Congress Debates Limits on State Business Activity Taxes

Congress Debates Limits on State Business Activity Taxes
July 1, 2004

Congress is debating legislation that would limit state attempts to collect taxes from out-of-state businesses. A hearing before a subcommittee of the House Judiciary Committee in May revealed fierce opposition by state tax officials to the proposed limits, but also strong support from business spokespersons and advocates of federalism.

States Chasing Businesses

Louisiana has attempted to tax out-of-state media companies merely because they broadcast signals into Louisiana. The Alabama revenue department tried to tax a credit card company solely because it issued cards to customers in Alabama. A regulation in Oregon indicates the receipt of franchise fees or royalties from Oregon sources subjects a business to Oregon taxation, even if that business has no physical connection to the state.

Other states assert a business could be subject to taxation merely as a result of a truck passing through the state, a listing in a phone book, having a Web site on a server, having a bank account, or obtaining a loan.

C. J. Horne, owner of a small software company in South Carolina, recently got a tax bill from the state of New Jersey. Revenue officials in the Garden State wanted nearly $600 in corporate taxes and fees from Horne for selling software to a customer in New Jersey. The state also wanted $600 every year so long as Horne's customer continued to use the software. Horne was puzzled, since neither he nor his business had ever set foot in New Jersey.

"No small business can pay $600 in taxes and fees just for the privilege of participating in interstate commerce with a state," Horne said.

Debate Launched Decades Ago

Congress tried to put an end to states' efforts to intrude on interstate commerce in the late 1950s by passing Public Law 86-272, the Interstate Income Tax Act of 1959. The law said a business was not liable to pay state taxes merely because it made sales of tangible personal property in a particular state.

The law was passed in response to a U.S. Supreme Court decision in Northwestern States Portland Cement Co. v. Minnesota, where the Court held the state of Minnesota could levy taxes on a business's net income solely because of sales made to customers in the state. The Supreme Court did not require a physical connection to the state in order to trigger business taxation, so Congress responded by enacting the first federal restrictions on state tax authority in U.S. history.

Since 1959, commerce has become increasingly interstate and even international in scope. Friction is growing between business owners like Horne and state revenue officials, who fear the federal government will act again to prevent them from taxing business activity in their states.

Business leaders warn recent aggressive tax actions by state revenue departments will have a harmful effect on the economy. They say the same principle that led Congress to adopt P.L. 86-272 in 1959 applies to the new economy as well.

"One of our nation's founding principles that still resonates today is 'no taxation without representation.' But this concept of paying taxes in the jurisdiction where the business actually receives benefits and services is in danger of being eroded in some states," said Mike DiConti, who works with the Business Roundtable.

HR 3220 Would Set Limits

HR 3220, the Business Activity Tax Simplification Act of 2003, introduced by Representatives Bob Goodlatte (R-Virginia) and Rick Boucher (D-Virginia) on October 1, 2003, would limit efforts by states to tax business activity originating outside their borders. The measure currently has 30 cosponsors.

HR 3220 would codify the physical presence standard for state taxation of business activities. The measure also would extend that protection, which currently applies only to the sale of tangible personal property, to the sale of services and intangibles as well.

Commenting on the bill's introduction, Boucher said, "(N)o clear standard exists to define the taxation of business activity by the states. This uncertainty has allowed several states to impose unfair taxes onto businesses ... The Business Activity Tax Modernization Act would rectify the unfairness which currently exists by setting a physical presence nexus standard."

State and Local Taxers Oppose Bill

HR 3220 was heard in the Subcommittee on Commercial and Administrative Law of the House Judiciary Committee on May 13, 2004. Several groups representing state or local governments, including the National Governors Association (NGA), National League of Cities (NLC), and Multistate Tax Commission (MTC), condemned the bill.

Rick Claybaugh, from the North Dakota Office of State Tax Commissioner, testified on behalf of the NGA, saying, "The NGA opposes HR 3220 because it would unduly interfere with the ability of states to determine and manage their own tax policies. Most importantly, HR 3220 runs directly counter to our system of federalism and places Congress in the position of making decisions that for over 225 years have been reserved to state and local elected officials."

NLC claimed HR 3220 would cause state and local governments to "lose more than $60 billion annually in revenues." When confronted with the fact that state and local governments collect less than $60 billion per year in total corporate income taxes, NLC changed its statement to assert that a "substantial portion" of the $60 billion would be lost.

The MTC contends bills like HR 3220 are contrary to federalism and state sovereignty. Maryland Deputy Comptroller Stephen Cordi said, "(H.R. 3220) runs roughshod over federalism by imposing from above a substantial number of federally mandated state tax exemptions overriding hundreds of existing state and local laws and rules."

"(HR 3220) would send the message that the widely criticized style of income shifting associated with WorldCom and Tyco in order to avoid state taxes is just fine with Congress," said Norris Tolson, North Carolina Secretary of Revenue. "The inevitable surge in opportunistic tax sheltering would create new state revenue shortfalls in 40 states--and more in New York City and other cities around the U.S. This new epidemic of tax sheltering would put a further crimp on essential services such as education, transportation, and infrastructure at a time of already historic state budget shortfalls."

Consistent with Federalism

One of the witnesses at the hearing, Iowa State Representative Jamie Van Fossen (R-Davenport), testified in support of HR 3220 saying it is consistent with federalism and would be good for state and local governments.

"Federalism, like the separation of powers, is a tool we use to limit government's power and enhance the liberty of our citizens," Van Fossen said. "Whenever state government goes beyond the powers given to it by the people and the Constitution, such as when a state tries to impose taxes on businesses located outside its jurisdiction, we should not hide behind the mantra of federalism and excuse such action."

Van Fossen also took issue with claims HR 3220 would cause state revenue loss. "(Congress is) not forced, as the opponents of this bill claim, to choose between public schools and corporate profits," said Van Fossen. "Rather, (Congress is) going to decide whether federalism is a two-way street, granting license to states as well as restricting state power outside its own borders. Enacting legislation like HR 3220 is the best medicine Congress can prescribe for healthy state economies."

Art Rosen, testifying for the Coalition for Fair and Rational Taxation (CRAFT), said the federalism and state sovereignty concerns of NGA (and other state groups) were misguided. "Legislation regarding states and localities imposing, regulating, or removing tax burdens placed on transactions in interstate commerce is not only within Congress' realm of authority, it is also--I respectfully submit--Congress' responsibility."

Debate Expected to Continue

While questioning at the hearing was sparse, it appeared likely the business activity tax will get caught up in the debate over two other state tax issues in Congress: the Internet Tax Moratorium and the Streamlined Sales Tax Project.

While Congress plays politics with state tax policy and interstate commerce, it remains unclear whether small business owners like Horne will ever get the green light to resume full participation in the American economy.


Chris Atkins is director of tax and fiscal policy for the American Legislative Exchange Council. His email address is cdatkins@alec.org.

For more information ...

The full text of HR 3220 is available through PolicyBot™, The Heartland Institute's free online research database. Point your Web browser to http://www.heartland.org, click on the PolicyBot™ button, and search for document #15186..

The text of testimony presented at the May 13 hearing is also available through PolicyBot™. Search for documents #15187 (Arthur R. Rosen, 17 pages), #15188 (Hon. Jamie Van Fossen, 3 pages), #15189 (Rick Clayburgh, 3 pages), and #15190 (Vernon T. Turner, 4 pages).

A webcast of the hearing is available at http://boss.streamos.com/real/hjudiciary/commercial/com051304.smi.