States are increasingly taxing corporations’ economic presence, not just their physical presence, according to Bloomberg BNA’s 15th Annual State Tax Survey.
Previously, states used physical presence as the determining factor as to whether or not an out-of-state business is liable for collecting sales or use tax for products sold within the state, indicated Steven Roll, managing editor of Bloomberg BNA State Tax and Accounting. In response to the digital economy, states are increasingly looking at economic presence, and are also adopting new rules aimed at taxing out-of-state companies’ receipts from services and intangibles that are attributable to in-state customers.
Roll and his colleagues at Bloomberg BNA have just completed the 15th Annual Survey of State Tax Departments (available for free here), in which states are asked to clarify their position on gray areas of corporate income tax and sales and use tax administration. All 50 states, the District of Columbia, and New York City participated in the survey.
New portions of the survey address the nexus consequences of registering with state agencies versus actually doing business in the state, drop-shipment transactions, and trailing nexus for sales tax purposes.
“We asked questions aimed at a state’s position on nexus policies and the sourcing of receipts for income tax purposes,” said Roll.
The rules that matter
Nexus is the minimum amount of contact between a taxpayer and a state, which allows the state to tax a business on its activities. It arises from two clauses in the Constitution. The Commerce Clause prohibits a state from unduly burdening interstate commerce, and the Due Process Clause requires a minimum connection between a state and the entity it wishes to tax. Public Law 86-272 further limits the states’ power to impose income tax by prohibiting taxing businesses whose only activity in the state is the solicitation of orders, so long as the orders are accepted at and delivered from a point outside the state.
Although the constitutional and legislative standards exist, states nevertheless vary in determining what particular activities performed within their borders trigger nexus for income taxation, according to Roll.
Part of the reason for this is that a key constitutional question remains undecided by the Supreme Court -- whether the states making corporate income tax nexus determinations must use the physical presence test established by the court in Quill. While the Supreme Court in Quill established a physical presence test for sales tax nexus, it left unanswered the question as to whether the physical presence test must also be used for income tax nexus. Almost from the time of the 1992 decision, the results have been varied and contradictory.
A number of state appellate courts have found that the physical presence standard established by Quill is limited to sales and use tax nexus, applying instead an economic presence test for income taxation.
As states continue to broaden their definition of economic nexus in their drive to increase state revenues, it is more important than ever for American corporations to be aware of these continuing changes, according to findings from the survey.
For corporate income tax purposes, most states have moved away from the traditional physical presence standard for determining whether an entity has nexus with the state. This year, only seven jurisdictions indicated that they apply Quill (i.e., require that a corporation have a physical presence in the state in order to create income tax nexus).
For sales tax purposes, due to the rise of affiliate, or “click-through” nexus, the physical presence standard also appears to be eroding, Roll observed.
“Corporations and businesses need guidance on where they are subject to tax based on evolving business trends,” said George Farrah, editorial director of Bloomberg BNA Tax and Accounting. “The Bloomberg BNA Survey of State Tax Departments is designed to do just that, enabling companies and tax practitioners to evaluate their tax exposure and help ensure they are complying with ever-changing state tax rules.”
“A minority of states (11 for income tax nexus and 10 for sales tax nexus) said they would find nexus if an out-of-state corporation registered to do business with their jurisdiction’s secretary of state,” Roll said. “About the same number of states said they apply their secretary of state’s definition of transacting business’ or doing business’ for purposes of nexus determinations. Typically, the secretary of state’s definition provides a list of activities that will trigger a registration requirement, while the tax definition is vague or merely references the U.S. Constitution.”
Other types of registrations are also likely to trigger nexus, according to Roll: “Sixteen states said they would find sales tax nexus if a corporation registered as a government vendor or contractor.”
State nexus policies also vary significantly with respect to complex multi-party transactions, according to Roll. “Drop shipments involve three parties a customer, a retailer and a third-party supplier that delivers goods directly to the customer,” he said. “While these arrangements are common, they can raise issues as to whether the out-of-state retailer is required to collect sales tax.”
The number of states that would find nexus for drop shippers varied greatly in the survey, based on the specific facts of each scenario, he indicated. “For example, 17 states said that nexus would be created when a manufacturer ships tangible personal property by a common carrier to in-state customers based on orders received from a distributor where the distributor itself has nexus with the state.”
By contrast, no states would find nexus for the manufacturer if the distributor lacked nexus.
“Where a distributor uses an in-state manufacturer as a fulfillment agent in the state to pack and ship orders by common carrier to in-state customers, 21 states said they would find nexus if the manufacturer holds title to the inventory until the corporation directs the manufacturer to ship the order,” Roll said. “A larger number of states 33 said they would find nexus if the corporation itself holds title to the inventory until directing the manufacturer to ship the order.”
The new nexus
One of the main areas that was addressed in the survey this year was corporate income tax sourcing, Roll indicated. “This refers to the rules a state uses to determine if it will impose its corporate income tax on an activity that is conducted in more than one jurisdiction.”
“Sourcing is the new nexus,” he said. “For corporate income tax purposes, nexus is often a foregone conclusion for many types of transactions,” he explained. “The focus now is on determining which states are owed tax on multijurisdictional sales of services or intangibles. Depending on each state’s sourcing rules, a transaction could escape state tax or be taxable in more than one state.”
The survey found increased attention to the sourcing of receipts from sales of intangible property and services. Previously, nearly all of the states’ sourcing rules were based on the location where the majority of the costs of performance were incurred. More recently, there has been a growing minority of states using a market-based approach that focuses on sales made to customers within its borders.
“The sourcing rule that a state applies is driven by how it characterizes a transaction,” said Roll. “The survey found that states are characterizing new or emerging products or business models such as the sale of digital goods or intangibles to fit within the definitions of long-established taxable transactions,” he said. “For example, the characterization of cloud computing varies among states and is often counter-intuitive. While most states characterize cloud computing transactions as the sale of intangibles or services, Utah treats these transactions as the sale, lease or license of tangible personal property.”
“Unlike previous years, most states chose only one approach to characterizing these receipts,” Roll said. Receipts from cloud computing are characterized as services in 12 states; the sale, lease, license or rental of intangible personal property in five states, and the sale of tangible personal property in one state.
“The survey results also indicate that market-based sourcing is the predominant approach to sourcing cloud-based transactions,” he noted.
“There is little uniformity across states from sourcing the income on services, intangibles and cloud computing, resulting in compliance confusion,” Roll observed. “Despite the shift towards a service-based economy decades ago, states are still unable to reach a consensus on how to source these transactions.”
Owning or leasing a Web server located within a state will likely produce both income tax and sales tax nexus with the state, according to the survey. Thhirty-eight states, plus the District of Columbia and New York City would find income tax nexus resulting from a Web server within their jurisdiction. Most of these jurisdictions also would find sales tax nexus based on a Web server in the state, according to the survey.
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