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Groundbreaking Washington State B&O Tax Ruling on Phone and Web Transactions

  • Sales Tax
  • September 23, 2015 | Mark Berens

On August 10, 2015, the Wedbush v. Seattle ruling clarified the rules for Washington State businesses making money the new-fashioned way: through revenue generated by phone and Web transactions. It’s something of a groundbreaking ruling, involving new technology bumping up against an old stalwart: the business and occupation (B&O) tax.

Old Faithful: The Washington State B&O Tax (And Why It Matters Here)

  • The B&O tax is placed on taxpayers for the privilege of doing business.
  • It is a gross receipts tax, meaning it’s based on all revenue brought in from an activity, not just profit or income.
  • It is imposed by the state of Washington, and by about 40 cities in the state, including Seattle, Tacoma, Bellevue, and Everett.
  • In 2008, the state legislature mandated that these 40 cities interpret some “allocation and apportionment” rules uniformly, to help taxpayers who do business in several of the cities.
  • These new rules affected how gross receipts are “sourced” for purposes of which city, if any, can tax that revenue.

There haven’t been many court challenges to the 2008 B&O changes. So the Wedbush Securities, Inc. v. City of Seattle case is important because it deals with service income (not income based on the sale of tangible goods), addresses how that income is apportioned when the business occurs in more than one location, and deals with business activities that take place largely over the phone or Internet.

The Challenge: How to Tax Services vs. Goods in the Information Age

Los Angeles-based Wedbush Securities, Inc. is a securities broker/dealer with customers and offices throughout the United States, including a Seattle location. Like many companies today, they make revenue through phone and Web transactions which, before January 2008, were subject to different, less-uniform rules and interpretations.

In January 2008, however, Washington State passed new rules for local B&O taxes, mostly to make regulations more uniform (and less confusing) for businesses. Among these changes was one addressing apportionment—a term used to decide whether a city has adequate connection to revenue from a service in order to tax that revenue. In the pre-Internet days, making connections between the sale of a service and the jurisdiction entitled to tax the revenue from that service was a bit clearer. Today, it’s not.

When a tangible good is sold, allocating the tax is relatively simple because it’s generally easier to pinpoint where the transaction began and ended (usually involving a physical address) and therefore, which city gets to tax the revenue.

For example, if Wedbush sold sailboats from a lot—a tangible (touchable) good from a fixed location—it’s pretty easy to make a connection between the point of sale and the city that could tax that revenue. However, Wedbush doesn’t sell sailboats from a lot—it provides an intangible service performed by employees in Seattle for customers scattered nationwide.

Now, add in the wrinkle that its Seattle employees transact business over the phone and online and send instructions for securities purchases and sales to others who actually close the transactions outside of Seattle—not to mention that service revenues are “apportioned” and not allocated (meaning, service revenues are proportionally divided between all of the cities where the business activity occurred)—and the apportionment challenge becomes all too clear.

The Solution: Tax It All, Let the Courts Sort It Out

The 2008 revisions to the apportionment rules tried to get on top of this new-economy model through an updated two-factor B&O tax formula based on both gross receipts and payroll (before this, the formula was based on rules by the city imposing the tax and local interpretations of the rules).

With the new rule advertised and in place, the audits began and the city discovered that during the period of January 1, 2008 through June 30, 2012, Wedbush’s Seattle location:

  • Reported a total gross service revenue of $28,670,412.02;
  • Had only paid tax to Seattle on the part of that total revenue that was obtained from clients with Seattle addresses; and
  • By failing to include income derived from all of its customers, had underpaid its taxes.

When Wedbush was notified of the underpayment, its representatives took a deeper look and, based on their interpretation of the rules, thought they were reporting their revenue correctly—enough to ask for a hearing to define a few of the more pesky definitions, including “service income” and “location.” They asked, and Seattle (and the courts) answered.

Defining “Location”--It’s as Easy as (i), (ii), (iii)

The crux of the Wedbush v. Seattle case is the definition of “location” as it relates to income generated from a service. As mentioned above, under the apportionment rules, a service taxpayer needs to pay taxes according to a two-factor formula including payroll and service income. The payroll part was pretty straightforward and not an issue between Wedbush and the city. What was at issue was “service income” and which income needed to be included in the calculation of what Wedbush owed Seattle. According to the regulations*, service income is in the city if:

(i) The customer location is in the city (Wedbush’s position: We paid taxes on that subset of our customers that is in Seattle, and that should be enough. Case closed.); or

(ii) The income-producing activity is performed in more than one location (Seattle’s position: We gotcha on this one, Wedbush. While it’s true that you have Seattle customers, you also make money from customers outside of Seattle.); and a greater proportion of the service-income producing activity is performed in the city than in any other location, based on costs of performance, and the taxpayer is not taxable at the customer location; or

(iii) The service-income-producing activity is performed within the city, and the taxpayer is not taxable in the customer location. (For purposes here, this third point is moot since neither side argued that this provision applied).

*Of course, there are A LOT of legal intricacies involving the full calculation of the tax in this case. For purposes here, we’re just bringing the meat of the case and how the outcome may affect your business. If you want more detail, here’s the ruling of Wedbush Securities, Inc. v. City of Seattle.

Wedbush: We Played by Your Rules, Seattle. We’re a WA business serving WA Customers. And Anyway, Our Other Customers Are More like Facebook Friends.

Wedbush argued that it did have some customers in Seattle, and as such, under subsection (i), that was the only revenue they needed to include as “service income in the city”—and therefore be taxed on—under the law.

Seattle, however, had a much broader interpretation. As is typically the case when large sums of money are involved, the parties took their dispute to court.

Unlike Wedbush, Seattle argued that really subsection (i) was not applicable, because really none of Wedbush’s customers were “located in Seattle” as Seattle had interpreted that section. Seattle argued that subsection (i) needed to be based on physical contacts between Wedbush and its customers, and since Wedbush’s customer service model was based on phone and Internet, and not physical contacts, none of their customers were located in Seattle.

Why would they argue that? Because a much broader definition of the services generating income from activities in the c
ity would lead to greater tax, and Seattle wanted to tap into the revenue earned from all of the customers served by the Seattle office, not just those that also happened to reside in Seattle. After all, the impact on city services (and thus the reason Seattle should be able to tax Wedbush) is based on the Wedbush office and its employees in that office, traveling on city streets, using utilities in the office, etc. Those impacts were the same on the city whether the customer was inside or outside of Seattle.

Court of Appeals: All Men are Pings.

The Court of Appeals upheld the city’s view, determining that—based on the totality of the section, including the provision that defined “customer location"—the city was correct and was entitled to more tax, given the extent of “income producing activities” (those phone calls and Internet contacts) that Wedbush’s employees were conducting from their Seattle offices.

Under subsection (i), the court determined, the city was reasonable in interpreting “customer contacts” as physical contacts. Here, there was no physical contact, which meant one had to proceed to the next subsection (subsection (ii)) to determine the service income that is used to calculate the B&O tax. The services for all the customers, regardless of whether they resided in Seattle or not, were performed in Seattle by virtue of the phone and Internet contacts made by Wedbush’s employees in Seattle.

Victory went to Seattle on August 10, 2015.

What It All Means

Officially, under RCW 35.102.130, an employer is required to pay taxes on both payroll and service income. When that service income is derived from customer contacts by telephone and the Internet, the entire amount is subject to the B&O tax, especially where the employer established an office in the city primarily to compete with other similar businesses (read more about this in the case link above—it’s also crucial to the ruling).

In short, if you are located in Washington and provide a service that’s conducted in person, online, or over the phone, you have to pay taxes on the income you earn. Simple as (i), (ii), (iii).


Avalara Author
Mark Berens
Avalara Author Mark Berens