On April 17, 2018 the U. S. Supreme Court heard oral arguments in the case of South Dakota vs Wayfair, Inc, Overstock.com, Inc., and Newegg, Inc. This is Case Number 17-494. This case is a direct challenge by the State of South Dakota to the 1992 U.S. Supreme Court case of North Dakota vs Quill, 504 U.S. 298. The 1992 case of Quill created what tax practitioners call the ‘substantial physical presence’ nexus standard as it applies to sales and use tax. As normally used, the Quill nexus test requires that the out-of-state retailer have some substantial physical presence in the taxing state before the taxing state can legally exert jurisdiction over the taxpayer and require the taxpayer to collect and remit the sales tax due on taxable purchases made by consumers in the taxing state. Since 1992, the type of contacts that meet this physical presence test have varied, but normally included employees entering the state, independent sales representatives working in the state, the ownership of property in the state, the rental of property in the state, the storage of inventory in the state, and the performance of services in the state. Recently, though, some states have proposed that electronic “cookies” stored on a customer’s computer would also create nexus.
In the Quill decision, the Court noted that Congress could enact laws to codify or overturn the Quill decision since their opinion turned on the interpretation of the Constitutional Commerce Clause for which Congress has the final say. For 26 years, Congress made no effort to resolve this issue. Having waited long enough, several states adopted statutes based on “economic nexus” rather than physical nexus. Under the economic nexus theory, out-of-state sellers with, for example, $100,000 of sales into the taxing state, are deemed to have nexus in the state even though they had no physical contact with the taxing state. This effort is directed at the growing e-commerce market place and other remote sellers that are not currently collecting tax on taxable sales.
South Dakota implemented one of these economic nexus statutes with an effective date of January 1, 2016. In February or March of 2016, South Dakota issued assessments for uncollected sales tax to the remote sellers Wayfair, Overstock.com, and NewEgg. Each remote seller met the $100,000 of annual sales threshold under the South Dakota economic nexus law. The taxpayers immediately challenged the legality of the South Dakota statute and won their cases at the trial court and South Dakota Supreme Court. This was exactly as the state of South Dakota had planned and had hoped for. Seems odd, but the South Dakota Revenue Department knew its only hope of overturning Quill was to lose its cases at the state level and then appeal these to the Supreme Court and hope the Court accepted their appeal. To the surprise of few, the U.S. Supreme Court accepted the State of South Dakota’s challenge to this case. So far, things are working out just as the state wanted.
There are several possible outcomes the Court to provide once it hears the case.
- Uphold Quill as it was written in 1992 and require that the out-of-state taxpayers have a physical connection with the taxing state before being required to register,
- Modify Quill to require physical connection for some type of taxes but eliminate the requirement for other types of taxes,
- Abandon Quill completely and adopt the economic nexus theory requiring minimal sales level in the taxing state before registration is required,
- Abandon Quill completely and not adopt the economic nexus rules, or
- Punt back to Congress, or
- Some combination of the above or something completely different.
Regardless the Court’s decision, there will be long-term chaos in the remote seller community. If the states prevail in any way, I would fully expect them to pounce on their newly found authority to tax all out-of-state business under whatever authority the Court gives them. I’m afraid that many states would attempt to collect taxes retroactively. If the states do not win or do not win as big as they want, they will become even more aggressive in identify out-of-state sellers that should be collecting tax. They will also continue to implement new policies as to what constitutes nexus under the Quill case. The states hate Quill and will do whatever they can to get rid of that rule.
All the commentaries I have read on this topic involve e-commerce companies selling property to individual and business consumers. In this scenario, the property is ordered online, the order is either merchant or third-party fulfilled from inventory, and then the order is sent to the purchaser via common carrier. However, if the Quill physical nexus requirement is abandoned or modified and no physical nexus requirement in the taxing state is needed before a state can force an out-of-state seller to collect their sales tax, the full impact will be much more expansive than is being discussed. An abandonment of the Quill nexus standard could greatly impact the sales tax collection obligations of the software and wholesale/distributor sectors.
The days of sending software to customers on a CD are nearly gone. Most software is now delivered electronically or downloaded from a website portal. Many software companies operate in a purely virtual world. Sales calls are done via web-conference or Skype and implementation and training are done remotely. Many software purchases are made by end-users with no contact at all with a salesman. Consumers order the software and receive an e-mail link to download and install the software. Most software companies likely have nexus in the state where they are headquartered and where they have employees remotely working. Twenty-years ago, very few states taxed downloaded software. Today, about 25 states tax non-custom downloaded software. Many also tax data processing services, electronic information services, and Software-as-a-Service (SaaS) when the benefit of the service is received in their state. So, what would a world without Quill mean for these remote software sellers?
Without the physical nexus requirement of Quill, these software sellers and data processing companies would be forced into the same sales tax collection model as other sellers of tangible personal property. This means that the software sellers would be required to collect tax on the software delivered to customers in states where those services are taxed. Without the physical nexus requirement of Quill, if the software is received in the taxing state and that state taxes downloaded software, the remote seller will be required to collect tax on the sale. This could also impact the taxation of technical support and software renewal agreements. The challenge with taxing electronic transmissions is that there is no traditional ‘shipping address’ that can be used to identify the location of the user at the time of the sale. It is likely that the shopping cart feature of these online software companies would need to be modified to identify the purchaser’s location. This might default to the zip-code of the credit card used for billing or some other element of the address to determine if the software is being used in a taxable state and to apply the correct tax rate.
The challenge with taxing remote data processing or SaaS charges is that the state where the product is used may differ from the state to which it is billed. The data processing or SaaS service may be used in a state that taxes the service, (i.e. Texas or New York), but billed to the corporate headquarters in a state that does not tax the service (i.e. Georgia or Florida). Some data processing or SaaS providers can track the location of the user of the SaaS or remote data processing service by using features built into the product. To know the point of usage at the time the billing is prepared and when tax is applied could be a challenge and a sales tax audit nightmare.
Sales taxes are normally sourced to the state where the service is consumed. Absent a clear indication on that location, the billing address is normally used. If the default billing state taxes these services, then 100% of the service is taxed even though only a small percent may have actually been used in that state. If the service is consumed in a state that taxes that service but no tax is charged, the retailer may have a liability for uncollected tax.
If Quill is overturned in whole or in part, sellers of software and providers of data processing, information services, and SaaS may be forced into new territories with regards to sales tax.
One of the general rules of sales tax is that all sales of personal property are deemed taxable unless the seller has a valid exemption certificate from the purchaser. The most common exemption certificate used by purchasers to avoid tax is the ‘resale’ exemption certificate. This includes the Multijurisdictional Resale Certificate published by the Multistate Tax Commission and the state specific forms provided by most of the other states. Wholesalers, like the software companies discussed above, can operate nationally by having presence in only a few states. Strategically located warehouses and arrangements with common carriers allow large and small wholesalers to quickly accept and fulfill orders from customers throughout the U.S.
The wholesalers I have as clients generally have most of the resale certificates from customers in the ‘ship to’ states where the wholesaler has nexus. This may only be a few states, though. In most cases, nexus is created by the presence of a salesman or the presence of property in the ship-to state. Without the physical presence test under Quill, wholesalers may be forced to request resale exemption certificates from customers in all states regardless of the wholesaler’s physical presence in that state. Failure to obtain the resale certificate could, upon audit, subject the wholesaler to a tax liability due to a missing resale certificates. This is one of the most common areas of exposure for wholesalers.
The problem could be even more extreme for wholesalers involved with third-party-drop shipment sales. Many e-commerce sellers never take passion of the property they sell. Rather, when an order arrives to the e-commerce retailer, that retailer immediately places an order with its distributor and requests that the distributor ship the property directly to the customer. This type of drop-shipment sale includes two separate sales that occur simultaneously at the point the property is delivered to the customer. First is a sale-for- resale from the supplier to the e-commerce retailer and the second sale is a retail sale from the e-commerce company to the final customer. Without the physical nexus requirement under Quill, the suppliers will be required to charge the e-commerce company sales tax on any drop-shipment sale that is not supported by a resale certificate valid in the ship-to state.
Thankfully, most states will currently accept a resale certificate from the e-commerce company’s ‘home state’. However, the additional burden of paperwork collection by the distributor and the need for them to monitor the type certificates required in the ship-to state could be overwhelming and crippling for distributors that may be supporting shipments and drop-shipments to thousands of customers. The failure of wholesalers to have the proper exemption documentation could pose significant nationwide audit risk. Without the Quill physical nexus requirement, distributors, suppliers, and wholesalers that sell property to other retailers on a nationwide basis could be unduly exposed to a tax liability simply because they have failed to obtain a resale certificate from customers located in states where the seller does not a physical presence.
Although the primary focus of the South Dakota case is on e-commerce retailers, there will be significant collateral impact on many different business segments if the Quill physical nexus standard is abandoned or significantly modified. I’ve noted that the software, data processing, and wholesale segments would be impacted directly, but there are most likely other business segments that have been sheltered from sales tax collection by invoking the Quill physical nexus doctrine. It would be folly for businesses that are not traditional e-commerce retailers to assume that a change to the Quill physical nexus rule would not affect them. Every business will be affected in some way.
By Ned A. Lenhart, MBA CPA
Interstate Tax Strategies