On July 28, the Massachusetts Department of Revenue (the “Department”) issued Proposed Regulation 64H.1.7 (the “proposed regulation”) that, if adopted, would require “internet vendors” to collect and remit sales tax on sales to customers in Massachusetts.  The proposed regulation comes in the wake of the Department’s revocation of Directive 17-1.  See Directive 17-2 (June 28, 2017).  Directive 17-1 imposed obligations on internet vendors similar to those imposed by the proposed regulation, but did so outside of the formal regulatory process. A public hearing on the proposed regulation is scheduled for August 24, 2017.

“Internet vendor” is broadly defined in the proposed regulation to include vendors making sales over the internet, whether through the vendor’s own website or through the website of a third party. The proposed regulation is yet another example of state efforts to enforce their sales and use tax laws in spite of the “physical presence” rule affirmed by the United States Supreme Court in Quill Corp. v. North Dakota, 504 U.S. 298 (1992).  Unlike other state laws and regulations that directly attack Quill’s physical presence rule, the proposed regulation asserts that internet vendors satisfy the physical presence rule by, among other things, owning or using software or cookies located on customer computers in the state.

Tax Imposed on Internet Vendors

The proposed regulation requires an “internet vendor” to collect and remit Massachusetts sales tax for its sales to Massachusetts customers if two conditions are satisfied during the prior calendar year:

  1. The internet vendor made $500,000 or more in sales to Massachusetts customers completed over the internet; and
  2. The internet vendor completed 100 or more transactions that were delivered to Massachusetts.

“Internet vendor” is broadly defined to include vendors making sales to Massachusetts customers over the internet, regardless of whether the sales were made through the vendor’s website or through the website of a third party, such as a “marketplace facilitator.” A “marketplace facilitator” “facilitates sales . . . through a physical or electronic marketplace” it operates. Earlier this year, both Minnesota and Washington enacted legislation imposing sales tax obligations on online marketplaces. Most recently, one chamber of the Pennsylvania Legislature passed legislation that would also impose sales tax obligations on online marketplaces.

Killing Quill or Within its Scope?

Massachusetts has taken a markedly different approach from the states attempting to “kill” Quill through laws or regulations openly defying the U.S. Supreme Court’s “physical presence” rule. Instead of attacking Quill head-on, the Department asserts the proposed regulation does not violate Quill’s physical presence rule. Rather, the Department asserts the proposed regulation falls within the scope of Quill, arguing that internet vendors are physically present in Massachusetts because they typically:

  1. Own or use software and “cookies” located on customer computers in Massachusetts;
  2. Have contracts or relationships with content distribution networks that use in-state servers or otherwise provide services in Massachusetts; and/or
  3. Make sales through marketplace facilitators or sales involving delivery companies that provide payment processing or fulfillment services.

When these contacts are considered, it appears that the Department’s nexus theory derives, at least in part, from the United States Supreme Court decision in Tyler Pipe Industries v. Washington Department of Revenue, 483 U.S. 232 (1987).  Under Tyler Pipe, an out-of-state taxpayer can have nexus in a state if it hires a third party to engage in activities in the state that “establish or maintain a market” for the taxpayer’s sales in the state.  Id. at 250.

The Department’s interpretation of Quill and Tyler Pipe, although stated matter-of-factly, is not clearly constitutional. For example, the Department’s assertion that ownership or use of software, including “cookies,” distributed to and stored on computers of the vendor’s Massachusetts’ customers creates nexus, appears to ignore the fact that in Quill, the vendor owned software in North Dakota that was used by its customers. Although there was no question that the software was owned by the vendor, the U.S. Supreme Court held that its presence did not constitute “substantial nexus” under the Commerce Clause. In its hearing notice for the proposed regulation, the Department argues that there is a difference in scale between the software found to be present in North Dakota in Quill and the software that a large internet vendor may own or use in a state today.

Even assuming an internet vendor owning or using its own software in Massachusetts creates physical presence, the Department’s nexus theory raises constitutional concerns. What if software used to make the sale belongs to a marketplace facilitator? The marketplace facilitator—not the internet vendor—has property in the state, and the proposed regulation would have the effect of imputing the marketplace facilitator’s physical presence to the internet vendor. Or what if a Massachusetts resident customer is outside of Massachusetts when he or she places an order with a vendor through the marketplace facilitator’s website or mobile application? In this scenario, the marketplace facilitator’s software is not used in Massachusetts, but the proposed regulation would nevertheless impose a Massachusetts sales tax collection obligation of the vendor.

Broader Reach than Directive 17-1?

The proposed regulation appears have a slightly broader scope than Directive 17-1. The Directive asserted that “ownership and use” of software in Massachusetts constituted physical presence in Massachusetts. In contrast, the proposed regulation seems to go further by asserting that a vendor could have Massachusetts nexus based merely on having a “property interest” or “use” of software in Massachusetts. Thus, even if an internet vendor does not actually own or have a property interest in software (including cookies) located on a computer in Massachusetts, it could still have nexus as a result of the use of software owned by others on a computer located in Massachusetts.

The Internet Tax Freedom Act

In addition to addressing the Commerce Clause issues implicated by the proposed regulation, the Department asserts that the proposed regulation does not violate the Internet Tax Freedom Act (“ITFA”).  P.L. 105-277 (1998).  ITFA prohibits the states from enacting “discriminatory” taxes on internet commerce. A “discriminatory tax” is defined in several ways, including as a tax on transactions consummated in e-commerce that is not imposed on equivalent transactions consummated through traditional commerce. The Department asserts the proposed regulation does not violate ITFA because the same transactions would be subject to tax regardless of whether they were consummated through e-commerce or traditional commerce. It seems likely that the Department included the discussion of the application of the standards set forth in the proposed regulation to traditional commerce in response to the declaratory action filed against Directive 17-1, which asserted that the Directive violated ITFA. In any event, the Department has made an ITFA challenge to the proposed regulations more difficult by expressly finding that the nexus standard set forth in the proposed regulation applies to non-internet vendors. However, there are very few cases (both at the state and federal level) adjudicating claims under ITFA, thus making it difficult to predict how a court would apply ITFA to the proposed regulation.

What’s Next?

The Department’s proposed regulation is markedly different from the “kill-Quill” legislation, and regulations adopted in other states, like South Dakota and Alabama. Whereas the laws and regulations adopted by other states have been premised on Quill’s physical presence rule supposedly being outdated, the Department has taken a different approach by asserting that the proposed regulation is permissible because most large internet vendors have an in-state presence that satisfies Quill’s physical presence rule. We expect other states may consider following the same approach as Massachusetts in justifying new legislation or regulation aimed at taxing internet vendors. In addition, with the rise of laws and regulations addressing online marketplaces, we expect future litigation to address restrictions on state taxing authority beyond the Commerce Clause, including ITFA and the Due Process Clause of the United States Constitution.