Welcome to Washington State (Even if You Never Bother to Visit)

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By Garry G. Fujita, Davis Wright Tremaine

State and local tax lawyers are familiar with the physical presence nexus standard; however, with certain taxpayers, that familiarity is useless under Washington's new economic nexus standards because tax may apply if:

• the seller's customers benefit in Washington from the purchased services, and

• the seller's Washington receipts exceed a threshold amount.

“Where” a customer benefits from a business service is not always obvious.

Don't Tax You, Don't Tax Me, Tax That Fellow Behind the Tree'1

These new standards became effective June 1, 2010, in an omnibus tax bill.2 This bill adopted economic nexus for “targeted” businesses—service businesses, financial businesses, and businesses that receive royalty and similar income.

According to the House Finance chair, the law will “level the playing field for Washington-based companies” by extending Washington's business and occupation (B&O) tax3 to out-of-state companies.4 This would result in relief of the tax burden on local businesses and make the out-of-state businesses pay “their fair share” on the business conducted in Washington.5

However, economic nexus would not shift the tax burden as intended if the state continued to apply the well-seasoned cost apportionment formula. So, the Legislature adopted the single sales factor apportionment to export gross receipts by Washington taxpayers and import gross receipts from out-of-state taxpayers. Taxpayers familiar with net income tax have seen a similar approach; some states might double weight the sales factor (e.g., California) or take an “all in” approach like Washington, relying only on the single sales factor (e.g., Oregon).

The Legislature gave the Washington Department of Revenue (DOR) the task of implementing economic nexus and single sales factor apportionment. DOR found this to be a daunting task, taking more than two years to complete:

• a rule on economic nexus, WAC 458-20-19401 (“Rule 19401”), became permanent Oct. 13, 2011 (17 months after the law became effective);

• a rule for financial institutions, WAC 458-20-19404 (“Rule 19404”), became permanent Oct. 15, 2012 (about 28 months after the law became effective);

• a rule for general application, WAC 458-20-19402 (“Rule 19402”), became permanent Oct. 18, 2012; and

• a rule for royalty and similar receipts, WAC 458-20-19403 (“Rule 19403”), became permanent Oct. 18, 2012.

There may be constitutional problems with this new law6 but this article will not focus on the potential constitutional infirmities of the statutes or regulations. Rather, the purpose of this article is twofold. First, the article is intended to make the reader aware that an out-of-state taxpayer may have B&O tax liability if its customer benefits in Washington from services that it purchases from that taxpayer. Second, it is intended to explain generally Washington's new approach and highlight the receipts portions of the rules.

Which Taxpayers Must Know About These New Nexus Rules?

This law does not apply to all taxpayers taxable in Washington. It only applies to taxpayers that have “apportionable activities.”7

Washington's B&O tax is based on different classifications that are typically taxed at different rates. Certain classifications (e.g., retailing, wholesaling, or manufacturing) do not apportion income; the gross receipts are already allocated to one state or another. Other classifications apportion gross receipts between the states. The nexus statute8 lists the tax classifications that apportion by reference to each RCW but the rule9lists them by industry name or activity:

• service and other activities;

• royalties;

• travel agents and tour operators;

• international steamship agent, international customs house broker, international freight forwarder, vessel and/or cargo charter broker in foreign commerce, and/or international air cargo agent;

• stevedoring and associated activities;

• disposing of low-level waste;

• title insurance producers, title insurance agents, or surplus line brokers;

• public or nonprofit hospitals;

• real estate brokers;

• research and development performed by nonprofit corporations or associations;

• inspecting, testing, labeling, and storing canned salmon owned by another person;

• representing and performing services for fire or casualty insurance companies as an independent resident managing general agent licensed under the provisions of Chapter 48.17, Revised Code of Washington;

• contests of chance;

• horse races;

• international investment management services;

• room and domiciliary care to residents of a boarding home;

• aerospace product development;

• printing or publishing a newspaper (but only with respect to advertising income);

• printing materials other than newspapers and publishing periodicals or magazines (but only with respect to advertising income); and

• cleaning up radioactive waste and other by-products of weapons production and nuclear research and development, but only with respect to activities that would be taxable as an “apportionable activity” under any of the other tax classifications listed if this special tax classification did not exist.

The “service and other” classification is the catch-all provision, i.e. if a taxpayer does not fit into any of the discrete statutory tax classifications,10 then this catch-all classification applies.11

When Does a Taxpayer Have Nexus in Washington?

Once it has been determined that a taxpayer has apportionable activities, then the next step is to determine if economic nexus is present. The statute12explains when a nonresident taxpayer has substantial nexus for B&O tax purposes—a nonresident individual or a business entity that is organized or commercially domiciled outside the state, in any tax year the person has:

• more than $50,000 of property in the state;

• more than $50,000 of payroll in the state;

• more than $250,000 of receipts from the state; or

• at least 25 percent of the person's total property, total payroll, or total receipts in this state.

This approach clearly abandons physical presence as the sole basis for nexus. In fact, the statute allows an out-of-state business to have limited physical presence without triggering nexus. It can have property in Washington as long as it is $50,000 or less or an employee in Washington as long as the payroll is $50,000 or less.13 And it can have a combination of property, payroll, and sales in Washington without nexus as long as less than 25 percent of the total property, total payroll, and total receipts are attributable to Washington.

However, it is also true that more than $250,000 of gross receipts and no physical presence whatsoever is sufficient to establish economic nexus, or in statutory terms, substantial nexus. The receipts standard is the most difficult to apply as this article will later demonstrate.

According to the rule, one must first sort revenue between apportionable income and non-apportionable income.14 Once the character of the income has been sorted, then income must be allocated to Washington under the applicable apportionment rule to be “receipts from Washington State.”15 The following sections address general rules for apportioning, apportioning royalty income, and apportioning financial income.

General Rules of Apportioning

The statute apportions receipts in the way one might expect. The numerator reflects the apportionable receipts allocated to Washington and the denominator is all apportionable receipts wherever earned in the world. The percentage is multiplied times worldwide apportionable receipts.16

The statute allocates receipts to Washington under a cascading approach, adopting seven allocation principles. RCW 82.04.462(3)(b)provides:

• Where the customer received the benefit of the taxpayer's service or, in the case of gross income from royalties, where the customer used the taxpayer's intangible property.

• If the customer received the benefit of the service or used the intangible property in more than one state, gross income of the business must be attributed to the state in which the benefit of the service was primarily received or in which the intangible property was primarily used.

• If the taxpayer is unable to attribute gross income of the business under the provisions above, gross income of the business must be attributed to the state from which the customer ordered the service or, in the case of royalties, the office of the customer from which the royalty agreement with the taxpayer was negotiated.

• If the taxpayer is still unable to attribute gross income of the business under those provisions, gross income of the business must be attributed to the state to which the billing statements or invoices are sent to the customer by the taxpayer.

• If still unable to attribute gross income of the business, gross income of the business must be attributed to the state from which the customer sends payment to the taxpayer.

• If the taxpayer is unable to attribute gross income of the business under the provisions above, gross income of the business must be attributed to the state where the customer is located as indicated by the customer's address, whether shown in the taxpayer's business records maintained in the regular course of business or obtained during consummation of the sale or the negotiation of the contract for services, including any address of a customer's payment instrument when readily available to the taxpayer and no other address is available.

• If the taxpayer is still unable to attribute gross income of the business, gross income of the business must be attributed to the commercial domicile of the taxpayer.

Summarizing, the first provision allocates the receipt to the place where the benefit is received, and if receipts can be allocated to more than one state, then allocation can be on a proportional basis. If a single or proportionate share cannot be determined, then the statute allocates the benefit to where benefit is primarily received (which means more than 50 percent), to where the client ordered the service, to where invoices are sent, to the location from where the customer sends the payment, to the customer's address maintained in the ordinary course of business or obtained during negotiation, and finally, to the taxpayer's commercial domicile, in that order.

Two points are clear from this provision. First, using the standard “where the customer received the benefit” is vague. Who determines what the benefit was and where it was received? For example, if a taxpayer hires a bankruptcy lawyer to file a petition in Washington state and all of the debt to be discharged is in Florida, then does the client receive the benefit in Washington? Or is it in Florida where the debts have been relieved? Second, allocating receipts based on the remaining provisions would only coincidentally be where the benefit was received.

The rule reduces the vague “benefit of the service” term by presuming objective standards as a proxy for the benefit location. The rule deems the benefit to be received at certain locations based on certain conditions:

• If the service relates to real property, then the benefit of the service is allocated to the location of the real property.17

• If the service relates to personal property, then the benefit is allocated to where the personal property is located (place of principal use) or intended or expected to be located (in the case of personal property being acquired).18

• If the service relates to neither real nor personal property, is provided to a customer who engages in business and the service relates to such business, then the benefit is allocated to where the customer's related business activities occur.19

• If the service relates to neither real nor personal property, is sold to a customer who does not engage in business or is unrelated to the customer's business activities, and requires that the customer be present, then the benefit is received where the service is performed20; if it relates to a known location, then the benefit is received at that location21; or if the two preceding tests do not apply, then the benefit is received where the customer resides.22

The taxpayer uses the next lower level only if the taxpayer is “unable to attribute” the receipt. The rule defines “unable to attribute” to be when a “taxpayer has no commercially reasonable means to acquire the information to attribute the apportionable receipts.”23 Cost and time may be considered as to what is reasonable.24

Once the receipts have been allocated, the apportionment percentage must be calculated. The receipts factor is the Washington-allocated receipts divided by worldwide receipts.25 However, before this computation can be done, the denominator must be modified under the “throw-out” rules.26 Throw-out receipts include receipts attributed to states where the taxpayer is not taxable and at least part of the activity related to the throw-out income is related to services performed in Washington.27

Whether the taxpayer is “taxable in another state”28means:

• the taxpayer is subject to a business activities tax by another state on the taxpayer's income received from engaging in apportionable activity; or

• the taxpayer is not subject to a business activities tax by another state on the taxpayer's income received from engaging in apportionable activity, but the taxpayer meets the substantial nexus thresholds described in Washington Administrative Code 458-20-19401 for that state.

Thus, if a taxpayer is subject to a business activities tax in another state on the apportionable activities, then the throw-out rules do not apply. The apportionable receipts need not be taxed; it is sufficient if the taxpayer is subject to a business activities tax.

Further, if the taxpayer is not subject to a business activities tax, then the throw-out rules still do not apply if the apportionable receipts would satisfy these economic nexus standards as if they applied in the other state or states.

Once the percentage has been determined, then the taxable measure is determined. Unlike the sales factor, the measure (worldwide receipts) takes into consideration deductions29 without regard to where the deduction might be attributed. Once the measure has been determined, then the factor is applied to arrive at taxable income.

Special Rules for Apportioning Royalty and Similar Income

As under the general rule, the receipts must be apportionable to fall under these provisions. The statute defines “apportionable royalty receipts” 30 as compensation for the “use of intangible property, regardless of where the property will be used.”31

“Intangible property” means “copyrights, patents, licenses, trademarks, trade names, and other similar intangible property/rights.”32Specifically excluded from apportionable royalty receipts are:

• compensation for natural resources;

• receipts for licensing of prewritten software to an end user;

• receipts for licensing digital goods, digital products or digital automated services; and

• receipts from the outright sale of intangible property.33

Unlike the general rule that depends upon where the customer benefits from the service, the allocation to Washington is determined by where the customer uses the intangible property.34 At first blush, this standard seems more concrete than where a custom benefits from a service, but DOR still needed a framework to apply the concept. That framework divides use of intangible property into three categories—marketing, nonmarketing, or mixed.35

“Marketing” includes activities like “marketing, displaying, selling and exhibiting.”36 The use of the intangible property is allocated to where the customer promotes the goods or services. A typical example would be licensing a trade name to a seller of goods or services, such as Burger King or McDonalds. The use occurs at those locations where the person sells Burger King or McDonalds products using the trade names. The receipts are allocated to Washington if all locations are in Washington or proportionally split, assuming there is data and a method to show proportional use among all the locations worldwide.

“Nonmarketing” is generally everything other than marketing use.37 The place of use is where the customer employs the intangible property.38 A typical example would be a patent that is used to manufacture a new product. The place of use would be where the manufacturer used the patent to produce the new product.

“Mixed” is what the name implies in that both marketing and nonmarketing uses occur.39 If there is a single fee, then the rule presumes that the fee is for marketing, subject to contrary proof by the taxpayer or DOR.40

Once the receipts have been sorted based on location to where the customer used the intangible property, then the tax computation is calculated as described in the general rules for apportionment. The Washington-allocated receipts are divided by total worldwide receipts, and that percentage is multiplied times the worldwide receipts from royalty and similar sources.

Special Rules for Apportioning Financial Income

This rule is somewhat constrained by statute. When Washington first allowed the taxation of financial institutions, it required DOR to establish rules that had to be consistent with how other states were taxing financial institutions: “The rule adopted by the department must, to the extent feasible, be consistent with the multistate tax commission's recommended formula for the apportionment and allocation of net income of financial institutions as existing on June 1, 2010.”41

The statute instructed DOR to develop a rule that must provide for a single sales factor apportionment.42 Unless the Multistate Tax Commission (MTC) has a single sales factor formula, the statute is potentially conflicted. The MTC-recommended approach is a three-factor formula with the ability to exclude factors if the three-factor formula does not fairly reflect the extent of the taxpayer's business activities.43

The statute also declared that the MTC's definition of “financial institutions” found in Appendix A44 of recommended apportionment for financial institutions is “advisory only.”45

“Financial institutions,”46include the following:

• any corporation or other business entity chartered under Title 30, 31, 32, or 33 RCW, or registered under the Federal Bank Holding Company Act of 1956, as amended, or registered as a savings and loan holding company under the Federal National Housing Act, as amended;

• a national bank organized and existing as a national bank association pursuant to the provisions of the National Bank Act, 12 U.S.C. Section 21 et seq.;

• a savings association or federal savings bank as defined in the Federal Deposit Insurance Act, 12 U.S.C. Section 1813 (b)(1);

• any bank or thrift institution incorporated or organized under the laws of any state;

• any corporation organized under the provisions of 12 U.S.C. Sections 611 to 631;

• any agency or branch of a foreign depository as defined in 12 U.S.C. Section 3101 that is not exempt under RCW 82.04.315;

• any credit union, other than a state or federal credit union exempt under state or federal law; and

• a production credit association organized under the Federal Farm Credit Act of 1933, all of whose stock held by the Federal Production Credit Corporation has been retired.

If the business does not fall within the list, then the general apportionment rules apply and not these special rules.

The statute47 broadly defines receipts and includes “gains realized from trading in stocks, bonds, and other evidences of indebtedness.”48 However, the term excludes amounts received from an affiliated person if those amounts are arm's length as required under 23A or 23B of the Federal Reserve Act.49

Once the taxpayer properly includes or exclude receipts, then the process sorts the receipts between Washington and other locations begins. The rule sorts receipts by reasonably objective standards but they are complex and arbitrary. Each receipt must be further categorized, using special allocation rules.

The rule begins with loans. Loan receipts include interest, penalties, and fees. If a loan is secured by real estate in Washington, then the receipts are allocated to Washington.50 A taxpayer cannot adjust the allocation by later substituting collateral.51 For example, if a loan is secured by real property in Washington, then the taxpayer cannot later shift the receipts to another state where the substitute property may be located.

If a loan is unsecured and the borrower is located in Washington, then receipts from the unsecured loan are allocated to Washington.52 Whether a borrower is located in the state depends upon whether the borrower is in business. The rule provides that if a borrower is engaged in a trade or business and maintains its commercial domicile in Washington, then the borrower “is located in this state.” If the borrower is not engaged in a trade or business or is a credit card holder and the billing address is in Washington, then the borrower or credit card holder is “located in this state.”53

The rule then turns to the net gains from the sale of loans secured by real property. It allocates only a portion of the net gains to Washington. It multiplies the net gains by the percentage that is created by dividing the Washington receipts from loans secured by Washington real property by the total receipts from all loans secured by real property.54 The rule also addresses the net gains from the sale of unsecured loans, using the same allocation principle as for secured loans.55

Regarding credit card receivables, the receipts are allocated to Washington if the billing address for the card holder “is in this state.”56 If there is a net gain from the sale of the credit card receivables, then the percentage created by the receipts allocated from billing addresses is multiplied times the net gain to determine how much of the net gain is allocated to Washington.57 If there are credit card reimbursement fees, then the portion allocated to Washington is done in the same way as net gains.58

Receipts from merchant discounts are allocated to Washington if the merchant's commercial domicile is in Washington.59 This discount may be netted against cardholder chargebacks, but not against interchange transactions fees or any issuer's reimbursement fees paid to another.60

Loan servicing fees are allocated in the same way as the sale of the loans in that the percentage created by the secured loan or unsecured loan receipts is multiplied times the loan servicing fees associated with each type of loan to determine the amount to allocate to Washington.61 However, if such loan servicing fees derive from loans that the taxpayer does not own, then only those receipts received from borrowers located in this state are allocated to this state.62

Service income that is not allocated under the special rules above does not default to the general apportionment rules. Instead, rather than allocating the receipts to the location where the customer benefits from the service, it is allocated to the place where the service is performed.63 So, if the service is performed in Washington, then the receipt is allocated to Washington. If the service is performed in more than one state, then the receipt is allocated to the place where the greater proportion of the service was performed based on the cost of performance.64

Receipts from investment assets and activities are also allocated. The rule allocates these receipts based on a formula, which is the average value of the investment assets “properly assigned to a regular place of business in this state” divided by the average value of all such investment assets.65 This percentage is then multiplied times the total receipts from investment assets and activities to arrive at Washington's portion. Receipts from trading assets and activities are allocated in the same way.66

“A regular place of business” is an “office at which the taxpayer carries on its business in a regular and systematic manner and which is continuously maintained, occupied and used by employees of the taxpayer.”67

Receipts from federal funds require special treatment. First, the interest from federal funds sold and securities purchased under a resale agreement is reduced by the interest expense on federal funds purchased and the securities sold under a repurchase agreement.68 The difference is part of the receipts factor. Once that amount is determined, then the receipt must go through the allocation rules.

Like the receipts from other investment assets and trading activities, the formula is the average value of the federal funds purchased and sold and the securities purchased and sold under a repurchase agreement “properly assigned to a regular place of business in this state” divided by the average value of all such funds and securities.69

Adding even more complexity, the taxpayer may elect, or DOR may require, to use an alternative method in order to more fairly represent the business activity.70 Essentially, rather than using the value of the underlying financial instrument, the alternative method substitutes gross income from the instrument for the instrument's value.

Author's Observations

These allocation and apportionment principles not only determine whether the receipts are allocated to Washington for purposes of the apportionment formula, but they are also necessary to determine if economic nexus exists. Thus, this tedious and complex allocation and apportionment exercise must be done every month to determine if the taxpayer has established substantial nexus.

Further, if a taxpayer is wholly unaware that it may have performed services that might trigger economic nexus, then the likelihood that the taxpayer has kept adequate records is extremely low. This can be problematic for the unsuspecting taxpayer because a taxpayer who does not maintain necessary books and records is “forever barred from questioning, in any court actions or proceedings, the correctness of any assessment.”71

Garry G. Fujita, partner with Davis Wright Tremaine, has focused on state and local tax matters for 27 years. He has chaired the Tax Section of the Washington State Bar Association and several of its subcommittees and is active in the State and Local Tax Committee of the Tax Section of the American Bar Association, including as a past editor-in-chief of the State and Local Tax Lawyer.


This document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.

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