Texas-sized sales tax sourcing changes proposed in the Lone Star State

Update August 10, 2020: The effective date for amendments to 34 TAC § 3.334 affecting sales tax sourcing and allocation rules for orders not received by sales personnel, has been delayed in order to give interested parties time to seek a legislative change; the changes are currently set to take effect October 1, 2021.

The Texas Comptroller wants to change how certain online sales are sourced. This could significantly impact the way businesses collect and remit local sales and use taxes in Texas. 

Perhaps the most controversial changes are proposed for in-state sellers who take online orders from consumers throughout the state. These sellers would be required to use destination sourcing when delivering taxable goods into local jurisdictions that have a higher tax rate than the jurisdiction where the sale is consummated (i.e., the seller’s place of business). Scott Peterson, vice president of governmental relations at Avalara, says this will make it much more likely sellers have to collect two taxes: their home city sales tax and the destination city use tax.

This is to account for businesses that establish a shell presence in districts offering tax incentives.  According to Comptroller Glenn Hegar, a loophole in the law has enabled some businesses and cities to “cut deals to source local sales tax on sales made over the internet solely to particular cities.”

It’s one of those, “you scratch my back, I’ll scratch yours” scenarios (my words, not his): The cities benefit from economic development when those companies set up shop and create jobs; the businesses benefit because some of the sales tax they collect gets kicked back to them. Changing the sourcing rules would make such arrangements less beneficial.

Hegar doesn’t fault businesses “for trying to boost their bottom line,” or cities that enter into such economic development agreements. Yet he wants taxpayers to benefit from the local taxes they pay. “You expect [local taxes are] going to address the needs of your community. ... I’ll bet you never imagined that your taxes were being shipped off to another community to fix their potholes. … But in some cases, that’s exactly what’s happening in Texas.”

The proposed changes to Rule 3.334 should close that loophole. They clarify that “an outlet, office, facility, or any similar location that contracts with a business to process certain orders or invoices is not a place of business of the seller if the comptroller determines that these certain locations are for the sole purpose to avoid tax due or to rebate tax to the contracting location.”

If adopted as proposed, there would be a grace period for economic development agreements entered into before September 1, 2019.

The proposed amendments also create a definition for “internet order,” to “distinguish an order placed through the internet as opposed to an order placed in person at a seller’s location.”

When a seller helps a customer by placing an online order for an item that’s not in stock, is the order categorized as placed in person or over the internet? Similarly, when a customer in a store pulls out a mobile device and places an order online rather than by standing in line, is the order considered to be placed in person at the store or over the internet? As the rule stands, it's not obvious.

The comptroller hopes to clear the confusion by amending “order placed in person” to include:

• When a purchaser is physically present at a seller’s location and the seller places an order for the purchaser using the seller's system, computer, or other device
• When a seller uses the internet, a phone, or a catalog to make an order on behalf of a customer

Since a purchaser may also use a personal mobile device, “order placed in person” specifically excludes internet orders placed from a purchaser's device when the purchaser is physically present at a seller's location.

Texas already requires remote sellers with $500,000 or more in annual sales in the state to collect and remit sales and use tax under its economic nexus rule. It also requires marketplace providers (e.g., Amazon, Etsy) to collect and remit sales and use tax on behalf of their marketplace sellers. Both requirements took effect October 1, 2019.

The proposed amendments for out-of-state sales bring TAC §3.334 up to date, while clarifying that out-of-state sellers and marketplace providers must collect the local use tax rate in effect at the destination of the sale. This could be the consumer’s residence, a store (if the consumer buys online and picks up in store), or even a warehouse — wherever the consumer gets hold of the goods.

The amendments also implement the single local use tax established by House Bill 2153. Remote sellers can elect to collect a single local use tax rate for all sales into the state instead of the different rates in effect in each jurisdiction. 

To understand why the comptroller is proposing these changes, it helps to understand the current sourcing rules for online sales — both remote and in-state. Prepare yourself.

There’s a 6.25% state sales tax rate in the Lone Star State, and local taxing jurisdictions may impose additional local sales and use taxes. However, the maximum combined sales and use tax in Texas cannot exceed 8.25%, so each jurisdiction’s rate is capped at 2%.

Texas is a big state, but with more than 1,500 different local taxing jurisdictions, districts sometimes overlap. When that happens, the combined sales and use tax rate may exceed 8.25% — and that won’t do.

So, the comptroller currently advises sellers to follow these four rules (see Local Sales and Use Tax Collection – A Guide for Sellers 94- 105):

1. Collect no more than the 2% cap
2. Collect local use taxes in the following order:
   1. City
   2. County
   3. Special purpose district
   4. Transit authorities
3. Do not collect a local use tax and a local sales tax of the same type (see #2)
4. Collect applicable local use taxes only if you’re engaged in business in the jurisdiction

The mind reels. No wonder Peterson says, “It is nearly impossible to correctly source in-state sales in Texas.”

The proposed changes to TAC §3.334 still don’t take a one-size-fits-all approach — maybe Texas is just too big for that. But they should make sales tax compliance in Texas less convoluted than it is now.  

If adopted as proposed, many of the changes would take effect April 1, 2020. For more details, see the proposed amendments to Texas Administrative Code (TAC) §3.334.