Massachusetts whips up new sales tax obligation for internet vendors that use cookies

Last updated, 7.3.17: Massachusetts was facing litigation over Directive 17-1. On June 28, before the directive took effect July 1, the department issued Directive 17-2: Revocation of DD 17-1 in Anticipation of a Proposed Regulation. Directive 17-1: Requirement that Out-of-State Internet Vendors with Significant Massachusetts Sales Must Collect Sales or Use Tax is revoked.

Massachusetts may have devised a creative way to tax sales by out-of-state retailers. Under a new tax directive, out-of-state internet retailers that lack a traditional physical presence in Massachusetts, but that use software or internet “cookies” to foster a certain amount of sales there, may soon be required to collect sales and use tax in the Bay State.

The recently released Department of Revenue Directive 17-1, “Requirement that Out-of-State Internet Vendors with Significant Massachusetts Sales Must Collect Sales or Use Tax,” maintains that internet vendors are different from mail order vendors. To fully understand why that distinction is important, it’s necessary to understand a landmark Supreme Court decision that predates internet commerce: Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

In Quill, the Supreme Court found that the state could not compel an out-of-state mail order company to collect and remit tax on its North Dakota sales because it did not have nexus — a connection substantial enough to trigger a tax obligation — with North Dakota. Upholding a previous ruling, Quill determined that the connection between the business and the state has to be physical in nature, and that using a common carrier to mail catalogs and ship goods to consumers does not create nexus.

Quill has been the gold standard for sales and use tax policy since 1992. However, the explosive growth of internet sales, many of which are untaxed because the vendor lacks nexus, has greatly reduced sales and use tax revenue from California to New York. In response to this decline, numerous states have adopted affiliate, click-through, or economic nexus policies, whereby nexus is created through relationships with in-state affiliates, financial gain from in-state website referrals, or simply having a certain amount of economic activity in the state.

Some of these policies directly challenge the physical presence precedent upheld in Quill. And indeed, the more time passes without an overarching solution to the perennial problem of remote sales tax, the more states push to overturn the decades’ old ruling. For example, Alabama, South Dakota, and Tennessee are all embroiled in litigation over their remote sales and use tax policies, and all hope for the opportunity to argue their case before the Supreme Court of the United States.

Alternatively, Congress could grant states the authority to tax remote sales. In fact, the Quill ruling asserts that “Congress may be better qualified to resolve … [and] has the ultimate power to resolve” the underlying issue. Three bills that could enable states to tax certain remote sales are gathering dust in the House, as is a measure that would codify Quill.

The Massachusetts Directive maintains that the “business and activities of Internet vendors are factually distinguishable from the business and activities of mail order vendors.” It further maintains that the physical presence precedent set by Quill should not be universally applied, but instead should be determined on a “case by case basis.”

According to the Directive, an internet vendor “purposefully avail[s] itself of the benefits of the state’s economic market” when it engages in “continuous and widespread solicitation of business” in a state. To support this claim, it points to a 2015 Supreme Court decision (Direct Marketing Association v. Brohl), wherein Justice Kennedy wrote in a concurring opinion, “Today buyers have almost instant access to most retailers via cell phones, tablets, and laptops. As a result, a business may be present in a State in a meaningful way without that presence being physical in the traditional sense of the term.”

One way online sellers reach potential customers is by putting temporary or permanent text data files, or “cookies,” on their devices. The Directive explains:

“Large Internet vendors store cookies on their customers’ computers and communication devices when the customers visit the vendor’s website. … Cookies facilitate sales by customizing the shopping experience and allowing each customer to readily log into his or her account, store items in a shopping cart, etc. Cookies also enable a vendor to track their customers’ behavior over time and to deliver ads that are specific to each customer. Vendors own the proprietary cookies that they place on their customers’ computers and devices. As in the case of in-state vendor software, the ownership and use of these in-state cookies results in in-state business activity by such vendor that distinguishes such vendors from the mail order vendors that were evaluated by Quill.”

While it is common practice for states to consider software to be tangible personal property and therefore taxable, Massachusetts could be the first state to claim that cookies can establish nexus. The amount of legal references contained in the Directive suggests that Massachusetts anticipates its new policy will be challenged — as, indeed, it is likely to be.

Beginning July 1, 2017, the business and activities described in the Directive will create nexus for remote internet retailers in Massachusetts when both of the following conditions are true:

• The internet vendor made more than $500,000 in Massachusetts sales during the preceding 12 months
• The internet vendor made sales for delivery into Massachusetts in 100 or more transactions

The Massachusetts Department of Revenue will not seek back taxes from affected internet sellers that comply with the new Directive.

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