When it comes to revenue, sales tax is where the action is.

State regulators are now collecting nearly $400 billion in sales tax, compared to 2003 when they collected just over $250 billion. In fact, nearly half of state revenue is derived from sales tax sources, according to Ryan Himmel, a CPA and chief executive officer of BidaWiz Inc., a networking and marketing platform for small businesses and accounting firms.

With the growing importance of sales tax to state revenue intake, there are naturally a number of contested issues at both the state and the federal levels, a number of which were addressed during the past year.

Legislative activity at the federal level involved the efforts to pass the Marketplace Fairness Act and the Internet Tax Freedom Act. The Internet Tax Freedom Act, which bars federal, state and local governments from taxing Internet access and from imposing discriminatory taxes, originally was scheduled to expire on Nov. 1, 2014. It was extended through Dec. 11, 2014, and then further extended through Oct. 1, 2015.

The Marketplace Fairness Act didn't pass, but had more activity than any prior bill, according to Diane Yetter, a well-known sales tax consultant and founder of the Sales Tax Institute. "The ITFA is more desirable and less controversial than MFA, and more bipartisan," she observed. "However, there's a fair amount of support for MFA on both sides of the aisle. Some of the concern over the bill regards its impact on small business. Jason Chaffetz, a Republican, said he will be introducing legislation during 2015 to address the concerns of Republicans, and I would expect it to be re-introduced in the Senate as well."

Activity in the click-through nexus arena (in which states assert sales and use tax nexus on remote sellers as a result of purchasers clicking on a link to the seller on their computer) continued to expand during the year, according to Yetter.

"Recently, Michigan proposed four separate bills," she said. "In December, the Michigan Senate passed click-through nexus legislation and sent it to the House for consideration. Illinois lost its case in the Illinois Supreme Court at the end of 2013, but revised the statute last summer and passed a new provision effective Jan. 1, 2015. The new statute modifies the definition of what is deemed to be an activity to include any type of referral. They lost the case because, under the Internet Tax Freedom Act, the original provision was discriminatory because it applied only to online referrals."

The more states that propose click-through nexus, the worse it is for business, Yetter indicated. "Every state has a slightly different rule, whereas if there were a national standard, it would be easier for small businesses to comply."

Direct Marketing Association v. Brohl, which attacks Colorado's use tax, was heard by the Supreme Court on Dec. 8, 2014. "The hearing by the Supreme Court will not decide whether the legislation is valid, but whether it can be heard by the federal courts," Yetter said. "The issue is going through the state courts separately."

 

CLOUDY QUESTIONS

The sales tax treatment of cloud computing continues to be addressed by state courts. Michigan takes the position that cloud computing is canned software. In Thomson Reuters Inc. v. Department of Treasury, the Michigan Court of Appeals reversed a lower court decision and found that Thomson Reuters is not liable for use tax on the sales of its Checkpoint online tax and accounting research service. The court stated: "Because the transaction at issue was primarily the provision of a service, not the transfer of tangible personal property, we agree with plaintiff [Thomson Reuters] that the use tax was improper, and that summary disposition in favor of plaintiff is warranted."

In Rehmann Robson & Co. v. Department of Treasury, the Michigan Court of Claims likewise determined that the sale of Checkpoint was not subject to use tax. In this instance the challenge was brought by the purchasers of Checkpoint. "The taxability of the exact same service was challenged by two taxpayers, the seller and the customer, and in both situations the state lost," said Yetter.

The reason that cloud computing and the taxability of computer related services is such a challenge is that there are issues related to both characterization (what is it that was bought or sold) and sourcing (which jurisdiction has the right to tax it), Yetter indicated.

"The two issues go hand in hand because you have to figure the character of the item before you can consider sourcing, but you need to know the source to know which state to look at to define the character," she explained. "There's a whole myriad of complexity involved in making these determinations."

"Sales taxes originated in the industrial era," observed Steve Roll, managing editor of state tax at Bloomberg BNA. "They apply fairly well to the consumption of tangible personal property, where tangible goods are delivered to a single physical location which vendors can determine with relative ease. In contrast, the delivery of digital goods poses numerous challenges. No physical address is needed, so it's hard to verify if the address is correct. To complicate matters further, digital goods might be used in multiple locations. For example, when you order a song from iTunes, it doesn't matter where you're doing it from. You could be on vacation in Key West or at home in Ohio. The vendor can ask customers for their address, but it's hard for the vendor to verify if the address is correct. Or, with cloud-based business software, business customers could have employees in multiple locations accessing the vendor's software."

"These issues present a continuing problem because the sales tax base is eroding as more goods that were once physical -- for example, books, music and software - are now purchased and delivered in a digital format," he said.

A national solution, such as the MFA, is not likely to pass Congress anytime soon, Roll believes. "There seems to be more support for it at the state level, even among Republican governors," he said.

"Part of the debate with MFA relates to how to determine which state gets to tax a transaction," he said. "Some believe origin-based sourcing should apply. Under origin-based sourcing, the jurisdiction where the business is located applies the sales tax. If the business is located in a no-sales-tax state, no sales tax would apply to the transaction. Under destination-based sourcing, the jurisdiction where the customer is located applies the tax."

"An interesting contrast is that beginning Jan. 1, 2015, the European Union implemented a destination-based collection system for consumer purchases of digital goods," he said. "It's a destination-based system with a series of cascading rules for determining the location of the customer. Contrast this with the states. Many do not tax digital property sold to consumers. As more states attempt to expand their sales tax base to apply to these transactions, businesses are likely to face inconsistent rules among the state jurisdictions."

Roll sees resistance at the state level to raising taxes, with more pressure placed on local governments to levy their own taxes. "There was a bill pending in Kentucky last year [H.B. 399] to allow municipalities to levy their own sales taxes," he said. "It might be more politically palatable to raise them at the local rather than at the state level."

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