In May of this year, the Oklahoma and West Virginia Supreme Courts held that Due Process bars the imposition of a state tax on a company. These decisions illustrate the U.S. Constitution’s Due Process Clause restraints on states’ taxing jurisdiction. Both are supported by U.S. Supreme Court precedent, including Quill Corporation v. North Dakota1 and J. McIntyre Machinery, Ltd. v. Nicastro.2 In 1992 in Quill, the U.S. Supreme Court emphasized a two part Constitutional nexus framework–nexus under the Due Process Clause and nexus under the Commerce Clause. Over the years, much attention has been given to Commerce Clause nexus because Quill articulated a physical presence standard for purposes of the Commerce Clause, but not for purposes of the Due Process Clause. In this article, we focus our attention on the Due Process elements of the two state court decisions from Oklahoma and West Virginia, as well as the holdings in Quill and McIntyre, and analyze the Due Process Clause constraints on states’ imposition of taxes.
As discussed in more detail below, the cases addressed herein support the following four conclusions: (1) the Due Process Clause purposeful availment test applies to all taxes; (2) Due Process may prohibit a state’s imposition of tax on an entity even though the entity targets a nationwide market; (3) arguments for nexus based on a “stream of commerce” theory are suspect; and (4) courts tend to apply a facts and circumstances test for determining whether the requirements of the Due Process Clause are satisfied. Moreover, unlike Congress’ power with respect to the Commerce Clause restraints reiterated in Quill, Congress may not pass laws that would lower the Due Process restraints on the states’ imposition of tax on companies.
Scioto Insurance Company v. Oklahoma Tax Commission
In May 2012, in Scioto Insurance Company v. Oklahoma Tax Commission, the Supreme Court of Oklahoma held that Oklahoma could not impose a corporate income tax on our client, Scioto Insurance Company (“Scioto”), as a result of its licensing of intellectual property to a related party.3 Scioto was organized as an insurance company under the laws of Vermont.4 It licensed intellectual property to Wendy’s International, Inc. (“Wendy’s International”) pursuant to a licensing contract that was executed outside of Oklahoma.5 Wendy’s International then sublicensed the intellectual property to Wendy’s restaurants, including restaurants located in Oklahoma.6
Scioto “ha[d] no say where a Wendy’s restaurant [would] be located, including Oklahoma.”7 The amount of money that Scioto received from Wendy’s International for use of the intellectual property was “based on a percentage of the gross sales of the Wendy’s restaurants in Oklahoma.”8 Wendy’s International’s obligation to pay Scioto was “not dependent upon the Oklahoma restaurants actually paying Wendy’s International.”9
The Oklahoma court held that “due process is offended by Oklahoma’s attempt to tax an out of state corporation that has no contact with Oklahoma other than receiving payments from an Oklahoma taxpayer . . . who has a bona fide obligation to do so under a contract not made in Oklahoma.”10 The court found no “basis for Oklahoma to tax the value received by Scioto from Wendy’s International under a licensing contract . . . no part of which was to be performed in Oklahoma.”11
Griffith v. ConAgra Brands, Inc.
Just a few weeks after Scioto was issued, the Supreme Court of Appeals of West Virginia (the State’s highest court) held that Due Process prohibited the imposition of tax on ConAgra Brands, Inc. (“ConAgra”) in Griffith v. ConAgra Brands, Inc.12 ConAgra licensed intellectual property to licensees that manufactured products bearing the trademarks, some of which were eventually sold in West Virginia.13
ConAgra licensed its intellectual property to related and unrelated parties and derived royalties from such licensing.14 ConAgra did not manufacture or sell products that bore the intellectual property.15 All such products were manufactured by ConAgra’s licensees in facilities that were located outside of West Virginia.16
Some of ConAgra’s licensees sold or distributed products bearing the intellectual property to wholesalers and retailers located in West Virginia and such licensees provided services in West Virginia to clients and customers.17 Notably, products that bore the ConAgra intellectual property were “found in many, if not in most, retail grocery stores in [West Virginia].”18 However, ConAgra did not direct or dictate the licensees’ distribution of products bearing the intellectual property and did not provide services to the wholesalers and retailers that were located in West Virginia.19
ConAgra centrally managed and provided for uniformity in brand image and brand presentation for its intellectual property. It paid the expenses related to defending its intellectual property and national marketing.20 ConAgra would have brought legal actions to protect its intellectual property rights exclusively in federal courts under federal laws that protect intellectual property, even if such actions “ar[ose], entirely or in part, from conduct occurring in West Virginia.”21
The West Virginia court found for ConAgra, holding that tax assessments against a foreign licensor “on royalties earned from the nation-wide licensing of food industry trademarks and trade names [did not] satisfy . . . ‘purposeful direction’ under the Due Process Clause.”22 In doing so, the court rebuffed the State’s assertions based on a “stream of commerce” theory that Due Process was not offended by noting the U.S. Supreme Court’s lack of consensus regarding the “stream of commerce” theory and distinguishing ConAgra’s facts from the facts of an earlier West Virginia decision that applied the “stream of commerce” theory.23
The U.S. Supreme Court Has Held That Due Process Requires Purposeful Availment
Quill Due Process
In Quill, the U.S. Supreme Court explained that the Due Process Clause “requires some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.”24 In analyzing Due Process, the focus of the Court is “whether a defendant had minimum contacts with the jurisdiction ‘such that the maintenance of the suit does not offend traditional notions of fair play and substantial justice.’”25 Furthermore, the U.S. Supreme Court explained that a foreign corporation without physical presence in a state may be subject to the state’s jurisdiction if it “purposefully avails itself of the benefits of an economic market in the forum State.”26 The Quill Court found that Due Process did not prohibit the imposition of a sales and use tax collection obligation on a “mail-order house that is engaged in continuous and widespread solicitation of business within a State” inasmuch as such a corporation “clearly has ‘fair warning that [its] activity may subject [it] to the jurisdiction of a foreign sovereign.’”27
Due Process Under McIntyre
In 2011, in McIntyre, the U.S. Supreme Court overturned a decision of the New Jersey Supreme Court and held that Due Process prohibited New Jersey’s assertion of jurisdiction over a corporation that was not physically present in New Jersey.28 McIntyre involved a tort action in the New Jersey courts against a manufacturer located in England with no physical presence in New Jersey, but that had products that ended up in New Jersey.29
McIntyre was a British manufacturer that had no office in New Jersey, owned no property in New Jersey, did not send employees into New Jersey and did not advertise in New Jersey.30 McIntyre held United States patents.31 It had an agreement with a distributor in the United States.32 That distributor “‘structured [its] advertising and sales efforts in accordance with [the manufacturer’s] ‘direction and guidance whenever possible’” and “‘at least some of the machines were sold on consignment to’” the distributor.33 Regarding its connection to New Jersey, the New Jersey courts stated that McIntyre’s only contact with New Jersey was that it had products ending up in New Jersey.34
In holding for McIntyre, the McIntyre Court reiterated a Due Process analysis that is similar to the analysis set forth in Quill. The U.S. Supreme Court explained that “[t]he Due Process Clause protects an individual’s right to be deprived of life, liberty, or property only by the exercise of lawful power” and applies “to the power of a sovereign to prescribe rules of conduct for those within its sphere.”35 The Court then reiterated the notions of fair play and substantial justice, as it did in Quill, as well as the fact that purposeful availment of the economic market of a state is necessary to satisfy Due Process standards.36 Applying this precedent, the McIntyre Court found that Due Process was not satisfied despite the fact that the foreign manufacturer “directed marketing and sales efforts at the United States.”37
The Due Process Clause as a Bar to State Taxation
Scioto and ConAgra are examples of the fact that the Due Process Clause serves as a barrier to states’ taxing authority. To the extent that Scioto and ConAgra are based on a lack of purposeful availment of a state’s market by the entity at issue, these decisions are consistent with Quill and McIntyre. The following are a few points to consider:
First, a purposeful availment analysis should apply to all state taxes. Quill’s physical presence rule, which some argue applies only to sales and use taxes, was articulated only in the context of the Commerce Clause.38 Quill’s Due Process analysis provides no basis for asserting that the purposeful availment standard only applies to one type of tax.
Second, Due Process may prohibit a state’s imposition of tax on an entity even though the entity targets a nationwide market. ConAgra licensed intellectual property nationwide. In McIntyre, the manufacturer “directed marketing and sales efforts at the United States.”39 The McIntyre Court explained that “a defendant may in principle be subject to the jurisdiction of the courts of the United States but not of any particular State” and that “jurisdiction requires a forum-by-forum . . . analysis.”40 Regarding McIntyre’s operations, the U.S. Supreme Court stated that “[t]hese facts may reveal an intent to serve the U.S. market, but they do not show that J. McIntyre purposefully availed itself of the New Jersey market.”41
Third, arguments that Due Process permits taxation of an entity by a state that are based on a “stream of commerce” theory are suspect. As noted in ConAgra, the “stream of commerce” theory is not supported by a consensus of the U.S. Supreme Court.42 In McIntyre, four Justices of the U.S. Supreme Court, i.e., not a majority, emphasized that, in their view, placing goods in the stream of commerce may indicate purposeful availment.43 However, the Justices stressed that “transmission of goods permits the exercise of jurisdiction only where the defendant can be said to have targeted the forum; as a general rule, it is not enough that the defendant might have predicted that its goods will reach the forum State.”44
Fourth, the above cases indicate that courts apply a facts and circumstances approach for determining whether Due Process prohibits the imposition of a tax on an entity. Under such an approach, the presence or absence of certain facts may not be dispositive to determining whether Due Process is satisfied. For instance, ConAgra did not direct or control third party distributing. By contrast, McIntyre’s third-party distributor in the United States structured its advertising and sales efforts in connection with McIntyre’s direction and guidance. Entities should carefully consider their individual facts.
One additional point for taxpayers to consider regarding Due Process is that Congress is unable to pass laws that would lower the Due Process restraints on states’ taxation of companies. In Quill, the U.S. Supreme Court reiterated that Congress had the “ultimate power” to nullify the U.S. Supreme Court’s jurisprudence regarding nexus under the Commerce Clause.45 Congress does not hold the same power with respect to the U.S. Supreme Court’s Due Process analysis as set forth in Quill, McIntyre and other U.S. Supreme Court decisions.46 Therefore, although Congressional action could nullify Quill’s Commerce Clause physical presence requirement, Congressional action cannot expand the states’ ability to tax companies under the Due Process Clause.
In 1992, the Quill Court emphasized that Due Process jurisprudence had “evolved substantially” in the years leading up to that decision.47 That evolution continues today with Scioto, ConAgra and McIntyre. These cases may lend support to a company’s arguments that Due Process prohibits a state’s imposition of tax on the company.
Previously published in substantially similar form in State Tax Notes, October 29, 2012.