Tennessee Court Rules that AOL Does Not Have Nexus in the State

In a decision that is possibly the first court-level opinion to address nexus with regard to Internet service providers, the Tennessee Chancery Court for Davidson County struck down a $9.6 million audit assessment against America Online (AOL) (America Online, Inc. v. Johnson, No. 97-3786-III (Mar. 13, 2001)). In response to a summary judgment motion, the court ruled that the assessment of sales and use, franchise and excise, and business taxes against AOL violated the Commerce Clause of the U.S. Constitution, because AOL did not have substantial nexus with Tennessee. The court specifically held that physical presence is necessary to satisfy constitutional nexus standards for all tax types, not just sales and use taxes.

The court's ruling relied heavily on J.C. Penney National Bank v. Johnson, 19 SW3d 831 (1999), in which the Tennessee Court of Appeals held that an out-of-state bank with no physical presence in Tennessee could not be subject to the financial institution franchise/excise tax merely because it had customers with credit cards in the state or affiliates with a presence in the state. However, the court's decision in AOL goes even further than J.C. Penney, holding definitively that physical presence is the standard for substantial nexus for all taxes (not just sales and use). Further, while J.C. Penney was significant because it rejected Tennessee's financial institution economic-nexus statute, AOL could have even broader implications, because it rejects the application of economic nexus for purposes of the state's franchise/excise (i.e., general corporate income) tax.

In AOL, the court found that none of six categories of activities offered by the state as evidence that AOL had nexus in Tennessee satisfied constitutional nexus standards. The activities were as follows:

1. AOL entered into contracts with Tennessee residents;

2. AOL's services originated or were received by customers in Tennessee;

3. AOL distributed free promotional items in Tennessee;

4. AOL owned the software loaded on its customers' computers;

5. AOL's customers could access local numbers in Tennessee; and

6. AOL leased equipment to a subsidiary in Tennessee.

The court dismissed four of the categories, noting that physical presence is not established by entering contracts, providing services, owning intangible software or providing access to local telephone numbers in a state.

Moreover, the court ruled that the presence of the tangible promotional items and leased property in Tennessee was not sufficient to establish nexus. For the promotional material (e.g., free diskettes entitling recipients to 100 free hours of AOL use), the court held that the disks sent to Tennessee by AOL were analogous to the presence of credit cards in the state, which were found to be insufficient to establish nexus in J.C. Penney. While this conclusion is certainly favorable to the taxpayer, the court failed to explain how the promotional materials were analogous to credit cards, noting only that the materials were "constitutionally insignificant," nor did the court attempt to reconcile its conclusion with the Supreme Court's statement in Quill Corp. v. North Dakota, 504 US 298 (1992), that a few floppy disks were insufficient to establish substantial nexus. It appears from the case's facts that the volume of promotional material sent into Tennessee by AOL far exceeded the number of floppy disks at issue in Quill.

The court also ruled that the presence of leased modems in the state was insufficient to establish nexus. The facts in the decision are very unclear in regard to the modems. It appears that AOL leased the modems from a third party and then subleased them to a subsidiary and others. The court noted that the Tennessee subsidiary used some of the modems, but that the subsidiary had no place of business in Tennessee. In finding that the modems did not establish nexus, the court analyzed the facts against Scripto v. Carson, 362 US 207 (1960). The court specifically noted that, even though the modems' presence may have helped AOL maintain a market in Tennessee "to some degree," it "did not substantially contribute" to AOL's ability to maintain a market in Tennessee or help in any way to establish a market for AOL in Tennessee. While the court's reading of Scripto is both well-reasoned and favorable to taxpayers, the court seems to have overlooked the fact that, even if the Supreme Court's attributional nexus standard is not met, AOL may indirectly own tangible personal property (modems) located in the state, which could arguably satisfy nexus based on physical presence.

Interestingly, the court that issued this decision (Davidson County Chancery Court) was the same court that ruled against J.C. Penney National Bank at the trial level (which was reversed later by the Tennessee Court of Appeals).

From Scott D. Smith, J.D., LL.M., Washington, DC