Foreign Entities Doing Business in the U.S. and Domestic Start-ups: Are you “Wayfair-aware?”
Setting the Stage
Foreign Direct Investment benefits the United States as foreign companies build new manufacturing and research facilities, creating employment opportunities across the country. Foreign companies are drawn to the U.S. by its large trading markets, educated workforce and stable political and business environments. However, a trap for the unwary exists in the form of a disjointed and mostly-unaffiliated U.S. state and local tax regime; over 10,000 distinct tax jurisdictions exist within the U.S., each looking for its “piece of the pie” in the form of income taxes, capital taxes and transaction taxes (e.g. sales and use taxes).
It is reasonable for a company with physical presence in a location to expect to be subjected to the taxing powers of that jurisdiction, however, what some foreign companies (and perhaps domestic start-ups that lack state and local expertise) may not know is that taxation without physical presence is becoming prevalent at the state and local level in the U.S. In fact, change to the assertion of economic nexus to state and local taxing regimes (both income and indirect taxes) is occurring so rapidly that many U.S. domestic corporations are frequently faced with unexpected tax liabilities. And a frequently heard but mistaken statement from foreign companies is, “Well, sales tax is no different from Value Added Tax that we already deal with now.” It is, in fact, very different.
Dating back decades, a physical presence requirement was the coin of the realm in the sales tax world, because of the 1967 case, National Bellas Hess, Inc. v. Department of Revenue of Illinois[i] and the 1992 case Quill Corp. v. North Dakota[ii] where the U.S. Supreme Court (“USSC”) reaffirmed the physical presence requirement of Bellas Hess to prevent undue burdens on interstate commerce. Quill’s physical presence requirement stood until South Dakota v. Wayfair Inc.[iii] in 2018 where the USSC overturned the decision of the South Dakota Supreme Court and found that the physical presence standard is “unsound and incorrect.” The USSC further found that the Substantial Nexus requirement of Complete Auto Transit is “clearly sufficient based on both the economic and virtual contacts” the remote sellers had with South Dakota; by defining specific transactional counts and dollar values as thresholds for the delivery of goods to South Dakota customers, the seller was found to be engaged in the substantial privilege of conducting business in the state.
The Nitty Gritty
So what does all that mean to you? Well, if you are responsible for tax filings for a U.S. domestic corporation, you are likely aware of South Dakota v. Wayfair Inc. and its fallout: the end of a physical presence requirement in many state taxing jurisdictions and the imposition of an economic nexus tax regime. (N.B. Most local jurisdictions continue to require a physical presence even if their particular state has transitioned to economic nexus.) If you are responsible for tax filings for a foreign corporation with significant physical presence in the U.S. with a U.S.-based tax department, you are likely also “Wayfair-aware.” However, if you are responsible for the tax filings of a foreign corporation with little or no U.S. physical presence then this might be a wakeup call. Likewise, if you are the tax director, controller or chief financial officer for a domestic startup lacking state and local tax expertise, then this might also be something for you to address in order to avoid significant sales tax exposure.
South Dakota’s “economic presence” standard for sales tax collection contradicted all prior case law:
- Retailers with no physical presence in South Dakota were required to collect tax if they have:
- $100,000 in annual sales; or
- 200 transactions during the calendar year
The USSC having upheld the constitutionality of this “threshold” nexus principle meant that physical presence is no longer required and that “threshold nexus” is the new brightline test. Is $100,000 the new threshold? Some states are as low as $10,000 (ID, OK, PA, WA) and some states as high as $500,000 (CA, MA, NY, TX). In terms of transaction levels, states have generally followed South Dakota’s lead (200 transactions) although some states have no transaction threshold, leading one to ask, “Does one large transaction create nexus?”
A concerning fact is that virtually all U.S. states now have Wayfair-like laws on the books for sales tax. Also concerning is that failure to reach a threshold does not equal a “no filing requirement” because a state can still argue that substantial nexus exists. And to add to the headaches, some states may apply Wayfair retroactively.
The Real Nitty Gritty
Other considerations that might effect those that are not “Wayfair-aware” include:
- Application of threshold(s)
- Which sales “count” (taxable versus non-taxable)
- The measurement period (prior year, current year, past 4 quarters, etc.)
- When must a company become compliant (immediately/grace period)
- Click-through nexus
- Do thresholds apply individually or collectively?
- Affiliate nexus
- Are the activities of affiliates taken into consideration?
What about income tax?
The concept of economic nexus for income tax gained national attention in 1993 when the USSC declined to review the South Carolina Supreme Court decision in Geoffrey v. South Carolina[i], an income tax case wherein South Carolina asserted nexus against a trademark company, taxing intercompany royalties without physical presence. The assertion of economic nexus in income tax has grown somewhat over the years and has been rebadged as “factor-based nexus” and is currently applied in nine states. Because of Wayfair, it is generally accepted that assertion of economic nexus for income tax will now grow to many more states.
What do I do now?
The number one rule in U.S. sales tax is, “When in doubt, collect.” This is not new advice and if a sales tax is not collected from a customer when required, it will come out of your pocket and reduce your profit margin; it becomes your problem and liability even though it did not start out that way. Deficient tax amounts are subject to penalties and interest and penalties typically and quickly can equal 50% of the tax amounts. And to top all else, no statute of limitations exists if no filings are made. Exposure never comes off the books. ARM yourself:
- The “benefit” of threshold nexus is the identifiable “line in the sand”
- Analysis is typically quick and painless (depending on product mix) even if remedy might not be
- Identify and attack material exposures
- Voluntary disclosure (to limit lookback period, penalties and/or interest)
- Every state has formal or informal programs
- Customer recovery/documentation
- Automation is a necessity
- Balance of exposure and administrative burden critical
- Training both accounting and tax personnel
GAGNONtax has been specializing in tax consulting, compliance and technology for over 20 years. Reach out today to see if we can help you solve your corporate tax challenges!
1 386 U.S. 753 (1967)
2 504 U.S. 298 (1992)
3 138 S. Ct. 2080 (2018)
4 114 S. Ct. 550 (1993)