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).