Trying to Have Their Coke and Eat It Too
Traditional businesses have long envied the taxfree advantages enjoyed by dot-com retailers. Though consumers may believe that the Internet is a tax-free zone, e-tailers are only spared the burden of state sales tax collection where they have no nexus that would subject them to the consumer's state tax jurisdiction. The nexus rules, however, are not quite cut and dry.
Although many brick-and-mortar retailer have formed e-tailer subsidiaries to reap the benefits of e-commerce, the authors point out that many companies have ignored alter ego and agency considerations, creating the possibility that the nexus of the parent will be attributed to the subsidiaries. Avoiding attributional nexus requires the companies to be distinct entities: They should avoid common officers and personnel, eschew joint promotion and advertising, and sell different products. It is also essential to keep customer service activities separate and maintain arm's-length pricing for any licensing agreements. If a careful division is maintained, the companies can enjoy the benefits of click-and-mortar operations while avoiding the dangers of the nexus minefield.
The bane of Main Street businesses, "e-tailers" enjoy the luxury of being able to sell to customers across the country (and the world) without the burden of collecting sales tax in every jurisdiction. By limiting their physical presence to one or two states, they effectively limit their sales tax collection responsibility to those states, giving them a competitive edge over traditional "brick-and-mortar" retailers. After years of howling over this inequity, many traditional retailers have decided that they'd rather switch than fight: Wal-Mart, Kmart, and Borders have all recently unveiled e-tailing operations.
But the megaretailers have a problem that pure e-tailers do not: Their brick-and-mortar operations give them nexus in most states and they are required to collect sales tax on their Internet sales in those states. The retailers' dilemma is compounded by the fact that consumers have come to expect all Internet sales to be tax-free (ignoring or forgetting that they are responsible for any applicable use taxes on such transactions).
Consumer expectations and increased competition have led many of the new "click-and-mortar" retailers to try to structure their way around collecting sales taxes. Many have broken their new e-tailing units out into separate subsidiaries or affiliates with a limited physical presence. The traditional retailer naturally wants to capitalize on its goodwill and name recognition, and therein lies the problem: If the retailer/e-tailer relationship is too seamless, there is a very real danger that states will treat the two entities as one for nexus purposes.
The new breed of click-and-mortar retailers must consider how much integration will be acceptable to taxing authorities. But where to draw the line? The authors' review of various websites indicates that many retailers may not understand the significance of this decision. Although the names have been changed, the problems presented in the following case study are real. Retailers should be warned that it was not difficult to find the incriminating evidence, and more likely than not the state tax auditors are not far behind. The stakes are high and the rules are anything but clear.
Retailer Inc. maintains retail outlets throughout the continental United States and has been an industry giant in the computer hardware business for the last decade. Retailer thought it especially important to establish a website, which it used to market, support, and sell its products. After the initial fanfare, however, sales from Retailer's website began to decline. Many of its customers complained about having to pay sales tax, believing that Internet sales were tax-free. Other customers didn't complain; they simply took their business to Retailer's biggest competitor, a pure e-tailer that only collected tax in the two states where it had a physical presence.
In order to compete, Retailer decided to form a subsidiary corporation, e-tailer.com, to handle its e-tail operations and sales. Retailer then purposefully structured its subsidiary to compete with the pure e-tailers. In a nutshell, it only collected sales tax in Arkansas, the only state in which e-tailer.com had a physical presence. Of course, Retailer wanted to take advantage of its name recognition and goodwill, so etailer.com's website provided the following services:
* Purchases from e-tailer.com could be returned to any local Retailer store;
* A store locator allowed users to find the nearest Retailer location; and
* A web page told "The Retailer Story," a concise history of the Retailer empire.
Given these facts-and current nexus case law-e-taller.com could be standing on quicksand. Recent case law indicates that states may be justified in ignoring the separate existence of an affiliated corporation where the facts indicate that its sole purpose is to be an alter ego of a related corporation.
Second, even if Retailer and etailer.com are not viewed as "one and the same" for nexus purposes, their relationship may come under the law of "principal and agent" and the wide body of case law that allows states to attribute the physical presence of an agent within a state to the out-of-state principal for nexus purposes.
If e-tailer.com's separate existence is disregarded, e-tailer.com will have nexus everywhere Retailer does. Regardless of whether an alter ego or agency theory is employed, the net result is that e-tailer.com may find itself responsible for a lot more sales tax than it bargained for.
The Nexus Rules
The nexus rules in New York State illustrate the complexity of the challenges facing Retailer. It is well estabished that an out-of-state vendor must have some physical presence in the taxing state before it can be obligated to collect its sales tax [Quill Corp. v. North Dakota, 504 U.S. 298 (1992)]. This physical presence need not be substantial [Orvis Co., Inc. v. Tax Appeals Tribunal, 86 N.Y.2d 165 (1995); in-state solicitation by out-ofstate traveling salesmen], it need only be more than the "slightest presence" [National Geographic v. California Equalization Bd., 430 U.S. 551 (1977); two unrelated business offices]. In New York, physical presence may be manifested by the presence within the state of the vendor's property or employees or agents acting on the vendor's behalf.
The U.S. Supreme Court has held that a remote seller whose only connection with customers in the taxing state is through a common carrier or the U.S. Postal Service is not subject to that state's sales tax collection requirements [National Bellas Hess v. Dept. of Revenue, 386 U.S. 753 (1967); see also Quill]. This establishes a "bright-line" safe harbor for remote sellers; however, any contact with the taxing state beyond this may give rise to sufficient nexus [See, e.g., Felt and Tarrant Co. v. Gallagher, 306 U.S. 62 (1939) (two soliciting sales agents and a rental office); Standard Steel Co. v. Washington Revenue Dept., 419 U.S. 560 (1975) (one resident employee operating out of his home); Vermont Information Processing, Inc. v. Tax Appeals Tribunal, 86 N.Y.2d 165 (1995) (troubleshooting visits by personnel in support of systems)]. As the U.S. Supreme Court ruled in Scripto v. Carson [362 U.S. 207 (1960)], this is true even where the contact is through an independent contractor operating within a state on the remote seller's behalf.
New York has thus far held that the mere solicitation of sales via the Internet is insufficient to establish nexus for sales and use tax purposes [e.g., DJ &J Software, Advisory Opinion, TSB-A98(66)S, NYS Dept. of Taxation and Finance (Sept. 9, 1998)]. Recent amendments to the New York tax law also provide that the storage of advertisements on a server or the dissemination and display of advertisements by an Internet service provider (ISP) will not create nexus with New York for sales or corporate franchise tax purposes [N.Y. Laws, Ch. 615, L. 1998; TSB-M97(1)C, NYS Dept. of Taxation and Finance Jan. 24, 1997)].
Given this precedent-and assuming that e-tailer.com's only physical contact with New York is through the Internet, post office, or common carrier-e-tailer.com will not have sufficient nexus to require the collection of New York sales tax. However, Retailer has the requisite nexus with New York, and that nexus could somehow be attributed to e-tailer.com.
Under the theory of attributional nexus, a state may attempt to assert jurisdiction over an out-of-state corporation when that corporation itself has insufficient physical presence in the state to establish nexus under Quill. States typically apply the principles of attributional nexus when they decide that the in-state activities of an entity are attributable to an out-of-state corporation, thus giving the out-of-state corporation sufficient nexus in the state. In applying attributional nexus, the states have generally taken two approaches:
* Alter ego theory. The out-of-state taxpayer is so dominated by or interrelated with the in-state affiliate that the taxpayers' separate existence is ignored. The affiliated companies are viewed as one, with a common nexus.
* Agency theory. An in-state company is deemed to be acting as the out-ofstate company's agent. The "agent's" nexus is attributed to the other company as though it had performed the agent's activities.
Alter Ego Amy
As a general rule, corporations are treated as separate legal entities. The presence of a parent corporation in one state does not imply that a whollyowned subsidiary will automatically be deemed present in that state for tax purposes, or vice versa [See Levitz Furniture Co. of the Eastern Region, Inc., Advisory Opinion, TSB-A-86(38)S, NYS Dept. of Taxation and Finance (Sept. 18, 1986)]. In order to prevent fraud or injustice, however, the corporate structure will be disregarded and the separate entity rule discarded, under certain circumstances [See Franklin Mint Corp. v. Tully, 94 A.D. 2d 877 Ord Dept. 1983), aff d without opinion, 61 N.Y. 2d 980 (1984)]. If the parent so dominates and controls the affairs of the subsidiary that the subsidiary is an instrumentality of the parent, the subsidiary may be considered the alter ego of the parent and ignored as a separate entity, and vice versa. In an alter ego analysis:
Indicia such as common officers and directors, common offices, and telephone numbers between corporate entities are relevant but are not sufficient by themselves to show that one corporation is the alter ego of another. Consideration must also be given to factors such as the degree of overlap of personnel, the amount of business discretion displayed by the corporations, whether the entities operate independently of each other, whether the parent corporation owns all or most of the stock of the subsidiary, and whether the parent corporation causes the incorporation of the subsidiary. Also significant is whether the corporations trade under their own names and whether they hold themselves out to the public as separate and distinct businesses. [Franklin Mint. It should be noted that the alter ego doctrine applies to parent and subsidiary corporations as well as to affiliated corporations.]
In any event, if e-tailer.com's separate existence is disregarded, Retailer and e-tailer.com will be viewed as one and the same for nexus purposes, meaning that e-tailer.com will have nexus everywhere Retailer does. In addition, this issue may be scrutinized on an ad hoc, state-by-state basis.
New York Authority
New York State has addressed the issue of attributional nexus in at least three separate advisory opinions. In Bottiglieri [Advisory Opinion, TSB-A88(20)S, NYS Dept. of Taxation and Finance (March 2, 1998)], a parent company doing business in New York sold memberships entitling members to purchase discounted merchandise. Historically, employees of the parent company periodically entered New York to service and solicit memberships. Under the New York rules, this presence alone created nexus. In response, the parent enlisted a network of out-ofstate vendors to sell their merchandise to club members. "Subsidiary," a direct marketer with no property or other presence in New York, was one such vendor. The parent company produced and mailed brochures advertising the club vendors' merchandise to members. Subsidiary did not solicit sales in New York; it merely sold tangible personal property to individuals placing telephone orders and then shipped the goods via the post office or commercial carrier. The parent took telephone inquiries but did not accept orders, referring them to the vendor.
Under the holding of National Bellas Hess, Subsidiary was not required to collect sales tax; nevertheless, New York found sufficient nexus through the parent because Subsidiary would have had nexus had the soliciting and selling activities been conducted by it as a single entity. As the commissioner noted, "The creation of Subsidiary as a separate corporate entity may not preclude the finding of sufficient nexus unless valid reasons for corporate reorganization-other than the separation of promotion and marketing activities-can be demonstrated."
In Harfred Operating Corporation [Advisory Opinion, TSB-A-86(28)S, NYS Dept. of Taxation and Finance (July 18, 1986)], a parent corporation operated retail stores in New York and created subsidiaries to operate similar stores in New Jersey. The companies' operations were conducted independently; each maintained separate books, records, and warehouse facilities. All sales were made on premises; no mail order sales were solicited. The companies had the same officers and directors and advertised jointly under the same business name with their locations separately listed.
The commissioner again recognized that the subsidiaries were not required to collect sales tax under National Bellas Hess but found nexus on the grounds that the subsidiaries were operating as the alter egos of their New York parent. This holding was partially based on the retailer's ownership of the subsidiaries and "a significant degree of overlap of administration and personnel," but there were two other deciding factors: First, the joint advertisements held the companies out to the public as one entity while claiming they were separate entities for avoiding sales taxes. Second, the proximity of the locations meant that "many of [the subsidiaries'] customers will be New York residents." In the commissioner's opinion, the subsidiaries were incorporated "as a means to make sales in New Jersey to New York residents in order to avoid collecting New York tax." Since this "would clearly produce injustice and inequitable consequences," the commissioner found sufficient nexus with New York to compel the subsidiaries to collect New York taxes.
In Spencer Gifts [Advisory Opinion, TSB-A-86(37)S, NYS Dept. of Taxation and Finance (Sept. 18, 1986)], the parent company (Parent) established a subsidiary (Mail Order) in New Jersey to solicit sales through the mail. Mail Order's only contact with New York was the shipping of merchandise via the post office or commercial carrier. Customer complaints and refunds were handled by mail or telephone by personnel located outside of New York. A sister company (Retail Stores) operated stores in 46 states, including New York. Retail Stores did not act as an agent of or otherwise facilitate Mail Order sales. Mail Order promotional materials were not available at Retail Stores. Retail Stores neither accepted customer orders for Mail Order merchandise nor handled complaints or refunds. Each company maintained its own merchandising and marketing departments, as well as separate warehouses, inventories, and bank accounts. There was no joint purchasing, and less than 5% of items sold were common to both. Transactions between Mail Order and Retail Stores were at arm's-length prices. Parent maintained executive offices in New York and performed certain advisory, tax, and financial planning services for Mail Order and Retail Stores. It also performed periodic reviews of each company's operations. Some employees of Mail Order and Retail Stores were covered by Parent's stock benefit and medical plans.
On the facts presented, the commissioner held that Mail Order was operating as the alter ego of neither Retail Stores nor Parent, and, therefore, no nexus existed to compel the collection of New York sales tax. The commissioner cautioned, however, that "additional facts which demonstrate that Mail Order is the alter ego of its New York affiliates would warrant a conclusion that there would be sufficient nexus to compel Mail Order to collect New York tax. In that instance, it would be unjust and inequitable to allow Mail Order to avoid tax collection responsibilities."
The issue of attributional nexus was also addressed by New York State's Division of Tax Appeals in NADA Services Corp. [NYS Division of Tax Appeals, Administrative Law Judge Unit (Feb. 1, 1996); administrative law judge decisions in the Division of Tax Appeals are not considered precedential]. Here, the National Automotive Dealers Association (Parent), a trade association with New York nexus, provided consulting and training services to auto dealerships. NADA Service Corporation (Subsidiary), a Delaware corporation with a principal place of business in Virginia, published and distributed three automotive publications through the U.S. mail: Automobile Executive, NADA Official Used Car Guide, and Trade-in Guide. Subsidiary's only connection to New York was through the mail. Parent members received complimentary subscriptions to Automobile Executive and NADA Official Used Car Guide, which accounted for 80% and 12%, respectively, of total subscribers to each publication. Parent purchased the subscriptions from Subsidiary at fair market value.
Parent's primary market was automobile dealers; Subsidiary's market was much broader. Parent and Subsidiary shared offices in a building owned by Subsidiary, which leased the premises to Parent at fair rental value. The companies and their respective departments were divided by partitions, dividers, or walls. The companies shared a receptionist, listed as a Subsidiary employee, whose salary was allocated to both companies. The companies also shared a general telephone number and an 800 number; calls were routed by the receptionist or an automated answering system.
Subsidiary's accounting, payroll, and data processing departments serviced Parent, whereas Parent's human resources and legal departments serviced Subsidiary. Each recipient paid the provider fair market value for such services. Subsidiary's 11-member board consisted of individuals serving on Parent's board or executive committee. The companies maintained separate minute books and board meetings, although such meetings were held on the same day. The companies maintained separate bank accounts. They maintained separate but identical payroll systems and health care plans and separate and different retirement plans, Subsidiary paid a fee to Parent for the use of its name, logo, and the phrase "the official publication of Parent" under a licensing agreement identical to another by an unrelated third party.
Even though Subsidiary derived a benefit from Parent's name recognition (for which it paid a licensing fee) and from certain cost-sharing efficiencies, it observed the formalities of a separate existence. In refusing to apply the alter ego theory, the Division of Tax Appeals found:
In sum, the two entities had separate though overlapping markets, separate main business functions, purposes, and goals, and went about executing those purposes on separate operational planes.... Petitioner here was not merely a "device"-it was a viable business enterprise conducting its own activities, carrying out its own purposes, and paying its expenses to unrelated creditors as well as its carefully determined portion of administrative expenses for services shared with its parent.
Alter Ego Cases in Other Jurisdictions Many other jurisdictions have considered the alter ego issue with varying degrees of success. In Current, Inc. v. State Board of Equalization [29 Cal. Rptr. 2d 407 (1994)], a parent company with California nexus had an out-ofstate mail order subsidiary with no property, employees, or offices in the state. According to the court, imputing nexus was inappropriate since neither parent nor subsidiary "was the alter ego or agent of the other for any purpose. Neither solicited orders for the products of the other, and neither accepted returns of the merchandise of the other or otherwise assisted or provided services for customers of the other." The court noted that each company "owned, operated, and maintained its own business assets, conducted its own business transactions, hired and paid its own employees, and maintained its own accounts and records ... [with no] integrated operations or management." The court also noted that the companies "were organized and operated as separate and distinct corporate entities. Neither held itself out to customers or potential customers as being the same as, or an affiliate of, the other. Each had its own trade name, goodwill, marketing practices, and customer lists and marketed its products independently of the other. Neither exploited the trade name, corporate identification, or goodwill of the other or purchased goods or services from the other."
Interestingly, the California Legislature recently clarified that dot-com affilfates of California retailers must collect sales tax on their sales (A.B. 2412). The California Department of Finance opposed the bill, and it was subsequently vetoed by the governor.
While Current illustrates ideal facts in an alter ego situation- maximum separation and independence-less favorable facts have withstood alter ego challenges. In SFA Folio Collections, Inc. v. Tracy, a company owned and operated stores in Ohio and its out-of-state affiliate sold similar products via direct mail. The affiliate's catalog was generally available at company stores, which might refer customers to the affiliate's catalog of out-of-stock items and would accept returns of merchandise sold by the affiliate. The companies sold similar lines of products, relied on the same goodwill, and accepted the parent's credit card for payment.
The court refused to impute the company's nexus to its affiliate, despite the company's acceptance of affiliate returns and distribution of affiliate catalogs. The court determined that some physical presence was required; an instate parent or sister company was not enough. It is worth noting that Folio probably would have been decided differently in New York, which does not require physical presence for attributional nexus.
Finally, in Bloomingdale's by Mail, Ltd. v. Dept. of Revenue [567 A.2d 773 (Pa. 1989)], a clothing merchant (Bloomingdale's) operated retail stores in Pennsylvania and created a subsidiary company (By Mail) to conduct an out-of-state mail order business. Based on two instances where the stores accepted returns of merchandise from mail order customers, the Department of Revenue argued that Bloomingdale's in-state retail stores acted as agents for By Mail. The court rejected the argument, finding that the returns were "aberrations from normal practice" and that it made no difference that customers of By Mail could pay for their merchandise with a Bloomingdale's credit card or that both companies used the "same advertising themes and motifs."
Implications. Each of the red flags raised by e-tailer.com's website is highly indicative of alter ego status and a cause for concern. Most problematic is the fact that Retailer stores will accept returns of merchandise purchased from the e-tailer affiliate. Moreover, e-tailer.com's store locator and corporate history pages go a long way toward establishing that Retailer and e-tailer.com are instrumentalities of one another and that their separate existence should be ignored for nexus purposes.
The U.S. Supreme Court's holding in Scripto would imply that e-tailer.com is asking for trouble. In Scripto, the Court determined that a Georgia-based retailer was required to collect and remit Florida sales tax because it had 10 parttime independent solicitor-brokers taking orders within the state on Scripto's behalf. The underlying theory was that the independent solicitor-brokers were acting as Scripto's agents within the state; since the agents were physically present within the state, so was Scripto.
In the case study under discussion, it appears that Retailer acts as etailer.com's agent within the various states by accepting and processing merchandise returns on its behalf-definitely posing serious problems under Scripto.
Avoiding Attributional Nexus
As discussed above, if the affairs of one corporation are so dominated or controlled by its affiliate such that the controlled corporation is the alter ego of the other, then the nexus of one will often provide sufficient nexus for the other. In addition, the mere presence of an in-state agent could subject the subsidiary to taxation. While no brightline rules can be distilled from the court opinions, they do offer some guidance as to how to avoid the alter ego characterization. With this in mind, brick-and-mortar retailers should consider the following advice when establishing a separate e-tailing unit:
* Avoid common officers and directors. If directors and officers between the affiliated corporations are virtually identical, this may indicate one corporation is the alter ego of another.
* Segregate personnel Shared secretaries, managers, and department heads are indicia of alter ego corporations.
* Give the affiliate business discretion The e-tailer affiliate must have the authority to act as its own entity. This includes discretion in employee hiring, website maintenance, and merchandise prices.
* Separate property, employees, accounts, and records. Of course, separate accounting is necessary; employees should be on separate payrolls and receive separate benefits. If there is any sharing of labor, record keeping, or other items, the associated costs should be shared and allocated on an arm's-length basis.
* Keep customer service activities separate. The retail stores should not facilitate Internet sales, nor should they handle complaints or refunds from the e-tail affiliate's customers. The etailer should maintain a separate, exclusive phone number for product inquiries or questions. In the same vein, the e-tailer should not refer its Internet customers to the retail stores.
* Maintain separate warehouses and inventory. The states may impute alter ego status where the parent and its e-tail affiliate share warehouses or inventory, even if costs are properly allocated. As a practical matter, the etail affiliate's use of a warehouse located within a state would constitute a physical presence in the state and would most likely give rise to taxable nexus. One way around this might be to have the e-tail affiliate buy its inventory from the retailer (at an arm'slength price) on an as-needed basis. A more aggressive approach might be to use the retailer to drop ship orders for the e-tail affiliate.
* Observe corporate formalities. Of course, the affiliate should take all steps to ensure it is acting as a separate entity, such as by having separate corporate meetings and employee directories.
* Sell different products. Another way to establish distinctions would be to allow the e-tailer to have a more diverse product line than the retail stores. There will be overlap in the type of merchandise sold, but if the e-taller serves a more diverse market, it has a better argument that it is a distinct entity.
* License the use of trade names and other intellectual property at an arm's-length price. In determining alter ego status, the courts have examined whether the affiliated corporations hold themselves out as the same entity. If companies trade under the same name, this tends to support a finding of alter ego status; however, most e-tailing endeavors are created with the goal of exploiting the goodwill associated with the retail trade name in the Internet market. Consequently, the affiliate should pay a licensing fee that is as close as possible to an arm's-length price for use of the established trade name.
* Advertise separately. Most retailers today include their website address on their advertisements, but doing so indicates that the companies are holding themselves out as one entity. One option is to avoid joint advertising altogether: The retailer would display no website on its advertisements. Consequently, the e-tailer would not advertise for the retailer (and would feature no store locator function). A more risky option would be for the retailer to charge the e-tailer an arm's-length price for advertising its website (or vice versa); however, this leaves the initial problem-that the companies are holding themselves out as one entityunsolved. The safest option is to advertise separately.
* Maintain separate web addresses. The Internet presence of brick-andmortar retailers should be carefully segregated from that of an e-tail affiliate. In the case study, Retailer should have its own website for general corporate and supplier information, investor relations, and all other non-e-commerce functions. If Retailer's site links to e-tailer.com, it should be very careful to charge an arm's-length price for the service. This would not eliminate the problems created by joint marketing.
* Have a stated, recognizable, and separate purpose. The courts have taken the purpose of the separate corporation into account when examining alter ego status. As such, there should be a documented reason for the creation of a separate entity solely for Internet sales.
* Engage experienced legal counsel This area of the law changes on an almost daily basis-it is not safe to shoot from the hip. Retailers should not only look to how other dot-coms are structured, but also engage experienced counsel that can tell them how dot-corns need to be structured today and in the future.
The Best of Both Worlds
It is only natural that traditional retailers want to get online. The problem is that they seem to want the best of both worlds: the tax freedom enjoyed by pure e-tailers coupled with seamless operation in conjunction with their brick-and-mortar stores. But by trying to have their cake and eat it too, many of these new hybrids may receive their just desserts. While none of the activities discussed above will, by themselves, compel or preclude state taxation, the facts and the law indicate that many click-and-mortar retailers need to rethink their Internet strategies.
Mark S. Klein, JD, is a partner and member of the state and local tax practice group and Timothy P. Noonan, JD, and Andrew AL Sabol, JD, are associates, all in the Buffalo, N. Y., office of the multinational firm of Hodgson, Russ, Andrews, Woods & Goodyear, LLP.…