Reed Smith Client Alerts

Today, the Supreme Court of Ohio upheld the Ohio Commercial Activity Tax’s (“CAT”) $500,000 factor-presence nexus test in the face of a Commerce Clause challenge. Specifically, in Crutchfield Corp. v. Testa, the court held that the Commerce Clause does not impose a physical-presence requirement for gross-receipts taxes, like the CAT. In so holding, the court determined that the CAT should be reviewed as though it were an income tax. This determination reaffirms that taxpayers may have an opportunity to apportion the CAT to reflect only the activities within Ohio.


Ohio enacted the CAT in 2005. It is imposed on any business that has at least $500,000 of Ohio gross receipts. It makes no difference whether a taxpayer is physically present in Ohio—it matters only whether the Ohio sales threshold is satisfied. Ohio adopted the $500,000 standard in an attempt to capture sales made through the Internet.

The cases involve three out-of-state sellers with no physical presence in Ohio: Crutchfield, Inc., Newegg, Inc., and Mason Companies, Inc. (collectively, the “Taxpayers”). Each taxpayer brought its own challenge to the CAT, and the cases were consolidated on appeal. The Taxpayers did not remit the CAT to Ohio, arguing that the $500,000 threshold was unconstitutional under the dormant Commerce Clause. The Taxpayers lost at the Board of Tax Appeals and appealed that decision to the Supreme Court of Ohio. The court held oral arguments on May 3, 2016 (see Reed Smith’s prior coverage). In a 5-2 decision, the court upheld the CAT and determined that the $500,000 threshold was sufficient to find a substantial nexus between the taxpayer and Ohio.

Majority Opinion

The court’s opinion was authored by Justice O’Neill, and was joined by Chief Justice O’Connor and Justices Pfeifer, O’Donnell, and French. The court, after clarifying that the Taxpayers properly raised both an as-applied and facial challenge to the CAT, reviewed whether the $500,000 threshold met the constitutional requirements of the Commerce Clause.

Quill’s Physical Presence Standard Does not Apply

In order for a state tax to be constitutional, it must satisfy the four-prong test articulated by the U.S. Supreme Court in Complete Auto Transit v. Brady.1 This test requires that a tax (1) is applied to an activity with a substantial nexus with the taxing state; (2) is fairly apportioned; (3) does not discriminate against interstate commerce; and (4) is fairly related to the services provided by the state.2 The Crutchfield case involves only the “substantial nexus” prong of Complete Auto, and specifically whether the U.S. Supreme Court’s decision in Quill Corp. v. North Dakota3 —requiring a physical presence for the imposition of sales and use taxes—applied to the CAT.

The Taxpayers argued that they cannot be assessed on the basis of their sales volume alone. In support of that argument, the Taxpayers asserted that the U.S. Supreme Court has always required a taxpayer to be physically present in the taxing state for that state to impose a tax measured on gross receipts. And without a physical presence, a taxpayer cannot have nexus merely through sales in excess of a statutory threshold alone.

The court rejected this argument, holding that Quill has not—and should not—be extended beyond sales and use taxes: “Quill’s holding that physical presence is a necessary condition for imposing the tax obligation does not apply to a business-privilege tax such as the CAT, as long as the privilege tax is imposed with an adequate quantitative standard that ensures that the taxpayer’s nexus with the state is substantial.”4 The court turned to the majority opinion in Quill for this proposition:

  • “[W]e have not, in our review of other types of taxes, articulated the same physical-presence requirement that Bellas Hess established for sales and use taxes.”5
  • “[O]ur cases subsequent to Bellas Hess and concerning other types of taxes [did not] adopt[ ] a similar bright-line, physical-presence requirement. . . .”6
  • “[O]ur reasoning in those cases does not compel that we now reject the rule that Bellas Hess established in the area of sales and use taxes.”7

But the court could not dispel the Taxpayers’ challenge simply by distinguishing Quill. This is because the Taxpayers also argued that another U.S. Supreme Court decision—Tyler Pipe Industries, Inc. v. Washington State Department of Revenue—required a physical presence for the imposition of a gross receipts tax.8 In this case, the U.S. Supreme Court reviewed Washington’s Business and Occupation Tax, effectively a gross receipts tax similar to the CAT. The Court held that Washington had sufficient nexus with an out-of-state seller to satisfy the “substantial nexus” prong, even though the taxpayer had no office, property, or employees in the state. Nexus existed because of Tyler Pipe’s use of independent contractors to “establish and maintain a market in this state for the sales.”9

In the present case, the Taxpayers argued that Tyler Pipe stands for the proposition that even if the taxpayer itself is not present in the taxing state, the use of independent contracts that are physically present is sufficient to create nexus if those independent contractors engage in activities to “establish or maintain” the taxpayer’s market for sales. Accordingly, they argued that the only way they could be subject to the CAT was through physical presence, either its own or by third parties “establishing or maintaining its market” within Ohio. The court again rejected this argument:

The most accurate characterization of Tyler Pipe . . . is that a taxpayer’s physical presence in a state constitutes a sufficient basis for the state to impose a business-privilege tax. We conclude that in construing Tyler Pipe, it is unwarranted to leap from the principle that physical presence is a sufficient condition for imposing a tax to the logically distinct proposition that physical presence is a necessary condition to impose the tax.10

By disposing of both Quill and Tyler Pipe, the court concluded that a physical presence is not required in Ohio to impose the CAT. The only remaining question, then, was whether the $500,000 sales-receipts threshold ensures that the Taxpayers have a substantial nexus with Ohio.

$500,000 Sales-Receipts Threshold as a Measure of Substantial Nexus

The court explicitly held that the CAT’s sales threshold satisfied the substantial nexus prong of Complete Auto: “We hold that the $500,000 sales-receipts threshold complies with the substantial-nexus requirement of the Complete Auto text.”11 In reaching this conclusion, the court relied on a balancing test articulated in Pike v. Bruce Church12. This balancing test provides that when a state 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.”13 In order for the CAT to pass this balancing test, the $500,000 threshold must not impose “excessive burdens” on interstate commerce. The court, without any substantial analysis, concluded that it did not, and was therefore a sufficient proxy to determine whether the Taxpayers had a “substantial nexus” with Ohio.

Dissenting Opinion

Justice Kennedy, joined by Justice Lanzinger, dissented from the majority opinion. In their view, Quill and Tyler Pipe directly apply to the case at hand, and the court is “bound by the [U.S. Supreme] [C]ourt’s prior holdings. . . .”14

The dissent rejected the majority’s creative reading of Tyler Pipe: “I see no evidence that gross-receipts taxes are meaningfully different from use taxes for substantial-nexus purposes, and I view Tyler Pipe’s reliance on physical presence as more indicative of a requirement than an option. That opinion suggests as much by its lack of other nexus-producing details.”15 The dissent continued: “Nowhere in Tyler Pipe did the Supreme Court indicate that anything less than a third-party contractor operating within a taxing state on a taxpayer’s behalf would satisfy the substantial-nexus requirement established in Complete Auto. . . .”16

Not only did the majority distort the central holding of Tyler Pipe, but it also failed to demonstrate precisely why the $500,000 threshold was a sufficient measure of a substantial nexus. What if a taxpayer made one sale to an Ohio purchaser for $500,000? Would that single sale create a substantial nexus for the taxpayer, even though that taxpayer never set foot in Ohio? The dissent argued that such a result “is an undue burden on interstate commerce of the sort that the Quill court was attempting to avoid.”17

The dissent acknowledged that Quill’s physical presence rule, at least as it relates to sales and use taxes, is under attack by numerous states in an effort to force the U.S. Supreme Court to reexamine the rule. But it is the role of the U.S. Supreme Court—not the Supreme Court of Ohio—to announce a new rule to determine when a substantial nexus exists. Moreover, Congress has the authority to pass legislation to abrogate the protections of Quill, but has not done so. Accordingly, only Congress or the U.S. Supreme Court have the authority to rebuke Quill’s physical presence rule.

Opportunity to Apportion the CAT?

The majority opinion, in concluding that the CAT is comparable to an income tax rather than a sales and use tax, implicitly leaves open the question of whether the CAT must be apportioned. In order to meet the constitutional requirements under the Commerce Clause, a tax must be “fairly apportioned” to prohibit multiple taxation of the same activity.18 One of the purposes of the Commerce Clause apportionment requirement is to limit the risk of multiple taxation on interstate commerce, “which is threatened whenever one State’s act of overreaching combines with the possibility that another State will claim its fair share of the value taxed: the portion of value by which one State exceeded its fair share would be taxed again by a State properly laying claim to it.”19

Here, the court recognized that the CAT is imposed on “gross receipts,”20 and under the Commerce Clause, a “gross receipts tax [is] simply a variety of tax on income, which [is] required to be apportioned to reflect the location of the various interstate activities by which it is earned.”21 Thus, for example, a taxpayer generating $50 million of receipts by manufacturing in Indiana and shipping to a customer in Ohio should apportion those receipts between Indiana and Ohio.

In this example, the risk of double taxation is obvious. Each state where a taxpayer manufactures its products has the right to impose a tax on the value attributable to products manufactured in the state. However, if those manufactured products are sold in Ohio, the CAT is imposed on the entire value of those manufactured goods simply because they are sold in Ohio, resulting in double taxation.

Therefore, a CAT taxpayer may be entitled to adopt an apportionment percentage to determine the portion of each dollar of taxable gross receipts that is fairly attributable to the taxpayer’s activities outside Ohio.

Opportunities for Voluntary Disclosure Agreements

The Crutchfield decision also serves as a reminder that the Ohio Department of Revenue has a CAT VDA program. This program is available for any business that has more than $500,000 of Ohio gross receipts that has not registered for the CAT because it lacked a physical presence in Ohio. The Department of Taxation has been assessing CAT liability against nonfiling businesses for tax years going back to 2005, when the CAT was first enacted. However, under the CAT VDA program, the look-back period is limited to three years and penalties are waived.22 Thus, for a nonfiling business facing up to 11 years of back year CAT exposure, plus interest and penalties of up to 60% of the tax liability, the Ohio CAT VDA program can be an attractive option.

For more information on how the Ohio CAT and the Crutchfield decision could affect your business, contact the authors of this Alert or another member of the Reed Smith State Tax Group.

  1. 430 U.S. 274 (1977).
  2. Id.
  3. 504 U.S. 298 (1992).
  4. Crutchfield v. Testa, Slip Opinion No. 2016-Ohio-7760 at ¶42.
  5. Quill, 504 U.S. at 314.
  6. Quill, 504 U.S. at 317.
  7. Id.
  8. 483 U.S. 232 (1987).
  9. Id. at 250.
  10. Crutchfield, at ¶50.
  11. Id. ¶52.
  12. 397 U.S. 137 (1970).
  13. Id. at 145–46 (emphasis added).
  14. Id. ¶61.
  15. Id. ¶67.
  16. Id. ¶68.
  17. Id. ¶73.
  18. Complete Auto, 430 U.S. at 279 (1977).
  19. Jefferson Lines, 514 U.S. at 184–85.
  20. Crutchfield Corp. v. Testa, Slip. Op. at 18, quoting Jefferson Lines, 514 U.S. at 190 (“The Court thus understood the gross receipts tax to be simply a variety of tax on income, which was required to be apportioned to reflect the location of the various interstate activities by which it was earned.”).
  21. Jefferson Lines, 514 U.S. at 190.
  22. CAT 2008-01 - Commercial Activity Tax: Voluntary Disclosure Agreements - Issued July 2008; Revised May 2009; Revised September 2010; Revised May 2012. 



Client Alert 2016-304