State and local income tax written in a note.
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Now that economic nexus for use tax purposes is the law of the land, states have leaped at the opportunity to update their sales tax laws, many focusing on marketplace facilitators and marketplace providers. Of course, this does not mean remote sellers that do not sell on a marketplace platform have been left out. All remote sellers, regardless of their sales platform, are required to collect tax on sales made into a state, subject to state-mandated thresholds, unless they are exempt from doing so by law. However, many states have local jurisdictions that have been empowered to levy sales and use taxes independent of the state levy.1 In these states, remote sellers must also be aware of the different local rates, and remit tax accordingly.
Some states, like Alabama, have attempted to ease the use tax compliance burden by levying a single rate applicable to remote sales. Alabama imposes a use tax rate of 8 percent, consisting of the state’s 4 percent rate, and another 4 percent that is allocated to local jurisdictions based on population. Yet local sales tax rates have undergone no adjustment. Alabama must be applauded for its effort to ease the compliance burden on remote sellers. At first glance, however, it appears the state’s solution may be unconstitutional under the U.S. Supreme Court’s decision in Associated Industries of Missouri v. Lohman.2
Good Intentions Can Backfire
In 1994 Missouri imposed a tax of 4.225 percent on sales made within the state, and a state use tax of 4.225 percent. The state permitted political subdivisions, such as counties and incorporated cities, to impose a local sales tax in amounts ranging from 0.5 percent to 3.5 percent. Taking advantage of this authority, roughly 1,000 localities imposed a sales tax. At least one locality did not impose sales tax, and no locality imposed a use tax. The state also imposed a 1.5 percent “additional use tax,” which was not paired at the state level with a corresponding sales tax, the purpose of which, according to the state supreme court, was to equalize the sales tax imposed at the local level on taxable in-state and out-of-state purchases. However, in over half of the local jurisdictions that imposed a sales tax, the state-imposed 1.5 percent use tax exceeded the sales tax. In its analysis of the comparative burden of the local sales tax and the state use tax, the state supreme court determined that by dollar volume, nearly all of these sales occurred in jurisdictions where the sales tax was greater than the additional use tax. Given the high average rate of local sales taxes, the effect of the additional use tax across the state was to place a lighter total tax burden on interstate commerce than on intrastate commerce, the state supreme court said. The additional use tax was intended to even the tax burden between interstate and intrastate trade, thus it was proper to analyze the case under the compensatory tax doctrine, which, the state supreme court said, allows states to “impose equivalent tax burdens on local and intrastate commerce.” The state supreme court framed the question before it as “whether a state use tax may impose a greater burden than the sales taxes in specific localities if on a statewide basis the use tax imposes a lesser overall burden than do all the various sales taxes.” Answering in the affirmative, the state supreme court reasoned that whether a tax structure discriminated against interstate commerce should be determined by comparing the overall effects of the additional use tax and the local sales taxes on interstate commerce on a statewide basis. Based on its analysis, the state supreme court concluded that on a statewide basis, the tax did not discriminate against interstate commerce, and thus did not violate the commerce clause.
The U.S. Supreme Court disagreed. For a tax to be compensatory “the burdens imposed on intrastate and interstate commerce must be equal,” as this requirement of equality has been the “common thread running through [our] cases upholding compensatory taxes.” In this case, whether the use tax is equal or lower than the sales tax depends entirely on the local jurisdiction where the purchaser lives. In jurisdictions where the use tax exceeds the sales tax, goods purchased from out-of-state vendors are subject to a higher tax than those purchased locally. This result contravenes the Court’s “strict rule of equality.”
The Court also rejected the state’s argument that rather than take the myopic view by examining each jurisdiction where the disparity between the use tax and the sales tax results in discrimination, the focus should be on the overall impact of the use and sales taxes on commerce across the state. In other words, the Court said, the state contends that some commerce clause discrimination in parts of a sales and use tax system is acceptable, as long as it is sufficiently limited to be offset “by preferential treatment for interstate trade” in other parts of the tax structure. Focusing on the question jurisdiction by jurisdiction provides too narrow a framework for a “proper constitutional analysis,” the Court explained. However, it has never intimated in prior cases that, under the commerce clause, subjecting interstate trade to discrimination in part of a tax system that is not justified by the compensatory tax doctrine can be balanced by according preferential treatment of interstate trade in other parts of the system, the Court said. Indeed, it has always rejected an examination of the quantifiable effects of discrimination, except under very limited circumstances, as a prelude for determining whether the discrimination is valid, the Court noted. Unless justified, actual discrimination is always impermissible, and its magnitude and scope “have no bearing on the determinative question whether discrimination has occurred.”
The Court quickly disposed of the state’s argument that because of the way the sales and use tax system was structured (the local jurisdictions independently determined their own sales tax rates and the state independently determined the use tax rate), there could not be any overall legislative intent to discriminate against interstate commerce. The Court countered that legislative intent is not relevant to the constitutional analysis; if the tax in fact discriminates, it is per se impermissible. Yet despite finding the use tax was discriminatory, the Court did not strike the tax in its entirety. There were some local jurisdictions in which the use tax was not discriminatory, i.e., in those jurisdictions where the local sales tax was 1.5 percent or higher. There is no rule requiring a legislature, to survive commerce clause muster, enact compensatory taxes in the same provision of state law, or that the same governmental entity must enact the law, the Court reasoned. Such a rule would elevate form over substance. The commerce clause only demands that however the compensatory tax system is structured, it not discriminate against interstate commerce.
Is Alabama’s Use Tax Constitutional?
Prior to 2016 Alabama counties and cities were permitted by the state to enact local sales and use taxes.3 In 2016 Alabama enacted the Simplified Sellers Use Tax Remittance Act,4 through which out-of-state sellers could voluntarily remit use tax to the state. For participating sellers, the state collected state and local use tax at a single rate, and after the state’s 4 percent use tax levy, the remainder was distributed to local jurisdictions based on population. After Wayfair
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As the Lohman Court said, equality between the sales and use tax is the order of the day. Alabama requires a locality impose sales tax at the minimum rate of 4 percent, to pass muster under the commerce clause. There are some local jurisdictions whose sales tax rates are far lower. Thus, it appears that for some localities, Alabama’s 4 percent local use tax rate is unconstitutional because the local sales tax rates are lower than the state-collected use tax rate. However, the crucial difference between Missouri and Alabama’s sales and use tax structure is that in Alabama, taxpayers who reside in localities where the sales tax rate is lower than the use tax rate collected by the state can apply for a refund of overpaid taxes. Thus, in the end, the sales and use taxes paid by in-state taxpayers are equalized. It is likely that the Lohman Court would have agreed because it held, in essence, that the paramount commerce clause concern is the sales and use taxes are truly compensatory, and how that equality is reached is a matter for the states to decide — provided it is reached.
Conclusion
With Way fair’s extension of economic nexus to sales and use taxes, states and those charged with collecting the tax — be they remote sellers or marketplace facilitators — are still finding their way to create tax structures that are compliance friendly. This should be of especial concern to states that have empowered local jurisdictions, either by legislative delegation or home rule, to levy their own sales and use taxes. The idea of levying a state-collected use tax, which is then distributed to local jurisdictions according to some formula, is sound. However, as Missouri found in Lohman, there is more to it than simply levying a state-collected use tax at a single rate while leaving varying local sales tax rates intact. The state must also devise a means to equalize the sales and use tax rates to make the taxes truly compensatory and thus able to survive a commerce clause challenge. Although it may not be the only approach, Alabama has implemented a mechanism that is not only constitutional but also eases the compliance burden for remote sellers and marketplace facilitators. States that face the same issue with respect to their local jurisdictions would do well emulate Alabama’s lead.
FOOTNOTES
1 Localities may also have tax bases that are different from the state’s base. A discussion of this potential issue is beyond the scope of this article.
3 Not all counties and cities in Alabama relied on the state to collect local sales and use taxes. Many were “self-administered,” meaning sales and use tax payments are remitted directly to the local jurisdiction. Today, local jurisdictions are permitted to levy sales tax only.
4 Ala. Code sections 40-23-191 through 40-23-199.3 (1975).
5 South Dakota v. Wayfair Inc. 585 U.S. ___ (2018).
6 “Alabama (AL) Sales Tax Rates by City (A),” Sale-Tax.com (as of July 1, 2020).