As published in Leading Internet Case Law, Volume 18, Issue 4, pp 3-7 (August 2018)

STATE TAX

Sylvia Dion Founder and Managing Member [email protected] PrietoDion Consulting Partners LLC, Massachusetts US Supreme Court overturns physical presence standard South Dakota v. Wayfair, Inc.1, US Supreme Court, judgment of 21 June 2018

On 21 June 2018, the Supreme Court of the US issued its highly anticipated decision in a case that has been referred to as the US state tax case of the millennium. At issue in this landmark case was a law enacted in 2016 by the State of South Dakota, which imposed sales tax registration, collection and remittance obligations on out-of-state retailers with no physical presence in South Dakota. By overturning the ‘physical presence’ requirement, the Supreme Court was in fact overturning a 51-year-old standard - which dramatically changed the state tax landscape in the US.

In 1992, 26 years prior to South Dakota v. Concurrent powers are shared by federal sale of tangible personal property, any Wayfair, Inc. (‘Wayfair’), the US Supreme and state governments, and include the product transferred electronically or Court afrmed in Quill Corp. v. North powers to tax and to maintain courts. services delivered into South Dakota; Dakota2 (‘Quill’) that states could not Finally, certain powers are not specifically or sold tangible personal property, any impose their sales tax obligations on delegated in the US Constitution, but product transferred electronically or out-of-state businesses that lacked a are understood to be necessary or services for delivery into South Dakota ‘physical presence’ in their state. In Quill, permitted to be employed by the Federal in 200 or more separate transactions7. the Supreme Court was asked Government, such as the ‘necessary and to reconsider its 1967 decision in proper clause’ of the US Constitution4. By enacting a law imposing sales tax National Bellas Hess v. Department This brief overview is important, as the obligations absent any physical presence, of Revenue of Illinois3 (‘Bellas Hess’), state’s ‘authority to tax’ and the Federal the South Dakota law clearly violated a decision that similarly held that Government’s enumerated authority Quill. Also notable were the numerous a physical presence was required ‘to regulate commerce with foreign justifications cited in SB 2016 for enacting before sales tax obligations could be nations, and among the several states, an economic nexus law, and anticipating imposed on out-of-state retailers. and with the Indian tribes5’ under the a legal challenge, language addressing of the US Constitution judicial concepts and procedures should The US system of are significant themes in the Wayfair a legal challenge be presented8. Prior to commencing discussion of the opinion, as is discussed further below. Wayfair decision, it is important briefly South Dakota’s economic nexus law to review the US governmental system South Dakota’s economic nexus law invites a legal challenge of federalism, which is a system of At issue in the Wayfair case was a law While one might question why a state government in which power is divided enacted on 22 March 20166 by the would enact legislation that clearly between a national (federal) government State of South Dakota - SB 106 - which violated Quill, the intent of South and various state governments. Under imposes sales tax collection, reporting Dakota’s economic nexus was also to the US federalist system, the US and remittance duties on out-of-state invite a legal challenge. In addition to Constitution gives certain powers to the (‘remote’) retailers whose South Dakota citing its justifications for enacting a Federal Government, other powers to activity meets certain economic law that clearly violated Quill, SB 106 the state governments, and yet others to thresholds. The South Dakota law specifically referenced Supreme Court both. A distinctive feature of federalism is requires certain remote sellers that sell Justice Kennedy’s concurring opinion in a relationship of parity between the two tangible personal property, products Direct Marketing Association v. Brohl9, levels of government in which there is a transferred electronically or services for in which he expressed his strong view division of powers between two levels of delivery into South Dakota, and that meet that the time had come to reconsider equal status. The US Constitution grants one of two economic thresholds in either Quill, urging that the Supreme Court certain enumerated powers solely to the previous or current calendar year, of the United States should reconsider the Federal Government, such as the to collect and remit South Dakota sales its doctrine that prevents states from powers to declare war, enter into treaties tax as if they had a physical presence requiring remote sellers to collect and regulate interstate and international in the state. Remote retailers subject to sales tax, and as the foregoing findings trade. Certain other powers are reserved South Dakota’s collection and remittance make clear, this argument has grown for the individual state governments. duties are those that, during the previous stronger, and the cause more urgent, These ‘’ include the or current calendar year: had more than with time.” Thus, incorporated into the power to establish local governments. $100,000 in gross revenue from the law were several ‘fast-track’ provisions

A Cecile Park Media Publication | August 2018 3 As published in Leading Internet Case Law, Volume 18, Issue 4, pp 3-7 (August 2018)

STATE TAX

In Wayfair, the Supreme Court noted the ‘physical presence’ rule that “has long been criticized as giving out-of-state sellers an advantage” becomes “further removed from economic reality” each year.

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permitting South Dakota to bring a application of the Commerce Clause14.” passing legislation that discriminates declaratory judgment action in a circuit A motion for summary judgment was against or excessively burdens interstate court against any person it believed granted to the retailers and, under the commerce. The US Supreme Court has met the ‘economic nexus’ criteria, and ‘fast-track provisions’ in the law, the State “long held that in some instances it directions to the circuit court to act on appealed directly to the South Dakota imposes limitations on the States absent the declaratory judgment ‘expeditiously’ Supreme Court. congressional action.” In Wayfair, and to presume that the matter could the Supreme Court considered this be resolved through a motion to dismiss Despite South Dakota’s persuasive limitation on state taxation, noting or a motion for summary judgment10. arguments that the US Supreme Court two key principles: (1) a state may not SB 106 also provided that the filing of a should reconsider Bellas Hess and Quill discriminate against interstate commerce; declaratory judgment action by the State because changes in circumstances and and (2) a state may not impose undue would operate as an injunction while technology had made these decisions burdens on interstate commerce. a case was pending, thus prohibiting the outdated, the South Dakota Supreme state from enforcing the sales tax Court afrmed the 6th Circuit Court’s The Wayfair decision reviewed the remittance obligations against any decision, stating that “[h]owever Commerce Clause principles and their taxpayer who did not comply11. Another persuasive the State’s arguments on the application to state taxes. In a 1977 provision in SB 106 would also allow any merits of revisiting the issue, Quill has landmark case involving a Missouri appeal to go directly to the South not been overruled [and] remains the transaction privilege tax, the US Supreme Dakota Supreme Court12. controlling precedent on the issue of Court provided standards for applying Commerce Clause limitations on the commerce clause to state taxes. In Legal actions commence interstate collection of sales and use its analysis in Complete Auto Transit, Prior to the 1 May 2016 efective date for taxes15.” South Dakota then appealed to Inc. v. Brady17 (‘Complete Auto Transit’), its economic nexus law, South Dakota the US Supreme Court, which granted the Supreme Court presented a four- filed a suit in the Sixth Circuit Court of certiorari on 23 January 2018. Oral prong test that requires that: (1) there South Dakota seeking a declaratory arguments were presented before must be a substantial nexus between the judgment against several large remote the US Supreme Court on 17 April 2018. taxpayer and the state; (2) the tax must online retailers: Wayfair LLC, Newegg be fairly apportioned; (3) the tax must not Inc. and Overstock.com Inc13. The South The discriminate against interstate commerce; Dakota Department of Revenue (‘the As discussed above, under the US and (4) the tax must be fairly related to Department’) had sent notices to these federalist system, the US Constitution the services provided by the state. retailers informing them of their grants certain enumerated powers requirement to register by 25 April 2016, to the Federal Government. The Ten years prior to Complete Auto Transit, based simply on the State’s assumption Commerce Clause of the Constitution the Supreme Court found, in National that they met the economic nexus sales afrmatively grants Congress the power Bellas Hess, that the State of Illinois and transaction requirements. The ‘to regulate commerce with foreign lacked the power under the due process retailers filed a motion for summary nations, and among the several states16.’ clause and commerce clause to require judgment, admitting that they each met Historically, the Commerce Clause a retailer to collect sales tax unless the SB 106’s economic nexus threshold but has been viewed as both a grant of retailer maintained a physical presence raising the afrmative defence that the congressional authority and a restriction in the state. In 1992, the Supreme Court South Dakota economic nexus law was on states’ regulatory authority. Thus, the considered the physical presence unconstitutional under Quill. The Sixth Supreme Court has consistently held that standard again, in Quill. It overruled the Circuit Court agreed, holding that SB 106 the Commerce Clause contains holding, however, “fails as a matter of law to satisfy the a further, negative command, known as and applying the doctrine of stare physical presence requirement that the ‘dormant’ Commerce Clause, which decisis, reafrmed the physical presence remains applicable to state sales and refers to the prohibition, implicit in the requirement as it applied to sales tax use taxes under Quill and its Commerce Clause, against states under the commerce clause. While Quill

4 LEADING INTERNET CASE LAW As published in Leading Internet Case Law, Volume 18, Issue 4, pp 3-7 (August 2018)

acknowledged that intervening cases “it is an inescapable fact of modern “produces an incentive to avoid physical such as Complete Auto Transit might commercial life that a substantial amount presence in multiple States, afecting dictate a diferent result if the issue of business is transacted [with no] need development that might be efcient or were being considered for the first for physical presence within a State in desirable20.” Furthermore, by “giving time, adhering to the physical presence which business is conducted.” The Court some online retailers an arbitrary requirement was necessary to prevent noted that although the Quill majority advantage over their competitors who undue burdens on interstate commerce. expressed concern that without the collect state sales taxes, Quill’s physical ‘physical presence’ rule “a state tax might presence rule has limited States’ Findings in Wayfair admit Quill decision unduly burden interstate commerce ability to seek long-term prosperity was flawed; physical presence is by subjecting retailers to tax collection and has prevented market participants not the correct interpretation of the obligations in thousands of diferent from competing on an even playing Commerce Clause taxing jurisdictions18,” the administrative field21.” The Supreme Court rejected In Wayfair, the Supreme Court noted costs of compliance, especially in the the ‘physical presence’ rule to “ensure the ‘physical presence’ rule that “has modern economy with its internet that artificial competitive advantages long been criticized as giving out-of- technology, are largely unrelated to are not created by this Court.” state sellers an advantage” becomes whether a company happens to have a “further removed from economic reality” physical presence in a state. For instance, The ‘physical presence’ rule arbitrarily each year. The Supreme Court held a small company with a single employee treats identical actors diferently that the ‘physical presence’ rule is an in every state would meet each state’s To emphasise the arbitrary treatment “incorrect interpretation of the Commerce physical presence nexus and be created by the ‘physical presence’ rule, Clause,” both as first formulated by significantly burdened with compliance the Supreme Court in Wayfair presented the Bellas Hess and Quill courts as costs. Yet, a large business with 500 a scenario in which a remote business well as it is applied today. Calling Quill employees located in one single state stocks a few items of inventory in a small flawed on its own terms, the Supreme and a webstore accessible by customers warehouse in South Dakota. Just across Court in Wayfair provided three key throughout the country might bear the border, in North Dakota, a second points supporting its position: significantly lesser compliance costs. business stores inventory in a major Despite acknowledging that due process warehouse and maintains a sophisticated 1. the ‘physical presence’ rule is not and Commerce Clause standards website with a virtual showroom a necessary interpretation of the may not be identical, Wayfair states accessible in every state. By reason of ‘substantial nexus’ requirement; that the reasons for rejecting physical physical presence, the business whose 2. Quill creates, rather than resolves, presence for due process purposes South Dakota presence is limited to market distortions; and apply as well to whether physical the few items of inventory stored in 3. Quill imposes the sort of arbitrary, presence is a requisite for an out-of-state the state must collect South Dakota formalistic distinction that the seller’s liability to remit sales taxes. sales tax on all orders shipped to South Court’s modern commerce Dakota customers. However, the second clause precedents disavow. The physical presence rule creates business, lacking any physical presence market distortions in South Dakota, cannot be subject Substantial nexus can be achieved The Supreme Court reasoned that to the same tax for the sales of the without a physical presence Quill places businesses with an in-state same items made through a pervasive The Supreme Court in Wayfair reasoned presence at a competitive disadvantage internet presence. This distinction simply that physical presence is a “poor relative to remote sellers. Calling makes no sense. The Supreme Court proxy” for measuring a company’s Quill a “judicially created tax shelter in Quill itself acknowledged that the compliance burden when doing business for businesses that limit their physical ‘physical presence’ rule is “artificial at its in multiple states. Although physical presence in a State but sell their goods edges22.” That was an understatement presence can frequently enhance a and services to the State’s consumers19,” when Quill was decided; and when the business’s connection with a state, the Supreme Court added that Quill day-to-day functions of marketing and

A Cecile Park Media Publication | August 2018 5 As published in Leading Internet Case Law, Volume 18, Issue 4, pp 3-7 (August 2018)

STATE TAX

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distribution in the modern economy are doctrine of “stare decisis can no longer Majority opinion considered, it is all the more evident that support the Court’s prohibition of a In an opinion written by Justice Anthony the ‘physical presence’ rule is artificial in valid exercise of the States’ sovereign Kennedy, who was joined by four other its entirety. Modern e-commerce does power27.” Recognising that reliance on justices - Thomas, Ginsburg, Alito and not align analytically with a test that stare decisis is a legitimate consideration Gorsuch - the Supreme Court held relies on the sort of physical presence when determining whether to follow that because the ‘physical presence’ defined in Quill. Thus, the Wayfair court an earlier case, the Supreme Court rule of Quill is unsound and incorrect, questioned why, if a single employee concluded that, in this case, Quill’s Quill and National Bellas Hess were or warehouse can create substantial physical presence standard is “no longer overruled. The South Dakota Supreme nexus, aspects of “pervasive modern a clear or easily applicable standard, Court decision was vacated, and technology” - such as in-state customer so arguments for reliance based on its the case was remanded for further computers, downloaded apps and clarity are misplaced28.” Even though proceedings not inconsistent with website cookies - cannot create Congress has the authority to change the Supreme Court’s opinion32. substantial nexus. A remote business the ‘physical presence’ rule, it should be can very well be “present in a meaningful vigilant in correcting a judicially created Dissenting opinion way without that presence being physical error. It is not the Supreme Court’s role In a dissent written by Chief Justice in the traditional sense of the term.” to “ask Congress to address a false John Roberts, who was joined by three constitutional premise of this Court’s own other justices - Breyer, Sotomayor and Adding to this argument, the Supreme creation29.” It is currently the Supreme Kagan - the dissenting opinion held Court in Wayfair noted that the Court, and not Congress, that is limiting that, while agreeing with the majority’s ‘physical presence’ standard renders the lawful prerogatives of the states. opinion that Quill’s ‘physical presence’ irrelevant a retailer’s “continuous rule was wrongfully decided, the and pervasive virtual presence”; The Supreme Court in Wayfair further dissenting justices opposed discarding accordingly, the Supreme Court cited numerous ‘unworkable’ state the ‘physical presence’ rule, as doing declined to follow a ‘physical attempts to apply the physical presence so has the potential to disrupt the presence’ rule that ignores “substantial standard to online retail sales, such as development of e-commerce that has virtual connections” to a state. defining ‘physical presence’ to include relied on the standard. The dissent the availability of downloadable apps argued that such an action should But, more than just being a technical and presence of digital cookies, ‘click- be undertaken by Congress, not the legal problem, the Supreme Court through’ nexus statutes, and notice Supreme Court, and that a heightened in Wayfair argued that the ‘physical and reporting requirements30. Such form of stare decisis should be applied presence’ rule is an “extraordinary statutes are “likely to embroil courts in due to Congress’s ‘superior authority’ imposition by the Judiciary on States’ technical and arbitrary disputes about in the realm of interstate commerce. authority to collect taxes and perform what counts as physical presence.” critical public functions23.” Thus, allowing The dissenting justices also took issue remote sellers to “escape an obligation The Supreme Court stated that “real with the majority’s sense of urgency to remit a lawful state tax is unfair and world implementation” of commerce to address the states’ significant loss unjust24” to competitors that remit the clause doctrines require that physical of sales tax revenue, noting that states tax, to consumers who pay the tax, presence must give way to the “far- have recently been able to collect more and to states that seek to “create and reaching systemic and structural remote seller sales tax revenue and secure the active market” that remote changes in the economy31.” E-commerce that harm to states has been “receding sellers supply with goods and services. has exploded since the time that Quill with time.” Further, the dissent argued The Supreme Court reasoned that was decided. For the states, this has that the majority ‘breezily discards’ the companies that avail themselves of translated into estimated revenue costs that its decision will impose on state benefits “bear an equal share of shortages ranging from $8 to $33 billion retailers, that the added burden will fall the burden of tax collection25.” Adding as a result of lost sales tax revenue. disproportionately on small businesses, further to its argument that the physical that the majority opinion “will surely have presence standard is arbitrary and Finally, the Supreme Court in Wayfair the efect of dampening opportunities unjust, the Supreme Court concluded addressed the argument that the for commerce in a broad range of new that it “has limited States’ ability to ‘physical presence’ standard allowed markets”33 and that the dissenting justices seek long-term prosperity and has online companies to grow without being were concerned that the “troubling prevented market participants from subject to the complexity of obstacles question” of retroactive application competing on an even playing field26.” of nationwide sales tax collection. could remain under state laws. Although compliance burdens may be Stare decisis does not warrant retaining legitimate concerns in some instances, Conclusion the ‘physical presence’ standard and particularly for small businesses, The Supreme Court decision is significant The Supreme Court gives great weight software ‘eventually’ will be available for many reasons - most importantly to the doctrine of stare decisis: that what at a reasonable cost, which ‘may’ because Wayfair overturned the been decided should be retained. In make it easier for small businesses to ‘physical presence’ standard that had efect, in order to say that stare decisis cope with such problems. Additionally, previously been established in the should not apply, the Supreme Court Congress is still free to enact federal decision in National Bellas Hess34 is overturning its own prior rulings. On legislation to address issues such as the and afrmed in Quill Corp v. North this point, in Wayfair it held that the additional burden on small retailers. Dakota35, which, for the previous 51

6 LEADING INTERNET CASE LAW As published in Leading Internet Case Law, Volume 18, Issue 4, pp 3-7 (August 2018)

years, had prohibited states from had enacted economic nexus laws in has the power to enter into treaties. imposing their sales tax obligations on previous years were met with similar legal Therefore the states are not a ‘party out-of-state businesses that lacked a suits challenging the constitutionality to’ or ‘bound by’ any bilateral tax treaty ‘physical presence’ in their states. of those states’ economic nexus laws into which the Government enters. The decision has already had a dramatic and were prohibited from enforcing Thus, although a non-US business may impact in the US, as states have rushed their laws due to their pending litigation. have treaty protection from US federal to adopt an economic nexus standard Other states enacted laws that were taxation, this protection does not extend for sales tax. As of 1 August 2018, more contingent on the Supreme Court to state taxation. States can therefore than 25 states had adopted economic abrogating the ‘physical presence’ impose their economic laws on non-US nexus as their standard for imposing standard. Now that the Supreme Court entities whose sales, transactions or sales tax obligations on remote sellers36 has rendered its opinion reversing Quill, other activities meet the economic nexus either through enacted state legislation states are free to enforce their economic standards established by that state. or regulation, or through administrative nexus law or adopt economic nexus policy statements. Many of these states’ if they have not already done so. The state tax decision of the millennium economic nexus laws are modelled has already had a dramatic impact on on the South Dakota law and use the For non-US entities who engage in the US state tax landscape and will same ‘more than $100,000 in sales’ or business in the US, this decision has undoubtedly have significant implications ‘200 or more transactions' economic significant implications. As noted not only for US-based companies, nexus standards. Several states that previously, only the federal government but for non-US businesses as well.

1. US Supreme Court Docket 17-494; argued April 15 days after enactment was 1 May 2016. 16. Article 1, Section 8, Clause 3 17, 2018; opinion issued 21 June 2018. However, due to legal action initiated prior of the US Constitution. 2. 504 U.S. 298 (1992). In Quill, the US Supreme to the efective date and the enforcement 17. 430 U.S. 274 (1977). of the South Dakota law, it was stayed. Court re-examined the ‘physical presence’ rule in 18. 17-494, pgs. 16-17. a case that presented a challenge to North 7. SB 106, Laws 2016, § 1. 19. Ibi d, pg. 18. Dakota’s “attempt to require an out-of-state mail- 8. A mong the South Dakota’s legislature’s order house that has neither outlets nor sales justifications for enacting its economic nexus law 20. Ibid. representatives in the State to collect and pay a were its finding that the state’s ability efectively to 21. Ibid, pg. 3. use tax on goods purchased for use within the collect tax from remote sellers was leading to 22. 504 US at 315. State.” The Court afrmed its holding in National significant revenue shortages and imminent harm Bellas Hess primarily on the principle of stare due to critical funding shortages for state and local 23. 17-494, pg. 3. decisis and afrmed its prior decision in government services (SB 106, Laws 2016, § 8(1)); 24. Ibid, pg. 21. National Bellas Hess, which required a physical that the loss of revenue from remote sales is 25. Ibid, pg. 22. presence in the state before it could impose its particularly significant for South Dakota, which is a sales tax obligations. state with no state income tax, and which relies 26. Ibid. 3. 386 U.S. 753 (1967). In National Bellas Hess heavily on sales and use tax revenues (SB 106, 27. Ibid. v. Department of Revenue (of the State of Illinois), Laws 2016, § 8(2)); that remote sellers who 28. Ibid, pg. 25. the appellant, a mail order house with a principal make a substantial number of deliveries into or place of business in the State of Missouri, have large gross revenues from South Dakota 29. Ibid, pg. 4. challenged an Illinois tax that required out-of- benefit extensively from the state’s market as well 30. For several years, states have enacted laws state retailers to collect and remit taxes on sales as infrastructure, yet many remote sellers that expand what constitutes a physical made to consumers who purchased goods for ‘actively market sales as tax free or no sales tax presence in order to comply with Quill. This use within Illinois. In Bellas Hess, the Supreme transactions’ (SB 106, Laws 2016, § 8(5),(3)); and has been included in increasingly aggressive Court held that a mail-order company “whose that modern computing and software options have laws and ever-expanding definitions of only connection with customers in the State is lessened the difficulty and burden on remote what constitutes a physical presence. by common carrier or the United States mail” sellers to comply with collection and remittance 31. 17-494, pg. 23. lacked the requisite minimum contacts with the duties (SB 106, Laws 2016, § 8(6)). 32. Although the Supreme Court overturned the state required by both the due process clause 9. Direct Marketing Association v. Brohl, and the commerce clause and unless the retailer ‘physical presence’ standard in its majority 135 S. Ct. 1124 (2015). Although the Direct opinion, the case was sent back, or remanded, maintained a physical presence such as “retail Marketing case dealt with Colorado’s 2010 outlets, solicitors, to the South Dakota Supreme Court to notification and reporting law, which imposed address whether there might be any other or property within a State,” Illinois lacked the administrative obligations and punitive sanctions power to require the retailer to collect its tax. valid grounds under which the law could be on ‘non-collecting’ retailers. challenged. It is unlikely, however, that a new 4. A rticle I, Section 8, Clause 18, US Constitution. 10. SB 106, Laws 2016, § 2. South Dakota’s economic and valid challenge will be presented. The ‘Necessary and Proper’ clause permits the nexus legislation, SB 106, was signed into law on 33. 17-494, pg. 38. Federal Government to ‘make all laws which shall 22 March 2016 by Governor Daugaard. The new be necessary and proper for carrying into law is set to go into eect on 1 May 2016. 34. 386 US 753 (1967). execution the foregoing powers, and all other 35. 504 US 298 (1992). powers vested by this constitution.’ 11. S B 106, Laws 2016, § 3. 36. As of 1 August 2018, the following states 5. 12. Ibid, § 4. Article 1, Section 8, Clause 3, US Constitution. have adopted economic nexus for sales 6. S B 106 had an efective date of 1 May 2016 13. All three retailers had no physical presence in tax: Alabama, Connecticut, Georgia, (SB 106, Laws 2016, § 9). The law states that the South Dakota. A fourth online retailer, Systemax Hawaii, Illinois, Indiana, Iowa, Kentucky, ‘Act shall be in full force and efect on the first Inc., was also served a notification to register Louisiana, Maine, Massachusetts, Minnesota, day of the first month that is at least fifteen and opted to comply with the law’s requirements. Mississippi, Nebraska, North Dakota, Ohio, calendar days from the date of this Act.’ As the 14. State v. Wayfair Inc., No. 32CIV16-000092, 2017 Oklahoma, Pennsylvania, Rhode Island, law was signed into efect on 22 March 2016, the WL 4358293, (S.D. Cir. Ct. Mar. 6, 2017). South Dakota, Tennessee, Utah, Vermont, first day of the first month that fell at least 15. 901 N.W.2d 754 (S.D. 2017). Washington, Wisconsin and Wyoming.

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