The Florida Bar
www.floridabar.org
The Florida Bar Journal
April, 2014 Volume 88, No. 4
Revisiting Nexus Standards: Establishing U.S. Jurisdiction to Tax Cross-border Commerce

by Brianne N. De Sellier and John M. Kelleher

Page 31

In 1789, Benjamin Franklin famously observed, “[I]n this world, nothing can be said to be certain, except death and taxes.” Franklin might have been correct about death, but in this modern era of electronic commerce and virtual retailing, the international tax environment has become uncertain at best. The emergence of electronic commerce has challenged the U.S. tax system to re-evaluate jurisdictional nexus standards in order to adapt to the realities of the modern business climate. In particular, questions have been raised as to whether traditional international tax principles continue to be a viable approach to establishing U.S. jurisdiction to tax cross-border commerce.

Traditional U.S. International Tax Principles
When a foreign taxpayer generates income in the United States, both the United States (the source country) and the foreign taxpayer’s country of residence (the residence country) generally have jurisdiction to tax that income. The overriding objective of the U.S. system of international taxation is to equitably resolve these competing claims in a way that stimulates global commerce while simultaneously mitigating risks of multiple taxation and tax avoidance.1 In this respect, there are two fundamental approaches to resolving competing claims to tax the same income: 1) residence-based taxation; and 2) source-based taxation.2

Under principles of residence-based taxation, income is taxed in the taxpayer’s country of residence, regardless of where the income is earned.3 Under principles of source-based taxation, by contrast, income is taxed in the country in which it is earned, regardless of the taxpayer’s residence.4 The United States employs a hybrid approach under which jurisdiction to tax cross-border income is predicated on principles of both residence-based taxation and source-based taxation.5 U.S. citizens, resident aliens, and domestic corporations are subject to U.S. taxation on worldwide income in accordance with principles of residence-based taxation.6 Foreign taxpayers, on the other hand, generally are taxed in accordance with principles of source-based taxation.7

The Internal Revenue Code (IRC) provides that foreign taxpayers engaged in a trade or business within the United States are subject to U.S. taxation on income that is “effectively connected” to the conduct of trade or business within the United States.8 The treaty counterpart is that a foreign taxpayer is subject to U.S. taxation only on business profits attributable to a U.S. permanent establishment.9 The majority of inbound business activity that occurs in the United States involves foreign companies domiciled in countries with which the United States has a bilateral income tax treaty. Therefore, the U.S. generally must establish its jurisdiction to tax the business profits of a foreign enterprise under treaty principles, which typically limit the scope of U.S. taxing jurisdiction to situations in which the foreign enterprise has a “permanent establishment” within the United States.

The Permanent Establishment Concept
The term “permanent establishment” is defined as “a fixed place of business through which the business of an enterprise is wholly or partly carried on.”10 Traditional examples of permanent establishments include stores, offices, branches, and factories.11 In addition, the activities of an agent acting on behalf of a foreign enterprise in the United States may create a permanent establishment for the foreign enterprise.12 Some tax treaties have even extended the definition of permanent establishment to deem a permanent establishment to exist when a foreign enterprise performs services within a jurisdiction for more than a specified length of time.13 In essence, the permanent establishment concept demands an integral and ongoing physical presence within the United States as a prerequisite to U.S. taxation.

Historically, the permanent establishment concept emerged in the early 20th century as a byproduct of the second Industrial Revolution.14 The second Industrial Revolution facilitated innovations in transportation which, in turn, enhanced business mobility and created unprecedented opportunities for foreign businesses to enter previously inaccessible U.S. markets.15 As a result, there was an influx of foreign capital into American markets.16 Of course, with foreign exploitation of American markets came U.S. taxation of foreign businesses. At the same time, however, these foreign-based businesses remained subject to taxation in their residence countries based on principles of residence-based taxation. As a result, double taxation of cross-border business profits became an issue, and the permanent establishment concept emerged as a mechanism for resolving competing claims to tax between the source jurisdiction and the residence jurisdiction.17 It is this concept of permanent establishment that forms the analytical foundation for modern taxation of cross-border commerce.

Modern Application of the Permanent Establishment Concept
The American business environment was of an industrial character when the permanent establishment concept emerged as the jurisdictional standard. Business capital consisted primarily of fixed assets (plants, property, and equipment),18 and the business climate of the time period effectively required foreign-based businesses to establish a fixed place of business within the United States in order to compete effectively in U.S. markets.19 Since then, businesses have globalized and mobilized their assets. In contrast to the industrial business environment of the early 20th century, foreign businesses now are able to reach American consumers without establishing a physical presence within the United States. As a result, courts and taxing authorities are struggling with jurisdictional questions in cases involving taxation of cross-border electronic commerce in which traditional permanent establishment principles seem out of place.20 In response, some commentators have questioned the continued viability of physical presence as the jurisdictional standard and have argued that economic presence should be viewed as a surrogate for physical presence in the modern business environment.21

Under an economic presence standard, the requisite permanent establishment essentially is implied from the economic presence of a foreign business within the United States. In theory, significant economic contacts with American markets would establish the requisite connection to the United States necessary to justify U.S. taxation. However, despite the theoretical seductiveness of an economic presence standard, such a standard arguably is unconstitutional under present law because a taxpayer’s physical presence within the United States appears to be a constitutional prerequisite to U.S. taxation under existing U.S. Supreme Court jurisprudence.

Bifurcated Nexus Analysis
In Quill Corporation v. North Dakota, 504 U.S. 298 (1992), the U.S. Supreme Court articulated a bifurcated nexus analysis, requiring both due process nexus and commerce clause nexus as constitutional prerequisites to the cross-border taxation of a foreign business. To be clear, Quill was a state tax case addressing a state government’s ability to require vendors to collect a use tax. It was not an income tax case, nor was it an international tax case. However, while Quill is about the imposition of a state use tax collection responsibility, it is nevertheless relevant to the income tax nexus inquiry in the international tax context. Quill’s in-depth explanation of the constitutional limitations imposed on a state government’s jurisdiction to impose a use tax collection obligation on out-of-state vendors without physical presence in the taxing state is instructive of the jurisdictional issues that confront national tax authorities in the international tax context and can, therefore, inform the nexus analysis.

Due process nexus requires a definite link or minimum connection between the taxing jurisdiction and the taxpayer that makes taxation fair and reasonable. 22 If a foreign business purposefully avails itself of the benefits of American economic markets, it has established the minimum contact with the United States required by the due process clause.23 Significantly, this is true even if the foreign business has no physical presence within the United States.24 In other words, due process nexus effectively is a standard of economic presence.

Commerce clause nexus, on the other hand, is a standard of “substantial nexus.”25 While the U.S. Supreme Court has provided little guidance regarding what is needed to satisfy the “substantial nexus” required by the commerce clause, the Court has explicitly indicated that commerce clause nexus demands something beyond the economic presence required by the due process clause.26 Consequently, replacing traditional physical presence nexus standards with a standard of economic presence would be tantamount to a rejection of the commerce clause prong of the U.S. Supreme Court’s bifurcated nexus analysis.

Several notable state court decisions have upheld the constitutionality of economic presence as a surrogate for physical presence in the state taxation context.27 Proponents of using an economic presence standard in the international tax context have cited these cases as instructive. However, the reasoning of these cases is flawed to such a degree so as to vitiate their persuasive value.

Geoffrey, Inc. v. S.C. Tax Commission
Geoffrey, Inc. v. Comm’n of Rev., 899 N.E.2d 87 (2009), cert. den., 129 S. Ct. 2853 (2009), was the landmark case that gave birth to the concept of nexus based on economic presence in the state income tax environment. In Geoffrey, the Supreme Court of South Carolina upheld the imposition of a state corporate income tax based on the taxpayer’s economic presence within the taxing jurisdiction. The Geoffrey court began its commerce clause analysis by stating the “well-settled” principle that a “taxpayer need not have a tangible, physical presence in a state for income to be taxable there.” Significantly, no authority was cited in support of this proposition. Most likely, this is because the proposition is not well-settled at all. There is no U.S. Supreme Court case that specifically dispenses with the physical presence requirement in the income tax context. Therefore, the South Carolina court’s naked assertion that the commerce clause does not require physical presence in the income tax context arguably has no basis in law.

Moreover, in concluding that the taxpayer’s economic presence was sufficient to establish the “substantial nexus” required by the commerce clause, the Geoffrey court cited three cases28 and a treatise. Significantly, all three cases are pre-Quill cases, and two of the cases are due process cases that make no mention of the commerce clause.29 Because a treatise is merely secondary authority, the Geoffrey court effectively cited pre-Quill due process cases to satisfy post-Quill commerce clause requirements.

KFC Corp. v. Iowa Department of Revenue
In KFC Corp. v. Iowa Department of Revenue, 792 N.W.2d 308 (Iowa 2010), cert. den. (2011), the Iowa Supreme Court upheld the imposition of a state corporate income tax based on the taxpayer’s economic presence within the taxing jurisdiction. In rejecting the physical presence requirement, the KFC court cited Wisconsin v. J.C. Penney Co., 311 U.S. 435 (1940), holding that commerce clause nexus is a standard of economic presence.30 However, a reading of the J.C. Penney case reveals that J.C. Penney was a due process case, not a commerce clause case. In addition, the KFC court relied on two other due process cases: International Harvester Co. v. Wisconsin Department of Taxation, 322 U.S. 435 (1944), and New York ex rel. Whitney v. Graves, 299 U.S. 366 (1937). Although the KFC court acknowledged that these cases were due process cases, the court proceeded to treat these due process cases as commerce clause cases.31 Thus, like the Geoffrey court, the KFC court effectively cited pre-Quill due process cases to satisfy post-Quill commerce clause requirements.

In addition, the KFC court emphasized that the U.S. Supreme Court has required physical presence only in the sales and use tax context and not in the income tax context.32 However, while it is true that there is no U.S. Supreme Court case explicitly requiring physical presence as a prerequisite to income taxation, this is arguably because the U.S. Supreme Court has never had occasion to consider the issue. Indeed, every state income tax case that has reached the U.S. Supreme Court has involved physical presence.33 It should also be emphasized that while there is no U.S. Supreme Court case explicitly establishing physical presence as a jurisdictional prerequisite to income taxation, there is also no case explicitly dispensing of the physical presence requirement in the income tax context.

Practical Considerations
Despite the theoretical appeal of the academic argument opposing the use of an economic presence standard, international organizations and tax authorities in many countries are taking more aggressive positions in practice. To date, there is no direct U.S. authority addressing whether electronic commerce can create a permanent establishment for U.S. tax purposes. However, the Organisation for Economic Co-operation and Development (OECD) published commentary that addresses the issue.34 While the OECD commentary is not binding for U.S. tax purposes, it provides helpful guidance as to when the activities of a server or a website may create a taxable presence within a jurisdiction.

As a threshold matter, the OECD commentary distinguishes between automated computer equipment (such as a server) and the data and software stored on that equipment (such as a website). A website, by itself, cannot constitute a permanent establishment because it is merely a combination of software and electronic data that does not, in itself, involve tangible property that could create a physical presence.35 By contrast, the server and other computer equipment on which the website is stored and through which the website is accessible is equipment with a physical location that can be viewed as a fixed place of business.36 Consequently, a server located in a jurisdiction may create a permanent establishment for tax purposes.

Conclusion
A taxpayer’s physical presence within the United States appears to be a constitutional prerequisite to U.S. taxation under existing U.S. Supreme Court jurisprudence. In addition, physical presence within the United States is required under the more than 60 tax treaties negotiated by the United States. Nonetheless, a risk presently exists for foreign companies conducting business through servers. The existence of a server in a jurisdiction may create a taxable presence within the jurisdiction and, thereby, expose the company to taxation in that jurisdiction. Accordingly, foreign companies with servers in the United States need to understand the risks associated with electronic commerce and consider tax strategies to mitigate that risk.


1 E.g., IRS Notice 98-11, 1998-1 CB 433; U.S. Model Technical Explanation Accompanying the U.S. Model Income Tax Convention of Nov. 15, 2006.

2 U.S. Dep’t of Treas., Blueprints for Basic Tax Reform 98 (Jan. 17, 1977).

3 Id.

4 Id.

5 Id.

6 Cook v. Tait, 165 U.S. 42 (1924) (holding that U.S. citizens are subject to U.S. taxation on worldwide income by virtue of U.S. citizenship, even if living abroad); I.R.S. Pub. No. 519 (2012) (providing that U.S. resident aliens are generally taxed on worldwide income).

7 I.R.C. §871(b) (relating to the taxation of foreign individuals); I.R.C. §882(a) (relating to the taxation of foreign corporations). See also U.S. Model Income Tax Convention, art. 7(1) (Nov. 15, 2006) [hereinafter U.S. Model Tax Treaty].

8 I.R.C. §§871(b) and 882(a).

9 U.S. Model Tax Treaty, art. 7(1).

10 U.S. Model Tax Treaty, art. 5(1).

11 Id.

12 U.S. Model Tax Treaty, art. 5(5)-(6).

13 E.g., United Nations Model Double Taxation Convention Between Developed and Developing Countries, art. 5(3)(b) (New York: United Nations 2011); OECD Model Tax Convention on Income and on Capital, art. 5 (Dec. 8, 2006).

14 Benjamin Hoffart, Permanent Establishment in the Digital Age: Improving and Stimulating Debate Through an Access to Markets Proxy Approach, 6 NW J. Tech. & Intell. Prop. 106, 108 (2007) [hereinafter Permanent Establishment in the Digital Age] (citing Arvid A. Skaar, Permanent Establishment: Erosion of a Tax Treaty Principle 65 (1991)).

15 Skaar, Permanent Establishment: Erosion of a Tax Treaty Principle 65 (1991).

16 Hoffart, Permanent Establishment in the Digital Age at 109.

17 Double Taxation and Tax Evasion Report, League of Nations Doc. C.216.M.85 1927 II (1927).

18 Id.

19 Hoffart, Permanent Establishment in the Digital Age at 109 (citing Skaar, Permanent Establishment: Erosion of a Tax Treaty Principle at 67).

20 E.g., Gunter Strunk & Bert Kaninski, German Federal Tax Court Skirts Question of Permanent Establishment in E-Commerce Case, Worldwide Tax Daily (Oct. 4, 2002) (criticizing German court for avoiding question of whether German company’s Internet server in Switzerland constituted a permanent establishment).

21 E.g., Luc Hinnekens, Looking for an Appropriate Jurisdictional Framework for Source-State Taxation of International Electronic Commerce in the Twenty-First Century 197 (1998); Richard L. Doernberg, Electronic Commerce: Changing Tax Treaty Principles a Bit?, Tax Notes Int’l 2417 (2000).

22 Quill, 504 U.S. at 306-08 (citing Miller Brothers Co. v. Maryland, 347 U.S. 340, 344-45 (1954)).

23 Id.

24 Id.

25 Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977).

26 Quill 504 U.S. at 313.

27 Note that many of the taxpayers involved in these economic presence cases have petitioned the Supreme Court for review, but the Court has uniformly denied certiorari, indicating that the issue is one for Congress to resolve.

28 Am. Dairy Queen Corp. v. Taxation and Revenue Department, 605 P. 2d 251 (N.M. Ct. App. 1979); International Harvester Co. v. Wis. Department of Taxation, 322 U.S. 435 (1944); Curry v. McCanless, 307 U.S. 357 (1939).

29 Int’l Harvester Co., 322 U.S. 435; Curry, 307 U.S. 357.

30 KFC, 792 N.W.2d at 314.

31 Id. at 325.

32 Id.

33 Wis. Dep’t of Revenue v. Wrigley Co., 505 U.S. 214 (1992) (people in taxing jurisdiction); Underwood Typewriter Co. v. Conn., 254 U.S. 113 (1920) (office in taxing jurisdiction); Bass, Ratcliff & Gretton, Ltd. v. State Tax Comm’n, 266 U.S. 271 (1924) (office in taxing jurisdiction); Hans Rees’ Sons, Inc. v. N.C. Comm’r of Revenue, 283 U.S. 123 (1931) (manufacturing in taxing jurisdiction); Butler Bros. v. McColgan, Franchise Tax Comm’r of Cal., 315 U.S. 501 (1942) (store in taxing jurisdiction); Mobil Oil Corp. v. Comm’r of Taxes of Vt., 445 U.S. 425 (1980) (gas stations in taxing jurisdiction); Moorman Mfg. Co. v. Bair, Dir. of Revenue of Iowa, 437 U.S. 267 (1978) (warehousing/distributing facilities in taxing jurisdiction); Exxon Corp. v. Dep’t of Revenue of Wis., 447 U.S. 207 (1980) (marketing activities in taxing jurisdiction); F.W. Woolworth Co. v. Taxation and Revenue Dep’t of N.M, 458 U.S. 354 (1982) (store in taxing jurisdiction); Container Corp. of Am. V. Franchise Tax Bd., 463 U.S. 159 (1983) (manufacturing in taxing jurisdiction); MeadWestvaco Corp. v. Ill. Dep’t of Revenue, 533 U.S. 16 (2008) (offices in taxing jurisdiction); Kraft General Foods, Inc. v. Iowa Dep’t of Revenue, 505 U.S. 71 (1992) (stores in taxing jurisdiction); Hunt-Wesson, Inc. v. Franchise Tax Bd., 528 U.S. 458 (2000) (offices in taxing jurisdiction); Allied-Signal, Inc. v. Div. of Taxation, 504 U.S. 768 (1992) (manufacturing in taxing jurisdiction).

34 OECD Committee on Fiscal Affairs, Clarification on the Application of the Permanent Establishment Definition in E-Commerce: Changes to the Commentary on the Model Tax Convention on Article 5 (Dec. 22, 2000).

35 Id. at 42.2.

36 Id.


Brianne De Sellier is with Crowe Horwath LLP in Ft. Lauderdale. She received her B.B.A. in accounting from the University of Miami, her J.D. from St. Thomas University School of Law, and her LL.M. in taxation from NYU School of Law.

John Kelleher is a partner with Crowe Horwath LLP in Oak Brook, Ill. He received his B.S. in accounting from the University of Central Florida and his M.S. in taxation from DePaul University.

This column is submitted on behalf of the Tax Law Section, Joel David Maser, chair, and Michael D. Miller and Benjamin Jablow, editors.

[Revised: 03-27-2014]