Federal Tax Reform Driving States to Digital Sales Taxes

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By Ryan Prete

Federal lawmakers’ efforts to control states’ taxing authority over remote retailers is adding pressure as potential federal tax reform threatens to further deplete states’ coffers.

“If Congress is going to ask states to pay more and more, then they shouldn’t limit how much revenue states can make,” said Joe W. Garrett Jr., deputy commissioner of revenue with the Alabama Department of Revenue, during a July 20 panel at New York University’s Summer Institute on Intermediate Taxation.

Proposals to slice Medicaid spending and to kill the state and local income tax deduction particularly have triggered an outcry from states.

In the meantime, some members of Congress are attempting to ensure states can’t collect sales tax from remote retailers. A House Judiciary subcommittee hearing is scheduled for July 25 on Rep. Jim Sensenbrenner’s (R-Wis.) No Regulation Without Representation Act of 2017 (H.R. 2887), which would in part codify the U.S. Supreme Court’s 1992 decision in Quill Corp. v. North Dakota. That decision, which a growing number of states are challenging through legislation or in court, prohibits states from imposing sales and use tax collection obligations on vendors without a physical presence in-state.

Garrett was joined at the NYU panel by other senior audit managers and general counsel from state taxing departments, including Harry P. Leonard, who said states’ futures will be informed by federal tax policy.

“States will be starved,” said Leonard, deputy commissioner in the Tax, Audit and Enforcement Division with the New York City’s Department of Finance. As state burdens increase, there will be more pressure on lawmakers and courts to address issues such as taxing out-of-state sales.

States’ traditional tax bases continue to erode in an increasingly digital world, which has prompted almost half the states to pass or propose changes to their tax codes in the last year to capture more online sales. Without the ability to collect tax, states won’t have an avenue to meet the obligations of running government and providing state-services, Leonard said.

Litany of Lawsuits

States have intensified efforts over the years to answer U.S. Supreme Court Justice Anthony M. Kennedy’s 2015 call for a case to re-examine Quill. Litigation over states’ respective statutes and regulations is winding through Alabama, South Dakota, Indiana, Tennessee, and Wyoming.

Alabama is among the states taking aim at Quill, directly challenging the physical presence rule with its “economic nexus” regulation that took effect in January 2016, requiring out-of-state companies that sell more than $250,000 annually into the state to collect and remit Alabama’s sales tax.

Garrett said the state has seen substantial compliance. For the first nine months of Alabama’s fiscal year (through June 30), the simplified remittance program has brought in $39.1 million, the department has told Bloomberg BNA. This compares with $2.3 million for the same period a year ago, when only about half as many companies were participating and Amazon hadn’t begun collecting in Alabama yet. The flat-rate sales tax program for out-of-state sellers has more than 100 participating companies that include Amazon.com Inc., Overstock.com, and Zappos, according to a list the state recently made public.

However, not all companies are complying. Newegg Inc. is challenging the Alabama regulation in a lawsuit before the Alabama Tax Tribunal. The case is still in the discovery stage, and the tribunal isn’t likely to take substantive action until the fall, Garrett said.

A lawsuit is also expected to challenge Ohio’s latest take on remote sales taxation. The state’s biennial budget included a provision that broadened the statutory definition of “substantial nexus” with the state and extended sales tax to companies selling $500,000 and who place “in-state software” on Ohio computers and phones or have servers located in Ohio.

‘Not Cookie Nexus’

However, Christine Mesirow, chief of the taxation section in the Ohio Attorney General’s office, said the state isn’t taking on Quill. She explained that Ohio has long treated in-state software as tangible personal property, and the amendments to the state’s nexus provisions focused on software—the statutory changes were made in an “abundance of fairness” to put taxpayers on notice regarding what may trigger their tax collection obligations.

Many have characterized the Ohio provision as enforcing “cookie nexus,” a perspective that Mesirow doesn’t share.

“This is not cookie nexus,” she said. While the state explored “cookie nexus” in the past, the statutory provisions focus on the use of software in-state.

The concept of website cookies creating sales tax “nexus” made a splash a few years ago when lawyers for Ohio argued that cookies were tantamount to physical presence in Crutchfield v. Testa. In that case, the Ohio Supreme Court upheld the state’s Commercial Activity Tax (CAT) against companies with $500,000 or more in sales regardless of physical presence in the state. However, the court didn’t address the issue of cookies.

Distinguishing ‘Quill’

On the other hand, a recent administrative directive in Massachusetts identified internet cookies as establishing in-state physical presence for Quill purposes. Massachusetts officials have noted that their approach doesn’t challenge Quill, but distinguishes Quill’s ruling between mail order vendors and internet vendors.

Directive 17-1 would have ordered out-of-state online retailers to collect the state’s 6.25 percent sales tax, if they had more than $500,000 worth of in-state sales and 100 or more in-state transactions within the past year. The same directive identified ways in which internet vendors may have in-state physical presence, including using cookies.

Trade associations filed suit against the directive, which they later withdrew after the state Department of Revenue revoked Directive 17-1. Michael Fatale, deputy general counsel for the Massachusetts Department of Revenue, said that the state is working towards similar rules in regulatory form.

To contact the reporter on this story: Ryan Prete in New York at rprete@bna.com

To contact the editor responsible for this story: Jennifer McLoughlin at jmcloughlin@bna.com

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