In the current economic environment, state governments are trying to expand the reach of sales taxes as they apply to internet sales of goods and services and other online transactions. There is a natural tension created when the various States are looking to increase tax revenues by characterizing where the sale occurs and the taxpayers are looking to minimize tax costs.
Sales taxes in the United States are generally borne by the final retail purchaser or consumer of goods and certain services; and should create little incremental cost to the businesses that provide those goods and services if efficiently administered. If, however, the business doesn’t apply the sales tax rules properly, any shortfall may become a liability of the business with no opportunity to recover the tax from its customer. An additional income tax may be a percentage of the bottom line and may put a serious dent in the net income of the company, but sales taxes are a significant percentage of gross income and may completely wipe out all of the company’s profit.
As an example, a few years back a small company in British Columbia set up a system to push data and ad copy to their customers all over North America. The service were exempt from U.S. sales taxes in almost all of the states and providing data services from Canada shouldn’t have been sufficient presence to create a tax collection responsibility. The company, however, leased dedicated data terminals to their customers as part of the plan. The terminal created a tax presence and the lease payments were taxable. The company missed this seemingly minor detail and the resulting sales tax bill from three years of operations bankrupted the company!
Sales Tax Obligation
One of the underlying principles of U.S. sales and use taxation is that for a vendor to be subject to the requirements to collect and remit the tax to the state; that vendor must first have sufficient nexus with the state so as to be subject to the State’s tax obligations. Please see our article that deals with U.S. tax nexus for more detailed information about this subject.
What to collect
There are a few basic questions that vendors ask when trying to figure out how much U.S. sales tax to collect on a sale, if any at all. The questions are;
- Is what I’m selling taxable?
- Is the person I’m selling to exempt or required to pay?
- What rate of tax should I apply?
These questions become more complicated when dealing in the realm of e-commerce and internet sales.
In addition to the previous three questions, companies conducting sales via the web need to first figure out where they are making those sales. The place of physical delivery occurs generally determines which jurisdiction gets to tax the transaction, but again, only if the vendor has nexus. Consider a company that may be headquartered in Canada, with their website hosted on a server in second country, purchasing goods from a supplier in a third country, then having the supplier send the goods directly to the U.S. customer with title passing in transit. Where did the sale take place? Did it happen in the U.S., in Canada or in the country where the server processed the order and payment? Generally, if the company has nexus in the place where the goods were delivered, they will collect and remit that state’s sales tax. But, what if they don’t have nexus? Where the seller doesn’t have nexus, there is no obligation for the vendor to collect and remit the tax. We understand that the purchaser is required to self-assess and pay the appropriate tax to the state, but that rarely happens. The end result is that in- state retailers are put at a distinct disadvantage and the states are always looking for creative ways to re-level the playing field.
One way the states are looking to level the playing field is to assert economic nexus on out-of-state vendors. The principle of economic nexus is that the out-of-state vendor has sufficiently directed their activity to the state to create Due Process nexus. Further, once beyond a bright-line threshold, the company’s economic presence is deemed to be substantial, which satisfies the Commerce Clause. So, states have come up with a system to create an obligation for out-of-state vendors despite prior case law. The states are arguing that the prior case law is outdated in the modern economy, and to date, the Supreme Court has not accepted any new cases in this area.
Digital goods pose a second layer of complexity. Since there is no physical delivery of digital property, the question of where and at what rate the tax should be applied is even less clear. States are currently grappling with the question of whether the tax should be applied where the vendor makes the digital goods available for download, where the transaction is processed, or where the purchaser makes use of the downloaded digital goods. The rising opinion is to locate the sale where the purchaser makes use of the digital goods, but there is no unanimous consensus. Since no state wants to forgo tax revenue, the potential for double taxation is significant.
With the advent of cloud computing and mere use of hosted applications, the sales tax questions become even more difficult to answer because there is no actual download of the goods or applications. The customer often is merely making use of the program hosted at some remote location. In this digital arena, many states are contending with the question of what is the true nature of the transaction. Was there a sale of an intangible digital good or the sale of a computing service? Nobody knows for sure yet where this will end up, but the debate will get interesting and the states will find new and creative ways to try to tax as many transactions as possAG TAX LLP Can Help
If you have any other tax-related queries, and/or need assistance with tax planning/filing please contact AG Tax. Our tax professionals are highly-experienced with U.S. and Canadian tax laws and can provide you the right guidance to handle your tax situation.
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