Wayfair has made quite an impact on the sales and use tax world, but there are a lot of unanswered questions when it comes to the impact Wayfair will have on states with net income/franchise tax regimes, especially when it comes to pass-through entities and financial services.
This uncertainty is important to start discussing because the financial services industry has come to prefer tiered partnership structures. Companies often structure their management companies, as well as their funds, as flow-through entities due to the tax benefit of flow-through income as compared to corporations. The physical presence nexus standard was a clear limitation in the past, and only some states applied economic nexus. With South Dakota v. Wayfair Inc., the nexus standard is much less clear. This article provides some insight and guidance into the inquiries that taxpayers should ask themselves and their tax preparers surrounding the issues.
The question has evolved from “Is the taxpayer located in the state?” to “How does the state define economic nexus, and does the taxpayer meet those thresholds?” to “How will the state interpret and impose its current statutes with the backing of Wayfair?” This creates a level of uncertainty in the field that will be discussed in this article.
To briefly reiterate, on June 21, 2018, the U.S. Supreme Court, in a 5-4 ruling, overturned Quill and National Bellas Hess, stating that the reasoning behind the physical presence nexus standard is “ … unsound and incorrect.” States may now require vendors that are not physically present in the customer’s state to register, collect, and remit sales tax on taxable sales to in-state customers. With this decision came an “unofficial kickoff” of a movement in the way we approach the new online business era from a state income/franchise tax perspective.
The following two important overall tax questions will spark thought and discussion; however, only time will tell if the states will apply the new standard in a way that some may deem unfairly or if they will be … way fair.
First, what will states that already have existing economic nexus regimes integrated into their income/franchise tax statutes do, given the new standard?
For states that have already nixed the physical presence nexus standard by adopting economic nexus statutes and regulations, Wayfair serves as support for the states’ positions on their statutes’ constitutionality. Wayfair could also act as support for states to retroactively apply economic nexus to broadly written statutes. Taxpayers may see states become more active in asserting economic nexus for income/franchise tax purposes, making it an uphill battle for a taxpayer to argue that substantial economic activity in a state does not warrant a filing responsibility in that state.
Even activities that are not directly related to income taxes may create issues for taxpayers. For example, it is possible that states with nexus statutes that define “registration with the state” as a nexus-creating activity may assert that a taxpayer registering with a state for sales and use tax may create income tax nexus and trigger filing requirements for income tax purposes as well. The state may argue that this is valid because registering with a state for sales and use tax means that a taxpayer is accessing the state’s market. Second, what can we expect from states that do not currently have an economic nexus regime as applied to income/franchise taxes?
States that do not have an economic nexus standard for income/franchise taxes will likely rely on Wayfair as support for new legislation or audit positions asserting expanded nexus. Most, if not all, states are expected to move to an economic nexus standard in time, since the Supreme Court effectively “blessed” economic nexus through the Wayfair opinion. The threshold in Wayfair was $100,000 of goods or services delivered to the state or 200 transactions for sales and use tax purposes. However, for income tax, states such as Michigan have a standard of $350,000 in receipts—significantly above the threshold in Wayfair. Some states have even indexed their thresholds for inflation each year like California, with a threshold above $250,000. The variance in legislation existed even before Wayfair, and, in this post-Wayfair world, states and the courts will be tasked with determining whether a threshold is required and what threshold will pass constitutional law muster.
Taxpayers need to actively monitor these thresholds to avoid surprises. Only time will tell what direction each state will take. Will a majority adopt the exact Wayfair standard? Will states amend existing economic nexus activities statutes for bright-line thresholds, or will states adopt de minimis activity language? Across the board, it will take time for the states to make their decisions on whether to adopt Wayfair-like statutes and regulations. State developments will be heavily scrutinized while decisions are made, since this new regime has such a big impact on the business taxpayer. To shed some light on this area, most recently in direct response to the Wayfair decision, Oregon and Hawaii have already adopted economic nexus statutes with bright-line thresholds.
So, what does this uncertainty mean for the financial services industry? Following are a few high-level considerations applicable to the financial services industry that the Wayfair decision directly impacts.
Any company that has taken a filing position based on its interpretation of a statute that physical presence is required may want to reconsider such position, unless the state has specifically stated that it will require physical presence. The argument that substantial economic activity by itself does not create a filing responsibility may be a hard argument to win. Management companies should consider reviewing any connections they may have to a state, including de minimis activities. As discussed above, Wayfair may allow states to assert a filing requirement for even less activity than registration. These uncertainties may impact certain service businesses, such as investment managers and debt funds.
Companies should confirm accurate sourcing of their receipts because the Wayfair ruling effectively could be used to reinforce the validity of market-based sourcing statutes and regulations. This becomes an issue especially for the financial services industry. Some states, such as California, rely on market-based sourcing rules in determining whether a company has economic nexus through a bright-line threshold. In order to determine whether a company has met the bright-line threshold, it may need to identify the ultimate customer of the benefit provided, which can be tricky, since the definition of the “ultimate customer” varies by state.
California is grappling with the definition of the “ultimate customer” or “beneficial owner,” as they call it, as it applies to partnerships that provide management services to both regulated investment companies and other companies. While its regulation is still in draft form as of March 31, California expects these partnerships to source the management fees received using a look-through approach to the fund’s investors. It defines the “beneficial owner” as the investor receiving the benefit of the management services.
There are several questions to think about in this context. Will management companies now need to look through the funds to which they provide services outside of the mutual fund context to determine whether they breached any economic nexus thresholds? Connecticut, for example, has already imposed such rule.
Will private equity companies need to file in every single state in which their investments file, even if they have a limited interest for both their flow-through and corporate blocker entities? We are already seeing increased audit activity, even when a blank K-1 is issued to the private equity company.
Entities may now have increased filing requirements due to the presumably lower “economic nexus threshold.” For example, debt funds in the business of loan origination that make loans to customers in various jurisdictions may want to re-evaluate their filing positions. Debt funds should, at a minimum, consider the following: Would a single loan to a customer in a state now create a filing requirement where, before, they would not file, unless they had an individual conducting activity physically in the state? Would having a security interest to a loan in the state now create nexus? Would having only a lien on a property be enough to pass constitutional requirements?
And what about a state tax audit? State audit positions on economic nexus might become more prevalent, especially since the definition of who the customer is in market-based sourcing states differs. States seem more willing to argue discretionary authority and adjust the reported apportionment percentage as a result.
With the expectation that state taxing authorities will be successful in defending economic nexus, a company may need to review its related state income tax reserves, since the amount of state tax due for a business may increase. It has been widely reported that on July 13, 2018, Wells Fargo adjusted its reserves following the Wayfair decision. The bank’s $5.2 billion Q2 earnings included a $481 million net discrete income tax expense directed to state income taxes as a direct result of Wayfair. Other companies may want to follow suit and consider their positions with the expectation that many states now have a clear opportunity to increase enforcement of economic nexus based on an application of Wayfair to corporate income and franchise taxes.
While Wayfair creates a lot of state ambiguity in the corporate income/franchise tax realm, there are definitive trends that can be applied to adequately prepare and plan. The years following Wayfair certainly did not come without their fair share of tax changes, but the grey areas and interpretations by the states should make economic nexus for corporate income/franchise tax purposes a hard topic to bid “fair” well to for years to come.
Recent Legislative Changes and Updates on the Horizon
On Oct. 18, 2019, Massachusetts released its final regulation 830 CMR 63.39.1, which the state amended to reflect the Wayfair decision. The final regulation subjects corporations, financial institutions, and insurance companies to income tax under Chapter 63, “where the volume of the corporation’s Massachusetts sales for the taxable year exceeds $500,000.”
The Texas Comptroller, on Dec. 20, 2019, adopted amendments to the margin tax nexus rule 34 TAC Section 3.586. The amendments established economic nexus with a threshold of $500,000 in Texas receipts for entities that do not have a physical presence in the state. Taxpayers’ franchise tax reports due on or after Jan. 1, 2020, would be impacted.
Pennsylvania also issued a Tax Bulletin adopting new nexus requirements due to the Wayfair case for the Pennsylvania corporate income tax. Pennsylvania now requires businesses carrying on activities in Pennsylvania and using the state’s marketplace, regardless of physical presence, to file Form RCT-101 if the business meets the minimum threshold. That minimum threshold is $500,000 or more per year of direct or indirect gross receipts in “any combination of gross receipts ….”
Localities are addressing Wayfair as well. The City of Philadelphia updated its “doing business” regulation for the Business Income and Receipts Tax to include an economic nexus provision effective January 1, 2019, with a $100,000 gross receipts threshold. San Francisco also approved Proposition D establishing economic nexus and subjecting all businesses with more than $500,000 in total San Francisco-sourced gross receipts to the city’s business taxes, regardless of physical presence in the city.
Also, of note is a recent Supreme Court case involving a trust’s beneficiary who lives in North Carolina. In a unanimous opinion, the Court ruled that a trust beneficiary’s residence in a state does not establish enough of a connection for the state to tax it. The Court cited Wayfair in its opening discussion as overruling Quill’s decision regarding the Due Process clause requiring a “definite link, some minimum connection, between a state and the person, property or transaction it seeks to tax.” This opinion is significant in the Wayfair world because it sets up a limitation and a set of rules surrounding a particular set of facts. Namely, if a trust distributes income to an in-state resident, the state will be able to tax that income. In Kaestner, the trust did not distribute income. This was the most significant fact that led to the Court’s ultimate conclusion, but not the most significant part of the opinion as it relates to Wayfair.
The Court determined that the presence of in-state beneficiaries alone does not empower a state to tax undistributed trust income. However, it was the Court’s discussion revolving around the “pragmatic inquiry into what exactly the beneficiary controls or possesses and how that interest relates to the object of the State’s tax” that relates back to Wayfair. The Court analyzed previous cases where connections existed between the trustee and the trust (i.e., a trustee that had the power to dispose of the property that could have been a source of wealth in the state). So, while the Court eventually concluded that, since the income was not generated in North Carolina, the income was not distributed in North Carolina, and since the trust was originally created in New York, the trust could not be taxed, the most significant conclusion was that the beneficiaries did not have control or the type of connection to the trust to benefit from the trust.
On May 16, 2019, the Governor of Oregon signed into law HB 3427, which establishes the threshold for purposes of the state’s new commercial activity tax. On April 18, 2019, Hawaii’s governor signed SB 495, adopting economic nexus for income tax purposes. Hawaii’s new threshold is if “the person engages in or solicits two hundred or more business transactions with persons within the State; and the sum of the value of the person’s gross income attributable to sources in this State equals or exceeds $100,000.” Hawaii deemed this standard effective July 2, 2019, and applicable to tax years beginning after Dec. 31, 2019.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Aleksandra Sterina is an FSO Indirect Tax Manager, James Thomas is an FSO Indirect Tax Partner, and Mackenzie Hager is an FSO Indirect Tax Manager at Ernst & Young LLP. The authors would like to thank Kathleen Swift, FSO Indirect Tax Executive Director at Ernst & Young LLP, for her contributions to the article.
The views expressed are those of the authors and are not necessarily those of Ernst & Young LLP or other members of the global EY organization.
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