State corporate tax policies adapt to digital economy
President Trump’s recent tweet about “internet taxes” reignited debate about sales tax liabilities for businesses that sell products online. Internet sellers have been grappling with the murky sales tax implications of online sales for well over a decade.
Increasingly, though, they are also beginning to focus on the uncertainty surrounding state corporate income taxes. This area is particularly fraught for businesses that sell electronic products and services—such as apps, streaming video, cloud computing, gaming, online research and so forth—to customers in states where the business lacks a physical footprint. These “pure e-commerce” sellers face uncertain obligations and immense potential liability, and yet most states provide little, if any, guidance. A wave of litigation is sure to result.
For sellers of pure e-commerce seeking to pin down their corporate income tax responsibilities, two questions are paramount. The first is whether a state can and does assert jurisdiction to impose tax on a seller of pure e-commerce (and, if so, whether the U.S. Constitution and federal law provide any additional protections for the seller). The Supreme Court and federal law establish that a company must have certain contacts with a state in order to establish tax “nexus” there.
Few states have considered the nexus implications of pure e-commerce transactions specifically. Some states have “economic nexus” laws asserting jurisdiction to tax based on the amount of sales, property or payroll in the state. These laws, based purely on dollar amounts, would sweep in sales of pure e-commerce goods and services to customers in the state. The constitutionality of economic nexus is uncertain, but the U.S. Supreme Court has consistently declined to hear challenges to the concept.
If the seller does have nexus with a state, the next question is how the seller apportions its pure e-commerce sales under the state’s law. This inquiry involves two main issues: how a state classifies a particular transaction (as a sale of tangible personal property, a service, or intangible property) and how to source a transaction for purposes of the sales factor. A handful of states have provided detailed guidance, but most have offered little to no guidance concerning apportionment of pure e-commerce transactions.
To assist businesses in navigating this uncertain landscape, we put together a detailed survey and sent it to state taxing agencies. We received responses from a robust group of nineteen. Fourteen of these indicated that engaging in a purely electronic transaction with a customer in the state may—on its own—create corporate income tax nexus.
Agencies for many states, such as California, Connecticut, Florida and Georgia, all of which have a large tax base and are home to significant multistate players, made a good faith effort to complete the survey but repeatedly emphasized the importance of “facts and circumstances” in making a nexus determination.
More clarity emerged from other agencies, including the five indicating that engaging in a purely electronic transaction with a customer in the state will not—on its own—create corporate income tax nexus. These agencies were from Indiana, Kansas, Nebraska, New Jersey and Texas. The New Jersey Division of Taxation cited the New Jersey Tax Court’s decision to this effect in Quark, Inc. v. Director, a rare case on point.
For apportionment, we first asked how the state would classify and source each pure e-commerce transaction for purposes of the state’s sales factor. While many states have issued guidance on the classification of software for sales and use tax purposes, the corporate income tax treatment of software, online services and licensing agreements is still largely unsettled. Our other apportionment questions delved even more deeply into pure e-commerce sourcing, and into computation of apportionment factors (figures used to determine ultimate tax liability). As in the nexus responses, the states frequently emphasized “facts and circumstances” without specifying what facts and circumstances would be determinative.
The survey responses underscored our sense that businesses engaged in pure e-commerce transactions are navigating a highly uncertain state income tax landscape. Most states lack guidance on the complex nexus and apportionment issues that arise in the context of these transactions. These questions will inevitably lead to litigation in the coming years, particularly as more states adopt economic nexus and market-based sourcing laws. Pure e-commerce continues to be a large growth segment of our economy and the questions and complexities surrounding these transactions will only continue to mount. We hope our survey will help states realize the need to be proactive on these issues.
For more information, download our free special report, State Corporate Income Tax E-Commerce Study.