The Ohio Supreme Court has recently been busy analyzing the interplay of constitutional rights and state taxation. State taxation rights are limited under the Due Process Clause of the Fifth Amendment and the dormant Commerce Clause of Article I, Section 8 of the United States Constitution. Two significant state tax cases were decided by the Supreme Court of Ohio in 2016, one under the dormant Commerce Clause and the other under the Due Process Clause. The Due Process Clause will be addressed in a future blog post. But for now, this blog will take a look at how the Commerce Clause applies to the Ohio Commercial Activity Tax (“CAT”).
Crutchfield Corp. v. Testa, decided on November 17, 2016. Crutchfield Corp. (“Crutchfield”) was a Virginia-based computer company. It had absolutely no physical presence in Ohio as it employed no Ohioans and had no facilities in the state. Rather, it only shipped product to Ohio customers via the United State Postal Service or equivalent common carriers, after purchase orders were received over the internet. The Ohio Department of Taxation assessed commercial activity tax on Crutchfield based on ORC §5751.02(A), which levies the tax on the privilege of doing business in Ohio. The tax owed was substantial because of the sales volume sourced to Ohio. It is crucial to note that CAT is different from both the general state sales tax and the state income tax. CAT is a tax on the privilege of conducting commerce in Ohio and was enacted to replace personal property taxes applied to businesses.
For CAT, the Ohio Revised Code provides certain bright-line presence tests under which an out-of-state entity becomes subjected to the tax. One of the tests (found in ORC §5751.01(I)(3)) states that entities with taxable gross receipts of at least $500,000 attributed to Ohio become subject to Ohio CAT, regardless of seller’s domicile. This bright-line test was the subject of the dispute between Crutchfield and the Ohio Department of Taxation.
Based on prior case law, Crutchfield argued that substantial nexus between the taxpayer and the state was required to justify taxation under the Dormant Commerce Clause. Substantial nexus requires a fundamental and significant connection between two parties, such that a taxable relationship is supported. Crutchfield claimed that physical presence in the state was a prerequisite to finding substantial nexus existed under its reading of the dormant Commerce Clause. Substantial nexus has been required by various courts to support certain taxes levied by a state, including things like sales tax, in many prior cases. The Commerce Clause exists to create an area of trade that is free from state interference. However, the concept of substantial nexus has not been analyzed by the courts as to privilege taxes like the Ohio CAT.
In response to Crutchfield, the Ohio Department of Taxation argued that no physical presence was required for substantial nexus related to privilege taxes. Further, the state argued that the statutory demands of imposing the tax on sales over $500,000 was sufficient to establish substantial nexus, making the privilege tax constitutionally valid under the Commerce Clause. The Supreme Court of Ohio agreed. The Court held that physical presence may well furnish a sufficient basis for finding a substantial nexus, but it is not the only basis for finding it. Additionally, the Court stated that physical presence in Ohio is not a necessary condition for imposing a tax on the privilege of conducting business in Ohio. All that is truly required is that the tax is imposed with an adequate quantitative standard that ensures the taxpayer’s connection (or nexus) with the state is substantial. The $500,000 sales threshold was considered sufficiently substantial. Therefore, the Ohio CAT, as applied to out-of-state entities, was deemed constitutional under the Commerce Clause by the Ohio Supreme Court, even without any physical presence.
It is important to note that this threshold level of sales applies to out-of-state taxpayers. Entities that voluntarily form in Ohio, register in Ohio, are physically housed in Ohio, or otherwise potentially purposefully avail themselves to the privileges of being in Ohio automatically subject themselves to Ohio CAT regardless of sales volume. There is no constitutional challenge at that point.
Though the Supreme Court of Ohio has issued its ruling, Crutchfield can file an appeal before the United State Supreme Court for a final say on the applicability of the dormant Commerce Clause to state commerce privilege tax. Ohio Supreme Court Justice Kennedy penned a dissenting opinion in Crutchfield in which he believed physical presence was required by prior case law determined by the Supreme Court of the United States. Thus, it is conceivable that a successful argument may exist and the Supreme Court of the United States could overrule that of Ohio.
Please be sure to check out my next blog discussing limitations on the state by the Due Process Clause and how it relates to the sale of pass-through entity interests held by those domiciled outside of Ohio.