Tax Strategy: What’s at stake for retailers and their tax advisors from Wayfair
Despite the Supreme Court’s decision in Wayfair, state sales and use tax nexus uncertainty continues even as the ink is barely dry on the ruling that overturns the long-standing mandatory Quill requirement that only physical presence meets the constitutional substantial nexus test.
With omni-channel commerce and digital disruption, sales tax obligations for the retail sector have never been more complex and dynamic.
And with the recent decision by the Supreme Court in Wayfair to overturn the decades-old physical presence nexus standard of Quill, states can now follow in South Dakota’s footsteps or may take their own paths to implement sales tax on the billions of dollars spent annually on online sales.
The court’s decision has significant impact on states, businesses and consumers alike. It is critical for businesses to stay current and if they haven’t already done so, to establish processes and solutions to meet their tax obligations as nexus laws and regulations will continue to evolve at a feverish pace.
What were the key developments leading up to the Wayfair case?
1. State revenue shortfalls. In 1992, when the Supreme Court decided Quill, it was estimated that the states were losing between $694 million and $3 billion per year in sales tax revenues as a result of the physical presence rule. Now estimates range from $8 billion to $33 billion.
2. Growth of U.S. sales tax jurisdictions and complexity. Nationally, there are a total of 10,708 jurisdictions in the United States that impose a sales tax, as of June 30, 2017, ranging by state on the high end from 1,277 in Missouri, 1,153 in Texas, 908 in Iowa, and 800 in Alabama, to just one each in the states of Connecticut, Indiana, Kentucky, Maine, Maryland, Massachusetts and Michigan.
The number of sales tax jurisdictions has grown each year and is up from about 6,000 at the time of the Quill decision. That’s almost double, and expect that rate of growth to continue at least at a similar rate as states face the prospect of increasing revenue shortfalls, particularly as the result of federal tax reform legislation passed at the end of 2017.
3. Nexus alternatives to physical presence. Particularly since Quill, many states have aggressively tested the limits of the meaning of “physical presence,” adding new nexus laws under a number of approaches, including:
- Economic nexus (the Wayfair case);
- Click-through nexus;
- Affiliate nexus;
- Marketplace nexus;
- Cookie nexus; and,
- Use tax notice/reporting.
Even a brief review of the creative and aggressive actions by the various states to introduce alternative nexus standards prior to the Wayfair decision illustrates the retailer’s challenges in sales tax compliance, with many states introducing two or even three new types of nexus.
4. Streamlined sales and use tax agreement. Another state-inspired approach has been the adoption of a streamlined sales and use tax agreement, the goal of which was to find solutions for the complexity in state sales tax systems that resulted in the U.S. Supreme Court holding in Quill. The agreement focuses on improving sales and use tax administration systems for all sellers and for all types of commerce. However, before Wayfair, only 23 states had adopted it in some form or another.
Inside the ruling
What did the Wayfair court say and not say about state sales and use tax nexus?
The South Dakota law at issue is S.B. 106, effective May 1, 2016, which requires that any entity exceeding an annual sales threshold of $100,000 or 200 separate transactions in South Dakota collect and remit South Dakota sales tax. This is often referred to as “economic nexus,” rather than “physical presence nexus,” because it is based entirely on economic presence, not physical presence.
This placed the statute clearly and intentionally at odds with Quill for the specific purpose of getting the Supreme Court to review it — and the court’s ruling overturned the Quill physical presence test as “unsound and incorrect.”
To many, the Wayfair case can be confusing because the court remanded the case back to South Dakota. Here is why it is important: The Wayfair court used the four-prong test of Complete Auto to test the validity of the South Dakota nexus statute. That test has been the appropriate test for decades — state taxes are valid so long as they:
- Apply to an activity with a substantial nexus with the taxing state;
- Are fairly apportioned;
- Do not discriminate against interstate commerce; and,
- Are fairly related to the services the state provides.
In Quill, the court held that only physical presence meets the first prong of the above test — “substantial nexus.” In Wayfair, the court said that physical presence is not the only way to establish the first prong of the four-prong test — substantial nexus. For example, economic presence in this case did just that. However, since the other three prongs of the Complete Auto test must also be met, the case was remanded back to South Dakota — to reconsider the South Dakota nexus statute in light of all four prongs of the test, but this time without the mandatory physical presence standard for the first prong of the test — substantial nexus.
In overturning Quill as unsound and incorrect, it opened the door for states to enact nexus laws that do not require physical presence.
So, what did the court mean by calling Quill nexus “unsound and incorrect?” Here is what the court said:
- “The physical presence rule has long been criticized as giving out-of-state sellers an advantage. Each year, it becomes further removed from economic reality and results in significant revenue losses to the states. These critiques underscore that the rule is an incorrect interpretation of the Commerce Clause.”
- “The physical presence rule of Quill is also an extraordinary imposition by the judiciary on states’ authority to collect taxes and perform critical public functions.”
- In the absence of Quill, the test simply asks “whether the tax applies to an activity with a substantial nexus with the taxing state.” In the South Dakota law, “the nexus is clearly sufficient. It applies only to sellers who engage in a significant quantity of business in the state, and [companies like Wayfair] are large, national companies that undoubtedly maintain an extensive virtual presence.”
The immediate consequences
Many states already have legislation on the books with different effective dates, which can be described as “economic presence” laws because they have some “volume of economic activity” requirement to establish nexus, just like the South Dakota statute. However, the immediate issue is the effective date for collecting the tax, which varies with each state. For example:
- States like Hawaii and Vermont have July 1, 2018, effective dates and have already made announcements to use “catch up” procedures for transactions in 2018 before the Wayfair decision.
- Kentucky and Iowa, on the other hand, have announced that taxes will be collected on a “prospective” basis, with Iowa saying specifically Jan. 1, 2019.
- Idaho announced that it is “still reviewing” next steps.
- Ironically, South Dakota must wait while the case is being wrapped up in the state court system on remand, so the injunction preventing the enforcement of the law will remain in place.
- The Minnesota Department of Revenue will provide more guidance within 30 days.
- Louisiana will require remote retailers to collect sales and use tax if they meet certain sales thresholds. The thresholds apply to tax periods on or after the date of the Wayfair decision.
- Illinois, Wisconsin and Alabama will require remote retailers to collect use and service use tax when they meet certain sales thresholds. This collection requirement begins Oct. 1, 2018.
- Indiana will not enforce the law retroactively and will soon provide a specific date for enforcement.
Bottom line: State-specific guidance is being announced almost daily, and recommendations from groups like the National Conference of State Legislatures, the Multistate Tax Commission and the Streamlined Sales Tax Governing Board are forthcoming as well — all of which should be tracked carefully by retailers and their tax advisors.
The long-term consequences
Physical presence may no longer be a necessary element of sales tax nexus, but that doesn’t mean issues in this area will be greatly simplified. Once you eliminate the physical presence requirement, it opens up so many other things.
It’s a win for the states, particularly the smaller, less populous states with fewer brick-and-mortar retailers. But states like New York and California, which have very complex statutes on the books, will have to make some significant changes to their laws.
Wayfair has an especially important impact, particularly on those states that don’t impose state and local income taxes, because it’s their primary source of tax revenue.
New Hampshire is a state without a sales tax. According to a recent announcement, the governor plans to call a special session to consider legislation to protect New Hampshire businesses from improper attempts by other states to force collection of sales and uses taxes.
In addition, senators from two other “non-sales tax states” (Oregon and Montana) have joined the senator from New Hampshire to introduce federal legislation (Senate Bill 3180) titled, “A bill to regulate certain state impositions on interstate commerce” in an effort to overturn the U.S. Supreme Court’s decision in Wayfair.
It remains to be seen what the states will actually do, but state governments and their taxing authorities are well advised to adopt the economic presence nexus standard along lines similar to the South Dakota statute, which specifically requires only a certain volume of economic activity measured by either amount or number of sales in the state.
It’s a safe bet that if states follow the South Dakota model, they won’t be challenged by taxing authorities, tax advisors, retailers or anybody else.
It will take most states months to get their collection systems up and running. This is not likely to take place until January 2019 for many jurisdictions. A key feature of the South Dakota law was that there would be no retroactive imposition of sales tax on e-commerce sellers. Theoretically, states can impose sales tax retroactively as far back as 10 years, but most states would not go in that direction, because it would be challenged.
More legislative action?
There will be a lot of pressure for Congress to step in and simplify the sales tax collection and compliance process by providing one set of rates and standards that apply to all states that impose the sales tax. Several states that don’t currently impose a sales tax are actively considering doing so now that they effectively have been given a “safe harbor” to do so on e-commerce. Tax advisors and retailers, in particular, take note.
Although the Wayfair decision only applies to sales and use tax for the moment, there are some commentators who suggest that Wayfair may eventually be extended to other types of income, such as corporate income tax.
Whether the states will repeal or retain some of the other alternative nexus laws, e.g., cookie nexus, reporting/notice laws, click-through nexus, etc., currently on the books is an open question. State legislative actions over the coming weeks will have to be monitored carefully.
Next steps for retailers
To ensure that businesses will stay sales and use tax-compliant with the expanded nexus standards and minimize risks to their businesses, best practices should be put in place:
- Understand their nexus profile — where do they have a sales tax obligation based on evolving standards?
- Assess their capability to accurately, consistently and efficiently meet their obligations.