The growth of internet based e-commerce sales and companies offering software as a service has been phenomenal in recent years. The U.S. Commerce Department estimates that e-commerce sales increased from $229 billion in 2012 to $390 billion in 2016. This has impacted traditional retail sales which serves as the base for sales tax revenue and is an important factor in apportioning income of multi-state businesses. Unfortunately, tax rules have not kept up with this changing trend. Federal legislation has not addressed many of the issues created by the digital economy so states have been free to adopt their own rules. As states are anxious to find new revenue sources they have adopted some aggressive tax generating rules.
An entity is not subject to a state’s authority to tax unless it has nexus, which is generally defined as a connection to the state. In the past, this was interpreted as a physical presence in the state. The nexus rules have been expanded by most states to now include the concept of economic nexus. If a taxpayer has nexus it can create state income tax filing and sales tax collection requirements. As a result, it is important to be aware of activities that can create these filing and reporting requirements.
There has not been consistency in how states have applied the concepts of physical and economic nexus to taxpayers operating in the digital economy. As a result, an activity that creates nexus when carried on in one state may not create nexus if it occurs in a different state. Some activities that create nexus are “invisible” so the taxpayer may not even be aware they are occurring.
Activities, determined by various states, that create nexus and therefore the right to impose tax reporting include:
• Owning internet server located in state
• Leasing server located in state
• Leasing space on third party server located within state
• Paying a web hosting provider to provide web services using a server located in state
• Generating sales using an internet link with a third party located within the state
• Selling remote access to canned software
• Sales of data (such as music files) located on a server within the state
Do you know where your servers are located? If not, you may have a state tax filing requirement and not even know it!
Relief from the confusing array of state regulations has been offered by Rep. Jim Sensenbrenner (R-Wis). On June 12, 2017, he introduced the No Regulation Without Representation Act of 2017 that seeks to codify physical presence as the only activity that can create nexus. With all the timely issues Congress needs to address, and likely significant resistance from state revenue departments, the prospects for passage do not appear good.