that enterprise makes in the state which are attributable to a PE. This makes it very relevant to determine the profits which are attributable to the PE if a PE has been constituted. When looking at the enterprise as a whole, in principle all its profits are taxed at the resident state except for the profits which can be attributed to a PE in another state.
5.1. Guiding principles
Paragraph 1 of Article 7 is based on two principles. The first one is the PE-principle, which means that only if an enterprise has a PE in another state it should be considered to be participating sufficiently (nexus) in the economy of the other state, giving the other state the right to tax its profits to a certain extend.95 This is a limited prevalence of the source-country versus the resident-country.
The second principle states that the so-called force of attraction-view has been rejected: this view means that all the profits which an enterprise of another state makes in a state can be attributed to its PE if one has been established, regardless of whether they are actually conducted through the PE.96 Practically the rejection of this view means that a foreign enterprise may have a PE in a state, or even multiple PE’s, but still have economic activity in that state of which the profits are not attributable to a PE.97 An example of this is if the enterprise has an Agency-PE established in the state, but also separately performs activities which fall under the exemptions of paragraph 4. The paragraph 4-activities will then not be taxed in that state.
94 OECD Model Convention Article 7. 95 Ibid.
96
Ibid.
32 Even though a PE has been established, the profits made with the use of facilities will not be automatically attributed to the PE. This is in line with the wording of Article 5, which has the through which-condition for the establishment of PE. As long as the profits cannot be attributed to the PE they remain untaxed in the other state. This corresponds with the basic principles of the PE, which combine resident and source taxation. If the force of attraction-view would be in place, the establishment of a PE would as far as the profits in that state go be equal to a (limited) form of residency taxation of non-resident corporations, with the PE constituting residency.
According to paragraph 2, attributed as the PE’s profits should be
‘’to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment.’’98
5.2. Separate entity and arm’s length principles
This derives from the separate entity approach and arm’s length principles.99 The PE is by a legal fiction considered to be a separate and independent company, even though it does not have a separate legal form, the ability to manage its own affairs or even independent outside appearance. These principles are in line with the idea behind the concept of PE, which is limited taxation in the source country overriding the principle of residency taxation.100
The authorized OECD approach in attributing profits to a PE takes two steps. Firstly, a functional and factual analysis must be taken to identify the significant activities and responsibilities of the PE.101 This tries to view the PE as a separate enterprise. In step one, the significant people functions and risks of the PE are identified, as well as its rights and other functions. Also, free capital is attributed. This means that the PE should have sufficient capital for its functions, and risks. This attribution should be done in line with the arm’s length principle.
98 Article 7 paragraph 2 Model Convention.
99 OECD Report on Attribution of Profits to Permanent Establishments, 2010, p. 5. 100
Ibid., p. 10.
33 The second step is the determination of transactions done between the PE and other associated enterprises by looking at the functions performed, assets used and risk assumed. For the calculation of the profits, it has to be determined if the price which is paid in inter-company transactions is at arm’s length: would separate and independent enterprises agree to the same price for this transaction? This principle is laid down in Article 9 of the OECD Model Convention.
The second paragraph of Article 9 states that when determining profits made in international transactions made between, states will make adjustments so to make the transactions as they would have been made between independent enterprises.102 Otherwise, the taxable base in a country may be artificially lowered or altered because the price paid is not in line with what separate and independent companies would agree with in a normal transaction. When determining this, the OECD recommends the usage of OECD Transfer Pricing Guidelines (hereafter: TP Guidelines).103 These TP Guidelines give shape to the arm’s length principle. In a normal transaction between independent companies the price of the transaction is determined by the market.104 However, when associated companies engage in transactions they are not necessarily (only) driven by that market.105
It should be noted that the application of TP Guidelines is certainly not limited to transactions between PE’s and associated enterprises: they also apply between legal entities of associated enterprises. Paragraph 3 states that where a correction is made by a state in accordance with paragraph 2 concerning the profits which are attributable to a PE and this leads to double taxation, the other state shall make an adjustment to the amount of tax charged on those profits.
Paragraph 4 determines that if profits include items of income which are dealt with separately in other articles of the convention, then they go before the application of Article 7. In conclusion, for the determination of taxable income attributable to a PE, two steps have to be taken. Firstly, the PE is considered to be a separate, independent entity. Secondly, the transactions in which the PE is involved have to be determined as if they were at arms’ length.
102 OECD Commentary Article 7.
103 OECD Report on Attribution of Profits to Permanent Establishments, 2010, p. 11. 104
OECD Transfer Pricing Guidelines p. 14.
34 5.3. Considerations
In previous chapters I have lamented the absence of the market as a contributor to the establishment of nexus under the PE concept. This enables multinationals to be active in market countries without paying tax on their profits therein, or very little. It should be noted that also the current TP Guidelines are critized for their failure to take the market into account when determining the at arm’s length price.106 This means that, even if the PE as defined in the OECD Model Convention would be more oriented towards market-based nexus this would require a corresponding adjustment of the TP Guidelines. Otherwise nexus would be constituted, but with no or very little attributable profits.
As can be read in the OECD BEPS report under the Action Points 8, 9, and 10, the current TP practice is under scrutiny as well since its outcomes do not always lead to equitable results.107 This thesis will however not go deeper into the exact working of the determination of taxable income for PE’s. In this chapter I have elaborated on the attribution of profits to PE’s. For the attribution of profits the PE is deemed to be a separate and independent company. This applies even if the PE engages in dealings with associated companies. When determining the profits attributable to PE’s the TP Guidelines apply.
106 L. Sheppard, ‘Is transfer pricing worth salvaging?’, Taxanalysts - U.S. State Tax Considerations For
International Tax Reform, 2014, p. 75.
35 6. The constitutional framework for nexus in state taxation in the United States
Although the United States is a country with a federal structure, its states have considerable fiscal sovereignty.108 States are free to tax as long as they abide a limited number of Constitutional and federal laws. Dale Siu argues that there are three guiding issues constraining state taxation from a federal level: economic connection (nexus), nondiscrimination of interstate commerce, and fair apportionment.109
States are not bound by tax treaties entered in by the United States on a federal level when it comes to state taxes. This includes the definition of subjective tax obligation: mostly described by the term nexus, states are free to define when sufficient nexus e.g. connection is established for their state taxes to be levied. This means that it is possible for a foreign company without a physical presence in the United States to have nexus for a state’s corporate income tax, whilst the company does not have a taxable presence in the form of a PE under the applying bilateral tax treaty between its country of residence and the United States.110
6.1. Due Process Clause and Commerce Clause
I will firstly discuss the constitutional and federal legal framework on nexus for state taxation. One important Clause in the United States Constitution (hereafter: Constitution) is the Due Process Clause which is included in the fifth and fourteenth Amendment.111 The Fifth Amendment reads:
‘’Nor shall any person ‘’…’’ be deprived of life, liberty, or property, without due process of law …’’112
The Fourteenth Amendment reads:
108 Tenth Amendment United States Constitution; Archie Parnell, Constitutional Considerations of Federal
Control Over the Sovereign Taxing Authority of the States, 1979, p. 231.
109
E. Dayle Siu, ‘Lessons From U.S. State Corporate Taxation In a Regional Transition to Unitary Taxation’,
Taxanalysts - U.S. State Tax Considerations For International Tax Reform, 2014, p. 96.
110 C. Fisher, ‘State Tax Considerations for Foreign Entities’, 2014. U.S. State Tax Considerations For
International Tax Reform, 2014, p. 129; A. Athanasiou, ‘Unfettered by Bilateral Treaties, State Tax Can Catch
Foreign Enterprises Off Guard’, Taxanalysts - U.S. State Tax Considerations For International Tax Reform, 2014, p. 141; W. Hellerstein, ‘Designing the Limits of Formulary Income Attribution Regimes’, Taxanalysts -
U.S. State Tax Considerations For International Tax Reform, 2014, p. 36.
111 Fifth and Fourteenth Amendment United States Constitution; W. Kolarik, ‘Untangling Substantial Nexus’,
The Tax Lawyer, Vol. 64 Issue NO. 4, 2010, p. 857.
36 ‘’Nor shall any State deprive any person of life, liberty, or property, without due process of law ...’’113
In Miller Bros. Co. v. Maryland (hereafter: Millers Bros), the Supreme Court ruled that ‘’due process requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.’’114
Another important factor to consider in the area of state taxation in the United States is the so-called dormant Commerce Clause in the Constitution.115 The Commerce Clause states that
‘’[The Congress shall have Power] To regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes;’’116
This gives the U.S. Congress the authority to restrict the sovereignty of states when it comes to interstate commerce. Congress can enact laws which will override any states’ law that hinder interstate commerce. The reach of the Commerce Clause however is not limited to the actual overruling of states laws: it also restraints state law which does not even exist yet because of the Supremacy Clause of the U.S. Constitution stated in Article 6 of the Constitution, since congressional power is the supreme law of the land.117 So even without explicit congressional action, the Commerce Clause restrains the legislative possibilities of States to make laws on commerce, such as tax laws.118 This explains the term dormant Commerce Clause.
6.2. Public Law 86-272
One very specific federal constraint on nexus for state income taxes is Public Law 86-272. This provision, enacted after the Supreme Court held that an-out-of-state corporation which solicited orders in Minnesota could be held liable for Minnesota income tax, prohibits state income taxation (on net income, so franchise taxes are not prohibited) on out-of-state sellers
113
Fourteenth Amendment U.S. Constitution.
114 Miller Bros.Co.v.Maryland, 347 U.S.340, 344-45 (1954).
115 W. Kolarik, ‘Untangling Substantial Nexus’, The Tax Lawyer, Vol. 64 Issue NO. 4, 2010, p. 853. 116 Article I, Section 8, Clause 3, U.S. Constitution.
117
W. Kolarik, ‘Untangling Substantial Nexus’, The Tax Lawyer, Vol. 64 Issue NO. 4, 2010, p. 853.
37 which only solicit orders in that state.119 This however only applies to the solicitation of orders for tangible personal property.120
In this chapter I will discuss case law on nexus which mainly revolves around sales and use taxes. Both the PE and MTC Nexus Standard do not usually apply to sales and use taxes but to taxes on (business) income and profits. It is however useful to take a look at the Constitutional and federal framework of state nexus issues. After the landmark decision Quill I will continue with nexus case law that is specific for income taxes. When doing this I will take in account articles of Kolarik and Handel.
6.3. Dormant Commerce Clause
Kolarik lists three ways in which the dormant Commerce Clause limits state regulation of interstate commerce.121 The first possibility is that the dormant Commerce Clause invalidates states laws which regulate commerce outside the states’ borders. Secondly, discrimination against interstate commerce is prohibited
‘’unless the discrimination is demonstrably justified by a valid factor unrelated to economic protectionism.’’122
The last possibility is that state laws are prohibited when they unduly burden interstate commerce, except insofar the law pursues a valid local public interest and has an incidental effect on interstate commerce.123 A law imposed to pursue a valid local public interest can still be struck down if the burden on interstate commerce is disproportionate in relation to the local benefits.124
In Allied-Signal, Inc. v. Dir., Div. of Taxation, the Supreme Court ruled
119
Rick Handel, ‘A Conceptual Analysis of Nexus in State and Local Taxation’, The Tax Lawyer, American Bar Association, 2010.
120 Ibid., p. 679.
121 W. Kolarik, ‘Untangling Substantial Nexus’, The Tax Lawyer, Vol. 64 Issue NO. 4, 2010, p. 854. 122
W. Kolarik, ‘Untangling Substantial Nexus’, The Tax Lawyer, Vol. 64 Issue NO. 4, 2010, p. 854; Wyoming v. Oklahoma, 502 U.S. 437, 454 (1992).
123 W. Kolarik, ‘Untangling Substantial Nexus’, The Tax Lawyer, Vol. 64 Issue NO. 4, 2010, p. 854; Pike v.
Bruce Church, Inc., 397 U.S. 137, 142 (1970).
124
W. Kolarik, ‘Untangling Substantial Nexus’, The Tax Lawyer, Vol. 64 Issue NO. 4, 2010, p. 854; Pike v. Bruce Church, Inc., 397 U.S. 137, 142 (1970).
38 ‘’that the principle that a State may not tax value earned outside its borders rests on the fundamental requirement of both the Due Process and Commerce Clauses that there be "some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.", Miller Brothers Co. v. Maryland, 347 U. S. 340, 344-345 (1954).’’125
The Supreme Courts points out that in a union of states, the possibility to tax profits outside a state’s jurisdiction would lead to double taxation on business. The definite link required, this minimum connection, is the nexus threshold which has to be reached before a state can impose a tax. In Wisconsin v. J.C. Penney Co. the Supreme Court ruled that assessed must be
‘’whether the taxing power exerted by the state bears fiscal relation to protection, opportunities, and benefits given by the state.’’126
6.4. Miller Bros. v. Maryland
In his article on nexus for state taxation, Kolarik starts with the Supreme Court case Miller Bros. v. Maryland and argues that this is a useful starting point to understand the application of the dormant Commerce Clause’s substantial nexus requirement.127 Millers Brothers Corporation was a store from Delaware which sold goods to customers at its store. This included residents who came from Maryland. Some customers from Maryland took their purchases back home themselves, whilst others had theirs delivered at home by a truck from Millers Brothers or another delivery company.128
Maryland levied a use tax on "the use, storage or consumption" on purchases done outside the state. This required every seller to collect and remit this use tax, which Millers Brothers did not do. One time when a truck from Millers Brothers was in Maryland, the State of Maryland seized it because Millers Brothers had not collected and remitted the Maryland use tax. The Maryland State Supreme Court held the company
125 Allied-Signal, Inc. v. Dir., Div. of Taxation, 504 U.S. 768, 777 (1992); W. Kolarik, ‘Untangling Substantial
Nexus’, The Tax Lawyer, Vol. 64 Issue NO. 4, 2010, p. 857.
126 Wisconsin v. J.C. Penney Co., 311 U.S. 435, 444 (1940); W. Kolarik, ‘Untangling Substantial Nexus’, The
Tax Lawyer, Vol. 64 Issue NO. 4, 2010, p. 858.
127 W. Kolarik, ‘Untangling Substantial Nexus’, The Tax Lawyer, Vol. 64 Issue NO. 4, 2010, p. 858; Miller
Bros.Co.v.Maryland, 347 U.S.340, 344-45 (1954).
