Could Tennessee constitutionally tax out-of-state companies under the 2015 Revenue Modernization Act's 'economic nexus' rules, even if they had no physical presence in the state?

Subject

Opinion No. 15-37, Application of the Revenue Modernization Act, S.B. 603, 109th Gen. Assem. (Tenn. 2015), April 22, 2015

Plain-English summary

Tennessee's 2015 Revenue Modernization Act (Senate Bill 603) tried to do something a lot of other states had already done: make out-of-state companies pay Tennessee's franchise and excise taxes if they did serious business with Tennessee customers, even if they had no office, warehouse, or employee inside the state. The bill defined "substantial nexus" to include any company organized or domiciled in Tennessee, any company licensing intangibles (think trademarks, software code) used in Tennessee, and any company with "bright-line presence," meaning more than $500,000 in Tennessee receipts (or 25% of total receipts), more than $50,000 in Tennessee property, or more than $50,000 in Tennessee payroll during the tax year.

Senator McNally asked whether this would survive a Commerce Clause challenge, given that Tennessee's own Court of Appeals had ruled in 1999's J.C. Penney case that physical presence was required. The AG's answer: yes, defensible. The U.S. Supreme Court's 1992 Quill decision, which created the physical-presence rule, had been narrowed by later courts to apply only to sales and use taxes, not income or franchise taxes. By 2015, the majority of state supreme courts to address the question (South Carolina, West Virginia, North Carolina, Massachusetts, Indiana) had upheld income-tax assertions based on economic nexus alone. The AG also walked through how the new "market-based sourcing" sales factor would work for services, how receipts from licensing trademarks would be sourced to the location of the buyer, and how the existing intangible-expense add-back rules would interact with the new economic-nexus rules to avoid double taxation.

Currency note

This opinion was issued in 2015. Subsequent statutory amendments, court decisions, or later AG opinions may have changed the analysis. Treat this page as historical context, not current legal advice. Verify current law before relying on any specific rule, deadline, or remedy mentioned here.

The most consequential development: in 2018, three years after this opinion, the U.S. Supreme Court overruled Quill in South Dakota v. Wayfair, 138 S. Ct. 2080, eliminating the physical-presence rule even for sales and use taxes. The AG's prediction that Quill was on shaky ground proved correct, and the constitutional question the AG analyzed is now largely settled in favor of state taxing authority over remote sellers.

Common questions

Why was Tennessee changing its corporate tax rules in 2015?

For years, sophisticated companies had been using a structure made famous by the Geoffrey case (a Toys R Us subsidiary in Delaware that owned Toys R Us trademarks and collected royalties from its parent). Putting the intangible-holding company in a state with no income tax and no physical operations in the taxing state stripped earnings out of Tennessee returns. Other states began taxing those structures using "economic nexus" theories. Tennessee's own Court of Appeals had said in 1999 that physical presence was required, but it had narrowed that position in later cases. The Revenue Modernization Act tried to bring Tennessee in line with the trend and clarify what counted as substantial nexus.

What did "bright-line presence" actually mean for a company?

A company hit Tennessee's bright-line threshold if any one of three things was true during the tax year: more than $500,000 in Tennessee receipts (or 25% of its total receipts), more than $50,000 worth of property in Tennessee (or 25% of its total property), or more than $50,000 in Tennessee payroll (or 25% of total payroll). Hit any one of those thresholds and the company would owe Tennessee excise tax even without an office or employee in the state.

How would services like cloud computing or cell phone service be sourced?

The bill said a service was "in this state" if and to the extent it was "delivered to a location in this state." The AG declined to give bright-line answers for the listed categories (internet services, cloud computing, cell service, data, consulting, engineering) because the Department of Revenue had not yet adopted rules and the categories were too broad to address abstractly. The general intent, the AG explained, was to attribute sales to the state where the market for the service was located.

What happened to the J.C. Penney decision after this opinion?

The AG treated J.C. Penney as a 1999 decision that had been narrowed by Tennessee's own subsequent cases (AOL, Arco, Scholastic Book Clubs) and rejected by most other state courts. The U.S. Supreme Court ultimately mooted the entire physical-presence debate in 2018's Wayfair decision, which overruled Quill itself.

Why didn't the new economic-nexus rule make the old intangible-expense add-back rules unnecessary?

Both rules attacked tax-avoidance through intangible-holding subsidiaries, but in different ways. Economic nexus made the holding subsidiary itself taxable in Tennessee. The add-back rule prevented the operating affiliate from deducting royalty payments to the subsidiary. The AG explained that running both at once could in theory result in double taxation, but the existing statute already provided that the add-back deduction must be allowed when the recipient affiliate was itself taxable in Tennessee, which closes the loop.

Background and statutory framework

The Commerce Clause of the U.S. Constitution (Art. I, § 8, cl. 3) gives Congress power over interstate commerce, and the U.S. Supreme Court has long read it to also limit state taxation of multistate businesses, a doctrine called the Dormant Commerce Clause. Under Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), a state tax survives Commerce Clause challenge only if (1) it is applied to an activity with a substantial nexus to the taxing state, (2) it is fairly apportioned, (3) it does not discriminate against interstate commerce, and (4) it is fairly related to state services. The "substantial nexus" requirement is the prong this opinion focused on.

The U.S. Supreme Court's 1992 decision in Quill Corp. v. North Dakota, 504 U.S. 298, held that a mail-order company without physical presence in North Dakota could not be required to collect that state's use tax. Quill kept a "physical presence" safe harbor that had originated in National Bellas Hess v. Department of Revenue, 386 U.S. 753 (1967), based on stare decisis and reliance interests in sales-and-use-tax planning. Quill explicitly did not extend that physical-presence requirement to other taxes.

In Tennessee, J.C. Penney National Bank v. Johnson, 19 S.W.3d 831 (Tenn. Ct. App. 1999), had applied Quill's physical-presence requirement to franchise and excise taxes. Later Tennessee cases narrowed that holding: America Online, Inc. v. Johnson (2002) found nexus through in-state activities of third parties; Arco Bldg. Sys. v. Chumley, 209 S.W.3d 63 (Tenn. Ct. App. 2006), upheld tax based on third-party manufacturers carrying on activities in Tennessee; and Scholastic Book Clubs, Inc. v. Farr, 373 S.W.3d 558 (Tenn. Ct. App. 2012), declined Quill safe-harbor protection where the taxpayer relied on Tennessee schools and teachers.

Outside Tennessee, by 2015 the supreme courts of South Carolina (Geoffrey), West Virginia (MBNA), Massachusetts, North Carolina (A&F Trademark), and the Indiana Tax Court had all upheld income or franchise taxes against out-of-state taxpayers based on economic nexus alone. Justice Kennedy's 2015 concurrence in Direct Mktg. Ass'n v. Brohl had openly invited a challenge to Quill itself, foreshadowing the Court's eventual reversal in Wayfair.

Citations

• Tenn. Code Ann. § 67-4-2004 (definitions for franchise and excise taxes)
• Tenn. Code Ann. § 67-4-2007(a) (imposition of excise tax)
• Tenn. Code Ann. § 67-4-2105(a) (imposition of franchise tax)
• Tenn. Code Ann. § 67-4-2006(b)(1)(K) and (b)(2)(N) (intangible-expense add-back rules)
• Tenn. Code Ann. § 67-4-2012 (apportionment)
• Tenn. Code Ann. §§ 67-1-1801, et seq. (judicial review of tax determinations)
• U.S. Const. art. I, § 8, cl. 3 (Commerce Clause)
• Quill Corp. v. North Dakota, 504 U.S. 298 (1992)
• Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977)
• National Bellas Hess v. Department of Revenue, 386 U.S. 753 (1967)
• J.C. Penney National Bank v. Johnson, 19 S.W.3d 831 (Tenn. Ct. App. 1999)
• Arco Bldg. Sys. v. Chumley, 209 S.W.3d 63 (Tenn. Ct. App. 2006)
• Scholastic Book Clubs, Inc. v. Farr, 373 S.W.3d 558 (Tenn. Ct. App. 2012)
• Geoffrey, Inc. v. S.C. Tax Comm'n, 437 S.E.2d 13 (S.C. 1993)
• Tax Comm'r of W. Virginia v. MBNA Am. Bank, N.A., 640 S.E.2d 226 (W.V. 2006)
• Direct Mktg. Ass'n v. Brohl, 135 S. Ct. 1124 (2015) (Kennedy, J., concurring)
• Okla. Tax Comm'n v. Jefferson Lines, 514 U.S. 175 (1995)

Source

• Landing page: https://www.tn.gov/attorneygeneral/opinions.html
• Original PDF: https://www.tn.gov/content/dam/tn/attorneygeneral/documents/ops/2015/op15-37.pdf

Original opinion text

STATE OF TENNESSEE
OFFICE OF THE ATTORNEY GENERAL
April 22, 2015
Opinion No. 15-37
Application of the Revenue Modernization Act, S.B. 603, 109th Gen. Assem. (Tenn. 2015)

Question 1

Section 7 of Senate Bill 603, referred to as the Revenue Modernization Act, would impose the excise tax on any entities having "substantial nexus" in Tennessee, as that term would be defined by Section 5 of the bill. In light of J.C. Penney National Bank v. Johnson, 19 S.W.3d 831 (Tenn. Ct. App. 1999), is this provision constitutionally defensible?

Opinion 1

Yes. The bill's definition of "substantial nexus" is rooted in a widely-accepted theory of "economic nexus" that has attained significant currency through court decisions in many states.

Question 2

Section 8(i)(1)(C) of S.B. 603 provides that, for purposes of calculating the taxpayer's Tennessee receipts factor, sales of services are "in this state . . . if and to the extent the service is delivered to a location in this state." How will this rule be applied (i.e., where is the service "delivered") with regard to:

• services provided over the Internet?
• cloud computing services?
• cell phone services?
• data services?
• computer consulting services?
• engineering services?

Opinion 2

The general intent of Section 8 of S.B. 603 is to attribute sales, for purposes of calculating the taxpayer's Tennessee receipts factor, to Tennessee when Tennessee represents the location of the market for those sales. Section 8(i)(1)(C) would be construed within that framework. Because of the breadth of the types of services covered by this subsection, the Commissioner of Revenue would have considerable discretion to determine the manner of attribution through appropriate regulations.

Question 3

Under Section 8 of S.B. 603, are receipts derived from licensing intangibles (such as trademarks, trade names, etc.) used in connection with marketing tangible personal property attributed to the state where that tangible personal property is sold to the consumer or the state where the licensee is located?

Opinion 3

Under the terms of Section 8, receipts from the licensing of intangibles would not necessarily be attributed to either of the states identified in this question. Section 8 would attribute these receipts to the location of the purchaser of the tangible personal property in question.

Question 4

Section 8(i)(2) of S.B. 603 provides that "[i]f the state or states of assignment under subdivision (i)(1) cannot be determined, the state or states of assignment shall be reasonably approximated." How will this provision be administered and what will be the procedure for reviewing determinations made under this provision?

Opinion 4

As with all statutes establishing taxes administered by the Commissioner of Revenue, the Commissioner will possess the authority to determine when and how to invoke this provision, both through rulemaking and through the general functions necessary to administer the franchise and excise taxes. Those determinations will be subject to judicial review through challenges filed by taxpayers in chancery court under Tenn. Code Ann. §§ 67-1-1801, et seq.

Question 5

If Section 5 of S.B. 603 is adopted, is there any need for the excise tax provisions requiring intangible expenses to be added back to a taxpayer's taxable income or to not be deducted without the Commissioner's prior approval (Tenn. Code Ann. §§ 67-4-2006(b)(1)(K) and 67-4-2006(b)(2)(N)) and, if not repealed, would those provisions pose a risk of multiple taxation?

Opinion 5

The provisions in question are not necessarily duplicative, and current law forecloses any risk of multiple taxation should both provisions be enacted.

ANALYSIS

Question 1 — Economic Nexus

Section 5 of S.B. 603 would add the following definition of "substantial nexus in this state" to Tenn. Code Ann. § 67-4-2004, the definitional section for the franchise and excise tax statutes:

( ) "Substantial nexus in this state" means any direct or indirect connection of the taxpayer to this state such that the taxpayer can be required under the Constitution of the United States to remit the tax imposed under this part and part 21 of this chapter. Such connection includes, but is not limited to, the following:

(A) The taxpayer is organized or commercially domiciled in this state;
(B) The taxpayer owns or uses its capital in this state;
(C) The taxpayer has systematic and continuous business activity in this state that has produced gross receipts attributable to customers in this state;
(D) The taxpayer licenses intangible property for use by another party in this state and derives income from that use of intangible property in this state; or
(E) The taxpayer has bright-line presence in this state. A person has bright-line presence in this state for a tax period if any of the following applies:
(i) The taxpayer's total receipts in this state during the tax period, as determined under § 67-4-2012, exceed the lesser of five hundred thousand dollars ($500,000) or twenty-five percent (25%) of the taxpayer's total receipts everywhere during the tax period;
(ii) The average value of the taxpayer's real and tangible personal property owned or rented and used in this state during the tax period, as determined under § 67-4-2012, exceeds the lesser of fifty thousand dollars ($50,000) or twenty-five percent (25%) of the average value of all the taxpayer's total real and tangible personal property; or
(iii) The total amount paid in this state during the tax period by the taxpayer for compensation, determined under § 67-4-2012, exceeds the lesser of fifty thousand dollars ($50,000) or twenty-five percent (25%) of the total compensation paid by the taxpayer.

Section 7 of the bill would amend Tenn. Code Ann. § 67-4-2007(a) to read: "All persons, except those having not-for-profit status, doing business in this state and having substantial nexus in this state shall, without exception other than as provided in this part, pay to the commissioner, annually, an excise tax." (Emphasis added.)¹ The purpose of the addition of "substantial nexus" to Tenn. Code Ann. § 67-4-2007(a) is thus to explicitly bring within the scope of the excise tax any business entities engaging in the practices described in Section 5.

More broadly, "substantial nexus" is a concept rooted in the Commerce Clause of the United States Constitution. The Commerce Clause authorizes Congress to "regulate Commerce with foreign Nations, and among the several States," U.S. Const. art. I, § 8, cl. 3. The United States Supreme Court has long interpreted the Commerce Clause to have a negative implication that "prohibits discrimination against interstate commerce and bars state regulations that unduly burden interstate commerce." Quill Corp. v. North Dakota, 504 U.S. 298, 313 (1992). This negative implication is also known as the Dormant Commerce Clause. Under the Dormant Commerce Clause, courts "will sustain a tax against a Commerce Clause challenge so long as the '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." Id. at 311 (quoting Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279 (1977)). See also Arco Bldg. Sys. v. Chumley, 209 S.W.3d 63, 69 (Tenn. Ct. App. 2006) (perm. app. denied). "Substantial nexus" is thus the first-prong of a four-part test for determining whether a state may impose a tax under the Commerce Clause.

The United States Supreme Court's most recent interpretation and application of the substantial nexus requirement was in Quill, which addressed whether companies soliciting sales in a state in which they had no physical presence should be required to collect and remit sales and use taxes in those states. Though the Quill Court agreed that its more recent Commerce Clause rulings "signaled a 'retreat from the formalistic constrictions of a stringent physical presence test in favor of a more flexible substantive approach,'" 504 U.S. at 314, it nevertheless decided not to overturn a safe harbor from sales and use tax requirements established in National Bellas Hess v. Department of Revenue, 386 U.S. 753 (1967), because it found value in "a bright-line rule in the area of sales and use taxes," 504 U.S. at 316, and because Bellas Hess had "engendered substantial reliance" on the part of taxpayers. Id. at 317.

In J.C. Penney National Bank v. Johnson, 19 S.W.3d 831 (Tenn. Ct. App. 1999), the taxpayer challenged its liability for Tennessee's franchise and excise taxes on the grounds that its lack of physical presence in Tennessee failed to satisfy substantial nexus despite its conduct of a credit card business with Tennessee customers. Our Court of Appeals noted that, under Quill, "physical presence is required in order to satisfy the substantial nexus requirement of Complete Auto." Id. at 839. Finding that "[t]he only real issue" in the case was thus whether the case could be distinguished from Quill, the court found "no basis for concluding that the analysis should be different . . . for franchise and excise taxes," id., found the taxpayer to have no meaningful physical presence in Tennessee, id. at 840-42, and held that the taxpayer was not subject to tax in Tennessee.

Since J.C. Penney, our appellate courts have taken an increasingly broader view of nexus. In America Online, Inc. v. Johnson, 2002 WL 1751434 (Tenn. Ct. App. 2002), the Court of Appeals found that the taxpayer could be subject to taxation in Tennessee under Quill and Complete Auto because of "a substantial number of businesses operating in this state helping make the AOL service available to Tennessee customers," even though AOL itself had no offices, employees, or real property in the state. In Arco, the Court of Appeals upheld the imposition of sales and use taxes against an out-of-state taxpayer that sold buildings to Tennessee customers while contracting with third-party manufacturers to actually construct the buildings and deliver them to the Tennessee customers. The Arco Court relied on those manufacturers carrying on activities in Tennessee on Arco's behalf to establish a physical presence. And in Scholastic Book Clubs, Inc. v. Farr, 373 S.W.3d 558 (Tenn. Ct. App. 2012), the Court of Appeals declined to grant the Quill safe-harbor protection to the taxpayer because its connection to Tennessee was not limited to contact with customers through the mail or common carrier since it relied on Tennessee schools and teachers to facilitate sales to Tennessee customers. Taken together, these cases evince a broader understanding of substantial nexus, one that is not limited to a strict definition of physical presence but instead looks to "whether substantial business activities 'have been carried on in the taxing state on the taxpayers' behalf,'" Arco, 209 S.W.3d at 73, beyond the bright-line contours of the Quill safe harbor.

Around the country, a theory of "economic nexus" has developed in cases applying other states' equivalents of Tennessee's franchise and excise taxes to taxpayers without a physical presence in those taxing states. "Under an economic nexus theory, jurisdiction to tax exists if an out-of-state corporation avails itself of the benefits of the economic market of a state and without regard to that corporation's physical presence in the state." Walter Hellerstein, State Taxation ¶ 6.31 (3d ed. 2014). This approach has been followed in several states, including South Carolina (Geoffrey, Inc. v. S.C. Tax Comm'n, 437 S.E.2d 13), West Virginia (Tax Comm'r of W. Virginia v. MBNA Am. Bank, N.A., 640 S.E.2d 226), North Carolina (A&F Trademark, Inc. v. Tolson, 605 S.E.2d 187), Indiana (MBNA Am. Bank, N.A. v. Ind. Dep't of State Revenue, 895 N.E.2d 140), and Massachusetts (Capital One Bank v. Mass. Comm'r of Revenue, 899 N.E.2d 76). In relying on economic nexus principles, these courts have often expressly disregarded or rejected the reasoning of J.C. Penney, and have interpreted Quill to apply only to sales and use taxes.

Certain portions of S.B. 603's definition of "substantial nexus" would cover taxpayers that may have no physical presence within Tennessee and would come within the province of economic nexus. In the light of the foregoing authorities from both Tennessee and other states, any assertion that S.B. 603's definition of "substantial nexus" would fail to meet the substantial nexus prong of Complete Auto would appear to be a minority opinion. Certainly the contrary assertion—that the Commerce Clause permits Tennessee to tax companies falling within S.B. 603's definition of substantial nexus—is defensible under the United States Constitution.

Question 2 — Determination of Location of Delivery

Section 8(i)(1)(C) of S.B. 603 provides that, for purposes of calculating the taxpayer's Tennessee sales factor, sales of services are "in this state . . . if and to the extent the service is delivered to a location in this state." You have asked how this provision would be applied to several types of services. The categories of services identified (services provided over the Internet, cloud computing services, cell phone services, data services, computer consulting services, engineering services) are very broad, and the particular circumstances of each service provider within these categories might affect the location-of-delivery analysis. Additionally, because S.B. 603 has not yet been passed, the Department of Revenue has not yet had the opportunity to adopt rules and regulations that may be necessary to implement or administer § 8.

Without having the benefit of pertinent rules and regulations, this Office is unable to apply § 8 of S.B. 603 to a host of broadly-stated factual circumstances. Such an effort would run the risk of unduly interfering with the rulemaking authority vested in the Commissioner of Revenue.

Question 3 — Licenses of Intangibles

The next question is how receipts derived from licensing intangibles (such as trademarks, trade names, etc.) used in connection with marketing tangible personal property would be attributed under § 8 of S.B. 603. Subsection (i)(1)(D)(i) addresses the licensing of intangible property. That subsection provides that "intangible property utilized in marketing a good or service to a consumer is considered used in this state if that good or service is purchased by a consumer who is in this state." Section 8 of S.B. 603 would thus attribute receipts from the licensing of an intangible used in the marketing of tangible personal property to Tennessee if the purchaser of the good being sold is located in Tennessee.

Question 4 — Reasonable Approximation

Section 8(i)(2) of S.B. 603 provides that, "[i]f the state or states of assignment under subdivision (i)(1) cannot be determined, the state or states of assignment shall be reasonably approximated." You have asked how this provision will be administered and what procedures will be followed in reviewing determinations made under it.

Should § 8 of S.B. 603 be enacted it would become part of the excise tax law, the "supervision and collection" of which "is under the direction of the department of revenue." Tenn. Code Ann. § 67-4-2003(a). The Commissioner of Revenue "is vested with power to prescribe rules and regulations not inconsistent with law." Tenn. Code Ann. § 67-1-102(a). It is thus the Commissioner of Revenue who, as an initial matter, would be empowered to determine how best to construe and apply § 8(i)(2) if it were adopted.

The Commissioner's determination of when and how to invoke the "reasonable approximation" provision could result in either an assessment against the taxpayer of unpaid franchise and excise taxes or in the denial of a refund claim made by the taxpayer on the basis of a reasonable-approximation claim. Senate Bill 603 makes no provision for a specific review of these decisions, and so the general laws and procedures pertinent to the Department of Revenue would necessarily apply. Under those procedures, in the event of either an assessment or the denial of a refund claim, the taxpayer would have the opportunity to file suit in the appropriate chancery court under the procedures established by Tenn. Code Ann. §§ 67-1-1801, et seq. Under those procedures, the standard of review is de novo in the chancery court. Tenn. Code Ann. § 67-1-1802(c)(2). In proper judicial challenges to actions taken by the Commissioner, those courts will rely on basic canons of construction, the experience of states with similar statutes, and the appropriate deference accorded to the Commissioner's construction of statutes committed to his or her administrative care. See, e.g., Covington Pike Toyota, Inc. v. Cardwell, 829 S.W.2d 132, 134 (Tenn. 1992) (holding that "[i]n the absence of a clear showing that a rule is arbitrary or contrary to statute, a court should not substitute its judgment for the Commissioner's").

Because this bill has not yet become law, the Commissioner of Revenue has not adopted rules or regulations to administer it, and the courts of this State have had no opportunity to apply these provisions to real cases and controversies. Until such developments occur, it would be inappropriate for this Office to attempt to superintend the Commissioner's statutory responsibility to administer this law.

Question 5 — Relationship Between Economic Nexus and Intangible Expense Add-back

The last question is whether the adoption of S.B. 603's "economic nexus" provisions (discussed above under Question 1) would obviate the need for certain provisions in the excise tax statute that require a taxpayer to add back to net earnings or losses certain intangible expenses and that prohibit the deduction of certain intangible expenses without the prior approval of the Commissioner of Revenue. You have also asked whether there would be a risk of multiple taxation if both these provisions and the economic nexus provisions of S.B. 603 are given simultaneous effect.

Tennessee Code Annotated § 67-4-2006(b)(1)(K) provides that "[a]ny otherwise deductible intangible expense paid, accrued or incurred in connection with a transaction with one or more affiliates" be added back to a taxpayer's net earnings or losses. Tennessee Code Annotated § 67-4-2006(b)(2)(N)(i) provides that only an "intangible expense, or portion thereof, that is paid, accrued or incurred in connection with a transaction with one (1) or more affiliates" that "did not have as its principal purpose the avoidance of the tax levied" may be subtracted from net earnings and losses, and then only if the taxpayer applies for and the Commissioner of Revenue approves the deduction.

These provisions are specifically designed to thwart tax-avoidance gambits such as the one at issue in Geoffrey. Under these statutes, the parent of such an intangible holding company is required to add back to its net earnings any intangible expenses—if they were otherwise deductible—paid to the intangible holding company and is not permitted to deduct those expenses unless it demonstrates to the Commissioner of Revenue that the expenses were not merely an artifice designed to shield some of the parent's earnings from taxation in Tennessee. Based on the economic-nexus jurisprudence discussed in response to Question 1, it is possible that some of the provisions in the "substantial nexus" definition of § 5 of S.B. 603 would require an intangible-holding-company subsidiary to pay excise tax in Tennessee. In that event, the Geoffrey-style structure would not remove some of the parent's earnings from taxation in Tennessee but would simply shift them from the parent's return to that of the intangible-holding-company subsidiary with the latter paying excise tax on an apportioned share of those earnings.

In spite of the similar goals of S.B. 603's economic nexus provisions and Tenn. Code Ann. §§ 67-4-2006(b)(1)(K) and 67-4-2006(b)(2)(N) in some contexts, both still appear necessary to thwart certain tax-avoidance schemes. For example, a Geoffrey-style company would often have a smaller apportionment ratio than its affiliate that has a physical presence in Tennessee because its apportionment factors for property and payroll would be zero. Only if the royalty payment were especially high would its ratio outstrip that of its affiliate physically present in Tennessee.

But as the request indicates, applying both economic nexus to tax an intangible holding company and the intangible expense add-back provisions to require a physically-present affiliate to add its royalty payments back to net earnings would result in both companies paying excise tax on the Tennessee portion of the same net earnings. This could implicate the issue of multiple taxation of those earnings. Like the substantial nexus requirement, the multiple taxation doctrine is an outgrowth of the United States Supreme Court's interpretation of the limitations imposed by the dormant Commerce Clause upon the taxing power of the states. Arising originally in Western Live Stock v. Bureau of Revenue, 303 U.S. 250 (1938), the doctrine of multiple taxation is implicated "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." Okla. Tax Comm'n v. Jefferson Lines, 514 U.S. 175, 184-85 (1995). This is similar to the second prong of Complete Auto requiring "fair apportionment," the "central purpose" of which "is to ensure that each State taxes only its fair share of an interstate transaction." Goldberg v. Sweet, 488 U.S. 252, 260-61 (1989). The interaction of S.B. 603's economic nexus provisions and the already-enacted intangible-expense add-back requirements would thus pose constitutional difficulties if it resulted in any unfair apportionment of earnings to Tennessee.

However, this potential problem is already addressed by existing law. Tennessee Code Annotated § 67-4-2006(b)(2)(N)(i) provides that the Commissioner of Revenue shall approve any application for the deduction of any intangible expense, or portion thereof, that is . . . (c) Paid, accrued, or incurred to an affiliate doing business in, or deriving income from, a state that imposes a tax on or measured by net income and, under that state's laws, the affiliate is subject to an income tax in that state.

Under this provision, an intangible holding company subject to taxation in Tennessee through economic nexus would qualify as a "an affiliate doing business in . . . a state that imposes a tax on or measured by net income," with that state being Tennessee. The royalty-paying taxpayer would thus have the right to have its intangible expense deducted to the extent provided in Tenn. Code Ann. § 67-4-2006(b)(2)(N)(i)(c). This provision would head off any concern that imposing tax on an intangible holding company while also adding that company's royalty receipts back to the net earnings of the affiliate payer of the royalties would result in an unfair apportionment of earnings or in multiple taxation.

HERBERT H. SLATERY III
Attorney General and Reporter

ANDRÉE SOPHIA BLUMSTEIN
Solicitor General

BRAD H. BUCHANAN
Senior Counsel

Requested by:
The Honorable Randy McNally
State Senator
307 War Memorial Bldg.
Nashville, TN 37243

¹ The emphasized language replaces the word "Tennessee." Section 10 of S.B. 603 would make a similar change to the tax-imposing section of the franchise tax statute, Tenn. Code Ann. § 67-4-2105(a). Sections 2 and 4 as well as section 16 of the bill would also add the "substantial nexus" concept to the operation of the business and sales and use taxes, respectively, but those provisions are not implicated by this request.