Retail has remained surprisingly robust throughout the pandemic, though what we’re buying, where we’re buying it, and how we’re paying for it have changed with the circumstances.
What the numbers tell us:
There can no longer be just one way: multichannel selling is essential (and complex)
The pandemic underscored the risks of relying on just one sales avenue when it prompted restrictions on in-person shopping, dining, and even travel outside the home or neighborhood.
Though shops and restaurants have, for the most part, fully reopened, the threat of mandatory closures or limitations lingers. Some parts of Australia were still under lockdown in October 2021, when outbreaks of the Delta variant and an exodus of employees were shuttering factories in Vietnam. Singapore was restricting activities in mid-November, shortly before detection of the Omicron variant raised fresh concerns.
We’re not done with this thing yet.
Even without government-mandated restrictions, some people still aren’t comfortable in public spaces, while others are delighted to be back in brick-and-mortar stores. Some folks like to shop online on desktops, laptops, or tablets; those with sharp eyesight may enjoy perusing mobile sites. There are consumers who go directly to their favorite retailers’ websites, those who comparison shop on marketplaces, and people who are inspired by what they see on social media and shoppertainment sites.
In short, different sales channels appeal to different people. They can also have different implications for sales and use tax compliance.
When it comes to the business licenses and permits needed to operate a brick-and-mortar store or other face-to-face sales operation (e.g., booth or kiosk), requirements differ from state to state. In general, both state and local licenses are required, and depending on what types of products or services you sell, you may need additional licenses and permits. It’s also important to track if and when licenses and permits expire, so you’ll know when to start the process of renewing them.
Special rules may apply in some states for certain types of sales operations. For example, although a kiosk isn’t considered a place of business in Texas, if you operate a kiosk in Texas, you’re required to register for sales tax.
Tax rates for kiosk sales in Texas are based on where orders are fulfilled: Kiosk sales shipped or delivered from a seller’s place of business in Texas are taxed at the rate in effect at the place of business — though if the local rate at that location is less than 2%, you may also need to charge the local use tax rate in effect at the delivery address. For kiosk orders fulfilled and shipped from outside the state, the tax rate is based solely on the delivery address.
ONLINE (DIRECT AND THROUGH MARKETPLACES)
Selling online to consumers in other states exposes your business to the economic nexus laws discussed earlier, as well as marketplace facilitator laws if you sell through marketplaces. It can also put you at risk of establishing other types of nexus.
Several states still enforce affiliate nexus laws that predate their economic nexus laws. Affiliate nexus is established through a connection between an out-of-state business and its affiliated entities in a state. It can result from use of in-state independent contractors or non-employee representatives to create or maintain a market in the state, or when an in-state business uses a similar name to promote or maintain sales for the out-of-state retailer.
Some states also still enforce click-through nexus laws, which base a sales tax collection obligation on referrals made through links on a website owned or operated by an individual or business in the state.
A number of states repealed their affiliate nexus and click-through nexus laws after the Supreme Court validated economic nexus with the Wayfair decision, but many didn’t. And interestingly, Illinois repealed click-through nexus as of June 28, 2019, then reinstated it effective January 1, 2020.
Cookie nexus laws may also need to be considered. Before the Wayfair decision, a handful of states creatively based nexus on the cookies internet sellers place on computers to track and promote sales in the state. Iowa and Rhode Island still have cookie laws on the books, though there seems to be no mention of cookie nexus on the Iowa Department of Revenue or Rhode Island Division of Taxation websites. Both Ohio and Massachusetts repealed their cookie laws, but the old laws could still create past tax liability for businesses.
Scott Peterson explains, “Though now repealed, those cookie laws were in effect and enforced before they were repealed. Sellers who used cookies and could have been subject to these laws when in effect should be careful if they are audited.” And indeed, the Massachusetts Department of Revenue has issued assessments based on its cookie nexus provision for periods predating Wayfair. However, the Massachusetts Appellate Tax Board abated one such assessment in December 2021, finding that the cookies, etc., the company used to promote sales in Massachusetts did not establish a physical presence nexus.
And of course, marketplace facilitator laws can complicate compliance in a variety of ways. Inventory used to fill marketplace orders can give a third-party seller physical nexus in a state, often unbeknownst to the seller. Selling through marketplaces can make it more difficult to determine whether you’ve met a state’s economic nexus threshold. It can also alert a state to your presence and make auditors wonder if you’re registered and collecting sales tax as you should.
BUY ONLINE, PICK UP IN STORE (BOPIS)
Selling online and letting customers pick up their purchases in store has been a lifeline for many businesses during the pandemic, though it existed during the beforetimes as well. Businesses offering this option need to understand how it can impact sales tax compliance and ensure sales systems are set up properly.
Ecommerce systems are often set up to calculate tax based on customers’ shipping and/or billing address. Yet if a customer collects the goods at the store, tax should be based on the rate in effect at that store.
The rates could be the same, of course: Some states (e.g., Maryland) don’t levy local sales tax, and in states that do, a customer could reside in the same sales tax jurisdiction as the store.
But it’s also possible for a customer and retailer to be in different jurisdictions. Missouri and Colorado are two states where buildings located across the street from one another can have different rates due to overlapping sales and use tax jurisdictions. And in the city of Bristol, one side of the street is in Tennessee while the other is in Virginia.
No matter the location of the customer or the store, collecting the proper sales tax rate is a critical aspect of sales and use tax compliance.
BUY NOW, PAY LATER (BNPL)
One interesting side effect of the pandemic is the emergence of more buy now, pay later (BNPL) options (also called point-of-sale loans). In 2021, 45.1 million people in the U.S. — about 21.5% of digital buyers — are expected to use BNPL services, an 81.2% increase over 2020. In fact, most major retailers now offer BNPL plans.
It feels a bit old school: Any fan of Popeye will remember Wimpy and his catchphrase, “I’ll gladly pay you Tuesday for a hamburger today.” Yet younger consumers with less disposable income are more likely to use BNPL services than their older counterparts. Gen Zers comprised 30.3% of BNPL users in the U.S. in 2021, and Millennials a whopping 42.7%. With 84% of survey respondents in Sweden using BNPL services, consumers in other countries may be even more enthusiastic about these plans than Americans.
Consumers should pay close attention to the true costs of BNPL plans (some collect $0.30 from every payment made). And as with BOPIS, merchants must understand how BNPL plans affect sales tax. For example:
- Should tax apply to the full amount with the first installment or to each payment separately?
- If the sales tax rate changes before final payment is made, should the new rate be applied to any remaining options?
- Are any fees associated with BNPL services subject to sales tax?
The answers likely vary by state. In Washington, retail sales tax and business and occupation (B&O) tax for merchandise sold on installment is due in the reporting period when the sale is made, although full payment won’t be received until later. Separate charges for insurance, interest, and finance charges may be excluded from the sales price for B&O and sales tax, though such charges are subject to other taxes in Washington.
Somewhat related, Missouri recently clarified how layaway orders affect the exemption provided during a sales tax holiday. To qualify for the exemption, final payment on a layaway order must be made, and the buyer must take ownership of the property during a sales tax holiday. Alternatively, the seller must accept an order during a sales tax holiday for immediate delivery upon full payment (even if delivery is made after the exemption period). Additional details are in Senate Bill 153.
Sales tax applies no matter how the sale occurs
No matter how you reach customers or manage their payments, if you have nexus in a state, you need to know which sales are subject to sales tax (and at what rate), which are exempt, filing and remittance requirements, and so forth. This can be challenging because sales tax rates, rules, and regulations are subject to change.
SALES TAX RATES CHANGE
Changes to sales and use tax rates and rules are a fact of life. Local rates change frequently in some states — Missouri is regularly featured in our sales tax rate change blog posts — while rate changes are less of a concern if you only make sales in Michigan and New Jersey. State sales tax rate changes occur far less frequently than changes to local rates.
It’s also common for the boundaries of taxing jurisdictions to change, and this can affect rates. Boundary changes often stem from growth or contraction, as illustrated by these taxing jurisdiction boundary changes in North Dakota. In rare instances, they may also result from gerrymandering.
SALES TAX RULES CHANGE
In addition to state or local district rate changes, government and tax officials sometimes change the taxability rules for certain products. They may go from taxable to exempt, like diapers and feminine hygiene products in Louisiana as of July 1, 2022. Or a product may become taxable, like plastic carryout bags in Washington state starting October 1, 2021.
Georgia is providing a temporary sales tax exemption for sales of fees, tickets, or charges for admission to certain exhibitions or fine arts performances. Not all fine arts exhibitions or performances qualify for the exemption, however, only those performed or exhibited by tax-exempt organizations or certain museums of cultural significance. The exemption took effect July 1, 2021, and runs through December 31, 2022.
States often carve out new exemptions to benefit specific industries or taxpayers, for one reason or another. Thus, as of November 1, 2021, Oklahoma sales tax doesn’t apply to certain sales of clothing to any Oklahoma chapter of a tax-exempt national organization, or to sales of tangible personal property or services to certain museums. On the other hand, some Nebraska lawmakers are working to broaden sales tax to many currently exempt services.
Some states do a good job of announcing rate and rule changes, but some don’t. If the Louisiana Department of Revenue has published information about the new exemption for diapers and feminine hygiene products, it sure hasn’t made it easy to find.
STATES TWEAK OLD TAX LAWS TO FIT NEW TECHNOLOGY
Whenever industry-disrupting products and services emerge, states must either determine how old tax laws apply, or adopt new laws.
For example, the Colorado Department of Revenue amended its tangible personal property rule in early 2021 to clarify that “the method of delivery does not impact the taxability of a sale of tangible personal property.” This enabled it to tax digital goods under existing policy. The Colorado Legislature later codified the new policy with the enactment of House Bill 1312. Scott Peterson notes that while the Department of Revenue thought their law worked, “the Legislature didn’t want to take any chances and enacted a new law.”
But sometimes, state lawmakers start from scratch.
Can digital ads be taxed?
One of the most controversial taxes to emerge recently is the tax on digital advertisements adopted by Maryland in early 2021. States being the copycats they are, similar taxes were subsequently introduced in several states, including Connecticut, Indiana, Montana, New York, Texas, Washington, Washington, D.C., and West Virginia.
Massachusetts is looking for the best way to tax digital ads, and its most recent effort is the most straightforward: Bill H.4179 would levy a 6.25% excise tax on gross revenue from digital advertising services by “persons with revenue from digital advertising services provided within the commonwealth.” To protect the smallest companies from the tax burden, the first $1 million earned from digital advertising services in Massachusetts each year would be exempt.
Otherwise, the Massachusetts plan is extremely light on details. There are basic enforcement issues to sort out, such as how to determine the location of the ad or which businesses and which sales these taxes will affect. Perhaps due to the enormity of the task, the Maryland Assembly left such details to the Maryland Comptroller to determine.
There’s no hurry: Maryland’s now fighting for the right to enforce its digital advertising tax. Two lawsuits are pending, one by the Chamber of Commerce of the United States of America and another by Comcast and Verizon. If other states pass similar laws, additional challenges will almost certainly arise.
Peterson believes “the constitutional challenges of taxing digital advertising and exempting all other forms of advertising are overwhelming.”
As states explore the best way to tax digital advertising services, other countries are adopting national digital services taxes. However, if a new global minimum tax deal proceeds as planned, their fate is in jeopardy. Put forward by the Organisation for Economic Co-operation and Development (OECD), the plan will subject roughly 100 of the world’s largest and most profitable multinational enterprises to a minimum corporate tax of 15% starting in 2023. It will also require the repeal of national digital services taxes.
Whether the repeal would extend to state-level digital advertising taxes is unclear. It certainly could, especially since Maryland’s tax includes variable tax rates that increase along with the taxpayer’s global revenue. According to Peterson, “While still a long way off and far from certain, the OECD’s multinational negotiations on corporate tax reform will likely affect a state’s ability to tax.”
Are online classes subject to sales tax?
Though online learning certainly isn’t new, the pandemic took it to new levels. Seemingly overnight, education and exercise classes that could no longer be offered in person were reaching homebound students over Zoom and similar platforms. You lived it, you know. What you may not know is whether the taxability of such classes changed with the medium.
“Determining whether or not online education and training sales are subject to sales tax can be inherently complex,” explains Scott Peterson. Three main factors tend to impact taxability:
1) Is there an interactive component (live vs. prerecorded)?
2) Are training materials included (do you download course materials)?
3) Is the online education content purchased via subscription?
In Washington, for example, the taxability of online classes is often based on how much students can participate. Classes occurring in real time, where students and teachers interact, are generally exempt. Yet if real-time interaction isn’t possible, tax typically applies.
On-demand classes are often subject to sales tax in Colorado too, but digital educational content tends to be exempt from North Carolina sales tax. Similar to Washington, Wisconsin generally exempts livestreamed online educational services but taxes prerecorded seminars and videos.
The persistence of COVID-19 and the efficacy of online and hybrid classes will likely lead more states to reevaluate tax policies affecting online learning. In addition to the format and the type of program or school, tax officials will likely consider whether any taxable products are sold along with the class (as with wine tasting classes).
Peer-to-peer car sharing
The rise in peer-to-peer (P2P) car sharing services has prompted many states to wonder, should P2P car sharing companies be regulated and taxed like car rental companies, or are they different?
More than 40 states levy a specific excise tax or surcharge on car rentals according to the Tax Foundation, and that’s usually on top of sales tax. Fewer tax P2P car sharing services, though “there have been ongoing debates in over 30 states about whether and how to treat peer-to-peer car sharing within rental car excise tax regimes.”
Where state and local sales taxes do apply to P2P car sharing, it’s often through marketplace facilitator laws. Under Indiana HEA 1001 (2019), marketplace facilitators are responsible for the tax on vehicles shared through their platform. For transactions not made through such platforms, the vehicle owner is generally liable for the tax due unless the transaction is exempt from both sales tax and the vehicle sharing excise tax (e.g., the person shares the vehicle for fewer than 15 days in the current or preceding calendar year).
Some states, like Colorado, have exempted car sharing from daily car rental fees because car sharing can benefit the state “by reducing traffic congestion, greenhouse gas emissions, and the amount of wear and tear on the highways.” Yet other states, including Florida and Nevada, have opted to tax and regulate this disrupter.
Connecticut isn’t quite sure how to treat P2P car sharing transactions, but it’s exploring the issue. Meanwhile, the Arizona Department of Revenue added P2P car sharing to its October 2021 tax rate tables.
NEW SOURCING RULES
Sales tax sourcing rules are also changing with the times. Sourcing rules dictate which sales tax rates and rules govern a transaction: those in effect at the location of the seller (origin sourcing), the location of the point of delivery (destination sourcing), or a combination of both (mixed sourcing).
Sales tax sourcing rules govern which jurisdiction’s rates and rules govern a transaction.
Colorado changes sales tax sourcing rules
Colorado switched to destination sourcing from origin sourcing in 2019, when it began taxing remote internet sales. Any business making $100,000 or more in retail sales into Colorado during the previous calendar year is required to use destination sourcing rules, but the state allowed an exception for small businesses with less than $100,000 in retail sales in the state.
The exception for small sellers ends February 1, 2022. As of that date, all retailers must apply destination sourcing rules as follows:
New Mexico adopts new sourcing rules
New sourcing rules for gross receipts tax took effect in New Mexico on July 1, 2021. Most internet sales of tangible personal property (and certain services) are now taxed based on the destination of the sale, not the origin. If the consumer takes possession of the property at the seller’s place of business, origin sourcing rules continue to apply.
Sourcing sales of services in New Mexico can be a bit more complicated. Generally, the rate is determined by the location where the “product of the service” is delivered. Though that’s often the same location as where the service is performed, it isn’t always.
Texas wants to change its sourcing rules but is stuck in legal purgatory
Businesses located in Texas generally source internet orders to the seller’s place of business, not the location where the goods are delivered. Yet this has created a bit of a situation in the Lone Star State: Localities where internet sellers are located reap the sales tax revenue while localities where the buyers live get nothing. So, Texas decided to switch to destination sourcing for online orders starting October 1, 2021 (unless the seller fulfilled the order at a place of business in Texas, in which case origin sourcing would still apply).
Localities benefiting from the current sourcing rules are challenging the new sourcing rules, so the policy change is on hold. It won’t be enforced unless and until validated by the courts. The case is expected to go to trial in June 2022.
New and different sales tax filing requirements
State and local governments also periodically change filing obligations.
Beginning January 1, 2022, certain business activities in Phoenix, Arizona, must be reported under new codes. For example, gross income from the retail sale/purchase of a single item of tangible personal property whose value is equal to or less than $11,631 (before taxes, add-ons, or sales price adjustments) is subject to the 2.3% tax rate. If the gross income exceeds $11,631, the 2.3% tax rate applies to the first $11,631, while any amount exceeding $11,631 must be taxed at 2% under a different code. Prior to January 1, 2021, the threshold was $10,968, not $11,631.
Colorado recently amended its timely filing discount (called a service fee or vendor fee). The 4% discount is available to all timely sales tax and use tax filers in Colorado through December 31, 2021, after which it’s only available to smaller businesses.
Under House Bill 21-1312, retailers with total taxable sales exceeding $1 million during a tax period may not retain any money to cover expenses incurred collecting and remitting Colorado sales tax for that period. Retailers whose taxable sales are under $1 million may retain 4% of their tax collections (up to $1,000 per month), to cover their tax-related expenses.
New and unusual sales tax holidays
Approximately 17 states typically offer one or more sales tax holidays each year. Sales tax holidays allow consumers to purchase certain products exempt from sales tax for a specific period of time. They can be a bit of a bear for the retailers required to temporarily suspend sales tax collections on certain sales, though they’re generally popular with consumers.
Illinois, Indiana, New Jersey, New York, and North Carolina all considered offering new sales tax holidays in 2021 or beyond, though none of the bills made it to governors’ desks. Arkansas, Florida, and Tennessee were more successful.
As in 2020, Tennessee offered a food sales tax holiday in August 2021 to help struggling businesses and consumers. Arkansas added certain electronic devices to the list of eligible items during its annual sales tax holiday, because “many students in the state have been forced to adapt to virtual education efforts as the result of school closures, personal health risks, and other factors.”
Florida took home the “Most Unbelievably Complicated Sales Tax Holiday” award for 2021. It’s one-time “Freedom Week” exempted the first $25 of the sales price of this, the first $75 of the sales price of that, and so on. For example, the first $30 of the sales price of a camping lantern or flashlight was exempt from Florida sales tax between July 1 and July 7, 2021, but any amount over $30 was subject to tax. If most sales tax holidays are a bear for retailers, this one was a grizzly.
Sales tax holidays don’t just apply to retailers in the state — they affect any business registered for sales tax that sells eligible items. Florida’s Freedom Week must have felt like hazing for remote retailers required to register under the state’s new economic nexus law, which took effect July 1, 2021.
These are many of the issues affecting retailers today, though certainly not all. Some of these may affect manufacturers as well, especially those selling directly to consumers in one or more states. There are also distinct tax compliance matters for manufacturers.
Manufacturers have always faced unique sales and use tax challenges, even during the best of times. The COVID-19 pandemic has only exacerbated the challenges. Though demand for goods is generally high, companies are having a hard time meeting it because of a worldwide shortage of both raw materials and labor.
According to The Manufacturing Institute, “the lack of skilled labor was the industry’s major challenge even before the pandemic … [and] it’s still a major concern today.” In fact, 77% of manufacturers surveyed recently anticipate ongoing trouble attracting and employing skilled workers, and the labor shortage is expected to reach approximately 2.1 million unfilled manufacturing jobs by 2030. Adding to the woes, many manufacturing facilities in Asia are still periodically shuttering due to outbreaks of COVID-19.
Thus, the Glasgow Distillery Co. is struggling to find glass bottles, labels, and the cardboard it needs to ship whisky once it’s ready to go; wait times for critical supplies have moved from six weeks to six months. And in September 2021, Daimler AG CEO Ola Källenius said the semiconductor chip shortage would likely affect its business into 2023. No wonder the Kiel Institute for the World Economy predicts economic growth to drop from 6.7% to 5.9% for 2021.
Much of the problem stems from the interconnected and interdependent nature of manufacturing today. Consider this: A producer of hot tubs in Utah sources parts from seven countries and 14 different states. The company estimates that to make one hot tub, roughly 1,850 parts “travel a cumulative 887,776 miles” — a winter storm in Texas, a lengthy wait at a port in China, or too little trucking capacity in Idaho can end up causing significant production delays.
Such supply chain issues can also impact sales and use tax compliance. For example, significant delays may compel a business to store inventory in transit in a new state. If that state taxes inventory in transit, as some do, that business could suddenly owe that state income tax. According to Scott Peterson, vice president of government relations at Avalara, “Most states with a corporate income tax view inventory as physical nexus.”
Alternatively, a company long used to operating in a “just-in-time mode” may find itself with an excess of some supplies while waiting for other critical inputs to arrive. The company could pull inventory to build out additional storage facilities or shelves and end up liable for use tax on that inventory.
And, of course, remote work policies can complicate exemption and resale certificate oversight when the certificates are on paper in an office. If no one is in the office due to stay-at-home orders, there’s no quick way to validate exempt transactions.
A 2019 study found that about one-third of business-to-business (B2B) customers said they preferred making at least 90% of their business-related purchases online. The pandemic has made the appeal of online business that much greater. This means manufacturers now need to be able to supply, collect, and validate exemption certificates online.
Even without the pandemic and any new tax issues it may spark, the manufacturing industry is a tough one for compliance. Because of this, it tends to be a prime target for auditors. In fact, many audits target just five industries:
- Wholesalers and distributors
- Food service
Some of the most common mistakes found by auditors typically involve:
- Failure to register where required
- Failure to report consumer use tax
- Missing exemption certificates and other document errors
FAILURE TO REGISTER WHERE REQUIRED
The 2018 Wayfair decision and subsequent economic nexus laws can affect businesses that deal primarily or exclusively in exempt transactions because many states count certain exempt sales toward their economic nexus threshold. So, even if all your sales are exempt, you can develop an obligation to register with the state tax authority, validate exempt transactions, and file timely returns.
SELLING DIRECTLY TO CONSUMERS
Of course, nexus also comes into play when manufacturers cut out intermediaries and sell directly to consumers, becoming a retailer in addition to a manufacturer.
There are advantages to selling directly to consumers: It’s something consumers increasingly want, for one, and it can increase margins for producers. However, it should be done with eyes wide open, especially with respect to tax compliance.
Even if you make little in the way of taxable sales to consumers, your exempt sales into a state could establish nexus and an obligation to tax your non-exempt sales. To tax them correctly, you’ll need to know how to source sales and be able to calculate and remit the correct rate of tax for each transaction.
PAYING TAX TWICE
Nexus can complicate compliance in other ways as well.
For example, if you regularly buy from out-of-state companies, you may have systems in place to remit use tax on those transactions because the remote seller hasn’t been required to collect sales tax. If that system remains in place after the seller establishes nexus and begins charging sales tax, you could end up paying tax twice: sales tax to the retailer and use tax to the state.
FAILURE TO REPORT CONSUMER USE TAX
Like all businesses, manufacturers frequently have consumer use tax liability.
States created consumer use tax to capture revenue lost when tax isn't collected on a taxable sale. Manufacturers often owe use tax when they use items purchased tax free for their own purposes, or when they move components purchased tax free in one state to a different state.
This self-assessed tax is generally considered harder to manage than sales tax because it often leads to:
- Failure to remit use tax as required
- Failure to accurately assess the location of the use
- Failure to account for a change in use that affects taxability
- Failure to properly account for various unique rules and conditions
Unfortunately, when mistakes are made, they tend to be made repeatedly, for years. As a result, a negative audit finding can lead to a hefty fine.
MISSING EXEMPTION CERTIFICATES AND OTHER DOCUMENT ERRORS
Companies with a lot of exempt transactions can benefit from a solid exemption certificate management system. The simple fact that different exemption certificates have different expiration dates in different states makes overseeing exemption certificates extremely difficult, especially for companies with thousands of certificates on file.
Depending on the size of your company and the number of exempt transactions made, you may need to collect and store 50 certificates, or 5,000. All need to be valid when collected and renewed before they expire, a fact complicated by the differing requirements in each state.
In Arizona, for example, both resale and manufacturing exemption certificates generally expire after one year, though some may be acceptable for up to 48 months. In Florida, resale certificates generally expire at the end of every year, while manufacturing certificates typically last five years. And in Colorado, manufacturing certificates never expire but resale certificates expire every two years.
Even if some certificates don’t expire, policies change. It’s best practice to validate them regularly so you can renew them if and when needed. If an exemption certificate you had on file with a vendor expires, an auditor may go after the vendor for the tax due. However, an auditor could also go after you for not remitting use tax on that transaction.
Validating certificates is critical, but it’s just one part of the process. Filling out forms is another, and it can be surprisingly difficult. According to Maria Tringali, senior solutions consultant at Avalara, there are 2,000+ available exemption certificates across the U.S. and 16,000 fields to consider — and that doesn’t include nonstandard forms. Tringali recommends leveraging a compliance tool for collecting certificates and validating these fields, as the task is tedious and time-consuming for employees.
It’s worth noting that manufacturers may need to file zero returns in states where they make only exempt sales. A zero return lets the tax authorities know companies were doing business in the state but not collecting tax because none was due. Zero returns are required in many states, including Virginia, and failure to submit a zero return can result in penalties and interest.
NEW AND DIFFERENT TAX CREDITS
Research and development (R&D) tax credits and/or sales tax exemptions for manufacturing equipment can also complicate compliance, particularly since they vary considerably from state to state.
For example, South Carolina provides numerous sales and use tax exclusions and exemptions for “manufacturers, processors, and compounders.” Typically, whether a machine is exempt depends on the “circumstances and use of the machine.”
A machine is generally exempt from South Carolina sales tax if it’s “an essential and indispensable component part of the manufacturing process and is used on an ongoing and continuous basis during the manufacturing process.” It doesn’t necessarily apply to “everything that can be useful to a manufacturer.” Determining whether the exemption extends to replace parts and attachments adds another layer of complexity.
By contrast, manufacturing machinery is generally taxed at a reduced rate in California. To qualify for the lower rate, a business must meet all following conditions:
- Be primarily engaged in certain types of business (i.e., be a “qualified person”)
- Purchase “qualified tangible personal property”
- Use that qualified tangible personal property in a qualified manner
Some of the fine print: The law provides that purchases subject to the partial exemption cannot exceed $200 million in any calendar year. There’s no proration, so if you begin business operations in October, you may claim up to the $200 million cap for that year. However, you cannot carry over any unused amount to the following year.
It’s the responsibility of each business to track the amount of qualifying purchases made in a calendar year. California will hold a company liable for the full sales tax on any purchases exceeding the $200 million limit.
To make matters more complicated, states sometimes change their policies. Kentucky recently created sales tax and gross receipts tax exemptions to stimulate the development of cryptocurrency mining in the state. Wisconsin is considering an exemption for materials used to construct workforce housing developments or conduct workforce housing rehabilitation projects.
These are just some of the factors manufacturers encounter when dealing with sales and use tax. Companies in the software industry face others.
Software and software services
Surely even Luddites must concede the advantages of software and software services after living through the darkest days of the pandemic. At times, the only way to interact with certain industries — and friends or family — was through the internet. COVID-19 hastened the digital transformation to such an extent that the United Nations Conference on Trade and Development (UNCTAD) believes, “we will look back at 2020 as the moment that changed everything.”
In its global review of COVID-19 and ecommerce, UNCTAD noted, “The COVID-19 pandemic has accelerated digital transformations. Digital solutions are increasingly needed to continue some of the economic and social activities remotely. They have been critical for telemedicine, telework and online education, not least to keep alive our social ties in times of physical distancing.”
Given the current conditions, businesses that provide and sell digital goods and services must know how to tax them. Unfortunately, that’s no simple task. Because software technology evolves more quickly than tax policy, old laws often don’t neatly fit new products and services.
The 45 states with a sales tax, plus Washington, D.C., categorize software up to 10 different ways for tax purposes. As a result, it can be extremely difficult to determine the taxability of specific software products and services from state to state. Whether sales tax applies or doesn’t apply to software transactions in a particular state depends on several factors, including but not limited to:
- Is it canned or custom?
- Is it digital or physical?
- Is it stand-alone or does it come with a service (bundled)?
Who buys the software can also affect taxability, as can how it’s delivered, how it’s classified, what it’s for, and where the seller and end user are located.
It’s hard to generalize tax laws related to software sales, because every transaction is unique. That said, canned software delivered in tangible form for business use is generally taxable in California. On the other hand, canned software for business use that’s delivered electronically in California is generally exempt, and canned software used in manufacturing or research and development is generally taxed at a reduced rate. Canned software delivered electronically for business use is also usually exempt in Florida, but it tends to be subject to sales tax in Ohio, New York, Texas, and several other states.
Tennessee typically bases the taxability of data processing and information services on the “purchaser’s primary purpose for the underlying transaction.” In Letter Ruling #21-08, the Tennessee Department of Revenue decided the primary purpose of a company’s online platform was the data the company processed and shared, not the service of processing and sharing the data.
This has to do with how digital products and services are classified. The company in question operates an online cloud-based platform, which commercial freight brokers and carriers use to post and search opportunities and determine the fair market value of freight hauling. The department concluded the services should be classified as exempt data processing and information services rather than taxable telecommunications services or software.
SOURCING SALES OF DIGITAL GOODS
If tax does apply to a software transaction, it needs to be applied at the proper rate. Determining the rate can be difficult if a seller doesn’t collect a buyer’s full address, and software companies often collect only a consumer’s five-digit ZIP code because with nothing tangible to deliver, they don’t need the delivery address. Yet it’s impossible for a business to calculate a sales tax rate with rooftop-level accuracy — or for a tax authority to confirm that tax was properly collected — if the location of the roof isn’t known.
The Streamlined Sales Tax Governing Board (SSTGB) is currently reevaluating its sourcing rules for digital goods and services with this problem in mind. It notes that even if sellers request the full address, “some purchasers may refuse to provide the information since it really is not needed to receive the product or because of the type of product being purchased the purchaser does not want to provide their address.”
A federal Digital Goods & Services Tax Fairness Act could help promote simplicity and fairness in the taxation of digital goods and services, and several bills have been introduced over the years. Yet since Congress appears “reluctant” to interfere with state and local tax issues, the SSTGB is urging states and the software industry to address this issue themselves.
The SSTGB surveyed 10 Streamlined Sales Tax (SST) member states that tax digital goods (it didn’t survey member states with no local sales and use tax or those that don’t tax digital goods). Based on the responses, it recommends collecting at the highest combined state and local tax rate in the 5-digit ZIP code if the seller doesn’t obtain a complete street address or 9-digit ZIP code, and reporting the sale as occurring in any jurisdiction with that highest rate. If multiple local jurisdictions within a 5-digit ZIP code have the same highest rate, the seller could report the tax as being collected in any of those jurisdictions.
The SSTGB further recommends holding the seller liable for tax if it doesn’t obtain a complete street address or 9-digit ZIP code tax from the consumer and doesn’t collect the highest possible tax due. The board offered several other options as well. It’s been studying this issue for years and will likely continue to do so in 2022.
According to Scott Peterson, “The challenge for sourcing digital goods is they can be used in multiple locations and the seller often doesn't know where the buyer uses the goods.”
BUNDLING DIGITAL GOODS AND SERVICES
States will also likely pay more attention to transactions that bundle digital goods and services in the coming months and years.
Determining the taxability of bundled products and/or services is always difficult, even when the products are tangible. Tennessee Department of Revenue Letter Ruling #21-04 reinforces that the complexity extends to the digital economy.
The department ruled sales tax applies to sales of subscription packages that contain at least one taxable item and are sold for one non-itemized price. But whether the company should report tax upfront, on the lump sum, or on a monthly or periodic basis depends on the terms of the sale.
Letter rulings are applicable only to the individual company being addressed, but they can be instructive for all businesses because they illustrate the types of questions tax departments ask when determining the taxability of goods or services.
THE TAXABILITY OF SOFTWARE ISN'T SET IN STONE
Sometimes, the taxability of a sale depends on who you ask. As more transactions occur online, more states will scrutinize them — some with an eye to tax them.
According to the Mississippi Department of Revenue, for example, sales of digital photographs are generally taxable. After a digital photographer challenged an assessment, the Mississippi Board of Tax Appeals reached the same conclusion as the department. Yet, the Mississippi Supreme Court disagreed, noting that neither photography services nor digital photography have been added to Mississippi’s list of taxable “specified digital products.”
Scott Peterson reminds that “generally, the burden to prove a purchase or sale is exempt falls on the person seeking the exemption,” while “the burden to prove something is taxable falls on the state.” Thus, as the department appeals the Supreme Court’s decision, it’s also working to clarify that sales of specified digital products by photographers and videographers are taxable.
Tax departments can also change their minds. For example, the West Virginia State Tax Department recently clarified that streaming services are taxable although earlier guidance suggested streaming services were exempt. Digital products are generally exempt from West Virginia sales and use tax.
The department noted, “West Virginia imposes a sales tax on the provision of services. The provision of streaming services is subject to this tax. However, rentals and similar nonpermanent use of digital audio visual works are not subject to this tax.”
In TSD-445, the West Virginia State Tax Department clarifies the difference between the two. A taxable streaming service provides “access to curated entertainment content in the streaming service’s catalog.” By contrast, an exempt digital product is “a discrete identifiable item” that can be purchased or rented.
The Mississippi Department of Revenue is also interested in expanding sales tax to certain cloud computing services, including Software as a Service (SaaS), Platform as a Service (PaaS), and Infrastructure as a Service (IaaS). The department says it’s amending the rule to “clarify the tax treatment of computer software sales and services when delivered through cloud computing,” though it seems the proposed rule would in fact change how the state taxes such sales.
Although the tax treatment of digital goods and services is still often shrouded in incertitude, states will figure it out. They must, because cloud computing isn’t going away. Perhaps with that in mind, the Multistate Tax Commission (MTC) is working toward “identifying potential best practices and areas for increased uniformity” for taxing digital products. It’s particularly interested in what it calls “The Washington Approach.”
In a nutshell, Washington state taxes broad categories of digital products and services then provides for a number of specific exclusions. It finds this practical in part “because the alternative — specifically identifying particular products for inclusion in the tax base — creates a system that becomes outdated quickly as technology changes and requires continual updating.” This, of course, can “create compliance and enforcement difficulties.”
In studying the issue, the MTC has identified the following concerns:
- A lack of uniformity in sourcing may lead to “nowhere sales or to sales subject to multiple taxation”
- “Expansion of the sales tax base may exacerbate … the regressivity of the tax”
- “Digital products may be too difficult to consistently define, which will only increase the overall complexity of the tax system”
This is a complicated issue, and it’s not going to get any simpler. As digital goods and services evolve and replace more traditional products and services, they’ll likely become even more prevalent. The MTC believes “the issue affects all states (regardless of whether they do or do not tax some digital products currently) and also the vast majority of taxpayers who may buy or sell these products.”
SPECIAL CONCERNS FOR REMOTE PROVIDERS OF DIGITAL PRODUCTS AND SERVICES
The MTC also thinks states may be more interested in taxing digital products and services now because they have the authority to tax remote sales. Any future tax efforts will be complicated by the fact that “few states will be writing on a clean slate. The MTC’s past experience suggests that it is particularly difficult to bring about uniformity where individual states have already committed to diverse approaches.”
This, of course, can make sales tax compliance extremely challenging for all taxpayers in the industry. There are also particular ramifications for out-of-state sellers because of economic nexus: Companies need to know which sales count toward states’ economic nexus thresholds.
Though West Virginia’s economic nexus threshold doesn’t specifically include or exclude intangible property, digital goods, or streaming services, the West Virginia State Tax Department now says streaming services do count toward the state’s economic nexus threshold. This will likely impact many streaming service providers’ nexus footprint.
Changing state tax policies as they relate to certain digital goods and services will take time, but there will likely be movement on this issue in 2022 because taxing sales of digital products is proving to be an excellent source of revenue. For example, Chicago’s controversial “Netflix tax” on streaming services more than tripled between 2016 and 2021 and increased by more than $30 million during the 2020–2021 fiscal year, when Chicagoans were at home due to COVID-19.
Explore tax changes affecting the hospitality, beverage alcohol, communications, tobacco, and energy sectors in 2022, as you continue reading the industry tax changes section.