Noteworthy 2018 Sales and Use Tax Cases
There were a few sales and use tax cases decided last year that are notable. The primary case is the United States Supreme Court’s landmark decision in South Dakota v. Wayfair, Inc. (2018) 138 S.Ct. 2080, which overturned the longstanding physical presence rule necessary to require an out-of-state retailer to collect use tax on sales made into a state. However, also of note are California Court of Appeal decisions in Littlejohn v. Costco Wholesale Corp (2018) 25 Cal.App.5th 251 and GMRI, Inc. v. California Department of Tax & Fee Administration (2018) 21 Cal.App.5th 111.
The cases are described below:
1. South Dakota v. Wayfair, Inc. (2018) 138 S.Ct. 2080. The background of this case involves a brief consideration of National Bellas Hess, Inc. v. Department of Revenue (1967) 386 U.S. 753 and Quill Corp v. North Dakota (1992) 504 U.S. 298.
National Bellas Hess involved an Illinois statute which imposed use tax collection responsibility on sellers “soliciting orders within [the] State from users by means of catalogues or other advertising.” National Bellas Hess was a mail order house with its principal place of business located in Kansas City, Missouri. It had no physical presence, i.e. no sales outlets nor sales representatives in Illinois, and its only contact with the state was by mail or common carrier. The Court stated that “to uphold the power of Illinois to impose use tax burdens in this case, we would have to repudiate totally the sharp distinction . . . [we] have drawn between mail order sellers with retail outlets, solicitors or property within a State and those who do no more than communicate with customers in the State by mail or common carrier as part of a general interstate business.” (Id. at p. 211.) The Court was unwilling to “obliterate” the distinction where those with physical presence were required to collect use tax, and those without physical presence were not.
Quill involved a North Dakota statute which imposed use tax collection responsibility on “every person who engages in regular or systematic solicitation of a consumer market in the state.” Quill Corporation had offices and warehouses in Illinois, but no physical presence in North Dakota; it solicited business for office equipment and supplies in North Dakota through catalogs, flyers, advertisements in periodicals and by telephone. Its annual sales in North Dakota were almost $1,000,000 made to 3,000 customers. The Court held that Due Process Clause “minimum contacts” and Commerce Clause “substantial nexus” are separate and distinct tests; i.e. an out-of-state company can have minimum contacts sufficient to confer in personem jurisdiction (i.e. jurisdiction over the company by a court) but not have substantial nexus to justify use tax collection; substantial nexus is acquired when the out-of-state company maintains a physical presence in the state, either directly or through third party representatives. “Like other bright line tests, the Bellas Hess rule appears artificial at its edges: whether or not a State may compel a vendor to collect a sales or use tax may turn on the presence in the taxing State of a small sales force, plant, or office. . . This artificiality, however, is more than offset by the benefits of a clear rule. Such a rule firmly establishes the boundaries of legitimate state authority to impose a duty to collect sales and use taxes and reduces litigation concerning those taxes. . . . Moreover a bright line rule in the area of sales and use taxes also encourages settled expectations and, in so doing, fosters investment by businesses and individuals . . . . [T]he continuing value of a bright line rule in this area and the doctrine of stare decisis indicate that the Bellas Hess rule remains good law.” (Id. at p. 315-18.)
In 2016, South Dakota enacted an “economic presence” standard for use tax collection: The Act required out-of-state sellers to collect and remit tax “as if the seller had a physical presence in the state” if the seller delivered “more than $100,000 of goods or services into the State or engage[d] in 200 or more separate transactions for the delivery of goods or services into the State.” Wayfair, Inc., Overstock.com, Inc., and Newegg, Inc. were all merchants with no physical presence, i.e. they did not have employees or real estate in South Dakota. Each of these companies easily met the minimum sales or transactions of the Act, but none collected the tax. South Dakota filed a declaratory relief action in state court; respondents moved for summary judgment that the Act was unconstitutional under Quill. The South Dakota Supreme Court gave judgment to respondents, noting that although the State had reasonable arguments, Quill remained good law. South Dakota conceded the Act could not survive under Bellas Hess and Quill, but asked the Supreme Court to review those decisions in light of current economic realities. The Court granted certiorari.
In a 5-4 decision, the Court concluded that the physical presence rule of Quill was “unsound and incorrect.” (Slip Opinion, p. 22.) In light of that decision, the Court overruled its decisions in both Quill and National Bellas Hess. (Id.) The Court observed that the first prong of the Complete Auto test (Complete Auto Transit, Inc. v. Brady (1977) 430 U.S. 274) simply asks “whether the tax applies to an activity with a substantial nexus with the taxing State. 430 U.S., at 279. [S]uch a nexus is established when the taxpayer . . . ‘avails itself of the substantial privilege of carrying on business’ in that jurisdiction.” (Slip Opinion p. 22.) [¶] Here, the nexus is clearly sufficient based on both the economic and virtual contacts respondents have with the State[,]” (id.) i.e. more than $100,000 in sale or 200 or more separate transactions for the delivery of goods or services into the State. No attempt was made to craft a new bright line test. The new inquiry is whether the taxpayer avails itself of the “substantial privilege of carrying on business” in a state.
As a result of this decision, many states, including California, have fashioned economic nexus laws with thresholds similar to South Dakota’s (i.e. $100,000 in sales or 200 transactions). The California Department of Tax and Fee Administration (“CDTFA”) website currently states:
“Beginning April 1, 2019, retailers located outside of California are required to register with the CDTFA, collect the California use tax, and pay the tax to the CDFTA based on the amount of their sales into California, even if they do not have a physical presence in the state. The new collection requirement applies to a retailer if during the preceding or current calendar year:
- The retailer’s sales into California exceed $100,000, or
- The retailer made sales into California in two hundred (200) or more separate transactions.
The new collection requirement is pursuant to Revenue and Taxation Code (RTC) section 6203 and the U.S. Supreme Court’s June 21, 2018 decision in South Dakota v. Wayfair, Inc.[.]
The new collection requirement will apply to taxable sales of tangible personal property to California consumers on and after April 1, 2019, and is not retroactive.”
A link to the CDTFA’s webpage provides more information regarding the CDTFA’s implementation of the Wayfair decision. http://www.cdtfa.ca.gov/industry/wayfair.htm.
2. Littlejohn v. Costco Wholesale Corp (2018) 25 Cal.App.5th 251. The California Constitution strictly limits refund actions to those provided by the legislature, (Cal. Const., art. XIII §32); however, in Javor v. State Board of Equalization (1974) 12 Cal.App.3d 1290), the Supreme Court suggested that the Legislature’s authority may not be exclusive and that courts retain a residual power to fill remedial gaps by fashioning tax refund remedies in “unique circumstances.” The Court failed to comment further regarding these “unique circumstances” when it decided Loeffler v. Target (2014) 58 Cal. 4th 1081, 1123-24.
The issue was recently addressed in McClain v. Sav-On Drugs (2017) 9 Cal.App.5th 684.
Sav-On Drugs collected sales tax reimbursement on its sales of lancets and diabetic blood test strips. Plaintiffs, a class comprised of customers who purchased these products, alleged the sales of these products were exempt from tax and sought an order compelling Sav-On to file a claim for refund. Sav-On disputed its duty to file a claim for refund; it had no financial incentive to do so because any refund would have to be refunded to each customer that purchased lancets or blood test strips.
The court concluded that “a court may create a new tax refund remedy – and accordingly, Javor’s ‘unique circumstances’ exist – only if (1) the person seeking the new tax refund remedy has no statutory tax refund remedy available, (2) the tax refund remedy sought is not inconsistent with existing tax refund remedies, and (3) the Board has already determined that the person seeking the new tax refund remedy is entitled to a refund, such that the refusal to create that remedy will unjustly enrich either the taxpayer/retailer or the Board.” (Id. at p. 689.) The court dismissed the action because the law did not provide the requested remedy and plaintiffs failed to establish any of the three prerequisites to the exercise of the judicial residual power to fashion new remedies.
The California Supreme Court granted review of the case in May 2017. Its review of the three part test creating a new tax refund remedy fashioned by the Court of Appeal will be most interesting.
Littlejohn v. Costco Wholesale Corp (2018) 25 Cal.App.5th 251 is a similar case which is being held pending the Supreme Court’s decision of the McClain case. In Littlejohn a customer sued Costco, the California Board of Equalization (predecessor to the CDTFA). and the manufacturer of Ensure nutrition shakes, to recover sales tax reimbursement he had paid on purchases of Ensure. Prior to 2002, Costco had sold Ensure tax free as a food product. In 2002, as a result of changes made to the labelling, the SBE considered Ensure to be a taxable nutritional supplement. In 2006 the labelling was changed again and an informal opinion of tax counsel advised Costco that Ensure was a non-taxable food product. A March 2013 letter from an Board auditor restated the position that sales of Ensure were not taxable; which position was restated in the SBE’s September 2013 Tax Information Bulletin.
Costco’s and CDTFA’s demurrer to the third amended complaint was sustained without leave to amend. The Court of Appeal affirmed, holding that the case did not involve allegations of unique circumstances showing that the Board had concluded consumers were owed refunds taxes paid on sales of Ensure, and a Javor remedy should be limited to the unique circumstances where the plaintiff’s allegations show that the state has been unjustly enriched by the overpayment of sales tax, and the Board concurs that the circumstances warrant refunds to consumers. (Plaintiff failed to establish the third prong of the McClain case.)
The California Supreme Court granted review on October 24, 2018, pending consideration and disposition of the related issue in the McClain v. Sav-On Drugs case.
3. GMRI, Inc. v. California Department of Tax & Fee Administration (2018) 21 Cal.App.5th 111. This case involved a challenge to the validity of Sales and Use Tax Regulation 1603(g) which provides that optional payments of tips, gratuities or service charges are not subject to tax; however mandatory payments are subject to tax, even if the tip is subsequently paid by the retailer to its employees.
GMRI, Inc. operated Olive Garden and Red Lobster restaurants in California. Customers were notified on their menus that an “optional” gratuity of either 15 or 18 percent (depending on the restaurant and the time period at issue) “will be added to parties of 8 or more.” The manager added the gratuity to the bill. The company removed the gratuity if requested; but unless such a request was made, the gratuity remained on the bill as a portion of the total amount due. The bill also included a blank line for an “additional tip.” All tips were paid by the company to the servers who provided service to the tables.
The company did not include the “large party” gratuities in its gross receipts, which according to state auditors was an error resulting in issuances of notices of determination. The company paid the tax and filed timely claims for refund, which were denied, and subsequently filed a complaint for refund in the superior court, where it asserted the large party gratuity was an optional payment under Regulation 1603(g) and not subject to tax. The trial court disagreed, as did the Court of Appeal.
The Court of Appeal held that the gratuity at issue was, in fact, a mandatory gratuity as defined in Regulation 1603(g), which was required to be included in the company’s gross receipts and, therefore, subject to sales tax. The Board of Equalization acted within the scope of its delegated power in enacting the Regulation 1603(g) because the Legislature did not define the circumstances under which a payment for services was considered part of the sale, and the regulation filled that gap. Finally, it was immaterial that the servers kept the gratuity.
It should be noted that the audit period in the GMRI case pre-dates the recent changes to Regulation 1603 which added subdivision (h) (dealing with “Tips, Gratuities, and Service Charges” after January 1, 2015) and goes into more detail when a “large party” tip is mandatory and, therefore, subject to tax.