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THE CONTINUED VIABILITY (OR LACK THEREOF) OF THE INDEPENDENT INSURANCE PROCUREMENT DOCTRINE FOLLOWING WAYFAIR

Introduction

Consider the last thing you bought online. Headphones? Shampoo? A watch? Where did you buy it from? Likely Amazon. The ubiquitous internet behemoth dominates the ecommerce business, with a whopping 43.5% of internet sales in 2017. [1] The next closest is eBay, with 6.8%. Wayfair makes up just 0.9% of internet sales. Nonetheless, most merchants would move land and sea to have a 1% market share in any market, especially one with such sunny growth potential. [2] Wayfair had a big presence in 2018, not only through its coffee table and lounge chair offerings, but in the U.S. Supreme Court. In a landmark, surprising 5-4 decision, the high court held that the state of South Dakota could constitutionally require Wayfair to collect sales tax from its customers. [3] This decision has implications beyond the collection of sales tax, and touches on many aspects of the law surrounding interstate commerce, including the insurance concept of independent procurement.

Sales Tax

South Dakota is one of 45 states that imposes a sales tax. [4] Like 44 of its sister states, South Dakota requires retailers to collect the sales tax from its customers and remit the tax to the South Dakota Department of Revenue. [5] This model works because there are relatively few merchants, at least compared to the number of consumers. Merchants impose and collect the tax from customers at the time of sale. Even though the merchant is the one who writes a check to the state at the end of the year (or quarter or month), the tax is effectively imposed on the customer.

However, there is no feasible, realistic way for a state to directly collect a sales tax from consumers in most instances. Doing so would require: (1) each consumer keep track of every single one of his or her yearly purchases, (2) calculate the applicable tax on each product (and do so honestly), and (3) pay the tax. For obvious reasons, compliance with such laws has proven to be notoriously low. Consumers don’t keep track of their yearly purchases, but merchants do keep track of their sales. Merchants have the computer systems in place to calculate, collect, and remit sales taxes. The consumer’s financial burden is far less when dispersed over an entire year, rather than paid in a single lump sum. And it is far easier for states to police and enforce compliance of merchants than of individual consumers. [6]

In 2015, South Dakota residents spent millions of dollars of Wayfair’s products. South Dakota did not collect a penny of tax revenue from Wayfair’s sales. The South Dakota Department of Revenue estimated the state was missing out on $48-$58 million per year in sales tax from online retailers. [7] Eager to recover some of this lost revenue, South Dakota enacted Senate Bill 106, which required sellers with gross revenue from sales in South Dakota of over $100,000 per calendar year, or sellers with at least 200 or more separate transactions in South Dakota, to collect and remit the sales tax from their customers. [8] Citing its newly enacted statute, South Dakota asked Wayfair to collect the tax on merchandise delivered to South Dakota residents. Following Wayfair’s refusal, South Dakota filed suit.

“Isn’t there some 1960s Supreme Court doctrine about the jurisdictional limits to tax transactions made by a company who lacks any physical presence in a state?” asked one Wayfair attorney. “Indeed there is,” agreed both the trial court and the South Dakota Supreme Court in 2017. [9]

The Due Process Clauses

The Due Process Clauses of the Fifth and Fourteenth Amendments to the U.S. Constitution limit the right of states to regulate and tax transactions outside their territorial boundaries. In the well-known Todd Shipyards case, a New York corporation, which did business in Texas, procured insurance policies from Lloyds of London and the Institute of London Underwriters covering risks on the insured’s properties in Texas. [10] The state of Texas sought to tax the transaction, and the insurer challenged the state’s authority under the Due Process clauses. Id. The case reached the U.S. Supreme Court, which held that taxing the nonresident insured in these circumstances violated Due Process because the insurer did not solicit business in Texas, had no employees or agents in Texas, and the adjustment and payment of losses took place outside of Texas. [11] “The only connection between Texas and the insurance transactions,” the Court noted, was “the fact that the property covered by the insurance is physically located in Texas.”

In a 1967 case, Bellas Hess, the U.S. Supreme Court held that a state’s ability to regulate and impose taxes on a transaction requires a definite link, with some minimum connection between the state and the person, property, or transaction the state seeks to regulate or tax. [12] The Court first distinguished between: (1) mail order sellers who do no more than communicate with customers in the state by such means as a part of a general interstate business, and (2) sellers with retail outlets, solicitors, or property (i.e., a physical presence) within the state, which are subject to taxation. Under the Due Process clauses, the State may not impose the duty of use tax collection and payment upon a seller whose only connection with customers in the State is by common carrier or the United States mail. Thus, the Court held that the state could constitutionally regulate and tax the latter group, but not the former. [13] Out-of-state sellers with no physical presence inside a state could contest state efforts to subject them or their sales to tax on Due Process grounds.

In Quill Corp. v. North Dakota [14] , decided in 1992, the Supreme Court considered a constitutional challenge to a North Dakota tax on transactions involving goods shipped to residents through mail-order businesses. Such businesses, which are in many ways the predecessors to Amazon, Wayfair, and the like, had no physical presence in North Dakota. Customers viewed catalogues with listings of items, and mailed their order and a check to the company’s office, and the company mailed the goods to customers across the country. In deciding Quill, the Supreme Court considered the formalistic, physical presence approach enunciated in Bellas Hess, and indicated that recent Due Process jurisprudence instead focused on a more flexible inquiry into whether a defendant’s contacts with the state made it reasonable for the defendant to anticipate being sued there [15] . The Court went on to state that while a mail-order merchant may indeed have, by availing itself of the benefits of doing business there, the minimum contact with a state to justify state taxation under Due Process considerations (even absent a physical presence of the merchant within the state), nonetheless the merchant may lack the “substantial nexus” with the State to justify imposition of the tax under the Commerce Clause [16] .

Cases subsequent to Quill followed this substance-over-form approach. In Associated Electric & Gas Insurance Services, Ltd. V. R. Gary Clark [17] , the Rhode Island Supreme Court held that the taxpayer (AEGIS), which had “purposefully availed itself of the benefits of an economic market in Rhode Island” by “managing to collect millions of dollars in premiums for excess liability of four natural-gas utilities that are domiciled within this state,” was subject to taxation in the state [18] . This was despite the fact that the taxpayer had no physical presence in the state, was neither admitted nor licensed as a qualified, unauthorized insurer there, and no taxpayer representatives came into Rhode Island in connection with the subject transactions. The holding in this case foreshadowed the Supreme Court’s analysis in Wayfair, decided this past June.

Independent Insurance Procurement

Todd Shipyards and Bellas Hess indirectly spawned what has become known as the independent procurement doctrine. Following those cases, a U.S. resident had a constitutionally-protected right to purchase insurance from an insurer of its choice. That right arose not out of an express constitutional guarantee but instead out of a constitutional limitation on the power of states. The independent procurement doctrine has been adopted by statute in a majority of the states [19] . In a majority of these states, the insured must report the transaction and pay the associated premium taxes. Notwithstanding this codification, however, the ability of unlicensed and unauthorized insurers to provide coverage for risks located within a state without being subject to tax has been called into question following the Supreme Court’s June decision in Wayfair.

The Wayfair Case Reaches the Supreme Court

When the Wayfair case reached the South Dakota Supreme Court, the Court held that the state could not compel Wayfair to collect sales tax from South Dakota residents. But South Dakota’s defeat – and Wayfair’s victory – were short lived. Reading the tea leaves left in recent dissenting opinions from several Justices, South Dakota brought its case to the U.S. Supreme Court. [20]

Quoting from Quill, the U.S. Supreme Court reaffirmed that due process considerations do not mandate a physical presence requirement in a state in order for that state to impose a tax on the seller of goods, because “it is an inescapable fact of modern commercial life that a substantial amount of business is transacted with no need for physical presence within a State in which business is conducted.” [21] Going further, the Court further stated that “the real world implementation of Commerce Clause doctrines now makes it manifest that the physical presence rule as defined by Quill must give way to the ‘far-reaching systemic and structural changes in the economy’ and ‘many other societal dimensions’ caused by the Cyber Age [22] .” Finding that the physical presence rule exalted form over substance and is obsolete in a time when a significant amount of interstate commerce is conducted over the internet, the court held the physical presence rule articulated in Quill to be “unsound and incorrect,” and expressly overruled both Quill and Bellas Hess [23] . While the Court held that there still must be a “substantial nexus” between a taxing state and an out-of-state seller, physical presence in a state is no longer a necessary element. Using the internet to effectuate a transaction with a resident of the state may be a sufficient nexus if the seller engages in enough transactions with residents in the state, though the Court did not specifically state how many transactions constitute “enough.” Although the Supreme Court’s decision dealt expressly with sales tax, its impact extends to any transactions made over the internet, which, in modern commerce, means transactions in quite nearly every industry, including insurance.

Independent Procurement After Wayfair

Following Wayfair, the ability of unlicensed and unauthorized insurers to provide coverage for risks located in a state, where such insurers have no other presence in that state, and avoid tax liability to that state is in question. This uncertainty arises, in part, because the right to independent procurement arises not out of an express constitutional guarantee, but instead out of a constitutional limitation on the power of the states. [24] A business’ physical presence in a state is no longer required in order to permit a state to impose a duty on sellers of goods or services to collect and remit tax to that state. Instead, a state must show that “the tax applies to an activity with a “substantial nexus with the taxing state.” [25] That nexus may be established by both the economic and virtual contacts a business has with the state [26] .

As stated above, Wayfair expressly overruled Bellas Hess and Quill, and strongly called into doubt the continuing validity and viability of Todd Shipyards. Following Wayfair, out-of-state insurers seeking to sell policies to residents of the various states face murky waters. A state may require a seller of goods or services to collect and remit state taxes so long as a substantial nexus between the tax and the activity on which the tax is imposed exists. The Wayfair decision blessed the South Dakota statute, which required a minimum of $100,000 in annual sales or a minimum of 200 separate transactions in a state annually, as satisfying this requirement. Whether statutes seeking to impose taxes on sellers with fewer contacts with a state than required by the South Dakota statute will pass constitutional muster remains to be seen. Additionally, the state statute at issue in Wayfair sought to impose a tax directly on the seller where there was no state law expressly requiring the purchaser (as in the case of state laws requiring payment of an independent procurement tax by the insured) to remit taxes on the transaction; whether the applicability of such a statute to a particular transaction might result in a different outcome remains to be seen.

The Supreme Court’s Wayfair decision may have far reaching effects on the independent insurance procurement doctrine. Unlike the physical goods shipped by Amazon and Wayfair, an insurance contract is a service contract. There is no physical product shipped, and the ethereal nature of the internet makes it difficult to define “where” an insurance transaction takes place – where the insurer is headquartered? Where the risk is located? Where the insured is physically located when he or she electronically accepts the insurance contract? In Wayfair, the Supreme Court suggested that “a company with a website accessible in South Dakota may be said to have a physical presence in the State via the customers’ computers.” “Between targeted advertising and instant access to most consumers via any internet-enabled device, a business may be present in a State in a meaningful way without that presence being physical in the traditional sense of the term.” [27] After Wayfair, insurers with any type of website may be said to be doing business in every state, since a website is accessible to consumers all across the country. Even absent an electronic presence, states may now be further empowered to seek to impose taxes on transactions such as those at issue in the Associated Electric & Gas Insurance Services case, infra, where the insurer has very little, if any, contact with the forum state, other than deriving an economic benefits as a result of property located within that state’s borders. States with aggressive insurance departments looking to generate additional tax revenue may begin auditing, regulating, and taxing insurance companies in connection with insurance transactions effectuated over the internet between in-state residents and out-of-state insurers, even in the absence of any aspect of the transaction occurring within a state’s borders (other than the location of the consumer or business purchasing the coverage, or the risk being insured, within the state’s borders).

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References


[1] See Rani Molla, Amazon Could Be Responsible for Nearly Half of U.S. E-Commerce Sales in 2017 , available at https://www.recode.net/2017/10/24/16534100/amazon-market-share-ebay-walmart-apple-ecommerce-sales-2017 .

[2] For comparison’s sake, 1% of American grocery sales would be $6.41 billion per year. See Statistia, Grocery Store Sales in the United States from 1992 to 2017 , available at https://www.statista.com/statistics/197621/annual-grocery-store-sales-in-the-us-since-1992/ .

[3] South Dakota v. Wayfair Inc. , 585 U.S. ___ (2018), available at https://www.supremecourt.gov/opinions/17pdf/17-494_j4el.pdf .

[4] See S.D. Codified Laws §§ 10-45-2, 10-45-4; see also https://taxfoundation.org/state-and-local-sales-tax-rates-2015/ .

[5] S.D. Codified Laws § 10-45-27.3.

[6] See, e.g., Direct Marketing Association v. Brohl , 814 F.3d 1129, 1133 (10th Cir. 2016) (Setting forth Colorado’s right to impose notice and reporting requirements on internet retailers, even though it could not tax them directly.).

[7] See South Dakota v. Wayfair, Inc. Joint Appendix filed in Supreme Court, at JA24, available at https://www.supremecourt.gov/DocketPDF/17/17-494/36736/20180226223007270_17-494%20JA.pdf .

[8] See S.D. Codified Laws § 10-64-2; see also South Dakota v. Wayfair, 138 S. Ct. 2080, 2088 (2018).

[9] State v Wayfair, Inc. , No. 32CIV16-000092, 2017 WL 4358293 (S.D. Circuit Court Mar. 6, 2017); State v. Wayfair Inc., 901 N.W.2d 754 (S.D. 2017).

[10] State Board of Insurance v. Todd Shipyards Corp. , 370 U.S. 451, 454-55 (1962).

[11] Id. at 454-56.

[12] Bellas Hess, Inc. v. Department of Revenue of State of Illinois , 386 U.S. 753, 756-57 (1967).

[13] Id. at 758.

[14] 504 U.S. 298 (1992).

[15] Id. at 309.

[16] Id. at 313.

[17] 676 A.2d 1357 (Sup. Ct. R.I. 1996).

[18] Id . at 1361.

[19] See , e.g., A.R.S. §20-107(B); Cal. Ins. Code §§ 1760-61, Cal. Rev. & T. Code §13210; F.S.A. §626.938; M.C.L.A. §500.402b; V.A.M.S. §384.051; N.Y. Tax Law §§ 1551; and Tx. Ins. Code §§101.053.

[20] See South Dakota v. Wayfair , Petition for Writ of Certiorari to the U.S. Supreme Court, available at http://www.scotusblog.com/wp-content/uploads/2017/10/17-494-petition.pdf .

[21] Id. at 2093.

[22] Id. at 2097, citing Direct Marketing Assn. v. Brohl, 135 S.Ct. 1124, 1135 (2015).

[23] Id. at 2099.

[24] See Todd Shipyards , 370 U.S. at 454-55.

[25] Wayfair , 138 S.Ct. at 2099, citing Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279 (1977).

[26] Id .

[27] Wayfair , 138 S. Ct. at 2095.