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Stephen Ehrenberg Annette Nellen

Affiliate nexus litigation: Everyone loses

Affiliate nexus law wins in New York, but loses in Illinois. Even if the U.S. Supreme Court steps in, everyone loses this tax collection contest.

November 14, 2013
by Annette Nellen, Esq., CPA

For decades now, state and local governments have had growing concerns about collecting all of the sales and use taxes their laws allow them to collect. Customers’ growing ability to buy from out-of-state vendors that are not legally required to collect sales tax leaves states increasingly dependent on a difficult-to-collect use tax. Thus, states will seize any opportunity to convert use tax that buyers must remit (but often don’t do so) to sales tax that sellers are required to collect and remit. But this desperate state of affairs seldom leads to the best tax rules and practices.

Desperate measures

An example of a desperate practice is the effort that started in New York in 2008 with enactment of what have become called “affiliate nexus” laws. These laws are also called “Amazon” laws as that company appears to be the key vendor states seek to convert to an all-state sales tax collector, despite the reality that, as an e-commerce company, Amazon needs few nexus-creating physical locations. (These are also called click-through nexus laws because they impose tax on sales made by “clicking through” from one website to another.) (For more on these laws, see Nellen, “Grabbing Remote Vendors,” Corporate Taxation Insider (July 31, 2008); and the author’s affiliate nexus website.)

Recent litigation

Two large internet vendors challenged the New York law—Amazon.com and Overstock.com. This litigation, which involved trials at three levels in the New York state courts, concluded in March 2013 with another loss for the companies. The New York state courts found that New York’s affiliate nexus law meets both the Due Process and Commerce Clause requirements of the U.S. Constitution. A dissenting judge, though, concluded that the law should be interpreted within the realities of e-commerce. He found it inappropriate for the law to treat, in effect, website advertising as “an in-state sales force.” (See Overstock.com, Inc. v. New York State Dep’t of Tax. and Fin., 20 N.Y.3d 586 (N.Y. 2013).)

In October 2013, the Illinois Supreme Court found that that state’s nexus law was “preempted” by the federal Internet Tax Freedom Act (ITFA), P.L. 105-277, and therefore unenforceable. With that finding, the court did not address the Commerce Clause challenge to the law. (See Performance Marketing Ass’n v. Hamer, No. 114496 (Ill. 10/18/13).)

Different statutory language in New York and Illinois

Despite enacting its affiliate nexus law after the first two rounds of litigation in New York had upheld that state’s statute, Illinois did not adopt New York’s exact statutory language.

The affiliate nexus laws of both states involve an agreement between a vendor and a resident who can earn a “commission or other consideration, directly or indirectly,” by referring customers to the vendor:

  • In New York, “by a link on an internet website or otherwise” (N.Y. Tax Law §1101(b)(8));
  • In Illinois, “by a link on the person’s Internet website” (35 Ill. Comp. Stat. 105/2).

The Illinois law applies only if the referral of customers is via a website. The New York law applies more broadly to a website link or other connection. As the Illinois court noted, the Illinois statute “does not require use tax collection by out-of-state retailers who enter into performance marketing contracts with ‘offline’ Illinois print publishers and over-the-air broadcasters.” The court observed that this type of promotion (known as performance marketing) can occur offline through magazines and television. The court found that by “singling out retailers with Internet performance marketing arrangements for use tax collection, the Act imposes discriminatory taxes within the meaning of the ITFA.”

The dissenting judge in the Illinois case believed the court should have also addressed the Commerce Clause issue. He predicted that the issue might come back to the court after November 2014 when ITFA expires. He also did not think that law was “discriminatory” as that term is defined in ITFA.

The Illinois statute also differs from New York’s by not including a rebuttable presumption to allow the vendor to show that the in-state affiliates are not soliciting sales. The court did not address that issue but likely would have found it relevant if the Illinois court had addressed the Commerce Clause issue.

Litigation does not solve the problem

The affiliate nexus laws certainly have raised some revenue (particularly in New York where Amazon started collecting tax in 2008). However, they do not address the entire sales and use tax collection problem. Consider the following issues:

Use tax gap remains: Vendors can avoid the affiliate nexus laws the states are using to force them to become sales or use tax collectors by canceling the contracts they have with in-state affiliates. This has been a common practice by Overstock.com and Amazon.com. For example, in August 2013, Amazon.com announced it was ending its Missouri associates program in response to that state’s enactment of an affiliate nexus law (see Davis, “Amazon Shuts Down Missouri Associates Program Over Sales Tax Dispute,” The Kansas City Star (Aug. 16, 2013)).

Also, these laws do not fully address the tax collection issues because many e-commerce vendors do not have in-state affiliates and therefore are not subject to the affiliate nexus law.

Income tax revenue takes a hit: When vendors cancel their contracts with in-state affiliates, the state loses income tax revenue because the affiliates lose income.

Litigation costs: The cost of litigating can be high not only for the vendors, but also for the state. As of October 2013, 12 states had followed New York’s lead by enacting their own affiliate nexus laws (Pennsylvania adopted the rule through administrative means in its Sales and Use Tax Bulletin.). The laws are not the same in all states. For example, the laws in Connecticut and Illinois did not include a rebuttable presumption to allow the vendor to show that the affiliates do not engage in solicitation. Thus, the court rulings in New York upholding that state’s law might not be the result in Connecticut if that state’s law is challenged in the courts. The Illinois courts did not address this issue, but if the tax is resurrected after ITFA expires, as the dissenting judge in the Illinois case predicted, the issue may arise in the next round of litigation.

Also, litigation in state courts is not necessarily the end. In March 2013, the Amazon.com and Overstock.com litigation had completed its run through three levels of New York state courts. In August 2013, both Overstock.com and Amazon.com asked the U.S. Supreme Court to hear their cases.

Time lost seeking a real solution: The time spent enacting and litigating the affiliate nexus laws distracts from time spent educating consumers about their use tax obligations. It also distracts from efforts to find easier ways to collect use tax, such as through better uses of technology (such as the state’s charging the sales tax at the same time the buyer’s credit card or PayPal account is used to pay for the item). Time could also be spent working with Congress to enact legislation that helps the states have a broader and more clearly legal way to collect use tax more consistently. For example, efforts should be undertaken to modify the Marketplace Fairness Act of 2013, S. 743, according to the suggestions of House Judiciary Committee Chairman Bob Goodlatte, R-Va., who in September released the principles he believes any internet sales tax legislation should follow.

Looking forward

Will the U.S. Supreme Court agree to hear Amazon.com’s and Overstock.com’s petitions for certiorari from the New York state courts’ decisions? If so, that should prove to be a significant step forward in understanding how the Commerce Clause should be interpreted in today’s e-commerce environment. The last time the Supreme Court decided a state tax commerce clause issue was the Quill decision (504 U.S. 298) in 1992. That case  involved catalog sales, not e-commerce.

Meanwhile, business models continue to change. These changes often involve vendors creating a physical presence in states so that customers can touch the goods, easily return items, or get their orders more quickly. Amazon.com has made several announcements in 2013 alone about opening distribution centers in various states and hiring thousands of workers. For example, on Nov. 1, 2013, Amazon.com announced it would open a 1 million-square-foot fulfillment center in Kenosha, Wis., that would employ more than 1,000 full-time workers (press release of 11/1/13). These facilities will make Amazon.com a sales tax collector.

In the 1992 Quill decision, the U.S. Supreme Court said that physical presence was needed before a state could require a vendor to collect use tax. Twenty-one years later, there seems to have been little progress in deriving an effective way to live with this holding. E-commerce enables vendors to sell with few physical locations. Many consumers continue either to not know about their use tax obligations or not take them seriously. States scramble to find workarounds, such as affiliate nexus laws, that too easily lead to litigation or losing business because of canceled contracts to get out of the law’s reach. Congressional efforts to help address the problem continue to raise good questions about how legal and how effective these laws are—questions that states and the business community struggle to resolve.

Solutions exist—likely ones that require thinking outside the box. Until more attention is devoted to real solutions, everyone loses as the use tax gap remains and litigation costs grow.

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Annette Nellen, Esq., CPA, is a tax professor and director of the MST Program at San José State University. She is an active member of the tax sections of the AICPA, ABA, and California State Bar. She is a member of the AICPA Tax Executive Committee and Tax Reform Task Force. She has several reports on tax policy and reform and a blog