Use State Voluntary Taxpayer Disclosure When Complying with Expanded Nexus

I. Introduction

Over the past 25 years new types of expanded non-physical nexus have come to be recognized. These types of expanded nexus are:

  • Economic Nexus: Income Taxes
  • Click-Through or Agency Nexus: Sales Taxes
  • Affiliate and Attributional Nexus: Sales Taxes and Income Taxes

Failing to comply with those expanded nexus standards can be just as serious to the financial well-being of the company as failing to comply with state tax obligations arising from physical nexus. This article suggests company-wide action plans for dealing with unanticipated[1] tax exposures arising from the application of the above-listed types of expanded state tax nexus. As a company plans to come into compliance, it will want to consider obtaining the following benefits[2] arising from participation in state voluntary disclosure programs:

  • Avoidance of the threat of criminal proceedings against the company and its management;
  • Avoidance of taxes accrued before the lookback period commenced;
  • Avoidance of failure-to-file and failure-to-pay penalties normally imposed on unpaid taxes accrued during the lookback period; and
  • Possible avoidance of interest on unpaid taxes accrued during the lookback period.

A brief discussion of (1) economic nexus, (2) “click-through” nexus and (3) affiliate and attributional nexus follows. In each case I suggest an appropriate action plan for affected companies to consider.

II. Complying With Economic Nexus Standards

“Economic presence” allows a state to tax a company’s income even if it does not have a physical presence in the state. Here is an example of an economic nexus statute from the State of New Hampshire:

“Business activity” means a substantial economic presence evidenced by a purposeful direction of business toward the state examined in light of the frequency, quantity, and systematic nature of a business organization’s economic contacts with the state. “Business activity” includes, but is not limited to, a group of actions performed by a business organization for the purpose of earning income or profit from such actions and includes every operation which forms a part of, or a step in, the process of earning income or profit from such group of actions….[3]

Below is an example of an economic nexus statute from the Commonwealth of Massachusetts:

“Engaged in business in the commonwealth” [means] … (d) regularly performing services in the commonwealth; (e) regularly engaging in transactions with customers in the commonwealth that involve intangible property and result in income flowing to the taxpayer from residents of the commonwealth; (f) regularly receiving interest income from loans secured by tangible personal or real property located in the commonwealth; or (g) regularly soliciting and receiving deposits from customers in the commonwealth. With respect to the activities described in clauses (d) to (g), inclusive, activities shall be presumed, subject to rebuttal, to be conducted on a regular basis within the commonwealth, if any of such activities are conducted with one hundred or more residents of the commonwealth during any taxable year or if the taxpayer has ten million dollars or more of assets attributable to sources within the commonwealth, or has in excess of five hundred thousand dollars in receipts attributable to sources within the commonwealth.[4]

Presently, about 35 states have adopted some type of “economic presence” standard including recent nexus legislation enacted by Alabama[5] (August 11, 2015); Tennessee[6] (May 20, 2015) and New York[7] (March 31, 2014). Under U.S. Supreme Court case law, a state cannot impose sales and use taxes without the physical presence of the taxpayer.[8] Also, a state cannot assert income taxes against an out-of-state vendor if the requirements of Public Law 86-272 apply. But Public Law 86-272 does not apply to sales of services[9] or to the sale or license of intangible personal property.[10] Thus, as a practical matter, states are permitted to impose “economic presence” nexus against three types of multi-state business income:

  • Sales of services;
  • Interest income;[11] and
  • Royalty income from in-state use of tangible personal property, such as registered trademarks.[12]

Action Required

A company must identify the foreign states from which its sales of services and/or royalty income are derived. Then, the company must confirm, state-by-state, if it has complied with the economic nexus rules of each state. As noted, these nexus rules may require the company to file corporate income tax returns to report services income and/or royalty income derived from these states.

The company might want to involve a tax-oriented law firm so that the law firm’s conclusions regarding possible income-tax non-compliance might be protected from disclosure under the attorney/client privilege.[13]

Where noncompliance exists, the company should consider resolving its exposure to foreign state income taxes under that state’s voluntary disclosure program to achieve the benefits listed on the first page of this article.

III. Complying With Click-Through or Agency Nexus Standards

These “click-through” nexus laws apply to sales taxes.[14] As noted earlier, out-of-state sellers of tangible personal property are exempt from sales taxes unless they have a physical presence in the taxing state. Under “click-through” nexus laws, an out-of-state seller is presumed to have physical presence (and thus tax nexus for sales tax purposes) with a taxing state if the out-of-state seller pays a commission to an in-state business who, through an internet link or otherwise, refers customers to the out-of-state seller’s website. The “click-through” nexus laws also require that (1) the referral results in a sale; and (2) the remote seller’s annual sales from those referrals reach a certain dollar threshold.[15]

The following states and territory have adopted some form of “click-through” nexus: Arkansas, California, Connecticut, Georgia, Illinois, Kansas, Maine, Michigan, Minnesota, Missouri, Nevada, New Jersey, North Carolina, Ohio, Rhode Island, Tennessee, Vermont, Washington and Puerto Rico.[16]

A. Action Required

First, a company must identify the vendors of foreign states to whom the company pays “click-through” commissions arising from the internet sale of tangible personal property. The company must then confirm, state-by-state, if the foreign state has a “click-through” nexus law and, if so, that it is collecting and paying over sales taxes to the foreign state.

Second, the company might want to involve a tax-oriented law firm so that the law firm’s conclusions regarding possible non-compliance might be protected from disclosure under the attorney/client privilege.[17]

B. Urgent Action Required

Where noncompliance exists, the companies should consider resolving its exposure to foreign state sales taxes under that state’s voluntary disclosure program to achieve the benefits listed on the first page of this article. The matter is urgent since there is potential criminal exposure to the company and its management arising from the intentional failure to collect and pay over sales taxes.[18]

IV. Complying with Affiliate and Attributional Nexus

Out-of-state companies with in-state affiliates may find themselves subject to sales and use taxes.[19] There are several types of affiliate and attributional nexus:[20]

  • Out-of-State Vendor Is in Same Line of Business as In-State Related Party. The out-of-state and in-state entities are related parties and are in the same or similar lines of business, sell similar products, use similar trademarks, etc. An example is Toys “R” Us.[21] States which impose this requirement on out-of-state vendors include: Alabama, Arkansas, Colorado, Georgia, Iowa, Kansas, Maine, Michigan, Missouri, New York, Nevada, Ohio, Oklahoma, South Dakota, Texas, Utah, West Virginia and Puerto Rico.[22]
  • Out-Of-State Vendor Uses the In-State Warehouse of a Related Party. An out-of-state vendor, such as Amazon,[23] is required to collect and pay over sales taxes if the out-of-state vendor uses an in-state warehouse owned by an affiliated entity. States which impose this requirement on out-of-state vendors include: Arkansas, Colorado, Georgia, Iowa, Kansas, Michigan, Missouri, New York, Nevada, Ohio, Oklahoma, South Dakota, Texas, Utah, West Virginia and Puerto Rico.[24]
  • In-State Related Party Performs Services for the Out-of-State Vendor. An out-of-state vendor is required to collect and pay over sales taxes if the out-of-state vendor, such as Barnes & Noble,[25] uses an in-state affiliate to perform services for it such as accepting returns. States which impose this requirement on out-of-state vendors include: Alabama, Arkansas, Colorado, Georgia, Iowa, Kansas, Maine, Michigan, Missouri, New York, Nevada, Ohio, Oklahoma, South Dakota, Texas, Utah, West Virginia and Puerto Rico.[26]
  • Out-of-State Related Party is a Member of a Commonly-Controlled Group that Has an In-State Retailer as a Component Member. States which impose this requirement on out-of-state vendors include: California,[27] Michigan, Ohio, Oklahoma and South Dakota.[28]

A. Action Required

An out-of-state vendor must identify the states to whom it sells tangible personal property. Then, the out-of-state vendor has to determine, state-by-state, whether the out-of-state vendor is responsible for sales taxes based on affiliate and/or attributional nexus, as outlined above.

An out-of-state vendor must also identify the states where affiliates may perform services as representatives, such as installation of tangible personal property or acceptance of the return of tangible personal property.[29] Then, the out-of-state vendor has to determine, state-by-state, whether the out-of-state vendor is responsible for income taxes arising from the sale of tangible personal property into the foreign state.[30]

The company might want to involve a tax-oriented law firm so that the law firm’s conclusions regarding possible non-compliance might be protected from disclosure under the attorney/client privilege.[31]

B. Urgent Action Required

Where noncompliance exists, the companies should consider resolving its exposure to foreign state sales taxes under that state’s voluntary disclosure program to achieve the benefits listed on the first page of this article. The matter is urgent since there is potential criminal exposure to the company and its management arising from the intentional failure to collect and pay over sales taxes.[32]

V. Conclusions

Expanded state nexus standards represent a serious threat to the financial well-being of both retailers (sales taxes) and service providers (income taxes).[33] While Congressional action is required to achieve clarity and uniformity, such Congressional action is not likely to be forthcoming any time soon. Meanwhile, companies are strongly advised to identify their exposure to expanded nexus laws and take effective corrective action to come into full tax compliance. In identifying their exposure, companies will want to consider using tax-oriented law firms to receive protection from the disclosure of their tax exposure under the attorney/client privilege.[34] In taking corrective action, companies will want to consider state voluntary disclosure programs that can help them avoid criminal exposure for the company and its management; reduce the “look-back period” for determining the amount of unpaid taxes; and eliminate penalties and, in some cases, interest on the unpaid taxes.

The material in this publication does not constitute legal advice. It is intended for general information purposes only. If legal issues arise, the reader should consult legal counsel. If you have questions or need assistance with regard to tax debts or tax controversies with the IRS, the attorneys at M. Robinson & Company may be able to assist you. Please feel free to contact us at 617-428-6900.

 

[1] The author emphasizes that the use of voluntary disclosure is appropriate in resolving unanticipated after-the-fact tax exposures. It is both unethical and probably illegal to advise or suggest to a client’s management that they intentionally flout the expanded nexus rules and then later attempt to take advantage of voluntary disclosure programs to mitigate their exposure and their company’s exposure to additional tax, penalties and interest. Moreover, the taxpayer will try to demonstrate its “good faith” through justified reliance on its tax professionals.

[2] State Voluntary Disclosure Programs: An Overview by Morris N. Robinson. State Tax Notes, Page 225, January 18, 2016.

[3] See RSA 7-A:1, XII

[4] M.G.L. c. 63 § 1.

[5] Alabama Act 505 (H.B. 49), 1st Spec. Sess., Laws 2015, adding ALA. CODE § 40-18-31.2.

[6] Tennessee H.B. 644 (Revenue Modernization Act).

[7] New York State Part A of Chapter 59 of the Laws of 2014. See New York State laws, Article 9-A Section 209(b).

[8] National Bellas Hess, Incorporated v. Department of Revenue of the State of Illinois, 386 US 753 (May 8, 1967) and Quill Corporation v. North Dakota, 504 US 298 (May 26, 1992). At least one state, Alabama, has challenged these case holdings by regulation.  See Alabama Rule 810-6-2-.90.03 which requires out-of-state sellers to collect and pay over sales taxes where the out-of-state seller has more than $250,000 in tangible personal property and conducts activities that might not involve physical presence under Alabama Code Section 40-23-68. See Alabama Code Section 40-23-68(b)(8) (“Solicits orders for tangible personal property by means of a telecommunication or television shopping system which is intended by the person to be broadcast by cable television or other means of broadcasting, to consumers located in this state;”).

[9] Public Law 86-272 also does not protect a company against gross receipts taxes, which are not based on income.

[10] Public Law 86-272; 15 U.S. Code § 381 (1959).

[11] Capital One Bank v. Commissioner of Revenue, 453 Mass. 1 (January 8, 2009).

[12] Geoffrey, Inc. v. Commissioner of Revenue, 453 Mass. 17 (January 8, 2009). One of the first such cases was Geoffrey, Inc. v. South Carolina Tax Commission, 313 S.C. 15 (July 6, 1993).

[13] Not all communications between an attorney and his/her client is protected under the Attorney/Client privilege. Communications related to the tax exposure of a company for use in determining whether or not to proceed under a voluntary disclosure program might qualify for protection under the attorney/client privilege. The reasoning is that the legal work is being performed in anticipation of potential future litigation should the client not be accepted into the state’s voluntary disclosure program. Communications related to the amount of the exposure for purposes of a filing with the Securities and Exchange Commission, however, are not protected. The reasoning is that the work was not performed in anticipation of future litigation. Rather, it was performed to support the state and local tax reserve in the SEC filing.

[14] They do not apply to corporate income taxes to the extent that Public Law 86-272 applies.

[15] The Tax Adviser, June 1, 2014. Clicking Through to Nexus? Sales Tax Nexus Lessons from 2013 by Mary Van Leuven.  http://www.thetaxadviser.com/issues/2014/jun/clinic-story-05.html (Last visited February 7, 2016)

[16] Disclaimer: The listings of states with various forms of expanded nexus were taken from sources believed to be reliable. The author did not, however, attempt an independent verification that (1) all listed states have the particular type of expanded nexus specified in the text; and (2) that no state with a specified type of nexus was omitted from the listings of affected states. In addition, no representation can be made that each state applies its individual nexus law identically. Thus, the reader is directed to confirm the application of each state’s expanded nexus law to each potentially affected business taxpayer.

[17] Not all attorney/client communications are privileged. See Footnote 14, above.

[18] For details regarding criminal exposure, see my January 18, 2016 article in State Tax Notes, cited in Footnote 3, above. Criminal exposure is intensified if sales taxes have been collected but not paid over to the taxing authority.

[19] Out-of-state companies are protected from state income taxes under Public Law 86-272. If, however, an in-state affiliate installs tangible personal property or accepts returns of tangible personal property as a representative of the out-of-state company, the protection against income taxes may be lost. See Paragraph (3), immediately below.

[20] For an authoritative but dated overview, see A New Way Forward for Remote Vendor Sales Tax Collection by Robert D. Plattner, Daniel Smirlock, and Mary Ellen Ladouceur. State Tax Notes, January 18, 2010, Page 187. The writers were high officials of the New York State Department of Taxation and Finance at the time they co-authored this article.

https://www.tax.ny.gov/pdf/stats/policy_special/a_new_way_forward_for_remote_vendor_sales_tax_collection.pdf?_ga=1.239046464.1502023043.1422485311 (Last visited February 7, 2016)

[21] Toys R Us operates in various jurisdictions. These entities are in the same line of business (retail sales); sell the same general products (children’s toys); and utilize the same intangible personal property (Geoffrey the Giraffe®). See New York State Department of Taxation and Finance TSB-M-09(3)(S (May 6, 2009) Example 1: “Because Company A and CompanyA.com use the same trade name in New York, CompanyA.com … must register for sales tax purposes and collect New York State and local sales tax.”)

[22] See Footnote 17, above: Disclaimer.

[23] See, for example, New York State Department of Taxation and Finance TSB-M-09(3)(S (May 6, 2009) (“[A]ctivities that will result in vendor status include, but are not limited to … fulfilling sales [instate] ordered from the remote affiliate’s Web site or catalog ….”)

[24] Id.

[25] See New York State Department of Taxation and Finance TSB-M-09(3)(S (May 6, 2009) Example 2: (“Customers of CompanyR.com can visit any of Company N’s retail stores to pick up catalogs or return purchases that were made through CompanyR.com’s Web site. Because Company N holds an ownership interest in excess of 50% in CompanyR.com and accepts returns and distributes catalogs, CompanyR.com … must register for sales tax purposes and collect New York State and local sales tax.”)

[26] Id.

[27] California also requires that the in-state member perform certain services on behalf of the out-of-state entity, including product development or solicitation. See, generally, Article 17, Regulation 1684(c)(2)(A) and (B).

[28] See Footnote 17, above: Disclaimer.

[29] These activities of affiliated representatives may remove the company from the protection against income taxes that the company would otherwise enjoy under Public Law 86-272.

[30] The best practice is to review the nexus tax regulations of each affected state.

[31] Not all attorney/client communications are privileged. See Footnote 14, above.

[32] See Footnote 19, above.

[33] Retailers are particularly vulnerable because uncollected sales taxes represent a sometimes significant percent of total retail sales.

[34] See Footnote 14, above.

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