Tax Law Update | June.29.2018
On June 21, the U.S. Supreme Court delivered its much-anticipated opinion in South Dakota v. Wayfair, overturning its own 50 years of precedent to rule that a state may now require an out-of-state business to collect sales taxes even where the business has no physical contact with the state. This ruling will have a profound impact on businesses that make sales through the internet of both tangible and intangible property, including software, digital products and Software-as-a-Service ("SaaS").
Under constitutional principles, a state cannot require a business to collect the state's sales tax if the business lacks "substantial nexus" with the state. Instead, resident consumers are generally required to self-report and pay so-called "use" taxes on such purchases in lieu of the sales tax. Prior to last week's holding in Wayfair, substantial nexus under 1967 and 1992 U.S. Supreme Court precedents required a physical presence in the state. However, with low consumer compliance rates in self-reporting use taxes and the rising impact of internet sales on state revenues, states have sought alternative means to subject out-of-state sellers to sales tax.
In one case, as described in Wayfair (and likely in response to U.S. Supreme Court Justice Anthony Kennedy's invitation in Direct Marketing Association v. Brohl to revisit the Court's prior physical presence rulings), South Dakota enacted a law requiring a business to collect and pay South Dakota sales tax if the business has annual sales above a threshold dollar amount or completes a certain number of sales transactions with South Dakota residents, regardless of whether the business had a physical presence in the State. Wayfair, Inc., Overstock.com, Inc., and Newegg, Inc., online retailers with no employees or real estate in South Dakota, sued South Dakota, claiming the law was unconstitutional because the retailers did not have the required physical presence in the State.
The U.S. Supreme Court in Wayfair upheld the South Dakota law and overturned its own precedent, concluding that its prior physical presence rule was "unsound and incorrect." Factors noted favorably by the Court in rendering its decision included the fact that South Dakota law applies only to companies doing a considerable amount of business in the State, the law is not retroactive, and South Dakota otherwise has taken steps to ease the administrative burden of sales tax compliance on out-of-state businesses.
Adoption and Enforcement of Economic Presence Nexus
Businesses should expect states to quickly adopt or enforce statutes providing for "economic presence" nexus standards similar to the South Dakota law. At least 19 states currently have adopted statutes imposing an economic presence nexus standard similar to the South Dakota law and 41 states (of the 45 states that impose a sales tax) expressed support for the economic presence standard to the Court. Many states with existing economic presence laws have delayed enforcement of their laws until the constitutionality of such laws has been determined, a restraint Wayfair has now removed.
For technology businesses, adoption of an economic presence standard will facilitate the ability of states to enforce sales tax on intangible property, including software, digital products, and SaaS, irrespective of the method of delivery and business locations. While many states, including California, exempt most intangible property from sales taxation, a growing number of states (including New York, Pennsylvania, Texas and Washington) tax certain intangible items, even when transmitted via electronic or other digital means.
Thresholds for Economic Presence
Wayfair now raises the question of how much economic activity in a state is necessary before "substantial nexus" exists. The Wayfair ruling blesses the economic thresholds in the South Dakota law: the law applies only to sellers that, on an annual basis, deliver more than $100,000 of goods or services into South Dakota or engage in 200 or more separate transactions for the delivery of goods or services into the State. Of the states that currently have economic nexus statutes, only two states (Pennsylvania and Washington) have thresholds below the South Dakota amounts, but sales tax collection under these statutes is required only as alternative to complying with detailed notice and reporting requirements. While states are likely to adopt the South Dakota thresholds in the near-term, in the future it is possible that states will attempt to impose lower thresholds as they seek to expand their sales tax revenue base.
Prior to release of the decision in Wayfair, many had expressed concern that if the physical presence standard was overruled, states might seek to impose economic nexus standards on prior taxing periods. The Court did not directly respond to the constitutionality of retroactive application of such laws, but noted that making both the buyer and the seller legally liable for a single tax risks a double tax burden and emphasized that South Dakota law's prohibition on retroactive application was a factor in favor of finding that the law was constitutional. Additionally, the Court explicitly stated that the two precedent cases which were overruled, "should be, and now are, overruled" (emphasis added). Finally, the amicus brief jointly filed by 41 states sought to reassure the Court that retroactive application of any new decision would be unlikely and limited. In fact, the comptroller of Texas recently announced that the State would not pursue the retroactive collection of sales and use tax. Additional legal questions and court challenges will likely arise for any existing and forthcoming state laws that do not limit retroactivity by their language or their implementation.
In addition to operational concerns, businesses anticipating future financing or acquisitions may find their sales tax compliance under heightened scrutiny while the question regarding retroactivity remains outstanding. Under the long-standing physical presence standard, maturing software businesses are often surprised to learn that a remote worker can trigger an obligation to collect sales tax on their sales into a distant state, even with respect to sales that would not be subject to sales tax in their home state.
Impact on Other Nexus Standards
The existing physical presence and other nexus standards remain intact after Wayfair. For example, under existing law, businesses that already have physical presence nexus will continue have substantial nexus for sales tax purposes. Additionally, although the U.S. Supreme Court has not ruled with respect to click-through nexus or affiliate nexus, these nexus standards are likely on firmer constitutional footing following Wayfair. This decision also likely solidifies the states' positions regarding economic nexus for non-sales taxes, such as income tax and gross receipts taxes.
The Wayfair ruling may come with a silver lining for businesses previously burdened with the uncertainty of whether they had nexus under the other more nebulous nexus rules. The benefit of an economic presence standard is that, in most cases, it creates a bright-light rule for compliance, easing the burden of navigating some of the complexities in determining whether a business has nexus and assessing the risks of either under-collecting or over-collecting sales taxes. We may also find that as states begin to rely on sales tax revenues generated under the economic presence test, we will see a retreat from more complicated click-through, affiliate and marketplace nexus standards.
Congressional ActionWayfair makes clear that Congress is free to adopt a federal standard for the collection of sales and use taxes. For example, Congress could pass a law similar to the Interstate Income Act of 1959 (enacted in response to a U.S. Supreme Court decision that was unpopular with businesses), which allows a business to send representatives into a state to solicit orders for tangible personal property without being subject to a state income tax if the orders are approved outside the state and shipped from outside the state. The threat of congressional action may encourage states to refrain from more aggressive action on issues like retroactivity and application to small businesses. We will continue to monitor congressional action in this space. Please reach out to us if you have any questions or concerns.