On December 29, 2004, the U.S. Bankruptcy Court for the District of Delaware issued a memorandum opinion wherein the Massachusetts Department of Revenue (“MDOR”) claim, as an unsecured creditor for unpaid sales and use tax, was denied by the Court.

The MDOR laid claim to sales and use taxes against Valley Media, Inc. (“Valley”), by virtue of Valley’s drop shipment of goods to Massachusetts customers.

As a wholesale distributor of music and video products (“Products”) in California, Valley conducted business (in part) through various internet retailers (“IRs”).  Massachusetts consumers visited the websites of the IRs, where they purchased Products.  The IRs then purchased the Products from Valley.  For ease of the delivery process, IRs instructed Valley to ship the Products (via common courier) directly to Massachusetts consumers with IRs’ customized invoices enclosed in the shipments.  The IRs paid Valley for the cost of the Products, as well as shipping and handling costs incurred by Valley.  All shipments were made Freight on Board (“FOB”) Valley’s shipping facility in California.

Valley disputed MDOR’s claim that it was responsible for collecting and remitting sales and/or use taxes of the drop-shipped Products by contending that that it did not deliver the Products or make “sales at retail” to consumers in Massachusetts.

Massachusetts General Laws covering sales tax states that an excise is imposed upon sales at retail in the commonwealth, by any vendor, of tangible personal property or of services performed in the commonwealth at the rate of five percent of the gross receipts of the vendor from all such sales of such property or services (with certain exceptions provided).  The law amplifies a “sale at retail” as a sale of services or tangible personal property or both for any purpose other than resale in the regular course of business.  The law further provides [in part] that the “delivery” in the commonwealth of tangible personal property is a retail sale in the commonwealth by the person making the delivery.

Valley maintains that it never made a “sale at retail” because it did not “deliver” tangible personal property in Massachusetts.  The order agreements between Valley and IRs clearly held that title and risk of loss with respect to all shipments will pass to the IRs upon delivery of the Products to the common carrier at the point of shipment in California.  Thus, the Bankruptcy Court viewed Valley’s transactions with the IRs and Massachusetts consumers as equivalent to a conventional sale to the IRs, followed by a resale to a consumer in Massachusetts (with delivery into Massachusetts) by the IRs.  The Court, after looking at commercial legal principles outside the “sales and use tax” regime (such as the Uniform Commercial Code and title passage rules), essentially concluded that because Valley did not “deliver” goods in Massachusetts, it did not make a “sale at retail” within Massachusetts.

As an alternative to the sales tax claim, the MDOR asserted that Valley was subject to a use tax obligation because it made sales of tangible personal property or services for storage, use, or other consumption in the commonwealth of Massachusetts.  For the same reasons noted above the Court concluded that Valley was not responsible for collecting use taxes on behalf of Massachusetts because Valley’s drop shipment arrangement was not equivalent to Valley making sales to consumers in Massachusetts.

The Court also concluded (in dicta) that MDOR was pursuing its claim against Valley because Supreme Court precedent (i.e., Quill Corp. v. North Dakota, 504 U.S. 298 (1992), prevented it from levying taxes against the IRs directly (likely because of insignificant or nonexistent connections between the IRs and Massachusetts).

This case alerts retailers of the importance of understanding its applicable legal relationships and chain of supply with its vendors and customers, and how the underlying legalities of such relationships may make the difference between a taxable event versus a non-taxable event.