Tax Foundation - Commentary

• Why the Quill Physical Presence Rule Shouldn't Go the Way of Personal Jurisdiction
  

  (The following article originally appeared in the November 5, 2007 edition of State Tax Notes).

  I. Introduction

  If a Delaware company sells its products to customers in West Virginia, which state has the power to tax the transaction? Should it matter if the company has no employees or buildings in West Virginia? If the company sells products in all 50 states, should all 50 be able to impose their taxes on the company?

  In 2006, Americans spent $108.7 billion in online retail transactions, a 23 percent increase from the year before and 2.8 percent of total sales. Although that proportion is still small, it is growing quickly, and the increasing role of the Internet is challenging traditional legal concepts. As the world becomes less concerned with geographic boundaries, legal concepts premised on geographic lines -- such as personal jurisdiction and state taxes -- have grown more strained.

  Personal jurisdiction -- the place where a defendant can be sued -- was once dominated by a physical presence rule. A state's ruling against a defendant could not be enforced unless he (or his property) was present in the state, because no state could reach beyond its territory. But in its landmark decision in International Shoe,1 the U.S. Supreme Court abandoned the physical presence rule and adopted a defendant-specific multifactor fairness inquiry, focusing on "the defendant's past conduct . . . , such as employing forum residents, renting forum property, and shipping products to the forum."2 If there are "minimum contacts," and it does not "offend 'traditional notions of fair play and substantial justice,'" the nonpresent defendant can be sued.

  In the 62 years since, the Court has tried in a series of cases to revise and restate those factors to reduce the unpredictability and confusion its rulings have caused. Nevertheless, its rulings have been described as "erratic,"3 a "doctrinal muddle,"4"inconsistent,"5 and "a mess."6

  Perhaps cognizant of that mess, the Court has stuck to a physical presence rule (the Quill rule) for determining when an out-of-state retailer can be compelled to pay taxes to a state or collect use taxes on purchases. But as states increasingly seek to tax nonresidents, especially for Internet transactions, "states are pushing for judicial adoption of economic nexus. Supported by some academics, economic nexus is a defendant-specific multifactor fairness inquiry much like that in International Shoe.

  The attacks against physical presence nexus are a mistake. Embracing economic nexus would repeat the personal jurisdiction mess and destroy reliance interests and legal certainty. Overruling the Quill rule would usher in decades of confusion, running the risk of damaging the national economy. The Supreme Court has preferred to leave resolution of that issue to Congress, but congressional inactivity and state overreaching may make judicial action necessary.

  Part II describes the confusion in personal jurisdiction from 1945 to the present. Part III explains the Quill physical presence rule in state taxation, and looks at academic and state criticism of that rule. Part IV argues that preserving the Quill rule is beneficial because it does not inflict damaging uncertainty on businesses, consumers, and those who give legal advice.

  
  II. The Mess of Personal Jurisdiction

  
  On Ninth Street in Columbia, Mo., a town of 96,000 (including 33,000 students) and home of the annual Ragtime and Jazz Festival, Richard King opened a small cabaret club, The Blue Note, in 1980. By 1996 business was good and King decided to set up a Web site for the club. Shortly thereafter, he learned that the Bensusan Restaurant Co. of Manhattan had filed a lawsuit against him, in New York federal court, for violating its "The Blue Note" trademark registered in 1985. King's only contact with New York was that his Web site could be accessed from that state.7

  Courts have long been sympathetic to people like King, who face the expense and worry of defending (often meritless) lawsuits in a faraway place. The U.S. Constitution's due process clause has been held to protect such individuals "against the burdens of litigating in a distant or inconvenient forum" by ensuring that states do not "reach out beyond the limits imposed on them . . . in a federal system."8 That principle -- that it is unfair to be sued in a state where one has virtually no connections -- is generally undisputed. The problem arises in drawing the line separating "virtually no connections" from "sufficient minimum contacts."

  The historical line was physical presence. Looking at the due process clause, the Court explained that "proceedings in a court of justice to determine the personal rights and obligations of parties over whom that court has no jurisdiction do not constitute due process of law."9 Unless a defendant appeared in person, enforcing a judgment against him was considered so unfair that it violated the U.S. Constitution. If there was such a judgment, other states could refuse to enforce it as an abuse of power. At the dawn of the 20th century, scholar Thomas M. Cooley summarized the rule in his Constitutional Limitations (1903): "No state has authority to invade the jurisdiction of another, and by service of process compel parties there resident or being to submit their controversies to the determination of its courts."

  The physical presence rule in personal jurisdiction encountered difficulties regarding property, motorists, and corporations. States could seize (attach) the in-state property of an out-of-state defendant pending the outcome of the case, provided the state gave notice to the owner. While those "in rem" actions (as well as divorce actions, which were treated similarly) were within the confines of the physical presence rule, it allowed states to reach defendants who lived outside the state. Courts also developed the concept of implied consent to allow states to reach outside their borders to prosecute nonresident motorists who inflicted damages or injury within the state. By driving on the state's roads, a motorist was held to have automatically consented to jurisdiction over any lawsuits that might arise from the driving, although he had to receive notice of the lawsuit.10

  The physical presence rule was stretched the most in suits involving corporate defendants, because corporations are a legal fiction and their physical existence is intangible. Some states required that corporations appoint an agent to receive service of process, and if a corporation was "present" without such an appointment, a state official was designated to receive service of process on its behalf. Determining presence became the critical question. "Under both the presence theory and the implied consent theory, the first question to be asked was whether the corporation was 'doing business' within the state. . . . '[D]oing business' gradually came to be a test in and of itself."11

  In 1945 in International Shoe, the Court abandoned the physical presence rule in favor of a defendant-specific multifactor fairness inquiry. The inquiry focuses "primarily on the defendant's past conduct . . . , such as employing forum residents, renting forum property, and shipping products to the forum" (emphasis added). If there are sufficient "minimum contacts" and "the suit does not offend 'traditional notions of fair play and substantial justice,'" the nonpresent defendant can be sued. Although that was clearly an attempt to fix the law, by unmooring personal jurisdiction from physical presence, "the Court has been unable to develop a coherent doctrine."12

  The doctrinal twists in a few cases depict that incoherence. In McGee v. Int'l Life Ins. Co.,13 the Court held that a Texas insurance company's one policy with a Californian constituted sufficient minimum contact with the state: "Residents would be at a severe disadvantage if they were forced to follow the insurance company to a distant State in order to hold it legally accountable." The Court dismissed concerns that the defendant would be forced to defend a suit in a distant forum. Prof. Kevin C. McMunigal described McGee as giving "equal attention to prospective factors never mentioned in International Shoe, including the forum's interest in regulating the defendant's conduct, the plaintiffs' inconvenience in using an alternate forum, and the likely location of witnesses."14 More broadly, "the Court has regularly added new factors in a process of gradual accumulation, each addition aggravating the test's ambiguity and complexity. . . . [ McGee ] foreshadowed two persistent problems in minimum contacts doctrine: the unexplained addition of new factors and the inconsistent shifting of t