This past Valentine’s Day, California’s Franchise Tax Board (FTB) implemented a convoluted workaround to a decades-old federal law protecting out-of-state businesses from state income tax obligations. Just over six months later, California is facing its first legal challenge over this dubious tax grab.
The Interstate Income Act of 1959, often called by its statute number as P.L. 86-272, protects out-of-state businesses from income tax obligations in states so long as their only activity in the state is the sale of tangible goods, or activities directly ancillary to the sale of tangible goods. In other words, a business in another state could not be required to pay California income tax on sales into California merely for selling to California consumers.
But California has long sought to aggressively enforce tax obligations on the basis of the most tangential relationships to the state, and so sought a means to get around P.L. 86-272’s restrictions. The result was Technical Advice Memorandum 2022-01, which claimed the right to assess income tax obligations on out-of-state businesses previously considered to be protected by P.L. 86-272 if they maintained a website that performed a number of common functions.
These functions included:
Offering post-sale customer service via email or chat if it is initiated through a button on the business’s website.
Offering post-sale customer service in the form of remote repairs or automatic software updates.
Soliciting and receiving branded credit card applications through its website.
Offering and selling extended warranty plans for products purchased through its website.
Posting open job descriptions and enabling viewers to apply through the website.
Contracting with a marketplace facilitator that has fulfillment centers in-state.
Selling intangible, or digital, goods, such as streaming music.
Placing digital “cookies” on customers’ devices “to adjust production schedules and inventory amounts, develop new products, or identify new items to offer for sale.”
Taken together, this list ropes in most businesses with modern websites. What’s more, many of these items are arbitrary and bear no relation to an increased presence in the state of California — simply representing the fulfillment of a common business function through a website rather than another means.
But while California’s action is somewhat half-baked, it may soon spread if it goes unchecked. New York has already begun the process of implementing a similar rule, and the Multistate Tax Commission recommended a substantially similar interpretation of P.L. 86-272 among its member states back in 2021. Massachusetts’ Supreme Judicial Court (highest state court) is considering a challenge to that commonwealth’s “cookie nexus” rules.
Thus, it was not long until California’s TAM faced a legal challenge. This comes from the American Catalog Mailers Association (ACMA), which has filed a complaint in California courts for relief, citing the TAM’s conflict with P.L. 86-272 and the United States Constitution, as well as the improper way the TAM was implemented (without going through the full process of regulatory implementation).
Courts should act quickly to strike down California’s P.L. 86-272 workaround and send a message to other states seeking to do the same. Small businesses around the country are already reeling from the fallout of the Supreme Court’s decision in South Dakota v. Wayfair that allowed states to impose sales tax collection and remittance obligations on out-of-state businesses. Allowing states to impose business income taxes, in contravention of federal law, would only multiply existing compliance burdens that small businesses are already overwhelmed by and impede interstate commerce.