States of Confusion: The 2000 State Tax Survey

The methods states use to determine taxable presence are all over the map.
George DonnellySeptember 1, 2000

What qualifies a corporation for a visit from the state tax man? These days, there are almost as many answers as there are states. Part of the problem is the fluid nature of nexus, which in state tax terminology defines the degree of business involvement sufficient to justify levying a tax. A company with a sales office in Minnesota clearly has nexus there–but so, depending on the state, may its subsidiary, regardless of whether the subsidiary itself has any tangible presence in the area. In some states, simply licensing trademarks, or issuing credit cards, is enough to trigger nexus. And although E-commerce companies, especially in retail, enjoy relative immunity from sales tax for now, states may figure out how to find nexus, especially if the businesses have bricks-and-mortar parents.

Companies and state governments have been playing cat-and-mouse games with nexus for several years. The inconsistency of state tax practices, such as those pertaining to nexus, not to mention actual tax rates, is the source of the special pain endured by executives who handle state and local tax. Instead of one nation, indivisible, the United States at times looks like an assortment of fiefs, each with its own tithes and court policy. Although local rule is at the core of the Constitution, the founding fathers never envisioned global corporations or the advent of the Internet and the virtual shrinking of geography.

This contentious tug-of-war between corporations and states is the inspiration for the third edition of CFO magazine’s state tax survey. Corporate tax executives again have rated the states on an assortment of tax-enforcement issues, including auditing fairness, tax court treatment, aggressiveness in asserting taxing rights, and the overall climate in the state. This year, for the first time, we let tax directors fill in the blanks to tell us about their biggest headaches–and they were not shy. Here’s a sampling of what bugs them:

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  • “Inconsistent treatment of similar transactions by different states.”
  • “States are too slow in resolving issues and responding to changes.”
  • “A wide range exists regarding the flexibility, common sense, and fairness employed by each auditor.”
  • “Managing the horde of state, county, and city tax filings.”
  • “Dealing with aggressive states like California and having to fight long court battles on ludicrous issues.”
  • “Lack of uniformity–but that’s also the biggest opportunity!”

Of course, corporations are not always the innocent victims in the state tax arena. Many devise tax-planning schemes that cleverly out-finesse departments of revenue, leaving state auditors holding an empty bag. In response, states have sought to expand the concept of nexus into broader, less-defined territory. On the surface, nexus may seem like a simple concept revolving around the issue of a corporation’s physical presence in a state. But in fact, nexus standards shift from state to state, with some Departments of Revenue drawing inspiration from the 1994 Geoffrey ruling in South Carolina. That ruling propagated the notion of “economic nexus,” after the South Carolina Supreme Court upheld the state’s claim that a special-purpose entity created to manage Toys “R” Us intellectual property had nexus with South Carolina, and thus was subject to income tax. The fact that Geoffrey Inc., the special-purpose entity that is a subsidiary of Toys “R” Us, was located in Delaware did not dissuade the court that the company had economic nexus with the state. Nexus was created through the toy stores to which Geoffrey licensed its trademarks.

The case sent shivers down the spines of corporate tax directors, who have since found their tax-planning vehicles, especially the use of special entities, more often challenged by revenue officials who claim they are merely shell companies. In economic nexus, strict physical presence isn’t required, only an economic connection between such an entity and other subsidiaries or even third parties that serve as its agents.

Taking their cue from Geoffrey, some states have waged war against tax-planning schemes and were accordingly rated in our survey on the aggressive side in pursuing economic nexus claims. Leading the pack this year was Massachusetts, whose revenue officials follow a directive to pursue intangible holding companies. It was followed by North Carolina, California, and Connecticut. On the flip side, there are states, most famously Delaware, that welcome special-purpose entities and serve as havens for tax planning.

And while the Delawares are few, corporations also have protection from overreaching states under the Due Process Clause and the Commerce Clause in the U.S. Constitution, which were designed to prevent states from burdening interstate commerce. The Due Process Clause requires only “minimum contacts” between the state and the object of the tax. The Commerce Clause, however, calls for “substantial nexus,” generally understood to be significant physical presence. But none of this is terribly clear, not even to judges weighing in on the matter. “The problem is that phrases like ‘minimum contacts’ and ‘substantial nexus’ do not really mean anything,” a Tennessee judge wrote in a recent decision on a state’s nexus claim. “There is no definitive line that marks a minimum contact, nor is there a specific point at which substantial nexus exists. The analysis in this area is necessarily done on a case-by-case basis.” And, accordingly, the interpretation varies from state to state.

In touch via credit card?

Some believe the Supreme Court needs to weigh in on the concept of economic nexus in order to create a brighter line. The Court’s previous guidance on nexus, in 1992, was spelled out in Quill, an appeal from North Dakota concerning a mail-order-catalog company the state claimed owed sales tax. North Dakota argued that Quill Corp. had nexus through its out-of-state catalog business, most physically obvious through the 24 tons of catalogs shipped through the state. However, the Court ruled that substantial nexus–for example, people, property, or inventory in the state, as defined in the Commerce Clause–was the critical standard the state had to establish in order to make a claim.

How, then, did South Carolina get past the Quill ruling in its Geoffrey decision? While the Quill ruling provided an answer for remote claims on sales tax, it left the door open for income and franchise tax claims. South Carolina successfully sidestepped Quill in the Geoffrey case, saying that economic nexus applied to the income tax of the special-purpose entity. At least a dozen states now pursue Geoffrey-type nexus regulation, according to David Cowling, an attorney with Jones, Day, Reavis & Pogue, in Dallas. Adding to Geoffrey’s attraction, the target of tax is the proverbial “guy behind the tree” who doesn’t vote in the state, says Cowling. Eventually, a Geoffrey-related case will be heard by the Supreme Court, says Cowling, to answer the question: “Does the physical-presence Commerce Clause standard in Quill apply to other taxes, like income taxes?”

Some think a recent Tennessee case involving J.C. Penney National Bank may ultimately serve as the Supreme Court test for the application of economic nexus to taxes other than sales. Tennessee tried to assert nexus for that purpose through the bank’s credit-card solicitations in the state even though the bank had no offices or employees there. The bank’s affiliation with the J.C. Penney stores, which are physically in the state, and the actual credit cards, which remained the property of the bank, tied J.C. Penney National Bank, which is incorporated in Delaware, to Tennessee, the state argued. Tennessee also maintained that the bank’s physical presence was not a “formal requirement” to prove nexus.

But last December, the Tennessee Court of Appeals rejected the state’s reasoning. The court did not find that actual credit cards created substantial nexus, pointing out that the cards, “in and of themselves, are worthless,” and that the accounts they represented were located, for tax purposes, in Delaware. The attempt to link the bank with the J.C. Penney Co. parent stores also was shot down, because the credit card operations were not affiliated with the retail stores, with the court noting that a customer could not apply for a credit card at a store.

“What the court really said was that the presence of those cards did not rise to a level of constitutional significance,” says Wayne Zakrzewski, head of state research, planning, and audit at J.C. Penney Co. “The property is somewhat ephemeral, and the court held that to give it constitutional significance was not a wise thing to do in providing guidance.”

For state tax observers, however, the most important outcome was the Tennessee court’s rejection of the notion that the substantial nexus from physical presence as articulated in Quill did not apply, because the state sought franchise and excise taxes, as opposed to the use taxes at issue in Quill. The court decided there was no reason to distinguish between the different types of taxes, a clear blow to the Geoffrey reasoning.

The Tennessee court not only saved J.C. Penney a $178,314 assessment, but also the additional claims of other states that would likely piggyback on a new legal precedent. “In addition, effectively, every dollar [that is taxed] once in Delaware would be taxed in every other state,” says Zakrzewski. But J.C. Penney was not itching for a fight. It tried to settle, as many corporations do, but the state wasn’t receptive, says Del Threadgill, director of tax at J.C. Penney Co. Although the state had misinterpreted the law, says Threadgill, “we did try to settle, and they were uncompromising in their position.”

For its part, Tennessee plans to pursue its case to the U.S. Supreme Court, says Jack Kopald, assistant commissioner for tax administration and general counsel for the state of Tennessee. But it’s just as eager as J.C. Penney to avoid a precedent. “The Court held that physical presence was required before Tennessee could tax a financial institution under our franchise and excise taxes, which is a constitutional issue,” says Kopald. “And if physical presence is required, it jeopardizes our ability to tax out-of-state financial institutions that do business in Tennessee and compete with in-state financial institutions. The Supreme Court has never ruled that physical presence is required when the tax is based on income, so the J.C. Penney case presents a question that is of great significance to every state in the union that has a similar tax.” For Tennessee, Kopald says, “the potential loss is measured in the millions.”

Making A Kmart Connection

Corporations face other threats from states eager to establish nexus. Although New Mexico is hardly on the radar of many companies, its aggressive tax policy may set an example for other states to follow, say some observers. One case involving the state that has attracted attention involves Kmart Properties Inc., a special-purpose entity set up by Kmart Corp. The state asserts that trademark licensing agreements between an out-of-state entity and an in-state store create nexus because the bricks-and-mortar store is serving as an agent for the special-purpose entity.

But that’s not the scenario Kmart had in mind when it established Kmart Properties in 1991 to manage its intellectual property, including trademarks, for tax purposes. The special-purpose entity licenses Kmart’s trademarks to the stores at 1.1 percent of sales, while the parent gets to deduct the royalty payment from its income. Yet the special entity doesn’t owe taxes on the trademark income, since it’s incorporated in Michigan, a state that excludes royalties from taxable income. Overall, Kmart Properties creates millions of dollars a year in state tax savings.

This attracted the attention of a New Mexico auditor, who testified that he was looking for companies that created subsidiaries to hold and license back intellectual property. In response, the state leveled an assessment on the special-purpose entity of nearly $2 million for the tax years 1991 through 1996. Kmart Properties, the state reasoned, owed both gross receipts tax (a New Mexico version of sales tax) and income tax because of its symbiotic relationship with the Kmart stores.

A New Mexico revenue-department hearing officer agreed, maintaining that the contractual relationships with Kmart placed its special-purpose entity in the state. Relying on a Supreme Court ruling in Scripto that found that an independent contractor working on behalf of a company–an agent–could establish nexus in a state, New Mexico connected the special entity with the store. “The concept that a contractual relationship with an in-state party tied to the establishment and maintenance of in-state markets can create sufficient physical presence in the state has been the law since the Court issued its Scripto decision in 1960, long before the current strategy involving the assignment and licensing of intellectual property was ever conceived in state tax circles,” noted the hearing officer. “In spite of the Court’s warning in Scripto that it would not grant constitutional significance to the shirking of obligations onto contractors lest it open the gates to a ‘stampede of tax avoidance,’ the tax professionals at Price Waterhouse, as well as Kmart, Toys “R” Us, and a host of other corporations apparently failed to heed its warning.”

Kmart is appealing the decision of the hearing officer. “It’s a very convoluted, nonsensical argument,” says Tim Van Valen, an attorney at Modrall, Sperling, Roehl, Harris & Sisk PA, the Albuquerque firm that is representing Kmart. “He really had to stretch. The license agreement was negotiated, executed, and performed entirely in the state of Michigan.”

The Kmart case is being watched closely. The message that agency nexus applies in trademark licensing would be a broadside to tax-planning schemes, and Van Valen says the Multi-State Tax Commission, a group of 45 states that tries to work as a bloc in applying state tax law, has made Kmart Properties a test case. Meanwhile, says Van Valen, “the Big Five are telling their clients to be extraordinarily careful about having an interest in New Mexico.”

A physical Internet?

The agency nexus concept could also rear its head in E-commerce, some predict. Generally, remote sellers such as E-commerce retailers are protected from sales and use tax by the Quill decision and its substantial nexus standard. Moreover, the moratorium on Internet taxation, set to expire in 2001, prohibits new taxes on the Internet.

But with the growing trend of bricks-and-mortar companies developing Internet arms that are not physically present in many states, the question arises about the role of traditional stores and whether they create nexus for the dot-coms. “They need to be very careful about the in-state stores being perceived as the agents for the dot-coms,” says Douglas Lindholm, executive director of the Committee on State Taxation, a trade association and lobbying group based in Washington, D.C. For example, the bricks-and-mortar stores may be used as return sites for Internet sales, a situation that could create a state nexus claim for the Internet division, says Lindholm.

“You’ve got to make sure that you keep things very separate,” he says. “There’s often a tension between the marketing department and the tax department, and guess who’s going to win that one?”

There’s an effort afoot by the National Conference of State Legislatures to streamline sales tax collection with unified rates and definitions, so that it would no longer interfere with interstate commerce, and to set the table for a tax on Internet commerce, says Lindholm. But it may be up to Congress to legislate around the Commerce Clause. “For the states, that’s anathema,” Lindholm says. “They don’t want any federal preemption of their taxing powers.”

While the justice or injustice of Internet taxation gets played out in the court of opinion, many states are finding that real tax courts are siding with corporations’ tax-planning schemes. Tax avoidance–as opposed to tax evasion–is a legitimate purpose for a special entity, some courts are saying. This spring, the Maryland Tax Court shot down the state’s claims in three cases that involved corporate affiliates. In MCI International Telecommunications Corp., Syl Inc., and Crown, Cork & Seal, Maryland revenue officials asserted that such subsidiaries had nexus through their relationship with in-state affiliates. The rulings are significant, says Cowling, because the three cases represent the tip of the iceberg in backlogged cases based on economic nexus in the state. “About three years ago, Maryland started looking aggressively to see who was making payment to out-of-state trademark companies,” says Cowling. “They sent auditors to Delaware to see how physical those companies seemed to be. There were approximately 150 cases all held up in suspense in the Maryland Tax Court.”

The Alabama Supreme Court also sided with a taxpayer, Sonat Inc., that deliberately created nexus for a subsidiary in order to qualify for dividend deductions off its gross income tax in the state. The subsidiary simply leased a workstation from the parent in order to qualify. The judge, in ruling for Sonat, quoted a 1938 decision: “The State cannot complain when the taxpayer resorts to a legal method available to him to compute his tax liability. The State is now saying to him that although you did what we said you could do with a certain result, that result is more beneficial to you than we intended.” For tax directors who complain of a cacophony of regulation, such language must be music to their ears. 

George Donnelly is a senior editor at


State tax officials may be tempted to dismiss a poor rating from corporate tax executives as an aberration. But the third biannual edition of CFO magazine’s state tax survey reveals consistent patterns that would undermine claims that a state was unfairly singled out or having a bad year.

We asked an assortment of tax executives, predominantly in the Fortune 1,000, to rate the states on issues concerning nexus, audit aggressiveness, administrative fairness, and overall environment. Based on 71 responses, two states stick out like sore thumbs: California and Massachusetts. Those states tied for first place two years ago when averaging the scores, but this year, California, propelled by its 4.54 rating in audit aggressiveness, had the highest average score. Following Massachusetts for overall poor ratings are Illinois, singled out for the lack of independence of its appeal process, New York, Pennsylvania, and Connecticut.

Strictly business?

When Polaroid Corp. received a $924 million settlement from Eastman Kodak Co. in 1990 following a patent-infringement lawsuit, the windfall served as an invitation for state tax authorities to chase additional revenue. The question: Was it business income, which would subject the settlement to income tax apportionment where Polaroid has nexus, or was it nonbusiness income, which would limit taxation to Polaroid’s state of incorporation? Such business/nonbusiness issues commonly become legal wrestling matches, as corporations try to preserve the bounty from intellectual-property disputes and, more often these days, pension income.

In Polaroid’s case, North Carolina decided to challenge the company’s assumption that its windfall was nonbusiness income. Defining the nature of income involves determining whether the source comes from “transactions and activity in the regular course of business.” But there is a second consideration in determining whether the income arose from assets used in the regular course of business. This second, “functional” test can also be used in courts to classify income. If Polaroid’s settlement was business income, then the company owed North Carolina nearly $500,000.

“Our principal argument was that it was not earned in the ordinary course of business,” says Jasper Cummings, an attorney formerly with Alston & Bird, in Raleigh, North Carolina (now an associate chief counsel at the IRS), who represented Polaroid. “The argument was also that the [North Carolina] statute did not have a separate functional test.”

The North Carolina Supreme Court disagreed. Although the windfall was extraordinary, it ruled in 1998 that “it is undisputed that Polaroid’s patents are an ‘integral part of its regular trade or business operations’… the patents can be characterized only as integral income-producing assets.” — G.D.


Faced with unprecedented surpluses, the California legislature is inventing ways to give money back to its constituents, recently weighing a $2.7 billion tax-relief bill that would put at least $50 in the pockets of every taxpayer in the state. California’s current generosity, however, is at odds with its reputation in the corporate world. Its auditing policy was rated by far the most aggressive in the country in CFO’s state tax survey poll. California was also the state in which companies were least likely to expand. That’s no fluke: California was first in audit aggressiveness in CFO’s 1998 poll, after finishing a close second to Kansas in 1996.

“The aggressiveness of the tax auditors in California is legendary,” says Rex Halverson, a state tax expert with KPMG in Sacramento. “They’re some of the better-trained auditors, and they’ll actually audit. They’re not just looking at things. They’re digging.”

Halverson has had a front-row seat both as a taxpayer, handling state and local tax at the Bank of America N.A., and as a bureaucrat, when he served in the state controller’s office and heard tax cases on California’s Board of Equalization. “The audit group, once they hook into a client and see opportunity, [will] bite his leg harder,” he says. “You get a lot of people moving around in Silicon Valley, and you often don’t have the tax department staying together. This creates chaos, and for auditors, it’s like sharks smelling blood.”

Halverson cites the case of one client whose audit was resolved favorably, only to find the same auditor return the next year to raise the same tax issues. “It forced the generation of hundreds of documents and hours of time to prove our case just because, in his mind, the facts may have changed,” says Halverson. “Auditors are requiring all sorts of proof and making every taxpayer substantiate his or her filing position over and over again.”

California’s aggressiveness also derives from its status as a state that requires unitary returns, which force what some might see as disparate business units to file a combined return. Many states allow companies to choose to file individual returns for those units instead. But California’s authorities can do a lot more digging, because they also challenge companies to unbundle combined returns if they feel that they are exploiting a unitary position.

Audits based on this approach are “very intrusive and go on forever,” says Prentiss Willson, a tax expert and the director of state and local practice and procedure at Ernst & Young LLP, in San Francisco. Describing audits as “the psychoanalysis of a business,” Willson adds that “you’re typically dealing with information that’s 10 years old.”

Other aspects of the state’s tax regime add to the conflict and confusion. California is one of the few states that ropes foreign subsidiaries into taxpayers’ unitary filings. Corporations are allowed to elect “water’s edge” status, which theoretically limits their exposure to U.S. operations. But even water’s edge companies have to account for foreign-source income and dividends, says Terry Ryan, director of state and local taxes at Apple Computer Inc. “No state has anything that approximates California’s water’s edge,” he says. “Those rules are really unfair to taxation, and they create an incredible burden that’s really unjustified. They could still raise the same amount of money and not make us jump through as many hoops.”

Then there’s California’s two-headed tax bureaucracy, with two independent, elected boards. The Board of Equalization (BOE) handles sales tax administration and all tax appeals, while the Franchise Tax Board (FTB) oversees all franchise and personal- income taxes. “There are too many layers of bureaucracy at the FTB,” says Halverson. It leads to delays, as cases go through multiple reviews, he says.

The FTB has just passed a regulation to limit the audit appeal process to two years, says Dean Andal, chairman of the BOE, who is in his second one-year term on the FTB. After two years, the case must move to the BOE. Andal, a conservative Republican and a critic of the tax climate in California, blames the liberal California legislature and the Department of Finance for encouraging the aggressive culture. “The Department of Finance is interested in only one thing, and that is more revenue,” says Andal. “To reform the audit process, you have to balance the [state’s] need for revenue with the need for a pro-business culture. I do believe we could have more business and more jobs if we were not viewed so negatively.”

But critics see bright spots, too, including the Taxpayer Advocate Service. “I can’t tell you how many times an advocate has solved an issue for my clients,” says Halverson. In addition, says Ryan, the R&D tax credit and the manufacturer’s tax credit have been welcome additions.

The Golden State’s robust financial health will probably not make life any easier for corporate taxpayers. “With the surplus, did they reduce any taxes on business? Not really,” says Ryan. “We would just like to see them simplify the system and make it less burdensome.” — G.D.