The tortoise and the hare: Economic nexus in California and San Francisco

The tortoise and the hare: Economic nexus in California and San Francisco

As the state of California slowly moves toward taxing remote sales, San Francisco rushes past with a tax on businesses with no physical presence in the city. Yet, just as in the story of the tortoise and the hare, California could come out on top.

The start: Supreme Court removes physical presence limitation

The story starts on June 21, 2018, when the Supreme Court of the United States overruled the physical presence rule that long prevented states from taxing remote sales. The decision in South Dakota v. Wayfair, Inc. (Wayfair) allows states to tax sales by businesses with no physical presence in the state.

In Wayfair, the court found the respondents’ “economic and virtual contacts” with the state to be a sufficient basis for a sales tax collection obligation (economic nexus). While it didn’t replace the physical presence rule with a similar bright-line test, the court did highlight three aspects of South Dakota’s tax system that “appear designed to prevent discrimination against or undue burdens upon interstate commerce.” These are the exception for small sellers, prospective enforcement of economic nexus, and the steps it has taken to standardize administration and reduce the costs of sales and use tax compliance.

Allowed to stand by the Supreme Court, South Dakota’s economic nexus law seems safe from future legal challenges. No wonder close to 30 states have adopted economic nexus provisions resembling it.

California moves slowly toward economic nexus

California’s working on a policy to tax remote sales, but it’s moving as slowly as the proverbial tortoise. The California Department of Tax and Fee Administration (CDTFA) hosted a public discussion on remote sales tax in October to garner input from businesses and tax experts. Officials said it would enforce economic nexus on a prospective basis, and likely adopt a small seller exception similar to South Dakota’s. The Mount Rushmore State requires remote sellers to collect and remit sales tax once they have more than $100,000 in sales or at least 200 transactions in the state in the current or calendar year.

Yet California’s eventual economic nexus policy may significantly differ from South Dakota’s. Currently, sellers are only required to collect district taxes in California if they have a physical presence in the district. Once the state adopts economic nexus, it could require both in-state and out-of-state sellers to collect district taxes once they have economic nexus (e.g., $100,000 sales or 200 transactions) in the district.

Until the state officially adopts a remote sales tax plan, there’s no way to know exactly what it will look like. Details are expected to be released by the end of the year. In the meantime, San Francisco has found a way to increase revenue from remote sellers without actually taxing remote sales.

San Francisco’s Proposition D

A majority of voters said yes to San Francisco’s Proposition D on November 6, 2018. Although known as the San Francisco Marijuana Business Tax Increase, it affects more than just marijuana businesses. It enables San Francisco to tax certain businesses with no physical presence in the city.

Nexus: Engaging in business within the city. Effective January 1, 2019, Proposition D expands “the conditions that subject a person to certain business taxes by including persons with more than $500,000 in annual gross receipts in the City.” It affects the following:

  • Payroll expense tax
  • Gross receipts tax
  • Early care and education commercial rents tax
  • Cannabis business tax
  • Business registration

The measure expands the definition of what it means to be “engaged in business in the City” to include a person that “has more than $500,000 in total gross receipts… in the City during the tax year.” It adheres to Section 956.1 of Article 12-A-1 to assign gross receipts as follows:

  • Gross receipts from sales of tangible personal property are in the City if the property is delivered or shipped to a purchaser within the City regardless of the f.o.b. point or other conditions of the sale.
  • Gross receipts from the rental, lease or licensing of tangible personal property are in the City if the property is located in the City.
  • Gross receipts from services are in the City to the extent the purchaser of the services received the benefit of the services in the City.
  • Gross receipts from intangible property are in the City to the extent the property is used in the City. In the case of financial instruments, sales are in the City if the customer is located in the City.

What does this mean for out-of-state sellers? Businesses that make sales in San Francisco and surpass the gross receipts threshold could be required to comply with the city’s new economic nexus provision. While it doesn’t require remote sellers to collect sales tax in the city, it does establish new business registration obligations and impose gross receipts tax, early care and education commercial rents tax, payroll expense tax and cannabis business tax obligations, if applicable.

Effective January 1, 2021, Proposition D also imposes “an additional gross receipts tax … on gross receipts from cannabis business activities,” though it exempts the first $500,000 of gross receipts and all retail sales of medical cannabis. Tax rates range from 1 to 5 percent, depending on the amount and type of sales, and could be adjusted to between 0 and 7 percent if approved by a two-thirds vote of the Board of Supervisors.

Show me the money. California could generate between $1 billion and $1.7 billion by taxing remote sales, according to a report released by the Government Accountability Office in December 2017. 

Proposition D is expected to increase San Francisco tax revenue by an estimated $2–$4 million in 2019, and $7–$16 million annually starting 2021. However, the exact fiscal impact of the expanded nexus provision is unclear: “The revenue implications … depend on the extent to which local wholesalers, retailers, and consumers directly receive shipments from these non-local businesses, as opposed to shipping through other distributors already subject to business tax.”

Furthermore, Proposition D could be challenged: It was approved by a simple majority of voters, not the supermajority the state requires for tax legislation. Affected businesses should pay close attention to these new requirements in the months to come.

While San Francisco Proposition D doesn’t directly impact sales tax compliance, its economic nexus provision does impose new local business registration requirements and tax obligations on certain remote sellers. Learn more about sales tax economic nexus and its potential impact on your business.

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