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While the U.S. Supreme Court’s decision in South Dakota v. Wayfair, Inc. directly affects the state and local sales/use tax collection obligations of remote sellers, the importance of Wayfair to state corporate income taxes cannot be overlooked. Indeed, the emergence of economic nexus as a means to assert state sales/use tax jurisdiction is of recent vintage, whereas it has been applied by a substantial number of states for corporate income tax purposes back to 1993. And with the Wayfair decision, economic presence nexus is now validated for state sales/use tax and income tax purposes. This Alert examines some of the state income tax consequences of Wayfair.
On June 21, in South Dakota v. Wayfair, Inc., the U.S. Supreme Court decided “that the physical presence rule of Quill is unsound and incorrect.” As a result, the Court also held that its 1992 decision in Quill Corp. v. North Dakota and its 1967 decision in National Bellas Hess, Inc. v. Department of Revenue of Illinois, were overruled. Although Wayfair dealt with a South Dakota statute that imposed a sales/use tax collection obligation on a remote seller that had $100,000 or more of sales to South Dakota residents or engaged in 200 or more separate transactions with South Dakota residents, the Court’s decision to repudiate the physical presence rule and overturn Quill and National Bellas Hess is not limited to state sales and use taxes.
Quill, Income Tax and Economic Presence Nexus Prior to Wayfair
Like Wayfair, the Quill case also directly involved the authority of a state to impose a sales/use tax collection obligation on a remote seller that did not have a physical presence within the state. While the Court in Quill removed any physical presence requirement for “minimum contacts” nexus under the Due Process Clause in favor of a jurisdictional rule requiring “purposefully directed” economic activity at a state’s residents, the Court in 1992 re-affirmed the physical presence rule for purposes of “substantial nexus” under the dormant Commerce Clause. However, in doing so, the Court also stated “[a]lthough we have not, in our review of other types of taxes, articulated the same physical presence requirement that Bellas Hess established for sales and use taxes, that silence does not imply repudiation of the Bellas Hess rule.” Several states seized upon this dictum to begin asserting economic presence nexus for purposes of income taxes, focused primarily on licensing of intellectual property, credit card receivables, and other financial services.
Beginning in 1993 with the South Carolina Supreme Court’s decision in Geoffrey, Inc. v. South Carolina Tax Comm., today approximately 14 states have their own case law confirming that an economic presence is sufficient to establish a substantial nexus under the Commerce Clause for purposes of their corporate income taxes. The U.S. Supreme Court never agreed to hear any of these cases. While the Court’s denial of certiorari is not tantamount to the Court’s agreement with the merits of the lower state court’s decision, with Wayfair these states’ position has been validated. In addition to the 14 states with economic presence case law, states such as New Hampshire, Oregon, and Wisconsin have enacted statutes that assert corporate income tax nexus when a corporation has a “substantial economic presence” or “significant economic presence.” Further, even prior to Quill and Geoffrey, the states of Indiana, Minnesota, Tennessee, and West Virginia asserted economic presence nexus over banks and financial organizations.
Although the Court was concerned with retroactivity in Wayfair, the South Dakota statute at issue operated prospectively only (and most similar sales/use tax statutes of other states, in addition to being of recent enactment, are being enforced prospectively only, with a few exceptions). However, the retroactive effect of economic presence nexus for state corporate income tax purposes is a real and practical concern. Corporate taxpayers will need to revisit income tax nexus positions they may have taken in prior years as a result of Wayfair (see below).
Factor-Presence Nexus Statutes
Similarly, in 2002, the Multistate Tax Commission (MTC) adopted a proposed model statute for a factor-presence nexus standard for business activity taxes (e.g., net income and gross receipts taxes). Ohio was the first state to adopt such a statute (for its commercial activity tax or “CAT”) in 2005. Since then, eight other states have adopted factor-presence nexus statutes for corporate income tax purposes: Alabama (2015); California (2011); Colorado (2010); Connecticut (2010); Michigan (2012); New York (2015); Tennessee (2016); and Washington (2010, for business and occupation tax purposes). Virginia has also asserted income tax nexus on out-of-state corporations that have any positive apportionment factor. In addition to property factor and payroll factor thresholds, these statutes assert income tax jurisdiction over an out-of-state corporation that has a minimum level of sales sourced to the state. The sales factor threshold may be as low as $350,000 for Michigan or as high as $1 million for New York. With the exception of Washington, the other states, including Ohio, use a $500,000 sales threshold, although Alabama’s and California’s sales thresholds (and property and payroll thresholds) are indexed to inflation (as is Washington’s). For example, for the 2017 tax year, California’s sales threshold is $561,951 (originally established at $500,000 for the 2011 tax year). Washington’s 2018 calendar year sales threshold is set at $285,000 (originally established at $250,000 in 2010).
These factor-presence nexus statutes have been challenged in some states. For example, the Ohio Supreme Court upheld Ohio’s factor-presence nexus statute as sufficient to establish a substantial nexus in Crutchfield Corp. v. Testa (2016). As a result of the Wayfair decision, including holding South Dakota’s $100,000 sales or 200 or more transactions thresholds as sufficient for substantial nexus, these state statutes appear to be on sound footing as far as the substantial nexus requirement of the Commerce Clause is concerned. While their retroactive enforcement could be viewed as an undue burden on commerce, given Geoffrey and progeny and now Wayfair, challenging retroactive application of Wayfair could be difficult for taxpayers.
For the same reason that states that have not enacted economic nexus statutes for sales/use tax purposes will now likely jump on board after Wayfair, it is also likely that more states will join the nine that have enacted such statutes for net income tax and gross receipts tax purposes.
Influence of the Market-Based Sourcing Trend
After Wayfair and the constitutional validation of economic presence nexus for income tax purposes, a corporate taxpayer’s state income tax nexus considerations must now also consider sales factor sourcing. For a taxpayer that does not maintain a physical presence in a state (e.g., employees, agents, offices, facilities, or other property or representatives), the sourcing of the taxpayer’s sales for purposes of the state’s sales factor will now largely determine if that taxpayer has nexus. The days of separate nexus studies or separate apportionment studies are over. They are now one and the same.
In tandem with factor-presence nexus statutes, single sales factor apportionment formulas, and unitary combined reporting, market-based sourcing with respect to receipts from sales of services and sales or licenses of intangibles is one of the major current state corporate income tax trends. From only a handful of states five years ago, today 25 states require market-based sourcing (and beginning in 2019, Colorado and New Jersey will be the 26th and 27th states, respectively). Arizona and Missouri also require market-based sourcing when single sales factor apportionment is elected (and Missouri will require market-based sourcing starting in 2020). Of the states that currently have factor-presence nexus statutes, all require market-based sourcing (Colorado starting in 2019).
For a service provider or licensor of intangible property, including software, market-based sourcing for purposes of the sales factor could expand these corporations’ income tax nexus exposure. As more sales are sourced to such taxpayers’ market states where their customers are located, if these states have enacted factor-presence nexus statutes (or simply assert audit positions based on existing “doing business” tax jurisdiction statutes and Wayfair), service providers and licensors will find an increasing income tax nexus environment.
Re-emergence of the Due Process Clause?
After Quill, the Due Process Clause declined in importance as a limit to a state’s exercise of tax jurisdiction. Ironically, after Wayfair, the Due Process Clause may now be the only effective limit on a state’s income tax jurisdiction, at least for some taxpayers. While one may presume that an out-of-state company wouldn’t have any sales sourced to a state for purposes of the sales factor if that company has not purposefully directed economic activity into that state, this is not always an accurate or realistic presumption. Further, because a state’s sales factor sourcing rules could now serve a dual role in addition to what they are intended to perform, a formulary division of income of a taxpayer that has nexus with the state, and also determine if such nexus exists, conflict with due process limitations on state taxing authority appear inevitable.
For “minimum contacts” nexus under the Due Process Clause to be satisfied, a taxpayer must purposefully direct economic activity to a state’s residents. A service provider that solicits a state’s residents for sales and provides services that benefit that state’s residents is likely to have purposefully directed such economic activity to those residents. However, what if those services are provided to a customer “X” in State A that, in turn, provides the services to (or the services benefit) customer X’s customers in State B? Under so-called “look-through rules,” a state market-based sourcing regulations may source the services receipts to State B. Even though the service provider has never directed any economic activity to residents in State B, it may have sales sourced to State B, because customer X purposefully directed economic activity into State B. If those State B sourced sales exceed $100,000 (or a state’s factor-presence sales threshold), Wayfair now instructs that is sufficient for substantial nexus under the Commerce Clause. But has the service provider satisfied Due Process Clause minimum contacts nexus with State B?
Similar results could occur for certain sellers of tangible personal property. Under some fact patterns, the seller of tangible personal property may have sales sourced to a destination state for sales factor purposes, but the seller has never purposefully directed economic activity to that state’s residents. The sale to the ultimate customer in the destination state may have been the result of the unilateral activity of a third party.
Public Law 86-272 was not Overruled
At least for sellers of tangible personal property, Public Law 86-272 (15 U.S.C. Section 381-384) remains as the principal limitation on the exercise of state net income tax jurisdiction, including for those states that have enacted factor-presence nexus statutes or that otherwise assert economic presence nexus for corporate income tax purposes. Therefore, as long as such seller’s activities in a state are limited to solicitation of orders for sales of tangible personal property (including activities entirely ancillary to solicitation), that are approved or accepted outside of that state, and that are filled by shipment or delivery from a point outside the state, the seller cannot be subject to a state’s net income tax. As a result, after Wayfair Public Law 86-272 will take on increased importance for sellers of tangible personal property. Conversely, states should be expected to narrowly interpret the protections of Public Law 86-272 and intensely scrutinize taxpayer claims of protection from net income taxes under the federal law.
ASC 740 Implications
While Wayfair will impact the accounting for sales and use tax contingent liabilities under ASC 450, the impact of the decision on accounting for state income taxes under ASC 740 should also be considered. Under ASC 740, existing income tax positions must be reassessed at each balance sheet date to determine whether an income tax benefit should be recognized, or continue to be recognized, and if so, how much of the benefit should be recognized based on new information. Depending on a corporation’s specific facts, an analysis should be performed so that existing state income tax positions after Wayfair are reassessed during the financial statement period that includes the June 21 date of the Wayfair decision. Given that a company may have taken a historic position in reliance on constitutional arguments that a physical presence was required before a state may impose an income tax, which position will now need to be re-evaluated in light of Wayfair.
For example, it has been widely and publicly reported that Wells Fargo adjusted its state income tax reserves after the Wayfair decision. In a July 13 announcement, the company disclosed a $481 million net discrete income tax expense mostly related to state income taxes and the Wayfair decision.
Beyond nexus, Wayfair also could have implications for existing and historic income tax return filing options and elections.
For more information, please contact your Marvin and Company, P.C. representative.