State Taxation and Regulation: the Modern Law

State Taxation and Regulation: The Modern Law

General Considerations.—Transition from the old law to the modern standard occurred relatively smoothly in the field of regulation,⁹⁹⁹ but in the area of taxation the passage was choppy and often witnessed retreats and advances.¹⁰⁰⁰ In any event, both taxation and regulation now are evaluated under a judicial balancing formula comparing the burden on interstate commerce with the importance of the state interest, save for discriminatory state action that cannot be justified at all.

Taxation.—During the 1940s and 1950s, there was engaged within the Court a contest between the view that interstate commerce could not be taxed at all, at least “directly,” and the view that the negative commerce clause protected against the risk of double taxation.¹⁰⁰¹ In Northwestern States Portland Cement Co. v. Minnesota,¹⁰⁰² the Court reasserted the principle expressed earlier in Western Live Stock, that the Framers did not intend to immunize interstate commerce from its just share of the state tax burden even though it increased the cost of doing business.¹⁰⁰³ Northwestern States held that a State could constitutionally impose a nondiscriminatory, fairly apportioned net income tax on an out-of-state corporation engaged exclusively in interstate commerce in the taxing State. “For the first time outside the context of property taxation, the Court explicitly recognized that an exclusively interstate business could be subjected to the states’ taxing powers.”¹⁰⁰⁴ Thus, in Northwestern States, foreign corporations, which maintained a sales office and employed sales staff in the taxing State for solicitation of orders for their merchandise that, upon acceptance of the orders at their home office in another jurisdiction, were shipped to customers in the taxing State, were held liable to pay the latter’s income tax on that portion of the net income of their interstate business as was attributable to such solicitation.

Yet, the following years saw inconsistent rulings that turned almost completely upon the use of or failure to use “magic words” by legislative drafters. That is, it was constitutional for the States to tax a corporation’s net income, properly apportioned to the taxing State, as in Northwestern States, but no State could levy a tax on a foreign corporation for the privilege of doing business in the State, both taxes alike in all respects.¹⁰⁰⁵ In Complete Auto Transit, Inc. v. Brady,¹⁰⁰⁶ the Court overruled the cases embodying the distinction and articulated a standard that has governed the cases since. The tax in Brady was imposed on the privilege of doing business as applied to a corporation engaged in interstate transportation services in the taxing State; it was measured by the corporation’s gross receipts from the service. The appropriate concern, the Court wrote, was to pay attention to “economic realities” and to “address the problems with which the commerce clause is concerned.”¹⁰⁰⁷ The standard, a set of four factors that was distilled from precedent but newly applied, was firmly set out. A tax on interstate commerce will be sustained “when the tax is applied to an activity with a substantial nexus with the taxing State, is fairly apportioned, does not discriminate against interstate commerce, and is fairly related to the services provided by the State.”¹⁰⁰⁸ All subsequent cases have been decided in this framework.

Nexus.—Nexus is a requirement that flows from both the commerce clause and the due process clause of the Fourteenth Amendment.¹⁰⁰⁹ What is required is “some definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.”¹⁰¹⁰ In its commerce-clause setting, the nexus requirement serves to effectuate the “structural concerns about the effects of state regulation on the national economy.”¹⁰¹¹ That is, “the ‘substantial-nexus’ requirement . . . limit[s] the reach of State taxing authority so as to ensure that State taxation does not unduly burden interstate commerce.”¹⁰¹² The broad inquiry subsumed in both constitutional requirements is whether the taxing power exerted by the state bears fiscal relation to protection, opportunities and benefits given by the state — that is, whether the state has given anything for which it can ask return.”²⁵

Often surfacing in cases having to do with the imposition of an obligation by a State on an out-of-state vendor to collect use taxes on goods sold to purchasers in the taxing State, the test is a “physical presence” standard. The Court has sustained the imposition on mail order sellers with retail outlets, solicitors, or property within the taxing State,¹⁰¹³ but it has denied the power to a State when the only connection is that the company communicates with customers in the State by mail or common carrier as part of a general interstate business.¹⁰¹⁴ The validity of general business taxes on interstate enterprises may also be determined by the nexus standard. However, again, only a minimal contact is necessary.¹⁰¹⁵ Thus, maintenance of one full-time employee within the State (plus occasional visits by non-resident engineers) to make possible the realization and continuance of contractual relations seemed to the Court to make almost frivolous a claim of lack of sufficient nexus.¹⁰¹⁶ The application of a state business-and-occupation tax on the gross receipts from a large wholesale volume of pipe and drainage products in the State was sustained, even though the company maintained no office, owned no property, and had no employees in the State, its marketing activities being carried out by an in-state independent contractor.¹⁰¹⁷ Also, the Court upheld a State’s application of a use tax to aviation fuel stored temporarily in the State prior to loading on aircraft for consumption in interstate flights.¹⁰¹⁸

Given the complexity of modern corporations and their frequent diversification and control of subsidiaries, state treatment of businesses operating within and without their borders requires an appropriate definition of the scope of business operations. Thus, States may impose a tax in accordance with a “unitary business” apportionment formula on concerns carrying on part of their business within the taxing State based upon the company’s entire proceeds. But there must be a nexus, or minimal connection, between the interstate activities and the taxing State and a rational relationship between the income attributed to the State and the intrastate values of the enterprise.¹⁰¹⁹

Apportionment.—This requirement is of long standing,¹⁰²⁰ but its importance has broadened as the scope of the States’ taxing powers has enlarged. It is concerned with what formulas the States must use to claim a share of a multistate business’ tax base for the taxing State, when the business carries on a single integrated enterprise both within and without the State. A State may not exact from interstate commerce more than the State’s fair share. Avoidance of multiple taxation, or the risk of multiple taxation, is the test of an apportionment formula. Generally speaking, this factor is both a commerce clause and a due process requisite, and it necessitates a rational relationship between the income attributed to the State and the intrastate values of the enterprise.¹⁰²¹ The Court has declined to impose any particular formula on the States, reasoning that to do so would be to require the Court to engage in “extensive judicial lawmaking,” for which it was ill-suited and for which Congress had ample power and ability to legislate.¹⁰²²

Rather, “we determine whether a tax is fairly apportioned by examining whether it is internally and externally consistent.”¹⁰²³ “To be internally consistent, a tax must be structured so that if every State were to impose an identical tax, no multiple taxation would result. Thus, the internal consistency test focuses on the text of the challenged statute and hypothesizes a situation where other States have passed an identical statute... .”

“The external consistency test asks whether the State has taxed only that portion of the revenues from the interstate activity which reasonably reflects the in-state component of the activity being taxed. We thus examine the in-state business activity which triggers the taxable event and the practical or economic effect of the tax on that interstate activity.”¹⁰²⁴ In the latter case, the Court upheld as properly apportioned a state tax on the gross charge of any telephone call originated or terminated in the State and charged to an in-state service address, regardless of where the telephone call was billed or paid.¹⁰²⁵ A complex state tax imposed on trucks displays the operation of the test. Thus, a state registration tax met the internal consistency test because every State honored every other States’, and a motor fuel tax similarly was sustained because it was apportioned to mileage traveled in the State, whereas lump-sum annual taxes, an axle tax and an identification marker fee, being unapportioned flat taxes imposed for the use of the State’s roads, were voided, under the internal consistency test, because if every State imposed them the burden on interstate commerce would be great.¹⁰²⁶

A deference to state taxing authority was evident in a case in which the Court sustained a state sales tax on the price of a bus ticket for travel that originated in the State but terminated in another State. The tax was unapportioned to reflect the intrastate travel and the interstate travel.¹⁰²⁷ The tax in this case was different from the tax upheld in Central Greyhound, the Court held. The previous tax constituted a levy on gross receipts, payable by the seller, whereas the present tax was a sales tax, also assessed on gross receipts, but payable by the buyer. The Oklahoma tax, the Court continued, was internally consistent, since if every State imposed a tax on ticket sales within the State for travel originating there, no sale would be subject to more than one tax. The tax was also externally consistent, the Court held, because it was a tax on the sale of a service that took place in the State, not a tax on the travel.¹⁰²⁸

However, the Court found discriminatory and thus invalid a state intangibles tax on a fraction of the value of corporate stock owned by state residents inversely proportional to the State’s exposure to the state income tax.¹⁰²⁹

Discrimination.—The “fundamental principle” governing this factor is simple. “‘No State may, consistent with the Commerce Clause, impose a tax which discriminates against interstate commerce . . . by providing a direct commercial advantage to local business.’”¹⁰³⁰ That is, a tax which by its terms or operation imposes greater burdens on out-of-state goods or activities than on competing in-state goods or activities will be struck down as discriminatory under the commerce clause.¹⁰³¹ In Armco Inc. v. Hardesty,¹⁰³² the Court voided as discriminatory the imposition on an out-of-state wholesaler of a state tax that was levied on manufacturing and wholesaling but that relieved manufacturers subject to the manufacturing tax of liability for paying the wholesaling tax. Even though the former tax was higher than the latter, the Court found the imposition discriminated against the interstate wholesaler.¹⁰³³ A state excise tax on wholesale liquor sales, which exempted sales of specified local products, was held to violate the commerce clause.¹⁰³⁴ A state statute that granted a tax credit for ethanol fuel if the ethanol was produced in the State, or if produced in another State that granted a similar credit to the State’s ethanol fuel, was found discriminatory in violation of the clause.¹⁰³⁵ Expanding, although neither unexpectedly nor exceptionally, its dormant commerce jurisprudence, the Court in Camps Newfound/Owatonna, Inc. v. Town of Harrison¹⁰³⁶ applied its non-discrimination element of the doctrine to invalidate the State’s charitable property tax exemption statute, which applied to nonprofit firms performing benevolent and charitable functions, but which excluded entities serving primarily non-state residents. The claimant here operated a church camp for children, most of whom resided out-of-state. The discriminatory tax would easily have fallen had it been applied to profit-making firms, and the Court saw no reason to make an exception for nonprofits. The tax scheme was designed to encourage entities to care for local populations and to discourage attention to out-of-state individuals and groups. “For purposes of Commerce Clause analysis, any categorical distinction between the activities of profit-making enterprises and not-for-profit entities is therefore wholly illusory. Entities in both categories are major participants in interstate markets. And, although the summer camp involved in this case may have a relatively insignificant impact on the commerce of the entire Nation, the interstate commercial activities of nonprofit entities as a class are unquestionably significant.”¹⁰³⁷

Benefit Relationship.—Although, in all the modern cases, the Court has stated that a necessary factor to sustain state taxes having an interstate impact is that the levy be fairly related to benefits provided by the taxing State, it has declined to be drawn into any consideration of the amount of the tax or the value of the benefits bestowed. The test rather is whether, as a matter of the first factor, the business has the requisite nexus with the State; if it does, the tax meets the fourth factor simply because the business has enjoyed the opportunities and protections which the State has afforded it.¹⁰³⁸

Regulation.—Adoption of the modern standard of commerce-clause review of state regulation of or having an impact on interstate commerce was achieved in Southern Pacific Co. v. Arizona,¹⁰³⁹ although it was presaged in a series of opinions, mostly dissents, by Chief Justice Stone.¹⁰⁴⁰ The Southern Pacific case tested the validity of a state train-length law, justified as a safety measure. Revising a hundred years of doctrine, the Chief Justice wrote that whether a state or local regulation was valid depended upon a “reconciliation of the conflicting claims of state and national power [that] is to be attained only by some appraisal and accommodation of the competing demands of the state and national interests involved.”¹⁰⁴¹ Save in those few cases in which Congress has acted, “this Court, and not the state legislature, is under the commerce clause the final arbiter of the competing demands of state and national interests.”¹⁰⁴²

That the test to be applied was a balancing one, the Chief Justice made clear at length, stating that in order to determine whether the challenged regulation was permissible, “matters for ultimate determination are the nature and extent of the burden which the state regulation of interstate trains, adopted as a safety measure, imposes on interstate commerce, and whether the relative weights of the state and national interests involved are such as to make inapplicable the rule, generally observed, that the free flow of interstate commerce and its freedom from local restraints in matters requiring uniformity of regulation are interests safeguarded by the commerce clause from state interference.”¹⁰⁴³

The test today continues to be the Stone articulation, although the more frequently quoted encapsulation of it is from Pike v. Bruce Church, Inc.¹⁰⁴⁴ “Where the statute regulates even-handedly to effectuate a legitimate local public interest, and its effects on interstate commerce are only incidental, it will be upheld unless the burden imposed on such commerce is clearly excessive in relation to the putative local benefits.... If a legitimate local purpose is found, then the question becomes one of degree. And the extent of the burden that will be tolerated will of course depend on the nature of the local interest involved, and on whether it could be promoted as well with a lesser impact on interstate activities.”

Obviously, the test requires “even-handedness.” Discrimination in regulation is another matter altogether. When on its face or in its effect a regulation betrays “economic protectionism,” an intent to benefit in-state economic interests at the expense of out-of-state interests, no balancing is required. “When a state statute clearly discriminates against interstate commerce, it will be struck down . . . unless the discrimination is demonstrably justified by a valid factor unrelated to economic protectionism, ... Indeed, when the state statute amounts to simple economic protectionism, a ‘virtually per se rule of invalidity’ has applied.”¹⁰⁴⁵ Thus, an Oklahoma law that required coal-fired electric utilities in the State, producing power for sale in the State, to burn a mixture of coal containing at least 10% Oklahoma-mined coal was invalidated at the behest of a State that had previously provided virtually 100% of the coal used by the Oklahoma utilities.¹⁰⁴⁶ Similarly, the Court invalidated a state law that permitted interdiction of export of hydroelectric power from the State to neighboring States, when in the opinion of regulatory authorities the energy was required for use in the State; a State may not prefer its own citizens over out-of-state residents in access to resources within the State.¹⁰⁴⁷

States may certainly promote local economic interests and favor local consumers, but they may not do so by adversely regulating out-of-state producers or consumers. In Hunt v. Washington State Apple Advertising Comm’n,¹⁰⁴⁸ the Court confronted a state requirement that closed containers of apples offered for sale or shipped into North Carolina carry no grade other than the applicable U. S. grade. Washington State mandated that all apples produced in and shipped in interstate commerce pass a much more rigorous inspection than that mandated by the United States. The inability to display the recognized state grade in North Carolina impeded marketing of Washington apples. The Court obviously suspected the impact was intended, but, rather than strike the state requirement down as purposeful, it held that the regulation had the practical effect of discriminating, and, inasmuch as no defense based on possible consumer protection could be presented, the state law was invalidated.¹⁰⁴⁹ State actions to promote local products and producers, of everything from milk¹⁰⁵⁰ to alcohol,¹⁰⁵¹ may not be achieved through protectionism.

Even garbage transportation and disposition is covered by the negative commerce clause. A state law that banned the importation of most solid or liquid wastes that originated outside the State was struck down, because the State could not justify it as a health or safety measure, in the form of a quarantine, inasmuch as it did not limit in-state disposal at its landfills; the State was simply attempting to conserve landfill space and lower costs to its residents by keeping out trash from other States.¹⁰⁵² Further extending the limitation of the clause on waste disposal,¹⁰⁵³ the Court invalidated as a discrimination against interstate commerce a local “flow control” law, which required all solid waste within the town to be processed at a designated transfer station before leaving the municipality.¹⁰⁵⁴ The town’s reason for the restriction was its decision to have built a solid waste transfer station by a private contractor, rather than with public funds by the town. To make the arrangement appetizing to the contractor, the town guaranteed it a minimum waste flow, for which it could charge a fee significantly higher than market rates. The guarantee was policed by the requirement that all solid waste generated within the town be processed at the contractor’s station and that any person disposing of solid waste in any other location would be penalized.

The Court analogized the constraint as a form of economic protectionism, which bars out-of-state processors from the business of treating the localities solid waste, by hoarding a local resource for the benefit of local businesses that perform the service. The town’s goal of revenue generation was not a local interest that could justify the discrimination. Moreover, the town had other means to accomplish this goal, such as subsidization of the local facility through general taxes or municipal bonds. The Court did not deal with, indeed, did not notice, the fact that the local law conferred a governmentally-granted monopoly, an exclusive franchise, indistinguishable from a host of local monopolies at the state and local level.¹⁰⁵⁵

In United Haulers Ass’n, Inc. v. Oneida-Herkimer Solid Waste Management Authority,²⁶ the Court declined to apply Carbone where haulers were required to bring waste to facilities owned and operated by a state-created public benefit corporation instead of to a private processing facility, as was the case in Carbone. The Court found this difference constitutionally significant because “[d]isposing of trash has been a traditional government activity for years, and laws that favor the government in such areas — but treat every private business, whether in-state or out-of-state, exactly the same — do not discriminate against interstate commerce for purposes of the Commerce Clause. Applying the Commerce Clause test reserved for regulations that do not discriminate against interstate commerce, we uphold these ordinances because any incidental burden they may have on interstate commerce does not outweigh the benefits they confer …”²⁷

In Department of Revenue of Kentucky v. Davis,²⁸ the Court considered a challenge to the long-standing state practice of issuing bonds for public purposes while exempting interest on the bonds from state taxation.²⁹ In Davis, a challenge was brought against Kentucky for such a tax exemption because it applied only to government bonds that Kentucky issued, and not to government bonds issued by other states. The Court, however, recognizing the long pedigree of such taxation schemes, applied the logic of United Haulers Ass'n, Inc., noting that the issuance of debt securities to pay for public projects is a "quintessentially public function," and that Kentucky's differential tax scheme should not be treated like one that discriminated between privately issued bonds. In what may portend a significant change in dormant commerce clause doctrine, however, the Court declined to evaluate the governmental benefits of Kentucky's tax scheme versus the economic burdens it imposed, holding that, at least in this instance, the "Judicial Branch is not institutionally suited to draw reliable conclusions."

Drawing the line between discriminatory regulations that are almost per se invalid and regulations that necessitate balancing is not an easy task. Not every claim of protectionism is sustained. Thus, in Minnesota v. Clover Leaf Creamery Co.,¹⁰⁵⁷ there was attacked a state law banning the retail sale of milk products in plastic, nonreturnable containers but permitting sales in other non-returnable, nonrefillable containers, such as paperboard cartons. The Court found no discrimination against interstate commerce, because both in-state and out-of-state interests could not use plastic containers, and it refused to credit a lower, state-court finding that the measure was intended to benefit the local pulpwood industry. In Exxon Corp. v. Governor of Maryland,¹⁰⁵⁸ the Court upheld a statute that prohibited producers or refiners of petroleum products from operating retail service stations in Maryland. No discrimination was found, first, because there were no local producers or refiners within Maryland and therefore since the State’s entire gasoline supply flowed in interstate commerce there was no favoritism, and, second, although the bar on operating fell entirely on out-of-state concerns, there were out-of-state concerns that did not produce or refine gasoline and they were able to continue operating in the State, so that there was some distinction between all in-state operators and some out-of-state operators as against some other out-of-state operators.

Still a model example of balancing is Chief Justice Stone’s opinion in Southern Pacific Co. v. Arizona.¹⁰⁵⁹ At issue was the validity of Arizona’s law barring the operation within the State of trains of more than 14 passenger cars, no other State had a figure this low, or 70 freight cars, only one other State had a cap this low. First, the Court observed that the law substantially burdened interstate commerce. Enforcement of the law in Arizona, while train lengths went unregulated or were regulated by varying standards in other States, meant that interstate trains of a length lawful in other States had to be broken up before entering the State; inasmuch as it was not practicable to break up trains at the border, that act had to be accomplished at yards quite removed, with the result that the Arizona limitation controlled train lengths as far east as El Paso, Texas, and as far west as Los Angeles. Nearly 95% of the rail traffic in Arizona was interstate. The other alternative was to operate in other States with the lowest cap, Arizona’s, with the result that that State’s law controlled the railroads’ operations over a wide area.¹⁰⁶⁰ If other States began regulating at different lengths, as they would be permitted to do, the burden on the railroads would burgeon. Moreover, the additional number of trains needed to comply with the cap just within Arizona was costly, and delays were occasioned by the need to break up and remake lengthy trains.¹⁰⁶¹

Conversely, the Court found that as a safety measure the state cap had “at most slight and dubious advantage, if any, over unregulated train lengths.” That is, while there were safety problems with longer trains, the shorter trains mandated by state law required increases in the numbers of trains and train operations and a consequent increase in accidents generally more severe than those attributable to longer trains. In short, the evidence did not show that the cap lessened rather than increased the danger of accidents.¹⁰⁶²

Conflicting state regulations appeared in Bibb v. Navajo Freight Lines.¹⁰⁶³ There, Illinois required the use of contour mud-guards on trucks and trailers operating on the State’s highways, while adjacent Arkansas required the use of straight mudguards and banned contoured ones. At least 45 States authorized straight mudguards. The Court sifted the evidence and found it conflicting on the comparative safety advantages of contoured and straight mudguards. But, admitting that if that were all that was involved the Court would have to sustain the costs and burdens of outfitting with the required mudguards, the Court invalidated the Illinois law, because of the massive burden on interstate commerce occasioned by the necessity of truckers to shift cargoes to differently designed vehicles at the State’s borders.

Arguably, the Court in more recent years has continued to stiffen the scrutiny with which it reviews state regulation of interstate carriers purportedly for safety reasons.¹⁰⁶⁴ Difficulty attends any evaluation of the possible developing approach, inasmuch as the Court has spoken with several voices. A close reading, however, indicates that while the Court is most reluctant to invalidate regulations that touch upon safety and that if safety justifications are not illusory it will not second-guess legislative judgment, nonetheless, the Court will not accept, without more, state assertions of safety motivations. “Regulations designed for that salutary purpose nevertheless may further the purpose so marginally, and interfere with commerce so substantially, as to be invalid under the Commerce Clause.” Rather, the asserted safety purpose must be weighed against the degree of interference with interstate commerce. “This ‘weighing’ . . . requires . . . a sensitive consideration of the weight and nature of the state regulatory concern in light of the extent of the burden imposed on the course of interstate commerce.”¹⁰⁶⁵

Balancing has been used in other than transportation-industry cases. Indeed, the modern restatement of the standard was in such a case.¹⁰⁶⁶ There, the State required cantaloupes grown in the State to be packed there, rather than in an adjacent State, so that in-state packers’ names would be associated with a superior product. Promotion of a local industry was legitimate, the Court, said, but it did not justify the substantial expense the company would have to incur to comply. State efforts to protect local markets, concerns, or consumers against outside companies have largely been unsuccessful. Thus, a state law that prohibited ownership of local investment-advisory businesses by out-of-state banks, bank-holding companies, and trust companies was invalidated.¹⁰⁶⁷ The Court plainly thought the statute was protectionist, but instead of voiding it for that reason it held that the legitimate interests the State might have did not justify the burdens placed on out-of-state companies and that the State could pursue the accomplishment of legitimate ends through some intermediate form of regulation. In Edgar v. Mite Corp.,¹⁰⁶⁸ an Illinois regulation of take-over attempts of companies that had specified business contacts with the State, as applied to an attempted take-over of a Delware corporation with its principal place of business in Connecticut, was found to constitute an undue burden, with special emphasis upon the extraterritorial effect of the law and the dangers of disuniformity. These problems were found lacking in the next case, in which the state statute regulated the manner in which purchasers of corporations chartered within the State and with a specified percentage of in-state shareholders could proceed with their take-over efforts. The Court emphasized that the State was regulating only its own corporations, which it was empowered to do, and no matter how many other States adopted such laws there would be no conflict. The burdens on interstate commerce, and the Court was not that clear that the effects of the law were burdensome in the appropriate context, were justified by the State’s interests in regulating its corporations and resident shareholders.¹⁰⁶⁹

In other areas, while the Court repeats balancing language, it has not applied it with any appreciable bite,¹⁰⁷⁰ but in most respects the state regulations involved are at most problematic in the context of the concerns of the commerce clause.

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Last modified: June 9, 2014