For the second time in as many months, a state high court has spurned the physical-presence principle as a prerequisite to state franchise and income taxation. Under that principle, a state may impose its taxes on a business only if that business has some physical presence in the state. In the past, some state courts have held this principle inapplicable in cases involving income taxation of intangible property holding companies. But the West Virginia Supreme Court decision in Tax Commissioner v. MBNA America Bank, No. 33049, slip op. (W. Va. Nov. 21, 2006) could signal a new trend among state courts to choose not to apply the physical-presence principle in situations that do not involve intangible property holding companies. In a four-to-one decision, the court held that the “substantial nexus” prong requires physical presence only in the context of sales and use taxes and does not apply to West Virginia’s corporate income and franchise taxes. The court’s decision highlights a growing conflict among state courts regarding the standard for “substantial nexus.”

Tax Commissioner v. MBNA America Bank

On November 21, 2006, the West Virginia Supreme Court ruled that the U.S. Supreme Court’s decision in Quill v. North Dakota, 504 U.S. 298 (1992) which required physical presence in a state to satisfy the “substantial nexus” prong of Complete Auto Transit v. Brady, 430 U.S. 274 (1977) applies only to state sales and use taxes. MBNA’s principal place of business and commercial domicile is in Delaware, and it had no physical presence (no employees or property) in West Virginia. MBNA issued and serviced VISA and MasterCard credit cards through which it derived revenue from West Virginia customers.

The court acknowledged that the facts in J.C. Penney Nat’l Bank v. Johnson, 19 S.W. 3d 831 (Tenn. Ct. App. 1999) were essentially the same as those in MBNA, but the West Virginia Supreme Court declined to follow the holding in J.C. Penney, which rejected as unconstitutional Tennessee’s attempt to tax income earned by a credit card issuer that had no physical presence in Tennessee. Although a number of state courts have opined on state nexus issues involving intangible property holding companies (e.g., Lanco, Geoffrey, A&F Trademark), the court in MBNA specifically stated that these cases have limited applicability to the instant case because the facts were distinguishable.

The court interpreted the physical-presence principle narrowly based upon (1) the Supreme Court’s application of stare decisis in Quill, (2) the specific facts of Quill (sales and use taxes), and (3) a discounting of Supreme Court dicta in National Geographic Society v. California Board of Equalization, 430 U.S. 551 (1977), which explained that a direct tax (e.g., an income tax) would require a higher Commerce Clause standard than a use tax. The court also discussed the dramatic evolution of the modern economy and the need to “eschew rigid and mechanical legal formulas in favor of a fresh application of Commerce Clause principles tempered with healthy doses of fairness and common sense.” The court wrote that the physical-presence principle makes little sense given the “development and proliferation of communication technology” and e-commerce, which makes it possible for businesses to derive revenue from states without ever traversing a state line. The court noted the challenge in applying the Commerce Clause to the modern marketplace and wrote that the framers of the Constitution could never have envisioned the modern economy because commerce at the time of the Constitutional Convention “consisted of goods transported in horse-drawn, wooden-wheeled wagons or ships with sails.”

Application of Economic Nexus Standard Beyond Intangible Property Holding Companies

The MBNA court’s application of an economic nexus standard to businesses other than intangible property holding company cases may signify more aggressive action by state taxing authorities. In the Lanco case [click here for our alert on Lanco], New Jersey signaled during oral arguments a willingness to extend its reach beyond intangible property holding company cases to everyday arm’s length transactions. The decision in MBNA demonstrates that courts in other states also may be receptive to such efforts by state tax authorities to expand the tax base.

For additional information, please contact any of the following lawyers:

Alan I. Horowitz, ahorowitz@milchev.com, 202-626-5839

Michael Lloyd*

*Former Miller & Chevalier attorney

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