The Dark Side of the Internet: States Now Imposing Taxes on Businesses Regardless of Physical Presence

10/27/2008

Does your company operate its business over the internet or make sales through its website? Do your customers or other businesses refer business to your website? Depending on the circumstances and the state, you might have inadvertently fallen into an ever-expanding trap of “nexus” with the states where your customers or the referring businesses are located. Nexus is the little term with a big impact that means you’re doing business in a state and it can exist regardless of whether you have a physical location in that state. A nationwide wave of lawsuits and challenges – from the likes of Amazon.com, StubHub, and e-Bay to name a few – is currently underway regarding the issue of whether an online business has nexus with a state for tax purposes.

The determination of whether a company has nexus with a state should be straight forward. You’re either doing business in the state or you’re not, right? Sometimes that is true. But combine outdated United States Supreme Court precedent, rapidly developing technology, sophisticated tax planning, and revenue-hungry states – and the result is one of the most litigated and complicated areas of state tax jurisprudence. Often, nexus is the entire basis for a state’s case against a taxpayer.

The New York Law.

In April 2008, the State of New York enacted a law that requires certain online retailers to collect sales tax even though the retailer does not have a physical presence in the state. Under the new law, an online retailer is required to collect sales tax on its sales if it pays a commission or other consideration to New York residents that provide referrals for the retailer. This is a substantial part of the way that “e-tailers” and multi-level marketing programs generate their revenue. Often, the profit margins are slim. Add a 5 to 9% tax, and the profit margins are nonexistent.

The controversy around the New York law hinges on the well-recognized cornerstone of U.S. constitutional sales tax jurisprudence that a taxpayer must have substantial physical presence (i.e., nexus) before a state may require the taxpayer to collect sales tax. Case law is clear that maintaining an office, hiring employees, or having agents in a state establishes a sufficient physical presence. The State of New York takes the position that the New York residents that make referrals are, in effect, independent contractors of, and affiliated with, the online retailer. Given the obvious impact of this type of law, Amazon.com and Overstock.com immediately filed lawsuits challenging the constitutionality of the New York law.

The Ripple Effect.

Many states have not known how to respond to the New York law, though some states have embraced the approach, while others have rejected it. In July, the California State Board of Equalization (SBOE), which is the agency charged with enforcing the California’s sales tax laws, concluded that referrals by California residents, alone, would not give rise to nexus with California. In reaching its conclusion, the SBOE stated no nexus would exist because the residents were making referrals for their own personal benefit – not for Amazon.com, Overstock.com, or any other retailer. This conclusion was not rooted in any federal or Supreme Court precedent, so uncertainty remains whether other states will adopt the New York approach or the California approach.

Unlike California, some states and municipalities have increased their enforcement and collections of other types of taxes. For example, the City of Chicago is suing eBay, Inc. (an online auctioneer) and StubHub, Inc. (an online ticket vendor/broker) to collect amusement taxes on all tickets sold online for Chicago entertainment events. In Georgia, the City of Atlanta has sued numerous online travel companies to collect unpaid hotel and occupancy taxes. As e-commerce continues to grow, determining how to tax online vendors will continue to remain a hot issue.

The Seemingly Innocent Questionnaire.

Have you ever received one of those irritating but harmless-looking business questionnaires from a state? Sometimes you’ll even notice that it asks for the company’s website and how the company receives referrals for business. As you may know, we refer to these little forms as tax “tar babies.” They seem harmless. But if you ignore them, the state will presume your presence in the state. On the other hand, if you do not believe you have nexus, you have to be careful of your responses to the questionnaire. The nexus questionnaire may be the primary basis for a state’s assertion that you have nexus with the state.

Technology is developing light years faster than the tax laws. Courts and states are being faced with issues that simply were not contemplated ten or twenty years ago. With declining tax revenues, New York, Chicago, Atlanta, and several other tax authorities have begun turning to what they see as an untapped market of tax revenue. They want their slice of the e-commerce pie. Until a streamlined nexus standard is adopted by the States, or established by Congress or the Supreme Court, the nexus uncertainty will continue.

Other Nexus Issues.

Online business is only one of many activities that can create nexus issues and planning opportunities for companies. For example, owning a partnership interest in an out-of-state partnership creates nexus in some states. For other states, the business operations of an out-of-state affiliate may be attributed to a company through an “alter-ego” theory. Hosting software on an out-of-state server can also result in a tax trap for the unwary if the server location is not carefully analyzed. All of these issues can be problematic, but careful planning can often avoid unintended tax consequences.

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