THE CENTER FOR STATE AND LOCAL TAXATION 2016 Summer Tax Institute Multistate Sales and Use Tax Track Robert W. Heller, J.D., LL.M. Clark Nuber P.S. 10900 NE 4th St., Suite 1700 Bellevue, Washington 98004 (425) 635-7424 www.clarknuber.com [email protected]

Table of Contents

I.

Introduction ................................................................................................................ 1

II.

General Overview ...................................................................................................... 1

III. Application of the Tax ............................................................................................... 6 IV. Exemptions .............................................................................................................. 11 V.

Registration & Reporting Requirements.................................................................. 16

VI. Manufacturing Issues ............................................................................................... 32 VII. Leases....................................................................................................................... 38 VIII. Taxable Services ...................................................................................................... 40 IX. Sales and Use Tax Audits ........................................................................................ 52

Appendix Streamlined Sales and Use Tax Agreement Marketplace Fairness Act

I.

Introduction

The following discussion is a general overview of sales and use tax principles and applications. The discussion is not state-specific, and addresses the common ways that states tax various transactions and industries. Each state’s sales tax rules are independent of other states, and a particular state may tax a transaction differently than discussed in this material. Any state-specific cases, rulings or other official materials provided as examples are current as of the date they were issued and may not represent the present state of the law or position of the issuing agency. Therefore, this material should not be referred to as a resource for answering any state-specific issue. II.

General Overview A.

What is a sales tax?

Among those state and local jurisdictions that impose a sales tax the tax has traditionally been imposed on the sale of tangible personal property, and in some instances on the sale of specifically identified taxable services. States are increasingly extending sales taxes to so-called “digital” products and services or “cloud computing” services, none of which fit neatly into traditional sales taxable categories. Sales taxes are generally imposed on the final consumer of a product or service, and are therefore, referred to as consumption taxes. There is no federal sales tax; sales taxes are only imposed by state and local governments. Currently, forty-five states impose sales taxes. The five states that do not impose sales taxes are New Hampshire, Oregon, Montana, Alaska (although several local jurisdictions impose sales taxes) and Delaware (although rentals of tangible personal property may be subject to tax). State level taxes are imposed at rates generally ranging from 5% to 7%. In addition to the state level tax, many localities also impose a sales tax. In most cases local level taxes are administered by the state revenue agencies and are reported and remitted to the states along with the state portion of the tax. Some localities in states such as Alabama, Colorado, and Louisiana, however, administer their local taxes separately and require the seller to complete a special local sales tax return. B.

Who is liable for sales tax?

States typically make either the seller or the purchaser primarily or nominally liable for the tax. In those instances where the seller is primarily liable for the tax, states may permit the seller to pass the burden of the tax directly on to the purchaser (shifting v. absorption). Where the purchaser is primarily liable for the tax, the seller generally has a statutory obligation to collect the tax from the purchaser and remit it to the state. Absorption of the tax by the vendor is not permitted and the tax must be separately stated on invoices or other documentation of the sale. In states where the purchaser is primarily liable, a seller who fails to collect sales tax from the purchaser is secondarily liable for the tax. Although the seller in these states is secondarily liable, the state may 1

elect to seek tax from either the purchaser or the seller and does not have to exhaust its remedies against one before proceeding against the other. Generally, in cases where the seller fails to collect the tax and is held liable, the seller may later seek the tax from the purchaser. In operation, the purchaser is generally the party that ultimately pays the tax. For purposes of determining who is liable for the tax, sales taxes can be categorized into four different types: Seller’s Privilege Tax A seller’s privilege tax is imposed on the seller for the privilege of making sales to consumers (or engaging in business as a retailer) within the state. States that impose seller’s privilege sales taxes include the following: Alabama Arizona California Connecticut Kentucky Michigan Missouri

Nevada South Carolina South Dakota Tennessee Wisconsin District of Columbia

Transaction Sales Tax Transaction sales taxes are imposed on the transaction. The seller and purchaser are generally jointly liable for the tax. Where tax is not collected on the transaction, later payment of the tax by the seller may give rise to a debt from the purchaser to the seller for the tax. Colorado Florida Georgia Idaho Illinois Indiana Iowa

Kansas Massachusetts Minnesota New Jersey Texas Virginia

Consumer Tax Under a consumer tax the liability for the tax falls nominally on the purchaser with the seller obligated to collect and remit the tax to the state. Louisiana Maine Maryland Mississippi Nebraska

Oklahoma Pennsylvania Rhode Island Utah Vermont 2

New York North Carolina North Dakota Ohio

Washington West Virginia Wyoming

Gross Receipts Tax The tax is imposed on the seller’s gross receipts. Except in the case of Hawaii, the tax may be excluded from the measure of the seller’s gross receipts. In Hawaii if the tax is passed on to the purchaser it becomes part of the measure of the seller’s receipts creating a pyramiding effect. Arkansas Hawaii C.

New Mexico

What is a sale?

In the case of tangible personal property, a sale is generally defined for sales tax purposes as the transfer of title, ownership, or possession of the property for a valuable consideration. For this purpose, states view the rental or lease of tangible personal property as a sale. Some states treat rentals or leases as periodic sales and subject each rental payment as a separate sale to tax at the time the rent is paid or becomes due. Others treat a rental or lease transaction as a single sale and require sales tax to be collected and/or paid on the entire stream of rentals at the time of the commencement of the transaction. Sales taxes are generally imposed on sales made at retail. A retail sale is generally defined as a sale to a person who is a “consumer.” For this purpose a consumer is the end user of the product or service and may be an individual or a legal entity (e.g., corporation, partnership, limited liability company, or trust). D.

What is the sales tax base?

Sales tax is generally imposed on the selling price paid or contracted to be paid in exchange for the taxable property or service, which normally consists of all consideration furnished by the purchaser or another for the benefit of the purchaser. In some cases, as will be discussed later, a portion of the tax taxable selling price may be furnished by a third party as an inducement to the purchaser to buy, such as a manufacturer’s rebate when applied to the purchase. As indicated above, sales tax is primarily imposed on retail sales of tangible personal property. “Tangible” is usually defined as something perceptible to the senses. Therefore, sales of intangible property (e.g., stocks or other evidences of ownership in business entities) are not subject to sales tax. In addition, sales of real property (e.g., land, buildings, etc.) are generally not subject to sales tax because the tax is normally only applicable to “personal,” rather than real property. Note, however, that construction materials are often 3

subject to tax when sold to a contractor or landowner even though they may become affixed to and become part of real property. While the tax is primarily imposed on the sale of tangible personal property, many states also impose sales tax on certain statutorily enumerated services, and with increasing frequency as noted above, certain electronically delivered property or services. Most sales taxes are designed to tax all sales of tangible personal property to consumers, but only selected services and electronic transactions. Several states, however, including New Mexico, South Dakota and West Virginia impose tax on all services unless specifically exempt. The sales taxation of services is discussed in more detail later in these materials. E.

What is use tax?

States that impose a sales tax also impose a use tax. The use tax is designed to work as a complement to the sales tax and applies to the use of tangible personal property by a consumer in the state when a sales tax has not been paid to the taxing state. U.S. Constitutional limits on the authority of states to impose sales taxes on out-of-state vendors (i.e., those without a taxable presence or nexus) have caused states to enact the use tax to deal with the situation of purchases made by in-state consumers where the state’s sales tax is not collected. In the absence of a use tax, in-state consumers would have a significant incentive to purchase taxable merchandise from out-of-state vendors. Example: ABC, a California manufacturer, needs to purchase $500,000 of new computer equipment. ABC purchases the equipment from Computers-R-Us, an Oregon vendor who ships the computers from California to ABC’s California location by common carrier. Computers-R-Us has no taxable presence in California. In the absence of a use tax, ABC could successfully avoid paying California sales tax on the transaction. The use tax is generally imposed on the first use of the taxable article or service within the state as a consumer. For this purpose, the term “use” is generally defined to mean the exercise of dominion and control over an article of tangible personal property within the state, and includes installation, storage, withdrawal from storage, distribution, or any act preparatory to use within the state. In the case of taxable services, use can include the beneficial enjoyment of the service within the state.

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F.

What is the use tax base?

The use tax base is generally the same as the sales tax base. However, the use tax is a complementary tax, and therefore, it is imposed only if that state’s sales tax has not already been properly paid. If another state’s sales or use tax has been paid, the states typically allow a credit for tax paid to the other state. Further, if the property has been used in one state prior to being used in a second state, the second state will typically impose the tax based on the fair market value of the property at the time of subsequent use. Example: ABC entity purchases a computer for use at its Ohio Plant and pays Ohio sales tax to its vendor. After using the computer for one year, ABC transfers the computer to another plant in Washington where it is put to use. ABC owes Washington use tax on the fair market value of the computer at the time it is put to use in the state. Collection of Use Tax by Seller The use tax is generally a tax imposed upon the purchaser. However, purchasers are not always the most compliant in filing use tax returns and remitting use tax to the states. For example, when individuals purchase clothes from L.L. Bean, very few purchasers actually self-assess and pay the use tax to the applicable state. Therefore, many states began to impose the collection burden on the seller of the property. The United States Supreme Court upheld the states’ requirement of sellers to collect and remit the use tax, provided that certain conditions are met. The most controversial condition is that the seller must have a non-de minimis physical presence within the state in order for a use tax collection obligation to arise. This physical presence is often referred to as “nexus” (meaning connection), and is the current jurisdictional requirement that must exist before a state can assert its taxing authority over an out-of-state seller. A physical presence exists if the seller owns or leases any property within the state. For example, a seller has nexus within a state if the seller stores inventory in the state, including the storage of consigned inventory. Physical presence is also established when the seller has employees or independent representatives soliciting sales or engaging in other market-making activities within the state. Representatives do not have to be employees of the seller or residents of the state in order to create a physical presence within the state.

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III. Application of the Tax A.

Elements of a taxable Transaction

In order for a state to impose sales or use tax on a particular transaction, each of the following must be present:

─

A Sale or use (taxable incident - usually requiring a purchase, but may involve a gift or bailment) That occurs within the taxing state (jurisdictional requirement) Of a taxable good or service (taxable base) For a valuable consideration (taxable measure)

B.

Presumption of Taxability

─ ─ ─

All sales of tangible personal property or the provision of taxable services occurring within a taxing state are presumed to be taxable unless a properly documented exemption from tax exists. C.

Sale

As indicated earlier in these materials, a sale is generally defined as a transfer of title, ownership or possession for a valuable consideration. Transfer of Title Title is generally considered synonymous with ownership and is the means by which one establishes ownership of property. The transfer of title without possession is still considered a sale for sales tax purposes. In some states a transfer of title solely for security purposes where the user retains possession and has the equitable right of redemption may not be considered a sale. Transfer of Possession The transfer of possession for a valuable consideration is considered a sale. Possession is generally defined as the exercise of physical dominion and control over property. In some states the grant of “constructive possession” is sufficient to create a sale for sales tax purposes. Constructive possession can arise when a purchaser obtains sufficient rights to control or dispose of property so as to be considered the possessor even though it is in the actual physical possession of another. Some states recognize that a pledge of possession of property as security for a loan (e.g. a pawn transaction) does not constitute a sale. Lien A sale may occur even though the seller retains a security interest in the article sold to ensure the payment of the purchase price. 6

Lease or Rental The lease or rental of property is generally considered a sale. There are two broad categories of lease transactions: an operating lease and a finance lease. An operating or “true” lease is a traditional lease arrangement where possession of property is granted to another in exchange for periodic rental payments. Although there are specific accounting rules that describe an operating lease, it generally exists when the economic life of the leased property is substantially longer than the lease term and any option to purchase requires payment of the fair market value of the property. A finance or “capital” lease, on the other hand, is a transaction that resembles a loan where the lender retains (or is granted) title to the property as security to ensure repayment. Generally both types of leases are subject to sales tax, but the timing of when tax liability arises may differ. Special tax problems related to lease transactions are discussed later in the materials. D.

Within the Taxing State

Perhaps it goes without saying, but in order for a particular sale to be subject to tax the taxable incident must occur within the taxing state. Determining the place of sale is often referred to as “sourcing” the transaction. As a practical matter this issue arises only when the goods are shipped to the purchaser from a point outside the taxing state. The purchaser’s receipt of the goods at the seller’s place of business determines the location of the sale. For the most part interstate sales of goods are deemed to occur in the state where the purchaser receives the merchandise (often referred to as the “destination” state). Intrastate sales of goods may be sourced either to the destination or the point of origin, depending on the state. The location of intrastate sales determines which local sales tax applies. Example: ABC Corp. places an order for widgets from its supplier in another state. The goods are shipped by common carrier to ABC’s plant from the supplier’s warehouse outside the state. Most states would treat the sale as occurring in the state where ABC’s plant is located because that is where ABC took delivery. Shipping terms such as where title passes and who pays the shipping charges generally do not alter where the sale takes place for sales tax purposes. Example: ABC Corp. places an order for lubricant from a supplier located in the same state as ABC’s plant. The supplier delivers the lubricant to ABC’s plant from the supplier’s in-state warehouse located in the next county. Some states will treat the sale as taking place at the supplier’s warehouse location. Other states may treat the sale as occurring at the location of ABC’s plant.

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E.

Taxable Good or Service

Tangible Personal Property Tangible personal property is property that can be seen, weighed, measured, felt, or touched, or that is in any other manner perceptible to the senses. It may include such things as electricity, water, gas, steam, and prewritten computer software. Tangible personal property does not include intangibles such as patents, copyrights, goodwill, and interests in business entities. Example: XYZ Publishing Company purchases the manuscript of a popular novel from the author, including all publishing rights. The manuscript is merely the tangible evidence of the underlying publication rights which are considered an intangible and are not subject to the sales tax. Example: John Jones purchases a rare collector’s edition of a novel signed by the author. The collectible novel is considered taxable tangible personal property. Sometimes it is difficult to tell when an item is tangible personal property or merely the non-taxable tangible evidence of intangible property. Example: A manufacturer develops business process know-how which it documents in drawings, designs, and manuals. It also develops computer programs which it uses in its business. The assets of the company are sold to a purchaser and $10 million is allocated to these items. Are any of these items tangible personal property? See Navistar Inter. Trans. Corp. v. Cal. St. Bd. of Equal., 884 P.2d 108 (Cal. 1994). (Note that California now permits the use of a technology transfer agreement where the intangible elements are identified and only the purchase price attributable to the tangible transfer medium is taxed. See Cal. Code Regs. § 1507.) Taxable Service Taxable services are generally enumerated specifically by statute. In some states broad categories of services are subject to tax, while in others only a limited number of services are taxable. A number of states do not tax services. Electronic Transactions As mentioned above, and discussed in greater detail below, products or services transmitted electronically over the internet or otherwise may be within the scope of a particular state’s taxing statute. Some states, including Washington, have enacted laws with broad scope that attempt to address all such transactions. Other states, such as New York, have attempted to extend existing laws intended for tangible personal property or data processing services to these transactions. 8

F.

Valuable Consideration (taxable measure)

Sales Tax Consideration can be anything given for value in exchange for the tangible personal property or taxable service sold. The taxable measure of a sales tax is generally the selling price. Deductions may be allowed for certain items if they are separately stated in the contract of sale or invoice. These include cash discounts or allowances, refunds, returns and finance charges. The following are typical items which may be considered part of the taxable selling price: Freight and handling charges: Many states require freight and handling charges to be included in the taxable measure of the sales tax. Some states will permit a deduction for these charges provided they are stated separately in the sales contract or customer invoice. Installation: Charges for installation are generally taxable unless separately stated and not merely incidental to the sale of the taxable item. Warranties and Maintenance Agreements: Charges for optional extended warranties and maintenance agreements may not be taxable in some states if separately stated. Mandatory warranties or maintenance agreements are typically considered part of the purchase transaction and included in the taxable measure. Because the taxable selling price includes anything of value given in exchange for property or services, barter transactions are subject to tax. The fair market value of any property, service or other consideration given in exchange will be considered part of the sales tax measure. In some states, trade-ins are deductible from the measure of the taxable selling price. Deductible trade-ins may be limited to property of the same general type as that purchased (e.g., motor vehicle traded in on purchase of a new vehicle). Use Tax The taxable measure of the use tax is generally expressed as the fair market value of the property at the time put to use in the state. In the case of newly acquired property or services, the selling price is generally the taxable measure for use tax purposes. G.

Credits Against Tax

Bad Debts Many states allow a seller to take a deduction or credit against current tax liability for credit transactions that become worthless. States generally require that the taxpayer claiming the credit be the retailer that made the sale on credit rather than an assignee or a third party lender. This issue normally arises when 9

credit purchases are made using a store branded credit card issued by a third party rather than on a store revolving credit account. States also may require that the debt be worthless within the meaning of § 166 of the Internal Revenue Code. See Savings Bank of Puget Sound v. Washington, 868 P.2d 127 (Wash. 1994), and Home Depot U.S.A. v. Indiana Dept. of Revenue, 891 NE.2d 187 (2008). Credit for Taxes Paid to Other States As a matter of comity among the states and in order to avoid U.S. Constitutional problems, all states provide some form of credit for sales and use taxes paid to other states. One complication that can arise is when states differ in their opinion of which state had the right to tax the transaction in the first instance. Generally, the credit is available only against the use tax in a state of subsequent use. Local jurisdictions can also be problematic because some states do not impose local taxes and a state level tax may not be creditable against local taxes. Article V of the Multistate Tax Compact provides as follows: Each purchaser liable for a use tax on tangible personal property shall be entitled to full credit for the combined amount or amounts of legally imposed sales or use taxes paid by him with respect to the same property to another state and any subdivision thereof. The credit shall be applied first against the amount of any use tax due the state, and any unused portion of the credit shall then be applied against the amount of any use tax due a subdivision.

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IV. Exemptions A.

Exempt Sales for Resale

Sales and use tax does not apply to sales that are not “retail sales.” “Retail sales” are generally considered sales by a retailer to the end user or consumer. “Retail sales” do not include sales made to people who are not the end users of the property. Purchasers that intend to resell the property are not the end users of the property. As a result, sales to these purchasers are not subject to sales tax. These sales are commonly called “sales for resale” or “wholesale sales.” By excluding sales for resale from the definition of retail sales, the sales tax is limited to the final sale of property. If sales for resale were not excluded from the tax, some sales would be taxed multiple times. States vary in whether they allow taxable services to be purchased for resale. Documentation Requirements How do you know whether the person you are selling to is going to use the property or resell the property? Consistent with the presumption of taxability, the general rule is to assume that the customer is purchasing the property for his or her own use and that the sale is therefore taxable. The seller should always charge tax unless the purchaser provides evidence that the property will be resold or other evidence that the transaction is exempt. Most states require that the seller obtain a written statement from the purchaser stating that the purchase is exempt for resale. States vary in the type of documentation they require; some states provide standard resale certificates while others do not require any particular form. Others may require the purchaser to have a state-issued seller’s permit in order to give valid resale documentation. In general, a valid resale certificate must include the following information: ─ ─ ─ ─ ─

The name and address of the purchaser The purchaser’s tax registration or sales tax permit number Description of the items sold The signature of the purchaser and the date signed The name and address of the seller.

In some states a seller may accept a blanket resale certificate that covers all purchases from a particular customer covering a fixed period of time. A blanket resale certificate avoids the necessity of obtaining a separate resale certificate for every transaction. Many states will accept the multistate jurisdictional form of resale certificate adopted by the Multistate Tax Commission. A copy of the form is available online at http://www.mtc.gov/Resources/Uniform-Sales-Use-Tax-ExemptionCertificate. 11

Good Faith Generally, once the seller obtains a resale certificate from the purchaser the seller is absolved from its liability for collecting and remitting tax on the sale. The seller does not have to thoroughly investigate whether the sale is really for resale; however, the seller must collect the resale certificate in “good faith.” In general, to satisfy the good faith acceptance requirement the seller must exercise caution that the transaction, or property being sold, is of a type that normally qualifies for exemption in the state. The seller must keep the exemption documentation on file to protect itself in the event of an audit. Some states require a seller to obtain a resale certificate within a certain period of time after the certificate in order to meet the good faith acceptance requirements. See NYS Tax Law § 1132(c)(1). The Streamlined Sales and Use Tax Agreement (SSUTA) provides for a relaxed standard of good faith in accepting exemption documentation. The SSUTA is discussed in greater detail in Section X of these materials. B.

Entity or User-Based Exemptions

All states provide exemptions to organizations that meet certain criteria. Generally, these exemptions are extended to: ─ ─ ─ ─

State and municipal government bodies Religious and charitable organizations Educational organizations Youth athletic programs

In addition, all states provide an exemption for sales to the federal government as required by the United States Constitution. States are also required by federal law to provide exemption under certain circumstances for transactions involving enrolled members of Native American tribes that take place on tribal lands. Documentation When the exemption is based upon the identity of the purchaser, the seller must collect an exemption certificate from the purchaser as evidence that the sale qualifies for the exemption. In this regard, as long as the seller accepts an exemption certificate in good faith, the seller does not otherwise need to prove that the sale is exempt. C.

Product-Based Exemptions

State sales tax laws provide a variety of exemptions based on the type of product or service sold. The most common exemptions of this type are for items that are generally considered to be family necessities. Sales taxes are often criticized on tax policy grounds as being regressive in effect (i.e., they impose a greater 12

burden on individuals at lower income levels). Exempting necessities is one way in which states attempt to mitigate the regressive impacts of sales taxes. Products and services falling in this category often include: ─ ─ ─ ─ ─ ─ ─

Food for human consumption, but generally not food prepared in restaurants, soft drinks, alcoholic beverages, or candy; Consumer utilities; Clothing; School supplies; Medical services; Durable medical equipment and other prescribed medical devices; and Prescription and over-the-counter drugs and medications.

Documentation When an exemption is based upon the nature of the product (commonly referred to as a “per se” exemption) the seller is generally not required to collect exemption documentation. D.

Use-Based Exemptions

Other exemptions are typically granted based on the way in which the product or service is used. These exemptions generally are commercial in their emphasis granted to certain industries or commercial uses. The following are examples of typical used-based exemptions: ─ ─ ─ ─ ─

Items used in performing a contract to improve real property for a governmental entity or non-profit organization; Agricultural supplies and equipment; Manufacturing machinery and equipment used in producing a product for sale; Aircraft, watercraft, or other transportation equipment used to transport persons or property for hire across state or international boundaries; and Natural gas and electricity used in manufacturing articles for sale.

Documentation When the exemption is based upon the use of item by the purchaser, the seller must collect an exemption certificate from the purchaser as evidence that the sale qualifies for the exemption. In this regard, as long as the seller accepts an exemption certificate in good faith, the seller does not otherwise need to prove that the sale is exempt. E.

Interstate and Foreign Commerce Exemptions

Historically, states have provided sales and use tax exemptions for transactions in interstate and foreign commerce. These exemptions were originally enacted in response to U.S. Supreme Court decisions that took a restrictive view of the 13

states’ ability to tax interstate and foreign commerce. Notwithstanding the more liberal view of the taxation of interstate and foreign commerce that has made its way into modern U.S. Constitutional jurisprudence, states continue to provide broad exemptions in this area. See for example Rev. Code WA § 82.04.610. Generally, these exemptions require that a sale into or out of a state retain its character as an import or export in order to fall within the exemption. This means that a shipment must be committed to the export stream or continue in the import stream without interruption. Extended storage, breaking down shipments for consolidation and forwarding, processing items and making them ready for sale in a local market are all activities that will usually result in a loss of exemption. Documentation Import / export exemptions generally require one or more of the following documents: ─ ─ ─ ─ ─ ─ ─

Bill of Lading Customs broker documentation Formal documents of entry issued by customs officials of destination country Air, water, or rail bills of lading Maquiladora exemption certificate Documents of sale State required exemption certificate signed by the purchaser (usually not sufficient alone without one of the foregoing)

States may also grant an exemption to nonresident individuals making purchases of items for use outside the state. These exemptions typically exist in states that are bordered by states with low or no sales taxes and are intended to promote sales to nonresidents in border locations. F.

Occasional or Bulk Sale Exemption

Most states provide an exemption for transactions that are occasional, casual or isolated in nature. Some states may have a separate exemption for the bulk sale of most or all of the assets of a business. The following are some of the limitations states impose on this exemption: ─ ─ ─ ─ ─

Seller may not hold or be required to hold a seller’s permit or other sales tax registration Seller may not be engaged in selling property of the type being sold Sale must be of an identifiable segment of a business Sale must be to a single purchaser Exemption generally does not apply to motor vehicles

Care should be taken to ensure that all requirements for exemption are met. Some states’ casual sale exemption relieves the seller of the duty to collect the 14

sales tax but does not exempt the purchaser’s use of the property from the use tax. The exemption also does not generally apply to inventory held for sale. Depending on the intended use of the inventory by the purchaser, the seller may be able to accept a resale certificate.

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V.

Registration & Reporting Requirements A.

Taxable Presence - Nexus

In order for a state to impose a sales or use tax collection and reporting requirement, an entity must have sufficient nexus with the state under both the Due Process and Commerce Clauses of the United States Constitution. According to case law interpreting these constitutional provisions in a state tax context, an out-of-state entity must have a minimum connection or taxable presence within a state before that state is permitted to exercise its taxing authority over the entity. The constitutional limitations on the imposition of a duty to collect a use tax on an out-of-state seller have been analyzed by the U.S. Supreme Court in several cases. Quill Corporation v. North Dakota, 504 U.S. 298 (1992). In Quill a mail order seller sent catalogs to businesses and individuals located in North Dakota soliciting orders for office supplies. The mail order seller filled orders from a location outside the state and shipped to customers by common carrier or the U.S. Mail. The mail order seller had no other contact with the state. North Dakota asserted that by purposefully directing its mail solicitation efforts at the North Dakota market, the mail order seller had an economic presence within the state that was sufficient to justify imposing a use tax collection responsibility on the entity. In rejecting North Dakota’s assertion of taxing jurisdiction, the United States Supreme Court addressed the requirements of both the Due Process and Commerce Clauses of the United States Constitution. The Quill Court confirmed that under the Due Process Clause there must be some “minimum connection” or “nexus” between a state and the entity, property, or transaction it seeks to tax. The Court held that the nexus requirements of the Due Process Clause were satisfied because the taxpayer “purposefully avail[ed] itself of the benefits of an economic market” in North Dakota. In so holding, the Court explicitly overruled the Court’s previous decision in National Bellas Hess v. Illinois Department of Revenue, 386 U.S. 753 (1967). National Bellas Hess required an entity to have a physical presence in the taxing state in order to establish sufficient nexus for Due Process Clause purposes. With respect to the Commerce Clause, the Quill Court held that “substantial nexus” does require some level of physical presence in a state before the state can impose a use tax collection requirement. The Court thus reaffirmed the bright-line physical presence test first articulated in the Court’s earlier decision in National Bellas Hess. In refusing to overrule National Bellas Hess, the Quill Court noted that the mail order industry had relied heavily on a physical presence standard for many years and that Congress failed to enact a lower taxable nexus threshold, which was within its powers under the Commerce Clause. Although the Quill Court acknowledged that a de minimis level of physical presence may exist that does not arise to substantial nexus, there is no bright-line level of physical presence that will constitute substantial nexus. The 16

Court also did not clearly establish whether the physical presence must be substantial or whether a small quantum of physical presence is sufficient if the other attributes of nexus, such as market exploitation, are substantial. National Geographic Society v. California Board of Equalization, 430 U.S. 551 (1977). In National Geographic the U.S. Supreme Court held that a nonprofit corporation that maintained two offices in California that solicited advertising for its magazine (which was unrelated to the mail-order business), and that made mail-order sales to California residents through an office in the District of Columbia, had substantial nexus with California. National Geographic operated a mail-order business that sold books, maps, atlases and globes. Activities related to the mail-order business occurred in Washington, D.C. Deliveries were made by mail from Washington, D.C. to California. The California activities subjected National Geographic to a use tax liability even though there was no functional relationship between its two California offices and the mail-order sales to California. California law required that every “retailer engaged in business in this state and making sales of tangible personal property for storage, use, or other consumption in this state” collect from the purchaser a use tax in place of the sales tax imposed by local retailers. The Court rejected the California Supreme Court’s “slightest presence” standard to establish nexus, but found that National Geographic’s maintenance of two offices in California and solicitation by employees of advertising in the range of $1 million annually established a sufficient presence to satisfy the substantial nexus requirement. Maintaining two offices in California and the activities that occurred there adequately established a “relationship or nexus” between the Society and California, rendering the imposition of the requirement to collect tax constitutional. Scripto, Inc. v. Carson, 362 U.S. 207 (1960). In Scripto the U.S. Supreme Court considered whether non-employee representatives (e.g., independent sales contractors) create a sales and use tax collection obligation for out-of-state sellers. In Scripto the taxpayer, a Georgia corporation, was found to have a use tax collection obligation by Florida on products it had sold to Florida customers. The taxpayer had no place of business in Florida, no regular employees or agents in Florida, and maintained no merchandise in Florida. Rather, the taxpayer used ten independent contractors (who did not work exclusively for the taxpayer) who continuously solicited sales in Florida. Sales orders were taken by the independent contractors in Florida and were approved and shipped by the taxpayer in Georgia. The Court held that the “minimum connection” (or nexus) between Florida and the taxpayer had been met, thereby enabling Florida to constitutionally require the taxpayer to collect the use tax. This minimum connection had been established by the continuous local solicitation by the independent contractors. The fact that the salesmen were not regular employees of the taxpayer and were classified as independent contractors was viewed as “without constitutional significance” by the Court. The only incidence of the sales transaction that was non-local was the acceptance of the order, the Court explained. 17

Multistate Tax Commission The Multistate Tax Commission (“MTC”) is an association of state taxing authorities which has issued a number of model state tax statutes and regulations, many of which have been adopted by various MTC member states. Following the Quill decision, the MTC drafted a set of guidelines for when states should consider taxpayer activities within the state sufficient to require the collection of state sales and use taxes. The guidelines list activities that constitute a physical presence within a state: ─

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Maintaining (a) the permanent presence of one or more employees or (b) the temporary presence of one or more employees where the temporary presence is significantly associated with the out-of-state business’ ability to establish and maintain the market in the state; Owning, leasing or maintaining real property located in the state, including an office or other facility; Owning, leasing or maintaining tangible personal property located in the state; Retaining a representative who solicits or conducts business or performs services on behalf of the out-of-state business in the state and this activity is significantly associated with the ability of the out-of-state business to establish and maintain a market in the state; Retaining a representative who owns, leases, uses or maintains an office or other establishment in the state, and this property is used in the representation of the out-of-state business and is significantly associated with the ability of the out-of-state business to establish and maintain a market in the state; Either on its own or through a representative maintaining in the state by private contract, and not by purchase from a common carrier in the common carrier’s status as a common carrier, telecommunication linkage that is significantly associated with the ability of the out-of-state business to establish and maintain a market in the state; Either on its own or through a representative performing or rendering services in the state.

In December 1995, the MTC issued Nexus Bulletin 95-1 which describes circumstances under which the maintenance of a network of authorized warranty service providers within a state will create a taxable presence for a mail order computer business. The bulletin addresses nexus considerations for income / franchise taxes as well as sales and use taxes. The MTC is currently in the process of promulgating a model affiliate nexus provision. The most recent published draft of this provision (published by the MTC on April 28, 2005) provides that an out-of-state vendor has substantial nexus for the collection of sales and use tax if both of the following apply: the out-of-state vendor and an in-state business maintaining one or more locations within the state are related parties; and the two entities use an identical or 18

substantially similar name, trade name, trademark or goodwill to develop, promote or maintain sales, or the in-state business provides services to the outof-state business related to developing, promoting or maintaining the in-state market. For this purpose, “related entity” is defined to include entities that meet certain ownership or control tests under Internal Revenue Code §§ 267, 318 or 1563, as well as entities with at least 50% common ownership or in which one entity directly or indirectly owns at least 50% of the other. Federal Legislation – Internet Tax Nondiscrimination Act On December 3, 2004, President Bush signed the Internet Tax Nondiscrimination Act of 2004 (P.L. 108-435), which reinstated and extended until November 1, 2007 the moratorium on taxes on Internet access and multiple or discriminatory taxes on electronic commerce originally enacted by the Internet Tax Freedom Act (P.L. 105-277, signed 10/21/98, as amended by P.L. 107-75, signed 11/28/2001). Following a number of extensions, the Act was made permanent by § 922 of the Trade Facilitation and Trade Enforcement Act of 2015, passed by the U.S. Senate on February 11, 2016 and signed into law by President Obama on February 24, 2016. The moratorium applies to direct taxes on Internet access, regardless of whether the tax is imposed on a provider of Internet access or a buyer of Internet access and regardless of the terminology used to describe the tax. Thus, states that did not impose and enforce a tax on Internet access prior to the effective date of the original Internet Tax Freedom Act (October 1, 1998) may not impose such a tax prior to November 1, 2007. The moratorium applies both to specific taxes on Internet access as well as to the application of general state sales or use taxes to Internet access, to the extent that state laws or regulations in existence on October 1, 1998 did not impose sales or use tax on Internet access. The Internet Tax Nondiscrimination Act states that it does not affect the ability of states or local jurisdictions to impose tax on charges for voice over Internet protocol (“VOIP”) or similar services utilizing Internet Protocol or any successor protocol. Essentially, VOIP is deemed to be primarily a telecommunications service rather than an Internet access service, and states and local jurisdictions are free to tax it as such. However, this exception to the Internet Tax Nondiscrimination Act does not apply to any services that are incidental to Internet access, such as voice-capable e-mail or instant messaging. The moratorium also does not restrict the imposition or collection of federal universal service fees; nor the imposition or collection of state or local taxes or fees used to support 911 or E-911 services if no portion of the revenue derived from the tax or fee is obligated or expended for any purpose other than the support of such services.

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“Amazon” and Other Attributional Nexus Legislation Since Quill’s confirmation of the physical presence requirement, states have continued to look for any connection an out-of-state retailer might have that could be construed as a physical presence. In some cases courts have suggested that, in addition to a seller’s direct physical presence, indirect physical presence may also create nexus for sales and use tax purposes. This has opened the door for states to pass laws stating that nexus for sales/use tax collection purposes may be created by certain activities conducted by an in-state affiliate for the taxpayer’s benefit. These so-called “Amazon” laws have several common characteristics. Some create a presumption of nexus-creating activity through the presence of independent contractors or other representatives in the state who receive a commission for referring customers to an out-of-state retailer by a link on an Internet website or otherwise (“click-through” arrangements). Other states have enacted new laws that impose tax collection responsibilities on out-of-state retailers who have in-state affiliates if within the state:     

The retailer sells a similar product as the affiliate; The affiliate uses in-state employees or facilities to promote sales by the retailer; The affiliate maintains a place of business to facilitate sales; The affiliate uses substantially similar trademarks as the retailer; or The affiliate delivers, installs, assembles, or performs maintenance for the seller's customers.

Still other states have enacted legislation mandating that if any out-of-state retailer is related to a retailer with physical presence in the state, then the outof-state retailer will be deemed to have nexus and a collection requirement in the state. States have deemed characteristics such as controlled groups and common stock ownership to indicate “related” for purposes of establishing nexus. Finally, some states have imposed certain remote seller notification provisions whereby non-collecting out-of-state sellers are required to give their purchasers notice that use tax is due on nonexempt purchases. Each of these categories of nexus provisions are addressed in further detail below. “Amazon Laws”: Click-Through Nexus and Affiliate Nexus In 2008, New York enacted legislation requiring out-of-state Internet retailers to collect and remit state sales tax on tangible personal property or services sold through links on websites operated by state residents or in-state businesses. The legislation appeared to target popular Internet retailers, including Amazon.com, 20

which previously did not collect New York sales tax from their New York customers. This law became known as the New York “Amazon law” after its perceived target. The law provides that a “vendor” includes a person making sales of tangible personal property or services to New York customers through an agreement with a New York resident for a commission or other consideration, by which the resident directly or indirectly refers potential customers, by a link on an Internet website, to the seller, if the cumulative gross receipts from such sales exceed $10,000 per year. In other words, potential customers reach the out-of-state retailer’s website by clicking on a link on the in-state affiliate’s website, thereby creating “click-through” nexus. N.Y. Tax Law § 1101(b)(8). As of the writing of this outline, similar click-through and affiliate nexus laws had been adopted in 10 states: Arkansas - Arkansas enacted legislation in 2011 creating a nexus presumption for certain members of a controlled group. The Arkansas law’s nexus presumption may be rebutted by showing that the affiliated person’s activities are not significantly associated with the retailer’s ability to establish or maintain a market in the state. Effective July 27, 2011. Ark. Code § 26-52-117. If there is not an affiliated person with respect to a retailer in Arkansas, the retailer is presumed to have nexus in Arkansas if the retailer enters into an agreement with an Arkansas resident, under which the resident refers potential purchasers to the retailer through an Internet link. This click-through nexus provision applies only if the cumulative gross receipts from referred Arkansas customers exceed $10,000 during the preceding 12 months. Effective October 25, 2011. Ark. Code Ann. § 26-52-117(d). California – In 2011, California enacted a law (A.B.x1 28) which specifically included as a retailer engaged in business in the state any retailer that is a member of a commonly controlled group and is a member of a combined reporting group that includes another member that, pursuant to an agreement, performs services in the state in connection with the tangible personal property sold by the retailer. A.B.x1 28 also included as a retailer engaged in business in the state any retailer that enters into agreements with a resident who refers potential purchasers to the retailer through an Internet link if the retailer has total California sales of more than $10,000 in the preceding 12 months that originated from such referral agreements and, within the same time period, total cumulative California sales of more than $500,000. In response to taxpayer-sponsored efforts to hold a voter referendum on the law, lawmakers passed A.B. 155, which repealed the remote sales tax nexus law retroactively to its original effective date of June 28, 2011. However, the provisions of A.B.x1 28 will become effective September 15, 2012 if federal 21

legislation requiring remote sellers to collect and remit sales and use taxes is not enacted on or before July 31, 2012. If such federal legislation is enacted but California does not elect to implement it by September 14, 2012, the state nexus provisions would become effective on January 1, 2013. A.B. 155 also increases the total cumulative sales threshold referenced above from $500,000 to $1 million. Cal. Rev. & Tax. Code § 6203. Connecticut - Connecticut enacted a click-through nexus provision with a $2,000-per-year threshold (i.e. nexus is created if the seller makes at least $2,000 of sales per year through referrals from in-state sources), with no rebuttable presumption. Effective May 4, 2011. Conn. Gen. Stat. § 12-407(a). Georgia - Georgia adopted click-through nexus provisions creating a rebuttable presumption for remote sellers to collect taxes if they do at least $ 50,000 in annual sales through in-state affiliates, as well as create nexus for an out-of-state business that is part of a controlled group with an entity in Georgia, has distribution centers or subsidiaries in the state, or has in-state affiliates that use the business trademark or company name. Effective October 1, 2012. Ga. Code Ann. § 48-8-2(8). Illinois - Illinois’s law includes a click-through nexus provision with a $10,000 per year threshold and does not contain a rebuttable presumption. Illinois also imposes a use tax collection requirement on retailers having a contract with a resident under which the retailer sells the same or substantially similar line of products as the resident in Illinois under the same or substantially similar name, trade name, or trademark, and the retailer provides a commission or other consideration based on the sale of such products. This provision applies if the cumulative Illinois gross receipts of the retailer from sales to state residents of tangible personal property under such contracts exceed $10,000 per year. Effective July 1, 2011. 35 Ill. Comp. Stat. 105/2(1.2). The Illinois Supreme Court has ruled that the State’s click-through nexus provision imposes a discriminatory tax on electronic commerce as prohibited by the Internet Tax Freedom Act (precursor to the Internet Tax Nondiscrimination Act, discussed supra), and is therefore unenforceable. Illinois enacted a replacement click-through affiliate nexus statute. The law provides for a presumption of nexus for a remote seller that realizes at least $10,000 in sales to customers as a result of referrals from Illinois affiliates. Effective January 1, 2015. P.L. 98-1089. Kansas – Kansas enacted a click-through nexus provision that includes a $10,000 per year sales threshold. The law creates a rebuttable presumption that a remote seller is doing business in Kansas subject to a sales/use tax collection obligation if the seller enters into an agreement with one or more Kansas residents under which the resident, for a commission or other consideration refers potential customers to the seller. The presumption may be rebutted by proof that the residents did not engage in any activity within the state 22

significantly associated with the seller’s ability to establish or maintain a market in the state. Effective April 25, 2013 (S.B. 83). Maine – Maine adopted a click-through nexus provision with a $10,000 per year sales threshold. The presumption may be rebutted by proof the resident with whom the seller has an agreement did not engage in any activity in the state on behalf of the seller that was significantly associated with the seller's ability to establish or maintain the seller's market in the State during the preceding 12 months. Such proof may consist of sworn, written statements from all of the persons within this State with whom the seller has an agreement stating that they did not engage in any solicitation in the State on behalf of the seller during the preceding 12 months; these statements must be provided and obtained in good faith. Effective October 9, 2013. Me. Rev. Stat. Ann. 36 § 1754-B(1-A)(B). Michigan – Michigan enacted its own click-through nexus provision that creates a presumption of nexus for remote sellers with Michigan affiliates and more than $1,000 in Michigan sales. The presumption applies only if the retailer’s gross receipts from all sales to Michigan customers exceed $50,000. The presumption may be rebutted if the retailer establishes it has (1) entered into a written agreement with its affiliates that prohibit solicitation activities in the state; and (2) obtained written statements from its Michigan affiliates that they did not engage in any solicitation activities in the state during the preceding twelve months. Mich. Pub. Act No. 554. Minnesota – Minnesota law creates a rebuttable presumption that a retailer has a solicitor in Minnesota, and so liable to collect sales and use tax, if it enters into an agreement with a resident under which the resident, for a commission or other substantially similar consideration, directly or indirectly refers potential customers, whether by a link on an Internet web site, or otherwise, to the seller. This presumption applies only if the total gross receipts are at least $10,000 in the 12-month period ending on the last day of the most recent calendar quarter before the calendar quarter in which the sale is made. Nexus is also created if retailer owns at least 50% of the affiliate's outstanding stock, or value of the other party or if an individual stockholder or the stockholder's family owns directly or indirectly at least 50% of the value of the outstanding stock of both entities. Minn. Stat. § 297A.66, Subd. 4a; Minn. Stat. § 297A.66, Subdivision 1(a). Effective for sales and purchases made after June 30, 2013. Missouri – A remote seller is presumed to be engaged in taxable business activities in Missouri if the seller enters into an agreement with a Missouri resident under which the resident, for a commission or other consideration, refers customers to the vendor, whether by a link on a website, an in-person presentation, telemarketing or otherwise, and the vendor’s cumulative gross receipts from sales to all Missouri customers referred by residents with such an agreement exceed $10,000 in the preceding 12 months. This presumption is rebuttable by showing that the Missouri resident did not engage in activity within Missouri that was significantly associated with the vendor's market in 23

Missouri in the preceding 12 months. Effective August 20, 2013. S.B. 23, Laws 2013. Nevada – Nevada’s legislation establishes a presumption of taxable presence if a retailer has more than $10,000 in sales resulting from click-through referrals in the prior four quarterly periods ending on the last day of March, June, September and December. The law provides a mechanism for rebutting the presumption of nexus by providing proof, through sworn statements, that the resident did not engage in any activity in the state that was significantly associated with the retailer’s ability to establish or maintain a market in the state. Effective October 1, 2015. Chapter 219, AB 380. North Carolina – North Carolina adopted a click-through nexus provision with a $10,000 per year threshold. The presumption may be rebutted by proof that the resident with whom the seller has an agreement did not engage in any solicitation in the state on behalf of the seller that would satisfy the nexus requirements of the U.S. Constitution. Effective July 1, 2009. N.C. Gen. Stat. § 105-164.8(b)(3). New Jersey – A rebuttable presumption of nexus is created for remote sellers who make sales of taxable goods or services through a commissioned independent contractor who directly or indirectly refers potential customers, by a link on an internet website or otherwise, to the seller. The presumption arises if such sales exceed $10,000 during the preceding four calendar quarters. The law provides that the presumption may be rebutted by proof that the independent contractor or representative did not engage in any solicitation activities in New Jersey sufficient to create nexus under the U.S. Constitution. Effective July 1, 2014. A.B. 3486, P.L. 2014, c. 13. Pennsylvania – On December 1, 2011, the Pennsylvania Department of Revenue released a Sales Tax Bulletin clarifying its existing statute already included click-through nexus. Pa. Dep’t of Rev., Sales and Use Tax Bulletin 2011-01 (12/1/11). On January 27, 2012, the Department issued a press release indicating that it would allow remote sellers until September 1, 2012 to become licensed and begin collecting sales tax in the state. The press release indicated that this would be the only deadline extension that will be offered. Rhode Island – Rhode Island adopted a click-through nexus provision with a $5,000 per year threshold. The presumption may be rebutted by proof that the resident with whom the seller has an agreement did not engage in any solicitation in the state on behalf of the seller that would satisfy the nexus requirements of the U.S. Constitution. Effective July 1, 2009; expanded effective October 1, 2011 to reach sales of “load and leave” computer software and package tour and scenic and sightseeing transportation services as well as sales of tangible personal property. R.I. Gen. Laws § 44-18-15(a)(2). Tennessee – The new law creates a rebuttable presumption of nexus when (1) a dealer enters into an agreement with one or more persons located in Tennessee 24

under which that person or persons, for a commission or other consideration, directly or indirectly refer potential customers to the seller and (2) the dealer’s cumulative gross receipts from retail sales made by the dealer from such sales are in excess of $10,000 during the preceding 12 months. The seller’s referral can be by internet website or any other means. A seller may rebut this presumption by demonstrating that the seller did not conduct any activities in the state that would substantially contribute to the seller’s ability to establish and maintain a market in Tennessee during the preceding 12 months. Effective July 1, 2015. H.B. 664, Laws of 2015. Vermont – Vermont has adopted a “click-though” nexus provision with a $100,000 per year threshold. The presumption may be rebutted by proof that the resident with whom the seller has an agreement did not engage in any solicitation in Vermont on behalf of the seller that would satisfy the federal constitution's nexus requirement during the tax year at issue. This provision takes effect on the date when 15 or more states have adopted requirements that are the same, substantially similar, or significantly comparable to Vermont's “click-though” nexus provision. The state’s attorney general is tasked with determining when this date has occurred. Vt. Stat. Ann.32 § 9701(9)(l). Washington – Effective September 12, 2015, Washington adopted a “clickthrough” presumption of nexus standard for both its retailing business and occupation (or “B&O”) tax and sales tax. The Washington statute is based on the New York law and provides for the same sales threshold of $10,000 during the prior calendar year and provides for a safe harbor if certain conditions are met. ESSB 6138, Chapter 5, Laws of 2015, 3rd Special Session. Nexus Through a Related Entity and Notice Requirements Effective March 1, 2010, Colorado enacted a two-part statute. First, out-of-state sellers must collect Colorado use tax if they are part of a “controlled group” that has a “component member” that is a retailer with a physical presence in the state. However, this presumption may be rebutted by showing that the component member did not engage in any constitutionally sufficient solicitation in the state on behalf of the out-of-state seller during the calendar year in question. The second requirement applies to out-of-state retailers that are not required to collect Colorado sales tax and that have total annual gross sales in Colorado of $100,000 or more. The law provided that such out-of-state retailers that do not collect Colorado sales tax are required to give their Colorado customers notice with each purchase that Colorado sales or use tax is due on all purchases that are not exempt from sales tax. The law specified that notice may be made on the internet website of the retailer or on an invoice provided to the customer. Soon after the law’s enactment, the Direct Marketing Association (DMA) filed a motion for a preliminary injunction in U.S. District Court in Colorado, asking the court to enjoin the Colorado Department of Revenue from enforcing the notice obligations, claiming they violate the rights of many DMA members 25

under the Commerce Clause. The court granted the injunction, and on April 3, 2012, a federal judge in Colorado ruled that the state's notice requirements on online retailers were unconstitutional and invalid because they "impose an undue burden on interstate commerce." However, the related entity nexus provisions of the Colorado law remain in effect. The Colorado Department of Revenue appealed the federal district court’s ruling to the U.S. Court of Appeals for the Tenth Circuit. The court of appeals found that, based on the Tax Injunction Act, 28 U.S.C. § 1341, the district court lacked jurisdiction to decide the matter and remanded the case to the district court with instructions to dissolve the permanent injunction. On December 10, 2013, the District Court dissolved the permanent injunction. Following the to the U.S. Court of Appeals’ ruling, the DMA filed a motion in state district court seeking to enjoin enforcement of the notice and reporting requirements. In February 2014 the state court issued a temporary injunction against the Department of Revenue and the DMA filed a petition for certiorari in the U.S. Supreme Court appealing the decision of the 10th Circuit Court of Appeals. On March 3, 2015, the U.S. Supreme Court unanimously ruled that the Tax Injunction Act does not bar the lawsuit challenging the Colorado notification law. The Court determined that the relief sought by DMA does not “enjoin, suspend, or retrain the assessment, levy or collection” of Colorado’s sales and use taxes. The Court remanded the case back to the 10th Circuit to consider the constitutional challenges to the Colorado law. Significantly, Justice Kennedy in a concurring opinion welcomed a challenge to Quill indicating that the physical presence requirement presented a burden for states trying to raise revenues in the present online environment that didn’t exist in 1992 when the case was decided. On remand, the 10th Circuit reversed the district court and held that the Colorado law does not violate the commerce clause. The court found that the law does not facially or directly discriminate against the interstate commerce clause and does not impose an undue burden on interstate commerce. It also noted that Congress is better qualified to solve the issue of when the states may enforce sales tax requirements on interstate sellers. Direct Marketing Assn. v. Brohl, No. 12. 1175 (10th Cir. February 22, 2016). Laws similar to the first part of the Colorado statute (imposing nexus on an outof-state retailer via a related in-state entity) have been enacted in the following states: Alabama – Alabama provides by statute that an out-of-state retailer has substantial nexus with Alabama for the collection of use tax if the out-of-state vendor and an instate business maintaining one or more locations in the state are “related parties.” In general, two entities are related parties if one entity owns at least 50% of the value of the other’s outstanding stock, applying the 26

attribution rules of IRC § 318. Additionally, the in-state and out-of-state entities must use identical or substantially similar names, trade names, trademarks or goodwill, or the in-state entity must be assisting the out-of-state retailer in developing, promoting, or maintaining the instate market. Ala. Code § 40-23190. Idaho - Idaho law states that an out-of-state retailer has substantial nexus with Idaho for the collection of use tax if the out-of-state vendor and an instate business maintaining one or more locations in the state are “related parties.” In general, two entities are related parties both entities are component members of the same controlled group of corporations, or one entity owns at least 50% of the profits, capital, stock, or value of the other entity (applying the attribution rules of IRC § 318). Additionally, the in-state and out-of-state entities must use identical or substantially similar names, trade names, trademarks or goodwill, or the in-state entity must be assisting the out-of-state retailer in developing, promoting, or maintaining the instate market. Idaho Code § 63-3615A. Minnesota – Minnesota law provides that an out-of-state retailer is considered to be maintaining a place of business in the state, and thus has substantial nexus with Minnesota for the collection of use tax, if the out-of-state vendor and an instate business maintaining one or more locations in the state are “related parties.” In general, two entities are related parties if one entity owns at least 50% of the value of the other’s outstanding stock, capital or value. An entity that meets the affiliated entity definition at any point in the previous 12-month period is an affiliate. Minn. Stat. § 297A.66, Subd. 4(a). Oklahoma - Oklahoma enacted a multipart statute effective July 10, 2010 that includes a deemed imposition of nexus, a rebuttable presumption of nexus, and a retailer notification requirement. Under the terms of this law, an out-of-state retailer is generally deemed to be engaged in the business in the state if the retailer holds a substantial ownership interest in, or is substantially owned by, an in-state retailer and the out-of-state retailer sells the same or similar line of products as the Oklahoma retailer under the same or similar business name, or the out-of-state retailer holds substantial ownership interest in, or is substantially owned by, a business that maintains a distribution house, sales house, or warehouse in Oklahoma, and delivers property sold by the retailer to consumers. These presumptions are not rebuttable. Further, an out-of-state seller is presumed to be a retailer engaged in business in Oklahoma if it is part of a controlled group of corporations that has a component member that is a retailer engaged in business as described above. “Controlled group of corporations” and “component member” are defined by reference to IRC § 1563. This presumption may be rebutted by showing that the component member did not engage in any constitutionally sufficient solicitation in the state on behalf of the out-of-state seller during the calendar year in question. Okla. Stat. tit. 68, § 1401(9).

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South Carolina - The law provides that owning, leasing, or utilizing a distribution facility, including a distribution facility of a third party or affiliate, within South Carolina is not considered in determining whether a person has nexus if certain requirements are met. These requirements include that the distribution facility in placed in service in 2011 or 2012, and it involves a capital investment of at least $125 million and the creation of at least 2,000 full-time jobs in the state. “Affiliate” means a person that directly or indirectly, through one or more intermediaries, controls, is controlled by, or is under common control with another person. The law is set to sunset on the earlier of January 1, 2016, or on the effective date of any law enacted by Congress that allows a state to require that its sales tax be collected and remitted even if the taxpayer lacks substantial nexus. Effective June 8, 2011. S.C. Code Ann. § 12-36-2691. South Dakota - A out-of-state retailer is considered engaged in the business in the state if (1) the retailer holds a substantial ownership interest in, or is owned in whole or in substantial part by, an in-state retailer; and the out-of-state retailer sells the same or a substantially similar line of products as the related in-state retailer under the same or a substantially similar business name, or the instate retailer promotes or facilitates sales by the out-of-state retailer to a consumer; or (2) the retailer holds a substantial ownership interest in, or is owned in whole or in substantial part by, a business that maintains a distribution house, sales house, warehouse, or similar place of business in South Dakota that delivers property sold by the retailer to consumers. Additionally, any retailer that is part of a controlled group that has a component member who is a retailer engaged in business in South Dakota, will be presumed to be a retailer engaged in business in South Dakota. This presumption may be rebutted by evidence that the component member that is a retailer engaged in business in the state did not engage in any activities on behalf of the retailer. Effective July 1, 2011. S.D. Codified Laws §10-45-2.5 through 2.8. Texas – A retailer has nexus in the state if the retailer has a substantial ownership interest in, or is owned in whole or substantial part by, a person who maintains a location in Texas from which business is conducted and if: (a) the retailer sells the same or a substantially similar line of products as the person with the location in Texas and sells those products under a business name that is the same as or substantially similar to the business name of the person with the location in Texas; or (b) the person with the location in Texas promotes or facilitates sales by the retailer to consumers, or performs any other activity to establish or maintain a marketplace for the retailer in Texas, including receiving or exchanging returned merchandise. Additionally, a retailer will be found to have nexus in the state if he holds a substantial ownership interest in, or is owned in whole or substantial part by, a person that maintains a distribution center, warehouse, or similar location in Texas, and delivers property sold by the retailer to consumers. In general, “substantial ownership” means directly or indirectly owning at least 50% of the value of the other’s stock, beneficial ownership interest in voting 28

stock, or capital/profits interest in the entity. Effective January 1, 2012. Tex. Tax Code Ann. § 151.107. Virginia – An out-of-state dealer is presumed to have sufficient activity within Virginia to require sales/use tax registration if a commonly controlled person maintains a distribution center, warehouse, fulfillment center, office, or similar location within the state that facilitates the delivery of tangible personal property sold by the dealer to its customers. This presumption can be rebutted by an outof-state dealer who demonstrates that the activities, conducted by the commonly controlled person within the state, are not significantly associated with the dealer’s ability to establish or maintain a market in the state. Effective September 1, 2013 or on the effective date of federal legislation authorizing the states to require a seller to collect taxes on sales of goods to in-state purchasers without regard to the location of the seller. Va. Code Ann. § 58.1-612.D. Wisconsin - A person that has a related affiliate in Wisconsin will have taxable nexus if the related affiliate uses facilities or employees in Wisconsin to advertise, promote, or facilitate the establishment of, or market for, sales of the out-of-state seller's items in Wisconsin. This includes providing services such as accepting returns or resolving customer complaints. In general, “related” means owning at least 50% of the value of the other’s stock, or at least 50% of the profits, capital, stock or value in a partnership, estate or trust, applying the family attribution rules of IRC § 318. Wis. Stat. § 77.51(13g)(d). Additionally, laws imposing a notice requirement have been enacted in 6 states (not including Colorado). In general, these laws state that out-of-state retailers which do not collect tax are required to give their in-state customers notice on each purchase that state sales or use tax is due on the purchase. States imposing such a requirement include Oklahoma, South Carolina, South Dakota, Tennessee, Utah, and Vermont. B.

Registration, Permit and Filing Requirements

Sellers maintaining a place of business within a taxing state are required to register with the state and obtain a sales tax permit for each retail location within the state. Out-of-state sellers who do not maintain a place of business within the state are generally required to register with the taxing state and obtain a use tax permit. Sales and use tax returns are generally due on a monthly, quarterly or annual basis, depending on the volume of taxable sales into the state. Returns are generally due on the 15th, 20th, or the 30th day of the month following the end of the assigned reporting period. Most states will accept the postmark date as the date of timely filing. It is generally advisable to obtain a stamped return receipt in the event of misdirected mail. More and more states are adopting methods of electronic filing and payment to streamline the reporting process.

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A number of states provide vendor allowances to partially offset the cost of collection of the state’s sales taxes. These allowances are generally a nominal percentage of the tax collected. Other allowances may be provided for timely or early payment. States vary in the statute of limitations applicable to sales and use taxes. The limitations period among the states varies from 3 to 5 years. The limitations period for assessing additional tax may not correspond exactly to the non-claim period for requesting refunds of overpayments. Direct Payment Permits Many states permit certain taxpayers with a high dollar volume of taxable purchases to obtain a permit which allows them to pay sales taxes directly to the state rather than to the taxpayers’ vendors. In order to obtain a direct pay permit states generally require the applicant to have demonstrated consistent compliance with sales and use tax reporting and payment requirements. A direct pay permit holder provides the permit to its vendors. Instead of paying tax to its vendors the permit holder self-assesses tax and reports it monthly to the issuing state. Drop Shipments Drop shipments are transactions where a seller fulfills an order to a customer through a third party supplier. Instead of shipping the product from its place of business, the seller directs the supplier to ship the product directly to the seller’s customer. In some instances the third party supplier has a taxable presence or nexus in the state of the seller’s customer. The sale from the supplier to the seller will be considered an exempt sale for resale in the destination state provided that the seller can give the supplier a valid resale certificate. If the seller is not registered for sales and use tax purposes in the destination state, the seller may not be able to give a resale certificate to its supplier. In such a case the supplier will be required to collect the sales or use tax from the seller. California, Connecticut, Hawaii, Maryland, Massachusetts, and Mississippi each require a purchaser to supply a state registration number in order to issue a valid resale certificate. Example: An online retailer based in State A makes an online sale to a customer in located California. The customer asks that the product be shipped to her home in California. The retailer does not maintain and inventory of the product but relies on its suppliers to fulfill orders on its behalf. The retailer places an order for the product from the manufacturer and directs the manufacturer to ship the product directly to its California customer. The manufacturer has a taxable presence in California. Under California law, the retailer may only give a resale certificate to the manufacturer if the retailer holds a California seller’s permit. Because the retail does not have nexus in California 30

it is not required to register and obtain a seller’s permit. In the absence of a resale certificate the sale is deemed to be a retail sale. The manufacturer is required to collect the California retail sales tax on the retail selling price, if known, or on the imputed retail selling price (10% above its wholesale price). See CAL. CODE REGS. Tit. 18, § 1706 (2000).

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VI. Manufacturing Issues A.

Manufacturing Exemptions

Ingredient or Component Part Exemption One of the major sales and use tax manufacturing exclusions or exemptions is property purchased for use as an ingredient or component part of tangible personal property to be manufactured or fabricated for sale. For example, New York defines “retail sale” as a sale of tangible personal property to any person for any purpose, other than for resale as such or as a physical component part of tangible personal property. Many states require a raw material to be an identifiable element of the final product in order to qualify for the exemption. States are often strict in their interpretation of what constitutes an identifiable element. For example, Arkansas provides an exemption from sales and use tax for the purchase of property which becomes a recognizable integral part of a product produced for sale. In one case, a taxpayer attempted to argue that its purchase of chlorine qualified for this exemption. The taxpayer argued that when chlorine is mixed with bromide it causes the bromide to become bromine, an industrially valuable oxidizing agent. The court, however, held that the chlorine did not become a part of the bromine since the chemical reaction of mixing the chlorine and bromide caused the bromide to release certain electrons which became a part of the chlorine. The taxpayer asserted that the chlorine became a recognizable integral part of the bromine since the chlorine’s oxidizing potential was transferred to the bromine. The court, however, held that such “potential” was not tangible personal property within the meaning of the exemption. Since the chlorine did not become a recognizable part of the bromine, the chlorine was held not to qualify for the exemption. Great Lakes Chem. Corp. v. Wooten, 587 S.W.2d 220 (Ark. 1979). Other states are more liberal. Illinois courts have ruled that barrels used to age bourbon whiskey, even though reused by distillers and sold after the aging process is completed, were a nontaxable ingredient in the manufacture of whiskey. Illinois exempts purchases of tangible personal property which is resold as an ingredient of an intentionally produced product or by-product of manufacturing. Although the state argued that the barrels were used primarily for the purpose of storage and were not ingredients of an intentionally produced product, the court held that the function of the barrels was to impart extractives to raw alcohol that caused the bourbon to take on a distinctive color, bouquet and taste. Without the use of the barrels, the bourbon could not be manufactured. Thus, the barrels’ function was held to be vital to the production of the bourbon. American Distilling v. Dept. of Rev., 368 N.E.2d 541 (Ill. 1977).

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Essentiality Test The states have applied different tests in determining whether the purchase or use of tangible personal property qualifies for the ingredient or component part exemption. For example, New York generally applies the essentiality test. In one case, the State Tax Commission held that the degree of consumption was not made a statutory factor and that the ordinary meaning of “component” is certainly broad enough to include detectable materials contained in a finished whole. Citing Finch, Pruyn & Co. v. State Tax Commn, 419 N.Y.S.2d 232 (1979). New York looks to the importance, i.e., essentiality, of the item in the production of the final product made available for sale. Primary Purpose Test Other jurisdictions have held that the exclusion applies only if the “primary purpose” of the article is its incorporation in the final product. California’s exemption for ingredient or component parts applies to the purchase or use of tangible personal property for the purpose of physically incorporating it into the manufactured article to be sold. The statute specifically provides, however, that the tax applies to the purchase of tangible personal property for the purpose of use in manufacturing, producing or processing. In determining whether a sale qualifies for the exemption, California courts have consistently looked to the primary intent of the purchaser or primary purpose of the purchase. In a California Supreme Court decision, pig iron and other materials used by a steel manufacturer were held not to qualify for the exclusion Kaiser Steel Corporation v. State Board of Equalization, 593 P.2d 864 (1979). The court determined that the materials were purchased primarily to aid in the manufacture of steel, even though a portion of the materials was incorporated into the steel. The court refused to consider the fact that the materials should qualify for the exemption on the basis that a small amount of the materials were incorporated into the steel. The court further stated that where there are simultaneous uses, but only one purpose (or primary purpose) for the purchase, the entire unit of material is taxed or not taxed depending on that purpose. Therefore, because all of the materials were purchased for use as an aid in the manufacturing process as opposed to becoming a component part of the finished product, all of the material was taxable. The fact that a portion of the materials remained in the steel as a finished product was irrelevant. This result is in direct contradiction with jurisdictions employing the essentiality test. Substantial Ingredient Test The substantial ingredient test applied by some jurisdictions falls somewhere between the essentiality and primary purpose tests. The rule generally requires the article to become a substantial ingredient of the final product. The Supreme Court of Nebraska has applied this rule in American Stores Packing Co. v. Peters, 277 N.W.2d 544 (1979).

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Nebraska provides an exemption from sales and use tax for tangible personal property that will enter into or become an ingredient, or component part, of tangible personal property manufactured, processed or fabricated for ultimate sale at retail. In American Stores, the taxpayer argued that cellulose casings used in manufacturing “skinless” meat products qualify for this exemption. The casing is made of three ingredients: cellulose, glycerin, and moisture. During the manufacture of the meat products, the casing is filled with meat, is subjected to a series of processes and is then removed. During the processes, however, an undetermined amount of the glycerin, a property of the casing, is impregnated into the meat. The court determined that the casing was not exempt; it does not become an ingredient or component of the meat in any real sense because it does not reach the ultimate consumer of the meat product. Consumable Items Used in Manufacturing Some states exempt purchases of property which are used or consumed in manufacturing even though such property is not an ingredient or component part of the property sold. Connecticut provides a partial exemption for materials, tools and fuels which become an ingredient or component part of tangible personal property to be sold, or which are used or consumed in an industrial plant in manufacturing, processing, or fabricating. In addition, a number of states, including Ohio and Minnesota, exempt materials used or consumed during production. Maine also provides an exemption for purchases of property that is consumed or destroyed in the manufacture of personal property for sale. However, Maine courts have narrowly interpreted the statute in refusing an exemption for the purchase of metal plates by a corporation engaged in printing because the plates were stored and reused in subsequent reprints of the same copy. The court held that the plates were not consumed in the process and, as such, were not covered by the exemption. On the other hand, Minnesota, in at least one decision, interpreted its statute much more broadly. In applying the exemption to a case involving similar metal plates, it was determined that the plates were of only nominal value after the printing process and had been “economically” consumed and were therefore exempt. Certain states attempt to quantify the exemption by useful life. For example, some states limit the consumable item exemption to property with a useful life of less than twelve or six months. Machinery and equipment In the spirit of promoting manufacturing and warehousing activity within the state, many states allow an exemption from sales and use tax for the purchase of certain property used in production. States vary greatly, however, in the scope and requirements for the exemption. New York, for example, provides a fairly broad exemption for machinery or equipment used or consumed, directly and predominantly, in the production of 34

tangible personal property. The exemption includes parts (regardless of useful life), tools, or supplies used in connection with such machinery, equipment, or apparatus and applies to New York state and all local jurisdictions with the exception of New York City. Connecticut, on the other hand, provides an exemption for machinery used directly in a manufacturing production process. Machinery includes the basic machines, including all of its component parts and contrivances (i.e., belts, pulleys, shafts, moving parts, and operating structures) and all equipment or devices used or required to control, regulate or operate the machinery. Other states limit the manufacturing machinery and equipment exemption to new or expanding businesses. In these states, replacement equipment will often not qualify for the exemption. Further, capital expenditure thresholds, job creation or increase in output criteria must often be met before the exemptions will apply (see discussion of incentives below). Many other states have designated specific operations to which the exemption for machinery and equipment will apply. New Jersey, for example, provides an exemption for sales of machinery, apparatus, equipment, building materials, or structures or portions thereof, used directly and primarily for cogeneration in a cogeneration facility (i.e., a facility whose primary purpose is the sequential production of electricity and steam, or other forms of useful energy, that are used for industrial or commercial heating or cooling purposes). Delineation of Manufacturing or Production In general, the manufacturing exemptions are only applicable to property used in the manufacturing process. For example, administrative, sales and shipping departments generally are not considered part of the manufacturing process. However, states vary on whether materials for handling, packaging and quality control are considered part of the manufacturing process. Therefore, it is important to determine at which point the manufacturing process begins and ends. Certain states consider the manufacturing process to include only those steps that result in a direct change to the property. However, most states have adopted the integrated plant theory, whereby all stages of a production phase are considered to be part of the manufacturing process. Missouri has adopted New York’s integrated plant approach in its determination of what constitutes manufacturing. The Missouri Supreme Court has stated that the integrated plant approach is consistent with the legislative intent behind the state’s machinery exemption. Moreover, modern manufacturing facilities are designed to operate on an integrated basis. To limit the exemption to machinery or equipment which produces change in the composition of raw materials involved in the manufacturing process would ignore the essential contribution of the other devices required for such operations. Floyd Charcoal Co. v. Dir. of Rev., 599 S.W.2d 173 (Mo. 1980). 35

Packaging Several states specifically exempt containers and packaging materials, while others do not currently have legislation governing the taxability of such materials. Those states lacking statutory guidance generally consider two approaches in making a determination as to the taxability of packaging materials: ─ ─

Have the containers and packaging been purchased for resale, thus qualifying for the resale exclusion; or Are the containers and packaging consumed by the vendor as an incident to sale and therefore taxable when purchased by the vendor?

Many states have specific sales and use tax laws governing the taxability of containers and other packaging materials. New York law, for example, exempts cartons, containers, wrapping and packaging materials, as well as supplies and components that are for use and consumption by a vendor in packaging or packing tangible personal property for sale. The packaging material, however, must be physically transferred to the purchaser. Returnable containers that are purchased by a vendor who does not transfer ownership of the container are subject to tax. Moreover, cartons or other packaging materials purchased by a vendor for the vendor’s own use or consumption are subject to tax. Likewise, sales tax applies to racks, trays, or similar devices used to facilitate delivery of the vendor’s product if such devices are not transferred with the product to the purchaser. California also has a statute governing the taxability of containers and other packaging. The California Revenue and Tax Code exempts: ─

─

─

Nonreturnable containers when sold without the contents to persons who place the contents in the container and sell the contents together with the container. Containers when sold with the contents if the sales price of the contents is not required to be included in the measure of the taxes imposed by this part. Returnable containers when sold with the contents in connection with a retail sale of the contents or when resold for refilling.

Ohio has a specific exemption for packages, packaging supplies, and packaging equipment. Although this exemption applies to manufacturers, it is separate and distinct from the manufacturing exemption. The delineation of what constitutes a “container” or “packaging material” differs by jurisdiction. Pursuant to New York regulations, packaging material includes, but is not limited to: bags, barrels, baskets, bindings, bottles, boxes, cans, carboys, cartons, cellophane, coating and preservative materials, cores, crates, cylinders, drums, excelsior, glue, gummed labels, gummed tape, kegs, lumber used for blocking, pails, pallets, reels, sacks, spools, staples, strapping, string, 36

tape, twine, wax paper and wrapping paper actually transferred with the product to the purchaser. Pennsylvania statutes provide an exclusion from sales tax for wrapping paper, wrapping twine, bags, cartons, tape, rope, labels, nonreturnable containers and all other wrapping supplies, when such use is incidental to the delivery of any personal property. In one court case, it was held that pallets are "nonreturnable containers" and exempt.

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VII. Leases As discussed above, leases are generally treated as periodic sales depending on the type of lease. Because the lessor retains title to the property being leased, the lessor will have a taxable presence in each location where the leased property is present, and therefore a duty to collect tax (if applicable). A.

Types of Leases Operating Lease ─ ─ ─ ─ ─

Transfer of possession only (title remains with lessor) Property generally reverts to the lessor at the end of the lease term, or may be purchased at fair market value. Also known as a “true lease” Generally the lessor’s purchase is for resale For accounting purposes, the lessee would deduct the lease payment as an operating expense and would not report the asset or liability on its balance sheet.

Capital Leases ─ ─ ─ ─

B.

Principal purpose is to allow the lessee to acquire the property by making the lease payments Property generally remains with the lessee at the end of the lease term following the payment of a nominal option price Also known as a “financing lease” For accounting purposes, the lessee capitalizes the asset, depreciates it and assumes the risks of ownership. Sales Taxation of Leases

Generally operating leases are taxed on the periodic rental stream at the time the payments become due. Capital leases are generally taxed up front on the entire lease stream. Exceptions For operating leases the following states permit the lessor the option of paying tax on the purchase of the property or to collect and remit tax on the rental stream: Arkansas, California, Colorado (on leases of less than 36 months), Michigan, Missouri, New Jersey (on leases over 28 days), and Rhode Island. For operating leases the following states require the lessor to pay the tax up front at the time the property is purchased: Maine and Illinois (the City of Chicago 6% transaction tax applies to the rental stream).

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Illinois requires the lessor under a capital lease to collect the tax as the payments become due. The City of Chicago 6% transaction tax does not apply to capital leases. Utah permits the lessee under a capital lease the option to pay tax on the purchase or collect the tax on the rental stream. Relocation of Leased Property One problematic area with leases is the movement of leased property from one state to another, particularly movement from an up-front state to one that requires collection of tax on the rental stream. The MTC has a uniformity proposal that would provide a credit for the tax paid upfront to the tax due on the later rental stream in the subsequent state. Rate Changes States vary in the application of tax rate changes to the periodic rental stream. Michigan and Oklahoma have determined that the rate change applies to the rental payments coming due after the effective date of the change. Texas applies the rate in effect at the time the lessee took possession of the property. Motor Vehicles States vary in their treatment of motor vehicle leases and care should be taken to ascertain the rules as they apply to motor vehicles.

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VIII. Taxable Services A.

Services

As mentioned above, most states tax enumerated services only. Therefore, unlike sales or purchases of property where all purchases are taxable unless specifically exempt, sales and purchases of services must be carefully examined to determine is such services meet the definition of the services specifically taxed by the state. Common Taxable Services While the states vary greatly in the services that are taxed, certain trends have evolved. Most states do not tax professional services, such as accountant services, legal services or medical services. Many states do tax personal services, such as beauty salon services, dry cleaning and other services that are considered “luxury services”. Other services that are often taxed include the following: ─

─ ─

repair, fabrication and installation service - many companies that provide repair service as an ancillary line of business neglect to collect sales tax on repairs. data processing and information services - there is often controversy as to what activities are included in the definition of the taxable service. cleaning and maintenance services

Mixed Transactions One of the most complex areas of taxing services, particularly in states that only tax sales of tangible personal property, involves the situation where one lump sum is paid for a transfer of both tangible personal property and services. If the service and the property each would be taxable on their own, there is no need to separate the transaction. However, in many cases property is transferred along with nontaxable services. The taxpayer then has the burden of separating the transaction and proving the nontaxable portion. Obviously, it is beneficial to assign a value to the tangible personal property and separately state this amount on the invoice. However, this is not always feasible and states have developed various formulas for dealing with "mixed transactions." In order to determine whether a particular transaction is taxable, states attempt to determine whether any tangible personal property was transferred along with the service. If tangible property was transferred, the next step is to ascertain whether the property was a substantial part of the transaction. The test which states use is generally called the "true object" test or the "inconsequential element" test. These tests help determine the consequentiality of the property transferred by seeking the real reason the purchaser entered into the transaction. 40

If the "true object" of entering into the transaction is to purchase tangible personal property, then the whole transaction is generally taxable. For example, in hiring a photographer, some states would view the true object of entering into this transaction to be the receipt of tangible personal property, the photograph. On the other hand, if the true object is to obtain the professional or personal services of the vendor, then the whole transaction is exempt, despite the transfer of some tangible personal property. Another example would be hiring an engineer who transfers his thoughts and ideas to the customer on blueprints. Certain states would deem the blueprints inconsequential because the real reason the consumer entered into the transaction was to obtain the professional services of an engineer. Other states would find the blueprints to be the true object and deem the entire transaction to be taxable. Some states have set a specific threshold to determine the true object of a transaction. A typical threshold is 10%; that is, if more than 10% of the selling price relates to property transferred, the true object of the transaction is considered to be the sale of property and the entire transaction is taxable. Non-taxable Services Separately Stated from Property In general, separately stating non-taxable services from taxable property on the invoice is sufficient to maintain the tax-exempt status of the services. However, even if non-taxable services are separately stated from the sale of property, some states will still tax the sale of property if the services cannot logically be segregated from the sale of property. Most states define taxable “gross receipts” as the total sales price of tangible personal property without deduction for labor or service costs that are a part of such sales. The disallowance of services has generally been interpreted as disallowing the actual labor incurred to produce the property. However, some states have concluded that certain services such as installation, freight and mandatory maintenance agreements are inseparable from the sale of property and are therefore included in the sales tax base. For example, although a Missouri regulation indicates that separately stated labor charges are exempt from Missouri sales tax, the Missouri Administrative Hearing Commission has ruled that such charges are not necessarily exempt from tax. Whether a service is part of a sale depends on the parties’ intention. It is an issue of fact. Indicia of intent include whether the seller will make the taxed transaction without the disputed service, Brinson Appliance, Inc. v. Director of Revenue, 843 S.W.2d 350, 352 (Mo. 1992); whether documentation or industry custom shows that title passes without the disputed service, Kurtz Concrete, Inc. v. Spradling, 560 S.W.2d 858, 862 (Mo. banc 1978); whether the seller derives “financial benefit from the delivery,” who controls the cost and means of delivery, who assumes the risk of loss during delivery, Southern Red-E-Mix Co. v. Director of Revenue, 894 S.W.2d 164, 166-67 (Mo. banc 1995); and how the parties treat the disputed 41

service in their records, Oakland Park Inn v. Director of Revenue, 822 S.W.2d 425, 426 (Mo. banc 1992). No single one of those indicia is conclusive evidence of the parties’ intent. Id. The record does not support Royal on those indicia of the parties’ intent. Royal Waterbeds, Inc. v. Director of Revenue, Mo AHC, No. 95-002014RV, July 19, 1996. B.

Software

In some states, rather than being framed as "service vs. property," this issue is litigated as "tangible vs. intangible," with controversies frequently involving purchases of computer software. In one case, taxpayers argued that consideration was being paid for the intangible right to use programs or that the knowledge or information transferred to the taxpayer was intangible Alternatively, the state argued that the magnetic tapes or diskettes had been enhanced in value by the programs and the entire purchase price was subject to tax. Comptroller of the Treasury v. Equitable Trust Company, 464 A.2d 248 (1983). The California Court of Appeals recently addressed this distinction in Nortel Networks Inc. v. State Board of Equalization, 191 Cal. App. 4th 1259, 119 Cal. Rptr. 3d 905 (2011). The court held that a manufacturer of telephone switching equipment (Nortel) was not subject to California sales/use tax on software that it licensed to operate switching equipment in California, under the state’s Technology Transfer Agreement (TTA) statutes. The court found that the software was exempt under the TTA statutes because it (1) was copyrighted; (2) contained patented processes; and (3) enabled the licensee to copy the software and to make and sell products – telephone calls – using the patents and copyright. Furthermore, it found that the SBE’s attempt to limit the scope of the TTA statutes by excluding prewritten computer programs in its implementing regulation was an invalid exercise of its regulatory power because the TTA statutes encompass “any” transfer of an interest subject to a patent or copyright, which included the prewritten programs at issue. Note that the Nortel decision does not apply just to licenses of software by itself, but also to the sale of hardware or products that include “embedded” computer software that the hardware utilizes in its operation. Most states consider “canned” or prewritten computer software to be tangible personal property and therefore taxable. However, most states consider “custom” software to be intangible property and therefore exempt from sales tax. The states tend to have an extremely narrow interpretation of what constitutes “custom” software. For example, most states conclude that modifications to canned software do not transform the canned software to custom software, although the modification services may be exempt. Another interpretation by states concerning customization is that software must be programmed specifically for a particular user. 42

Some states also allow sales and use tax to be avoided on purchases of canned software if the software is transmitted to the purchaser in electronic form only and the buyer does not receive any copies of the software on tangible media such as a disk or CD. Although the general trend among states is to tax sales of canned software regardless of the format in which it is transmitted, states which continue to impose sales or use tax only if software is transmitted on tangible media include California, Missouri, and Virginia. Cloud computing offers users a software component that states may characterize as software. This is often referred to as “Software as a Service” or an “Application Service Provider.” This is canned software, or software applications, that are accessed by the user under a license to use agreement where no tangible personal property is transferred. Ownership of the software is retained by the vendor and hosted on server owned by the vendor or a designated third party. Many states look to the extent at which the user is manipulating the software to characterize the transaction as the sale (or use) of software. States are not uniform in addressing this aspect of cloud computing. Typically states which tax electronically downloaded software will be likely to tax this software model but that is not always the case. At this time, only a few states have addressed this through formal legislation. C.

Digital Products & Services

Trends in the marketplace in recent years have left states increasingly concerned about the erosion of the sales and use tax base. A multitude of products and services available through electronic means has led to fewer purchases of traditional tangible personal property. Digital equivalents of tangible property available for download or streaming via the internet are just one example; books, music, videos. The Streamlined Sales and Use Tax Agreement, discussed later in these materials, does provide for consistent definitions of “specified” digital products for member states. The tax treatment of digital products continues to vary from state to state. Several states have chosen to expand the sales and use tax base to recognize transactions involving digital products as subject to sales and use tax either through formal legislation, case law, or informal policy decisions; while many states continue to exempt these types of purchases. The complication is the variety of services provided entirely through the internet, particularly “cloud computing.” Cloud computing is often associated with the use of software; however, cloud computing is also the provision of an infrastructure or a platform as a service. Many services are now automated and provided through the use of the cloud. The definitions and tax applications of these types of services vary widely among states. States will continue to attempt to characterize these services under an existing taxable service definition. Washington State addressed these digital services through formal legislation; See Washington Engrossed Substitute HB No. 2075 (Chapter 535, Laws of 43

2009), effective July 26, 2009, and Washington State Department of Revenue Special Notice: Digital Products, issued June 29, 2010. D.

Specific Services

Information Technology Services As discussed above, most states do not impose sales or use tax on custom computer programming services. Likewise, most states do not impose tax on separately stated charges for system design, hardware or software consulting, or data processing services. However, if such amounts are not separately stated or cannot be purchased separately from taxable items (e.g. hardware or canned software), many states will consider the entire contract amount to be taxable. In a handful of states (including Connecticut, Iowa, Ohio and Texas), data processing services are generally taxable even when purchased independent of other taxable items or services. Telecommunications Services Many states either include telecommunications services among those services subject to sales/use tax or impose one or more separate taxes or fees on telecommunication services. The definition of taxable telecommunication services varies significantly among the various states and local jurisdictions imposing such taxes, but most have broad language designed to include new and emerging telecommunications technologies such as cellular and satellite communications and voice over Internet protocol (VOIP). Note that the Internet Tax Nondiscrimination Act (discussed above) prevents states from imposing new telecommunications excise taxes to the extent that such taxes would apply to Internet access charges. Production and Fabrication Services Even among states that do not generally tax services, charges for production, fabrication and/or processing of tangible personal property are often subject to sales/use tax. The apparent reason for taxing these services is their similarity to manufacturing activities. In both cases, a new or different item is created from components or raw materials. In the case of the manufacturer, the cost of labor used in manufacturing is included in the selling price of the new item. By taxing fabrication services, states impose tax on the labor component even though the customer has supplied the raw materials. Printing Services Like production and fabrication services, most states tax printing services, unless the printed material is to be resold. Thus, a printer must typically collect sales/use tax on the entire charge to its customer, regardless of whether the printer or the customer supplies the paper, ink and other items used in the printing process. However, many states define manufacturing to include 44

printing, so that state sales/use tax exemptions for manufacturing machinery and equipment apply to printing equipment. Advertising Services Advertising is another area where the customer may be provided with a variety of tangible items as a result of the services performed. For example, the customer may receive artwork, logos and promotional materials in a variety of different formats and media, as well as master recordings and backup copies of radio, television and Internet advertisements. Typically, states do not impose sales/use tax on separately stated charges for development of campaigns and preliminary designs and materials, but do impose tax on separately stated charges for tangible items such as the production of finished artwork, copies of video tapes or other recordings, and items such as signs, displays and the like. A few states (including Idaho and Virginia) provide by rule that advertising agencies are subject to tax as a consumer on all purchases of materials or supplies, but are not required to collect tax on any amounts received from their clients. Construction Contractors Sales/use tax is generally not imposed on sales of real property. However, construction contractors can act as either retailers or consumers of the tangible personal property and taxable services, depending on the nature of the work involved in a particular project and the method by which the work is paid for. Contractors are typically treated as retailers when they resell tangible personal property in its present state without transforming it into real estate. For example, the sale of a freestanding refrigerator by a contractor is typically viewed as a retail sale of tangible personal property, since the refrigerator could be removed from the building relatively easily without damaging the building or the refrigerator. In contrast, paint applied to a building by a contractor is clearly consumed by the contractor and thus is generally not considered as being resold to the contractor’s customer. The typical rule is that if property is physically annexed or attached to real property such that removal of the property would be impracticable or would cause irreparable damage to the real property or the item in question, the item is deemed to be consumed by the contractor. As the contractor is considered to be the consumer of such items, the contractor is typically required to pay sales or use tax on the acquisition of the item, but is not required to collect sales tax from its customer. In a few jurisdictions, the type of contract may also affect the application of sales or use tax. In such states, a “lump sum” construction contract is not subject to sales or use tax, so the contractor is considered the consumer of all materials and supplied purchased for use in fulfilling such a contract. However, these states consider the contractor as the reseller of any materials provided or consumed under a “time and materials” contract, so the contractor would be required to collect sales/use tax on the separately itemized charges for materials 45

in this type of contract. Jurisdictions which make this distinction include Texas and the District of Columbia. In some states, the application of sales/use tax to contractors may depend on whether or not the contractor is the owner of the property in question. For example, the state of Washington taxes “speculative builders” differently from “prime contractors.” In Washington, a “speculative builder” is a person or entity that constructs or improves buildings upon real estate owned by the builder itself. A speculative builder is required to pay sales/use tax on all purchases of materials and supplies purchased for use in such a building project. However, the sale of the property and improvements is not subject to sales or use tax. In contrast, a “prime contractor” is defined as one who constructs, repairs, decorates or improves buildings or other structures on land owned by another. A prime contractor must collect sales or use tax on the entire contract price paid by its customer, but is not required to pay sales or use tax on the cost of any materials which become part of the structure being built or improved. Prime contractors must still pay sales or use tax on tools and equipment used by them and on supplies not incorporated into the structure in question. See Wash. Admin. Code 458-20-170 for further information on the application of Washington excise taxes to construction contractors.

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IX. Sales and Use Tax Audits A.

General Considerations

Understanding the Business A thorough understanding of a company’s business is invaluable in the context of a sales/use tax audit, whether you are the company employee tasked with managing the audit or dealing with the auditor, an outside service provider handling these same tasks, or the auditor him- or herself. If you are not already familiar with the business, its products or services, the financial and accounting records and information systems, and its prior sales/use tax reporting, investigate these areas and learn as much as you can, given time constrains and other responsibilities. If the company has been the subject of sales/use tax audits in the past, review the records from such audits carefully as they can provide a roadmap to issues likely to arise in the current audit. Audit Period and Audit Frequency All states have enacted statutes of limitations that provide the period for which tax assessment may be issued. As long as the taxpayer has filed sales/use tax returns, remitted all taxes it has collected to the state, and absent fraud or other intentional misrepresentations to the taxing authority, most states limit exposure to a period of 3 to 5 years. Generally, a sales/use tax audit will cover the maximum statutory period for assessments, so it is usual for an audit to cover a period of several years. For larger taxpayers, audits are often scheduled on a regular period coinciding with the limitations period (e.g. if the state has a four year limitations period, the taxpayer would be audited on a regular four year audit cycle). For smaller companies, audits may be more selective, depending on the taxing jurisdiction’s resources and other factors. However, if a state has audited a company in the past and issued a significant assessment, it is likely that the state will audit the company with greater frequency in the future – both to maximize the state’s tax revenues and to determine whether the shortcomings that caused the prior deficiency have been corrected. B.

Conduct of the Audit

Confidentiality Many states impose confidentiality requirements on their auditors, as it is often necessary to examine documents and information of a potentially private and sensitive nature in the context of an audit. However, note that such confidentiality provisions often specifically permit sharing of information with other governmental tax agencies. Thus, information gathered by one taxing authority during an audit may be shared with other taxing authorities and used to decide whether to audit a company and what issues to focus on during the audit. 47

Responding to Requests for Documents and Information During the initial meeting or correspondence between the auditor and the taxpayer, one of the topics to discuss is the scope of the audit, including the specific records to be reviewed. This is a good time to establish ground rules for the conduct of the audit, including the procedure for requesting and providing specific records and information. Especially if the taxpayer is a manufacturer, the auditor may wish to tour the facility to get a better understanding of the business. The taxpayer may want to accommodate the auditor to the extent reasonable, but is also entitled to understand the reasons behind any request made by the auditor. If a request for certain documents or information is burdensome or unreasonable, the taxpayer’s representative should discuss the request with the auditor to determine if there is a less burdensome alternative. However, the taxpayer should avoid outright refusal to provide information requested, as this is likely to antagonize the auditor and may result in a “jeopardy” or estimated assessment, which usually is the auditor’s worst case estimate of what the tax exposure might be. C.

Areas Typically Examined

Sales Tax Collection and Reporting If the taxpayer is a seller of tangible personal property and taxable services, expect the auditor to examine the documentation related to all sales and sales/use tax collections, and to reconcile these records with the amounts reported to the taxing jurisdiction on the company’s sales/use tax returns. If the company did not collect tax on certain sales (i.e. sales for resale, sales to manufacturers or sales that are otherwise exempt from tax), the auditor will likely request records of such transactions and copies of resale or exemption certificates, if required by the state to be kept on file by the seller. If the seller is involved in dock sales, drop shipments, leases or other unique transactions, the auditor may request records to determine is tax was appropriately collected and remitted. Use Tax on Capital Assets and Consumable Supplies Companies are generally required to self-report use tax on acquisitions of capital assets and consumable supplies, unless sales tax was paid to the vendor or such items are specifically exempted from tax. Sales/use tax audits typically involve the review of the company’s records related to such purchases, to determine whether sales tax or use tax was paid on all taxable purchases. For capital assets (especially those above a certain threshold amount), the auditor may examine all purchases. For consumable supplies and less costly capital assets, it is more common for the auditor to select a sample period and derive an “error rate,” which is then applied to the total amount of such purchases during the entire audit period to calculate the total amount of deficiency or overpayment on such purchases.

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D.

Use of Sampling Techniques

Many states allow sampling in conducting sales/use tax audits if the taxpayer’s records are so detailed, complex or voluminous that an audit of all such records would be unreasonable or impractical; if the taxpayer’s records are inadequate or insufficient, so that an accurate audit for the period is not otherwise possible; or if the time required to review all of the taxpayer’s records would be unreasonable in relation to the benefits derived, and sampling would produce a reasonable result. Although it is often the auditor who suggests the use of sampling, the taxpayer may also request sampling and some states have statutes requiring sampling to be used if it is requested and would produce a reasonable result. Often, the auditor is required to notify the taxpayer in writing if and to what extent sampling will be used in conducting the audit. The auditor should clearly explain the sampling methodology prior to selecting and reviewing the sample, and the taxpayer may object if it feels that the methodology would be too burdensome, or believes that the sample selected would not be typical and representative of the entire period under review. For example, if key tax department personnel were replaced in the third year of a four year audit period, and the company’s representatives believe that tax compliance practices and procedures were significantly improved since that time, the company should not agree to a single sample period from year one or two since this would likely result is an assessment in excess of the company’s actual liability for the period. Also, if the taxpayer or auditor identifies certain large and/or atypical transactions in a sample population that would unduly affect the error rate calculated, it may be appropriate to exclude such transactions from the sample so that a more accurate error rate is achieved. Other variables to be considered related to the sampling process include the appropriate subpopulations (e.g. divisions, product lines, geographic areas, sales channels), sampling unit and stratifications (generally by item cost or total invoice amount), number of sample periods, and sample size (i.e. number of transactions in each sample). Although many taxing jurisdictions have detailed rules and instructions for auditors that dictate some of these items, there may be room for the taxpayer’s representative to negotiate with the auditor and agree to a sampling methodology that is most likely to lead to an accurate and beneficial result. Once the sample has been selected and the records for the transactions included in the sample have been reviewed, the auditor will calculate an error rate and extrapolate this rate over the total amount of transactions of the given type during the audit period to determine the total tax underpaid or overpaid. As auditors typically focus on underpayments, the taxpayer or its representative should review the transactions sampled to identify any overpayments that the auditor may have missed, as well as to determine whether there is a valid reason for any underpayments identified by the auditor.

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E.

Dispute Resolution

During the Audit – Working with the Auditor and Audit Supervisor As issues arise in the context of the audit, it may be possible to discuss with the auditor and reach a resolution or accommodation that is acceptable to both sides. This highlights the advisability of maintaining a respectful, professional (and possibly even friendly) relationship between the auditor and the taxpayer’s personnel and representative, to the extent possible. However, many auditors see their task as identifying issues and potential liabilities, and will defer any uncertain issues to their supervisors or for resolution on appeal once an assessment has been issued. If this is the case, the taxpayer may wish to focus primarily on resolving any factual misunderstandings or disputes with the auditor, and defer discussion of legal and policy issues for supervisor’s conferences or appeal. The audit supervisor or audit manager may be more receptive than the auditor to discuss issues of law or departmental policy, and may feel that they have more authority to resolve such issues than does the auditor. If significant issues arise that cannot be resolved with the auditor, it may be worthwhile to request a meeting with the audit supervisor or present analysis of the issue to the supervisor and request that they instruct the auditor on the appropriate treatment of the issue. If the audit supervisor is also unreceptive to the taxpayer’s position, it may be possible to obtain guidance from the policy or appeals division of the taxing authority before the audit has been concluded, so as to resolve the issue prior to the issuance of an assessment. Administrative and Judicial Appeals Most taxing jurisdictions provide an avenue for administrative appeals of audit assessments or specific issues that were resolved unfavorably to the taxpayer in the context of an audit. Although such appeals are nominally impartial, the administrative law judge or similar person assigned to decide the appeal is typically an employee of the taxing agency and thus will often decide the issue in accordance with established departmental policy, where such policy exists. However, such appeals are a valuable opportunity for the taxpayer to develop both its legal position and the factual record upon which any subsequent appeals may be based. If a taxpayer receives an adverse decision from the administrative appeal, it may be possible to appeal the decision further within the agency’s administrative process. Some jurisdictions require that all opportunities for administrative appeal must be exhausted before the taxpayer is allowed to appeal the matter in court or to a quasi-judicial body such as a board of tax appeals. A judicial appeal is typically costly and time consuming, but may be the taxpayer’s first opportunity for a truly impartial review of the issue in question. In addition, a judicial appeal may spur the taxing authority to settle the case if it 50

wishes to avoid the establishment of binding precedent on the issue. Taxpayers should carefully consider whether the effort and expense of litigation is warranted before deciding on a judicial appeal. However, the expense may be justified, especially if amount at issue is significant and is likely to be recurring in future periods.

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X.

Streamlined Sales and Use Tax Agreement A.

Background

In Quill, the U.S. Supreme Court was faced with the question of whether an outof-state mail order retailer was required to collect a state’s use tax when the retailer’s only connection to the state was through catalog advertising sent into the state through the mails and shipment of products into the state in fulfillment of orders placed over the phone and by mail. In reaching its decision not to overturn the physical presence nexus standard in Bellas Hess, the Court found that a lower nexus threshold would burden interstate commerce. The Court pointed to the complicated patchwork of sales and use tax requirements imposed by over 6,000 state and local taxing jurisdictions in the U.S. And quoting from Bellas Hess, the Court noted: The "many variations in rates of tax, in allowable exemptions, and in administrative and record keeping requirements could entangle [a mail order house] in a virtual welter of complicated obligations" National Bellas Hess, Inc. v. Department of Revenue of Ill., 386 U.S. 753, 759-760 (1967). Quill Corp. v. North Dakota, 504 U.S. 298, fn 6 (1992). These burdens, the interests of the mail order industry which had relied on the Bellas Hess physical presence standard for twenty-five years, and the unique role that Congress plays in regard to the Commerce Clause, all weighed heavily in the Court’s reasoning in Quill. The Court concluded that it should defer to Congress to decide legislatively whether a lower nexus standard should apply to mail order sellers. As the mail order business grew during the early to mid-1990s to be replaced by the apparently more promising Internet as a retail sales channel, the states began to see mounting losses in state tax revenue. Recognizing that chasing individual consumers for use tax on purchases from out-of-state retailers was a lost cause, the states began to consider federal legislation as a way to require remote sellers to collect state sales and use taxes. The states acknowledged that in order to succeed before Congress they would need the support of the multistate retailer community. To get that support they would need to greatly reduce the burdens on multistate retailers through sales and use tax uniformity and simplification. B.

Streamlined Sales Tax Project

The Streamlined Sales Tax Project (“SSTP” or “the Agreement”) was organized in March 2000 as a result of the joint efforts of the National Tax Association, the Federation of Tax Administrators, the Multistate Tax Commission, the National Conference of State Legislatures, and the National Governor’s Association. Also key to the formation of the SSTP was the participation of business through the coordinating efforts of the Council On State Taxation. 52

The objective of the SSTP is to simplify and modernize sales and use tax collection and administration across state and local jurisdictions. A Streamlined Sales and Use Tax Agreement (“SSUTA”) was adopted by thirty-three participating states and the District of Columbia on November 12, 2002. C.

The Agreement

Purpose According to the SSUTA, its fundamental purpose is to: [S]implify and modernize sales and use tax administration in the member states in order to substantially reduce the burden of tax compliance. The Agreement focuses on improving sales and use tax administration systems for all sellers and for all types of commerce through all of the following: ─ ─ ─ ─ ─ ─ ─ ─ ─ ─

State level administration of sales and use tax collections. Uniformity in the state and local tax bases. Uniformity of major tax base definitions. Central, electronic registration system for all member states. Simplification of state and local tax rates. Uniform sourcing rules for all taxable transactions. Simplified administration of exemptions. Simplified tax returns. Simplification of remittances. Protection of consumer privacy.

Governing Board, Membership and Effective Date The SSUTA provides for the formation of a governing board comprised of member states to administer the Agreement. After the effective date of the Agreement, a state may become a member of the SSUTA if the effect of the state’s laws, rules, regulations, and policies are judged by the governing board to be in substantial compliance with each of the provisions of the Agreement. The Agreement is effective when at least ten states making up twenty percent of the total population of all states imposing sales and use taxes are judged to be in substantial compliance with each of the provisions of the Agreement. The Agreement became effective on October 1, 2005. The Agreement provides for two types of members: full members and associate members. Full members are states meeting the admission requirements set forth above. An associate member is a state that has achieved substantial compliance with the terms of the SSUTA taken as a whole, but not necessarily each provision. A state that was an associate member on January 1, 2007 may remain an associate member until such time as (1) the state rescinds its election for origin-based sourcing (at which time the state becomes a full member state); (2) the state has become a full member state; or (3) the governing board determines the state is not in substantial compliance with the SSUTA. 53

The following states are currently full members of the Agreement, and therefore members of the governing board: Arkansas Georgia Indiana Iowa Kansas Kentucky Michigan Minnesota Nebraska Nevada New Jersey North Carolina

North Dakota Ohio Oklahoma Rhode Island South Dakota Utah Vermont Washington West Virginia Wisconsin Wyoming

Currently, the only associate member state is Tennessee Uniformity of Administrative Procedures The SSUTA requires each member state to have a single state-level administered sales and use tax system. Although the state permits the imposition of local taxes, they must be centrally administered. Sellers may only be required to complete a single state level registration. State and local taxes must be collected at the state level and distributed by the state to local jurisdictions. No local jurisdiction my conduct its own audits of sellers registered under the SSUTA. Member states must all have a single state level tax rate, except that a state may have a second tax rate of zero for food items and drugs as defined by state law pursuant to the Agreement. Seller Registration The SSUTA requires a one-stop online registration system for all sellers willing to participate in the Agreement. A seller who registers under the Agreement agrees to collect sales and use taxes for all member states without regard to whether the seller has nexus in each of the member states.

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Rates and Boundaries Member states are limited in the number of tax rate and jurisdictional boundary changes that may be made in any year and are required to provide a minimum amount of advance notice of such changes prior to taking effect. The states agree to maintain databases of rate and boundary changes as well as rate look up databases in order to simplify the determination of correct tax rates. Uniform Sourcing Rules The SSUTA sourcing rules apply to all sales regardless of whether the sale involves tangible personal property, a digital good or a service. The sourcing rules do not apply to the sale of watercraft, modular homes, manufactured homes or mobile homes. Nor do they apply to the sale or lease of motor vehicles, trailers, semi-trailers, or aircraft that are not considered transportation equipment pursuant to the agreement. Special rules apply to sales of telecommunication services. The Agreement’s sourcing rules reflect a destination sourcing principle. This has been a significant point of controversy in states that use an origin method of sourcing for local tax purposes (e.g., California, Kansas, Texas, Utah and Washington). Change from an origin to a destination sourcing method causes a shift in local sales tax revenues that can have a significant impact on local government budgets. The change is also not viewed as simplification for small businesses that have been accustomed to using a single local tax rate on delivered items. To address the concerns raised by states where a change from origin to destination sourcing created an insurmountable political barrier to SSUTA conformity, the agreement was amended to provide an election for origin based sourcing on intrastate sales. Under the Agreement, a retail sale of a product (except for a lease or rental) is sourced as follows: ─ ─

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When the product is received by the purchaser at a business location of the seller, the sale is sourced to that business location. When the product is not received by the purchaser at a business location of the seller, the sale is soured to the location where the receipt by the purchaser (or the purchaser’s donee, designated as such by the purchaser) occurs, including the location indicated by instructions for delivery to the purchaser (or donee), if known to the seller. If the two rules above do not apply, the sale is sourced to the location indicated by an address for the purchaser that is available from the business records of the seller that are maintained in the ordinary course of the seller’s business when use of this address does not constitute bad faith. If the three above do not apply, the sale is soured to the location indicated by an address for the purchaser obtained during the consummation of the 55

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sale, including the address of a purchaser’s payment instrument, if no other address is available, when use of this address does not constitute bad faith. When none of the above rules apply, including the circumstance in which the seller is without sufficient information to apply the previous rules, then the location will be determined by the address from which the property was shipped, from which the digital goods or computer software delivered electronically was first available for transmission by the seller, or from the which the service was provided (disregarding for these purposes any location that merely provided the digital transfer of the product sold).

Leases are sourced according to the following rules: ─

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For a lease or rental that requires recurring periodic payments, each periodic payment is sourced to the primary property location. The primary property location determined from the address for the property provided by the lessee and kept in the lessor’s records, when use of this address does not constitute bad faith. Intermittent use of the property in other locations does not alter application of this rule. For a lease or rental that does not require recurring periodic payments, the payment is sourced the same as a retail sale in accordance with the previous rules.

Multiple Points of Use The SSUTA provides a form of direct pay permit for purchasers of digital goods, computer software delivered electronically and for services. Under this process, an eligible purchaser must give the seller a “multiple points of use” form. The form allows the purchaser to pay the tax to the jurisdictions in which the digital good, software or service is used according to a reasonable, consistent, and uniform method of apportionment supported by the purchaser’s records in effect at the time of purchase. The form remains in effect for all future sales to the purchaser. A purchaser holding a direct pay permit does not have to also provide a multiple points of use from. Uniform Bad Debt Recovery and Exemption Rules Bad Debts According to the SSUTA, states must allow sellers a bad debt deduction. The following rules apply to bad debts: ─ ─

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No interest is paid on bad debt deductions. Bad debt deductions are allowed on the return for the period during which the bad debt is written off as uncollectible on the seller’s books and records for federal income tax purposes. If the bad debt exceeds the amount of taxable sales, a refund claim may be filed within the otherwise applicable statute of limitations for refund claims. 56

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The rule permits an allocation among states of the bad debt if supported by the books and records of the party claiming the bad debt. To the extent a member state provides a bad debt deduction to any other party (e.g., assignee or person providing credit who is not the seller), the same procedures will apply.

Exemption Rules The Agreement provides limitations on a member state’s ability to adopt exemptions that are inconsistent with defined terms in the SSUTA. To the extent that the subject of an exemption is not within the purview of any definition prescribed by the Agreement, a member state is free to provide an exemption. The following rules apply to exemption certificates: ─ ─ ─ ─ ─

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The seller must obtain identifying information from the purchaser and the reason for claiming the tax exemption. A standardized form for claiming an exemption electronically is to be provided. No signature is required from the purchaser unless a paper exemption certificate is used. The seller is required to maintain proper records of exempt transactions. A seller is required to collect information required by SSUTA Section 317. A fully completed exemption certificate is one where the seller captures all the required data elements: o Purchaser’s name and address o Type of business o Reason(s) for exemption o ID number required by the state where the sale is sourced o If paper is used, signature of the purchaser A “good faith” standard for accepting a requirement for exemption documentation does not apply to a fully completed certificate received on or within 90 days after the date of sale. The member states are required to administer use-based and entity-based exemptions when practicable through a direct pay permit, an exemption certificate, or any other means that does not burden sellers.

Uniform Definition of Goods and Services The Agreement provides uniform definitions for certain items such as food, clothing, healthcare products and equipment, and computer software. Other definitions are still in progress (such as telecommunications and digital goods) and the Agreement provides that definitions for other items may be adopted by the governing board as needed to promote uniformity. To ensure the uniformity of taxability of items for which the Agreement provides a definition, each of the member states is required to publish a 57

taxability matrix in a form prescribed by the governing board. The taxability is to be downloadable electronically. Sellers may rely on the entries in each member state’s taxability matrix and are held harmless from errors in tax collection resulting from reliance on any erroneous information contained in the taxability matrix. Bundled Transactions The Agreement addresses transactions that involve a mix of taxable and nontaxable items, including taxable or non-taxable services. The following definition is provided for “bundled transactions”: A “bundled transaction” is the retail sale of two or more products, except real property and services to real property, where (1) the products are otherwise identifiable, and (2) the products are sold for one non-itemized price. A “bundled transaction” does not include the sale of any products in which the “sales price” varies, or is negotiable, based on the selection by the purchaser of the products included in the transaction. The definition does not include packaging or items that accompany the sale that are incidental or immaterial. It also does not include a product provided free of charge (i.e., the price does not vary regardless of whether the item is included or not). A transaction that otherwise meets the definition of a bundled transaction, is not a bundled transaction if: ─

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The sale is a sale of tangible personal property and a service and the tangible personal property is essential to the use of the service, is provided exclusively in connection with the service, and the true object of the overall transaction is a services; or The sale is a sale of services where one service is provided that is essential to the use of a second service and the first service is provided exclusively in connection with the second service and the true object of the transaction is the second service; or The sale includes taxable products and nontaxable products and the purchase or sales price of the taxable product is de minimis. De minimis means that the taxable product is 10% or less of the total purchase or sales price of the bundled products. The sale includes exempt tangible personal property and taxable tangible personal property, where the transaction includes food and food ingredients or certain medical items and the taxable items are 50% or less of the total purchase or sales price of the bundled tangible personal property.

The foregoing definition applies to tax periods effective January 1, 2008. States are free to tax bundled transactions in any manner consistent with the definitions 58

provided in the Agreement. Transactions involving telecommunication services, Internet services, or audio or video programming services, may be unbundled and the taxable and non-taxable components taxed accordingly, provided the seller can identify, by reasonable and verifiable standards, the nontaxable component. A similar segregation rule applies to these services when a different tax rate is applicable to components of a bundled transaction. Certified Tax Compliance Systems The SSUTA provides for three technology models for automated collection, reporting and remittance. These are: Model 1 – Certified Service Provider. Under this model the seller selects a service provider approved by the governing board to act as agent for collection and remittance. Model 2 – Certified Automated System. Under model 2 the governing board will certify automated sales and use tax compliance software developed by third parties. Software developers may submit automated systems to the governing board for certification. Model 3 – Proprietary System. This model allows sellers to have internally developed software certified for use in collecting and remitting tax. In order to be eligible for certification, the seller must be making taxable sales into at least five states with $ 500 million or more in sales revenue. Vendor Compensation Currently, twenty-seven of the forty-five states that impose a sales and use tax have some allowance for vendor compensation. The Agreement provides some limited seller’s compensation for sellers who adopt Model 2 and for sellers who either adopt Model 3 or do not use an automated collection system. Amnesty Sellers who voluntarily register under SSUTA are automatically eligible for amnesty for all uncollected retail sales and use taxes on sales into a member state. The Agreement’s amnesty provisions relieve all past liabilities for uncollected sales and use taxes – there is no look back period. Amnesty is subject to the following limitations: ─ ─ ─ ─

Only for taxes due in business’s capacity as a seller, not as a buyer. Seller must collect taxes in all member states for at least 3 years going forward to qualify for amnesty. Does not apply to collected but unremitted retail sales or use tax. Amnesty is not available with respect to any matters for which the seller received a notice of audit prior to registering under the Agreement or for which an audit has commenced. 59

Amnesty remains available until twelve months after a SSUTA member state becomes a full member.. Digital Goods Definition of “specified digital product.” ─ ─ ─

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Member states must conform by Jan 1, 2010. Specified digital products can’t be taxed as tangible personal property, telecommunication service or computer software. SSUTA includes presumption that specified digital products are only taxable if sold to an end user and if the right to permanent use is granted by the seller. Member states must specifically impose and separately enumerate the tax on non-end users or on rights to less than permanent use in order to remain in conformity. Member states may provide a product based exemption for specific items that fall within the definition of “specified digital product,” but must grant an analogous exemption to items that are not transferred electronically.

Various states have specifically addressed the taxation of digital goods either by taxing digital downloads of software or other non-software digital goods or content. For an example of a comprehensive statutory scheme taxing digital products see Engrossed Substitute HB 2075, Chapter 535, Laws of 2009, enacted by the Washington State Legislature. Other Unresolved Issues (among many) ─ ─ ─ ─ ─ ─

D.

Certain large states have not enacted the SSUTA to date (California, New York, Florida, Texas) Local base conformity/central administration of local tax. Will key states such as Louisiana, Colorado, Arizona and Alabama enact the legislation? Access to technology by middle market companies. Inadequate vendor compensation. Governance of multi-state compact. How to enact/implement future rule changes affecting multiple states.

Marketplace Fairness Act of 2013 The Marketplace Fairness Act (S. 743, H.R. 684) is a federal effort to bring uniformity to sales tax collection. If enacted, this bill would grant full member SSUTA states the authority to force remote sellers, who do not qualify for the small seller exemption, to collect sales and use tax so long as the SSUTA includes the minimum simplification requirements. It would also grant nonmember states collection authority if those states implement the simplification provisions related to the administration of taxes, audits, and filing of such taxes. This would be a significant shift from the 1992 decision in Quill v. North Dakota where the United States Supreme Court maintained that some 60

physical presence must be present in order for a state to enforce a sales or use tax collection obligation. In order for non-member SSUTA states to be granted this authority, the state must enact legislation that specifies the taxes to which the minimum simplification requirements apply and specify the products and services to which this authority does not apply. In addition, the state must provide all of the following minimum simplification requirements: ─ A single entity to administer state and local taxes; ─ A single audit of a remote seller for all taxing jurisdictions within the state; ─ A single sales and use tax return to be filed by remote sellers with the entity designated to administer state and local taxes, at the same frequency as non-remote sellers; ─ A uniform sales and use tax base among the state and local taxing jurisdictions; ─ Adopt a uniform rule for sourcing remote sales (the bill refers to the sourcing rules set forth in the SSUTA); ─ Indicate the tax treatment of products and services as well as any sales and use tax exemptions; ─ Indicate a rates and boundaries database; ─ Provide software free of charge to assist in determining the correct sales and use tax rate at the time of sale and filing sales and use tax returns; ─ Provide certification procedures for Certified Service Providers (“CSP); ─ Relief provisions for: o Remote sellers from errors or omissions by a CSP; o CSP’s from misleading or inaccurate information by a remote seller; or o Remote sellers and CSPs from incorrect information or ineffective software provided by the state. ─ 90 days’ notice of rate changes by the state to remote sellers and CSPs The bill specifically provides: ─

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Small Seller Exception – A remote seller with less than $1,000,000 in total US remote sales is exempted from a sales and use tax obligation in any state where it does not have a physical presence Nexus Provision – The authority provided by this bill to enforce the collection of sales and use tax is not intended to create nexus between the seller and the state. Limited Authority – This bill is not intended to subject a seller to franchise, income, occupation, or any other type of taxes other than sales and use tax. Although proponents of this bill emphasize that this will “level the playing field” and collect taxes that citizens are already required to pay, the bill, if passed without additional amendments, could have some unintended consequences, such as the cost of implementation. Although 61

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the bill provides for state provided software free of charge, businesses are likely to incur additional costs in training and implementing new procedures to administer the taxes. Determining small seller. The provisions in the bill do not account for non-taxable sales, leaving a seller with only nominal taxable sales into a state with collection authority, a collection obligation; there is no “by state” exemption or minimum requirements. Effect on brick and mortar stores. The bill does not specify sales made online or via the internet or web. Brick and mortar stores who do not meet the small seller exception will face the same sales and use tax collection obligations on remote sales destined for participating states. Application to digital downloads. The bill does not specifically apply to tangible personal property leaving digital products as fair game for taxation.

E. Marketplace Fairness Act of 2015 On March 10, 2015, a bipartisan group of senators introduced the Marketplace Fairness Act of 2015 (S. 698). This bill is substantially similar to S. 743 with the exception of a when a state may begin to require remote sellers to collect taxes under the Act. According to the bill a state may not assert jurisdiction over a remote seller not otherwise subject to a collection obligation for one year after the date of enactment and during the last calendar quarter of the first calendar year beginning after enactment. Streamlined Resources Governing Board website: http://www.streamlinedsalestax.org Governing Board rules: http://www.streamlinedsalestax.org/index.php?page=governing-board-rules Governing Board Bylaws: http://www.streamlinedsalestax.org/index.php?page=alias-7

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