The pundits are predicting that the likelihood of substantial federal income tax reform is remote for 2014. However, in regards to sales taxes, there is the potential for substantial changes and developments that could impact businesses, particularly remote sellers, and consumers in the coming year.
The interesting point is that the areas where changes are most likely clearly reflect the changes taking place in the national and global marketplace. The explosive growth of remote sales over the internet, and the onset of “cloud” computing, have sales tax jurisdictions playing catch up, with an increased chance of involvement at the federal level.
A short history lesson will help. Since the long ago dark ages of 1992, a U.S. Supreme Court Case, Quill Corp. v. North Dakota, has been the law of the land in terms of a state’s ability to require a business to collect and remit sales taxes. Quill was mail order vendor having no property, employees, or agents in North Dakota, but it did have a large number of customers located in-state. The Court had to determine if this degree of activity passed the threshold of physical presence, or nexus, required by the Commerce Clause of the U. S. Constitution and prior Court decisions. The Court decided it did not pass the threshold, and therefore North Dakota could not require Quill to collect and remit sales taxes on sales to its in-state customers. The Court did, however, indicate that ultimately the issue would be one best decided by federal legislation, and ever since the decision the states, taxpayers, and the courts have argued what level of physical presence is sufficient to create nexus.
In 1992, remote selling over the internet was a fraction of current levels, and cloud computing on a commercial level was non-existent. In 2014, both have become significant issues from a sales tax perspective. Let’s examine the most far reaching first- the taxation of internet sales.
In May, 2013, the Senate passed, with strong bipartisan support, the Marketplace Fairness Act, or MFA.
The MFA was passed, at least ostensibly, to level the playing field between brick and mortar businesses already collecting sales tax in a jurisdiction, and internet sellers without a physical presence that were not charging their customers sales taxes. Small remote sellers, those with less than $1.0M in annual, would be exempt. However, Congress made clear that a driving force in the legislation was to allow the states a way to collect sales taxes on the ever growing level of internet sales, versus on relying on customers to step up and self-assess taxes on internet purchases.
The MFA has languished in the House Judiciary Committee since last year. However, the MFA is getting renewed attention, and states and some industry groups are lobbying Congress to act, saying that something needs to be done at the federal level to resolve the issue.
Who needs to be concerned with this? Interestingly enough, not just companies with large internet sales.
Any remote sellers with nation-wide customers that have no physical presence outside their home state would be impacted by any legislation modeled on the MFA. Included would be mail order sellers, distributors, phone sellers, and others. The real issue is not so much the loss of any business from customers now required to pay sales taxes, but rather the heavy cost of compliance. There are over 10,000 sales taxing jurisdictions in the United States. Any MFA style legislation must take into account the complexity and cost of compliance inherent in properly calculating and remitting multi-state sales taxes, particularly for smaller and medium sized businesses. Additionally, state taxability of products is a hodgepodge of different interpretations and exemptions. Again, only well drafted legislation that simplifies the process and establishes consistency between taxing jurisdictions can avoid the problem.
One other area with evolving sales tax treatment concerns cloud computing. A full technical description of what cloud computing is, and isn’t, is beyond the scope of this article. For our purposes, let’s define cloud computing as a combination of software, applications, platforms, and related services, accessed by remote users, over the internet.
Cloud computing products and services are a dilemma form a sales tax perspective. The states have a complete mixed bag of interpretations of what cloud products are, whether or not the various components are taxable or not, and if taxable, where the sale takes place. Is the product a professional service, a software license, or something in between? If taxable, where does the sale take place? A vendor providing support may be in one state, with its server hosting the product in another, while the customer has multiple users accessing the product from mobile devices all over the country. The traditional model of sourcing taxable product sales to a set geographic delivery point just don’t apply with the typical cloud computing product.
While interested parties are calling for federal intervention in the issue, one thing is certain- individual jurisdictions will continue to decide the issue on their own, resulting in potential multiple exposures for buyers and sellers in the cloud computing space.
The author has seen multiple sales tax audits where cloud products, typically described as Software as a Service, or SAAS, are an issue with sales tax auditors. The process involves a thorough reading of the sales contract to try and determine how the products and sales purchased fit a particular jurisdiction’s guidance as to taxability, followed by determining where the sale or transfer actually takes place.
The takeaway in regards to cloud computing products- sales tax guidance is ambiguous, and the taxability of such products will come up under audit. Reviewing contracts and discussing sales taxability upfront is advised.
In closing, no one can predict how and when the federal government may get involved in these issues, or if the matters will be left to the states to determine on an individual and case by case basis. Business owners and consumers just need to be aware of the issues, and try to address them to the best extent possible before the sales tax auditor arrives.
Jeffrey Corey is senior counsel based out of our Rochester, NY office.