By Aftab Jamil and David Yasukochi, BDO, USA, LLP
The impact of the U.S. Supreme Court’s decision in South Dakota v. Wayfair, now over a year since it was handed down, continues to reverberate throughout the business world. As the year wears on, it’s clear the decision carries implications for industries beyond retail and, indeed, for the very basic functions of any business with multi-state operations, which clearly includes technology companies. Not understanding these implications can have significant financial consequences for technology companies—for example failure to collect sales taxes on remote sales can result in significant tax assessments for the seller beside other income tax related ramifications.
Management, with their tax advisor’s guidance, should be assessing potential sales and use tax exposures in light of Wayfair. Management should also consider how the Wayfair decision affects some less-obvious areas of their organizations. Managing the fallout from Wayfair requires a holistic view of how your business’ areas of operation intersect with sales taxes, as well as other state taxes, such as income taxes. In other words, it requires leaders at technology companies to develop a comprehensive understanding of their total tax exposure.
The technology industry continues to pull at the thread of the Wayfair decision, unraveling its implications from income tax obligations and mergers and acquisitions (M&A) repercussions, to financial reporting changes and new marketplace facilitator tax laws. As with most matters concerning taxes, these issues seem straight-forward but can be very complex.
Wayfair Sheds Light on Historical Noncompliance
In its June 21, 2018, decision, the U.S. Supreme Court replaced the physical presence nexus standard in favor of an economic one, thereby removing constitutional barriers to states’ lawful ability to collect sales and use taxes from out-of-state sellers. The Wayfair decision had a domino effect: States began adding or revising statutory language for remote sales/use tax collection, and several states introduced laws that automatically went into effect following the decision. As of the publication of this article, all but two states (Florida and Missouri) have enacted an economic nexus rule, which makes collecting and remitting sales taxes a likely necessity: If you aren’t collecting sales tax, or aren’t collecting the proper amounts, you may be taking on significant financial risks.
In light of the Wayfair decision, it is appropriate for every management team to reassess its organization’s nexus, or connection, with each state where it ships or delivers sales. For many, this assessment may reveal a business already had state tax nexus, even before the Wayfair decision was issued, because they had an in-state physical presence. For example, software providers often offer onsite installation and training to accompany their product sales. If this is the case, the software seller most likely already had an in-state physical nexus because of the onsite installation service performed in the state. It is prudent for such sellers to quantify their historical exposures and consider mitigating historical liabilities through voluntary disclosure agreements (VDAs) before registering for sales taxes.
State Income Tax Obligations Triggered
The tax implications of Wayfair extend beyond sales and use taxes. The Supreme Court held that an activity is subject to a state’s power to tax when “the taxpayer [or collector] ‘avails itself of the substantial privilege of carrying on business’ in that jurisdiction.” As such, Wayfair lifts the constitutional barriers to states imposing state income tax filing obligations on remote sellers, too.
Many businesses have been anticipating states will pass laws that codify not only their entitlement to sales taxes, but state income taxes, too. However, from the state income tax perspective, this generally has not happened. Most states already have a general nexus provision in their statutes that allows them to levy income taxes to the fullest extent allowed under the U.S. Constitution.
As a next step, states will likely clarify and/or enforce their preexisting laws. Massachusetts, for example, issued a proposed regulation indicating that if a remote seller’s sales volume exceeds the state’s sales tax safe harbor threshold, barring Public Law 86-272 immunity, the company will have an income tax filing obligation, too. Public Law 86-272 is discussed below, but as an overview: If you are selling tangible property such as hardware, then you may still be protected under this 1959 federal statute, which prevents states from levying an income tax on out-of-state companies if their activities within the state are limited to soliciting orders for the sale of tangible personal property and if the orders are approved and filled from outside the state.
Rather than proactively preparing to address any income tax exposure, many companies are delaying action until they receive a notification from state taxing authorities that says they need to file income tax returns. For obvious reasons, this isn’t the best way to manage potential tax exposure. To determine whether you may be required to pay state income taxes, first look at the composition of your sales. Are you selling tangible property or a service? For technology companies, it could be either, as many companies offer solutions that may include installation, training, maintenance and hosting services in addition to hardware/software products.
However, if you are selling SaaS solutions or tangible property that is installed by a company employee or contractor, these sales, by definition, contain a service element, which precludes Public 86-272’s applicability, unless the unprotected activities are de minimus.
Technology companies should also be aware of the possibility that while states may not seek to apply an economic nexus standard for sales and use taxes for periods prior to the June 2018 Wayfair decision, they may do so for other tax liabilities.
Financial Statement Obligations
Wayfair will also have an impact on financial accounting under GAAP, namely, Accounting Standards Codification (ASC) 450 for sales taxes and 740 for state income taxes.
ASC 450 outlines the accounting and disclosure requirements for loss contingencies. This GAAP rule provides that an estimated loss from a loss contingency must be accrued as a charge to income if both the amount of the loss can be reasonably estimated and if information indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements.
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 situation, an analysis should be performed to determine if state income tax exposure exists in non-filing states due to economic nexus or factor presence rules. 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, this position will now need to be re-evaluated in light of Wayfair.