E-commerce has changed the way many businesses conduct transactions in recent years. The days of brick- and -mortar transactions are changing to electronic transactions. The impact of these transactions has resulted in states trying to adapt their taxation rules with respect to these types of transactions.
On June 21, the U.S. Supreme Court issued its widely anticipated decision in South Dakota v. Wayfair, et al. No. 17-494. The court ruled in a 5-4 decision the physical presence rule for state tax jurisdiction was incorrect and not a requirement under the Commerce Clause of the U.S. Constitution. The impact is anticipated to dramatically change U.S. sales and use tax, and possibly income tax. It is arguably the most significant state tax decision from the court in at least 50 years.
Prior to Wayfair, taxpayers looked to the Quill Corp. v. North Dakota (1992) decision, which had affirmed the court’s 1967 decision from National Bellas Hess, Inc. v. Department of Illinois, that the substantial nexus requirement of the U.S. Constitution’s Commerce Clause (U.S. Const., art. I, section 8, cl. 3) requires a taxpayer (or tax collector) to have a physical presence in a state before the state can impose a state tax (or tax collection obligation).
Quill set the precedent that although substantial nexus was required under the Commerce Clause for sales and use tax purposes, it was not required under the Due Process Clause of the U.S. Constitution. Instead, after Quill, due process minimum contacts nexus only required a taxpayer to have purposefully directed economic activity at a state’s market.
In its Wayfair decision, the court ruled the Quill physical presence rule was flawed on its own terms. The decision stated the physical presence rule is not a necessary interpretation of the substantial nexus requirement, it creates rather than resolves market distortions, and it imposes the sort of arbitrary, formalistic distinction that the court’s modern Commerce Clause precedents disavow.
The court was clear the physical presence rule of the past did not reflect the current economic reality, where orders for products and services are done in seconds with the click of a button from a mobile device. The court compared the relationship between physical presence and compliance costs and found there was none.
The majority echoed the views of the states and traditional brick-and-mortar retailers that the physical presence rule placed more burdens on local businesses and put them at a competitive disadvantage compared to internet retailers. The physical presence rule had allowed remote sellers to take advantage of the benefits of a state’s market without sharing the burden of tax collection. As the court remarked, it had become a “tax shelter.”
Wayfair was a South Dakota case, but the decision has implications across the U.S. as more and more states follow South Dakota and enact their own economic nexus rules. South Dakota’s statute at issue provided that any business with at least $100,000 in sales to customers located within South Dakota and/or at least 200 transactions with South Dakota consumers was considered to have purposefully directed economic activity at the state’s market, and, thus, created nexus or a state collection responsibility on its taxable sales of tangible personal property and services. The court viewed South Dakota’s standard as sufficient for purposes of substantial nexus under the Commerce Clause, but remanded the case back to the South Dakota Supreme Court on whether it violated any other Commerce Clause principle previously developed in case law.
The Wayfair decision has potential implications for all retailers, businesses, and other types of taxes. Over 25 states have enacted similar economic nexus statutes, and states are ready to aggressively find retailers purposefully directing economic activities toward customers within their jurisdictions. Enforcement could be immediate where legislation already is enacted.
On June 21, many retailers, including remote sellers, marketplace facilitators, service providers, licensors of software and other businesses that have provided services or delivered products to customers from a remote location, will be required to start complying with state and local sales and use tax rules in previously unfiled states. Not all states tax the same items or services, or treat taxpayers the same. For example, not all states have an industrial processing/manufacturing exemption on the sale of manufacturing equipment, tools, and supplies used to transform products for sale to an end user. Some states tax services such as software as a service, streaming services and information services. Additionally, not all states exempt the sale of products or services to local governments or nonprofit entities. Some states limit their exemptions to specific types of nonprofit entities.
As businesses start to determine where they might have economic nexus post-Wayfair, the next step might be to determine if the products or services they are selling are taxable in the destination state. It will become important to collect exemption certificates taken in good faith from customers located in states that they may not have in the past. Businesses may have to become more familiar with state-specific exemption forms to ensure they have valid documentation. Many businesses will also need to evaluate their need for sales and use tax automated compliance software in order to meet their business needs and its compatibility with their enterprise software. The software must be capable of administering sales and use tax compliance across numerous state and local jurisdictions, exemption management and applying different product and service taxability definitions across the country.
The Wayfair decision will have wide-ranging implications on all businesses, not just internet retailers or consumers. It changed the playing field for both brick-and-mortar retailers and state and local governments. In determining collection and filing responsibilities for sales/use tax, the question is no longer whether there is a physical presence within a state, rather whether the dollar volume of sales and number of transactions with customers in a state in a tax year establishes economic nexus. With almost half of the states already enacting economic nexus rules, the rest will likely will follow suit. This is one opportunity for raising revenue without raising rates that state taxing authorities won’t want to miss.
Also, while the Wayfair case dealt with sales and use tax, states might use this ruling as support for economic nexus as it is applied to other state taxes, notably income tax. Many states have had “factor-based” economic nexus statutes in place for income and gross receipts taxes for years, although not without taxpayer challenges. The ruling in Wayfair is likely to embolden these states and states without economic statutes to pursue a more aggressive position on economic nexus.
Now is not the time for taxpayers to sit on the sidelines. In addition to the steps above related to the determination of taxability and addressing the compliance tasks imposed on them by this ruling, financial statement impact should be addressed. Taxpayers should consult with their financial statement auditor and tax adviser to evaluate and determine the potential implications with respect to sales and use taxes and indirect taxes under the respective Accounting Standards Codification (ASC) sections. This may include ASC 405 or ASC 450, depending on whether there is uncertainty regarding sales/use tax liabilities as a result of Wayfair.
Additionally, taxpayers should consider the potential impact on reserves and accruals related to income taxes under ASC 740, including the impact on current and deferred taxes, uncertain tax benefits, and disclosures.
Emily Irish is managing director with the local office of international accounting firm BDO USA LLP. The views expressed above are the author’s and not necessarily those of BDO. The comments are general and not to be considered specific tax or accounting advice or relied upon for the purpose of avoiding penalties. Readers are urged to consult their professional advisers.