Affiliate Nexus Law Update: Minnesota and Maine Approve New Statutes, Missouri Governor Vetoes Bill

While the Marketplace Fairness Act sits in committee in Congress awaiting hearings, two more states have enacted affiliate nexus statutes imposing tax on remote sellers. The governor of another state, however, declined to add his state to the list of jurisdictions enacting counterproductive, and arguably unconstitutional, “click through” nexus laws. Below is a quick round up of recent news in Minnesota, Maine, and Missouri:

Last week, Minnesota Governor Mark Dayton signed into law a click-through nexus bill which creates a rebuttable presumption for out-of-state retailers with in-state affiliates and which goes into effect for sales made after June 30, 2013. The new law states that an out-of-state seller is presumed to be soliciting sales in the state if it enters into an agreement with a resident for a commission or other similar consideration for referrals of potential customers, whether by a link of a website or otherwise. The presumption only applies if the seller has at least $10,000 of gross receipts in the 12 month period preceding the calendar quarter in which the sale is made. Sellers can rebut this presumption with proof that the resident did not engage in any solicitation on behalf of the seller that would satisfy the nexus requirement under the Constitution. The same bill also imposes tax on certain specified digital products which previously were exempt from sales tax.

Meanwhile, on June 5, Maine Governor Paul LePage signed into law a bill that creates a rebuttable presumption for out-of-state sellers with affiliates in Maine. Under Maine’s new law, sellers are required to register if they have an affiliate with a substantial physical presence in the state (other than a common carrier) if the affiliate sells similar products under a similar name, maintains a facility to help deliver property or services sold by the seller, shares trademarks with the seller, or provides various services to the seller’s customers. Out-of-state sellers can rebut this presumption by demonstrating that the affiliate’s activities do not help establish or maintain a market in Maine.

Maine’s new law also establishes click-through nexus for out-of-state sellers, similar to the Minnesota bill. As in Minnesota, the seller’s gross receipts must be in excess of $10,000 for the law to apply. Additionally, sellers can rebut the presumption by showing that the seller’s in-state referrer did not engage in any activity “significantly associated with the seller’s ability to establish or maintain the seller’s market” in the preceding 12 months. Proof can include signed, written statements obtained in good faith from referrers that they did not engage in solicitation on behalf of the seller. The Maine law is scheduled to go into effect on September 17, 2013.

Finally, also on June 5, Missouri Governor Jay Nixon vetoed a bill that would have added affiliate nexus and click through nexus provisions to Missouri’s tax code and would have required the Missouri DOR to enter into the Streamlined Sales and Use Tax Agreement. Legislators will have a chance to overturn the veto in September.

Traps for the Unwary: Taxation of Digital Products

Recently, I presented at a webinar hosted by Strafford Publishing on the subject of sales and use tax on digital products and services.  It almost goes without saying that the interstate sale of digital products—whether books or software—is complicated, if for no other reason than it requires analyzing the sales and use tax consequences of such transactions based upon forty-five states’ (and the District of Columbia’s) sales tax laws, which were adopted long before the advent of the digital age.  For example, the starting point for sales tax analysis in most states is whether the transaction involves the sale of “tangible personal property.”  Is a digital product such as a digital book that is downloaded by the customer tangible personal property?

The states do not provide for uniform treatment of the taxability of digital products from state to state, nor are all digital products taxed similarly within a given state.  Colorado, for example, taxes digital books and music, but does not tax digital software.  Twenty-five states tax digital books, music and videos, while thirty states tax prewritten software.

What makes analysis in this field even trickier are the different methods of delivery of digital products and the various pricing plans under which such products are sold.  For example,  under one delivery method, the seller provides the buyer an electronic access code to permit the buyer to download the digital product at the buyer’s convenience.  For a sale such as this, in addition to analyzing whether the underlying product is taxable, the seller must also determine whether the sale of the access code is taxable at the time of such sale.  The SSUTA, of which there are 24 member states, treats the sale of a “digital code” that entitles the purchaser to download a taxable digital product as a taxable transaction.  See Section 332(G).  But not every state, of course, is a member of the SSUTA and non-member states do not always follow this principle.  For instance, the non-member states of Texas, New York, and Illinois treat the sale of such access codes as tantamount to selling a gift card.  These states treat the sale of a gift card or access code as the sale of an intangible.  It is only when the gift card is redeemed that a taxable sale of tangible personal property has occurred.  See, for example, Ill. General Information Letter ST 10-0052-GIL (June 4, 2010).

The law is even cloudier if the seller sells for one price a “bundle” of rights to access not only a taxable product but also a non-taxable product.  For example, in Tennessee Department of Revenue, Revenue Ruling No. 12-11 (July 24, 2012), the Department of Revenue considered whether a bundled service that provided access to both reference books and computer simulation programs at a single price was taxable.  The Department noted that access to digital books is taxable, while access to the software is not taxable.  Nevertheless, because the provider charged one price for these products, the Department held that the entire “bundled” product was taxable.  This ruling falls in line with New York’s so-called “Cheeseboard Rule,” in which tax was due on the entire purchase price where a seller was selling for one price tax exempt cheeses together with a taxable cheese board.  See 20 NYCRR 527.1(b).

The conclusions that can be drawn are that a retailer of digital products should determine the taxability of the products it sells based on the nature of the products sold and the method of access or delivery of the products.  In addition, a seller should consider whether to sell its products for a “bundled price,” or to price its products separately, when selling distinctly taxable or nontaxable items such as software and other digital products.  If one price is charged, the seller is likely liable for tax on the entire price.

Tennessee Ruling Provides Another Wrinkle for Cloud Computing Services

A recent ruling by the Tennessee Department of Revenue (Ruling #12-11) illustrates some of the anomalies and pitfalls in properly taxing cloud computing services. The request for ruling concerned a service that provided Tennessee users access to software maintained on remote servers located outside of Tennessee. This is otherwise known as an SaaS service. In addition, the charge for the service permitted users access to certain databases, including certain reference materials such as dictionaries and encyclopedias. It would appear that the users did not download the references to their computers.

One of the anomalies in the ruling is that the Department stated that the SaaS portion of the service was not taxable, but access to the databases was taxable because the Department deemed the access to include the right to license and use digital books. As of January 1, 2009, the right to license and use digital books is taxable pursuant to an amendment to the Tennessee sales and use tax statute adopting the Streamlined Sales and Use Tax Agreement (“SSUTA”).

The Department’s basis for this distinction in taxability appears to be that access to software is not taxable because “title, possession, and control” of the software always resides outside of Tennessee. On the other hand, the taxability of digital books is predicated on the following underscored clause from Tenn. Code Ann § 67-6-233(a), which provides for the taxation of digital books when there has been the “retail sale, lease, licensing, or use of specified digital products transferred to or accessed by subscribers or consumers in this state.” (emphasis added). Section 67-6-231(a), providing for the taxation of software, includes only “software transferred by tangible storage media or delivered electronically,” but does not include access to the software. The difference between the two statutory provisions is subtle. On the one hand, digital books are taxable if the consumer in Tennessee has “access” to the books, without being required to download them. On the other hand, computer software is not taxable, even if the consumer has access to the software, so long as the consumer does not download the software to his or her computer in Tennessee.

Another anomaly pointed out in the ruling is the distinction between information services and digital books. The Department conceded in its ruling that data processing and information services are not taxable in Tennessee, and defined such nontaxable services as allowing “data to be generated, acquired, stored, processed or retrieved or delivered by electronic transmission.” Because the service at issue in the ruling included access not only to information maintained in a database by the service provider, but also access to reference materials such as a dictionary or encyclopedia, the non-taxable information service was transformed into access to digital books.

Finally, the “pitfall” is, as the Department ruled, because the charge was for the combined service of access to the software as well as access to the databases and the digital books, the entire transaction was taxable. This was the case even though the transaction fit within the definition of a “bundled” transaction (i.e., the sale of two or more services for one price), and some of the services were not taxable.  The ruling is in line with the old New York “cheeseboard” rule* and the proverbial expression that “one rotten apple spoils the bunch.” The lesson for a cloud service provider is that it should itemize charges for separate services; otherwise it stands the risk of taxation of the entire transaction. This is so, even in the SSUTA states, which only provide for “unbundling” services (i.e., permitting the showing of the portion of a bundled transaction that is not taxable) where the services consist of a bundled transaction of “telecommunications services, ancillary services, Internet access services, or audio or video programming services.” Most cloud computer service providers do not provide such components as part of their service offerings and so itemizing the services they actually provide is a constructive way to limit the tax hit.

* Under 20 NYCRR § 527.1(b), “Taxable and exempt items sold as a single unit. When tangible personal property, composed of taxable and exempt items is sold as a single unit, the tax shall be collected on the total price.  Example: A vendor sells a package containing assorted cheeses, a cheese board and a knife for $15. He is required to collect tax on $15.”

Proponents of Streamlined Sales Tax Legislation Remain Unwilling To Pursue Genuine Simplification, While Exaggerating The Amount Of Uncollected Use Tax on eCommerce Sales

Earlier this month, Massachusetts Congressman Bill Delahunt introduced H.R. 5660, “a Bill to promote simplification and fairness in the administration and collection of sales and use tax, and for other purposes.”  H.R. 5660 represents the latest effort by Congressional allies of the Streamlined Sales and Use Tax Agreement (“SSUTA”) to promote legislation that would overturn the substantial nexus standards that limit states’ power to impose sales and use tax collection obligations on out-of-state sellers, as reaffirmed by the Supreme Court in Quill v. North Dakota

Sadly, H.R. 5660 represents no real promotion of simplification of state sales and use tax systems over the level of improvement introduced in prior bills which fell far short of the mark. Indeed, H.R. 5660 is nearly identical to a bill introduced by Mr. Delahunt in 2007 that endorsed the SSUTA, the shortcomings of which Brann & Isaacson senior partner, George Isaacson, explained to Congress in December 2007.  Among the fundamental steps toward true simplification that the states have still refused to adopt (and that H.R. 5660 fails to require) are a reduction in the number of state and local taxing jurisdictions, a single sales tax rate for all jurisdictions in a state, uniformity in the tax base, and uniformity in the measure of tax for like transactions, to name just a few.

Furthermore, while further simplification remains elusive, there is growing evidence that states have substantially overstated the amount of revenue they “lose” through uncollected sales and use tax on Internet and other direct marketing sales by out-of-state vendors who are not required to collect such tax under Quill.  The SSUTA contingent has long relied upon a study conducted by a group at the University of Tennessee (the “UT Study”), which was most recently updated in April 2009.  The UT Study estimates that states will fail to collect between $45-50 billion in sales and use tax on direct marketing sales during the five year period from 2008-2012.

A more recent study, prepared by Jeffrey Eisenach and Robert Litan at Empiris LLC, entitled “Uncollected Sales Taxes on Electronic Commerce: A Reality Check” (the “Empiris Study”) and published in February 2010, presents a compelling critique of the UT Study.   The Empiris Study’s Executive Summary powerfully summarizes the study's conclusions, including the fact that total potential uncollected sales tax revenues in 2008 were less than three-tenths of one percent of all state and local tax revenues.  Also, it found that more than one-third of such uncollected tax revenues are associated with small businesses that would likely be excluded from use tax collection obligations under a “small business” exemption in federal legislation.  Overall, the Empiris Study convincingly shows that the amount of projected uncollected state and local sales and use tax is far less than claimed by states or projected by the UT Study.  Indeed, the Empiris Study concludes that “the increased collections associated with overturning Quill would be substantially lower than previously thought,” and would be approximately 33% of the amount estimated by the UT Study.

Such relatively modest amounts of additional tax revenue do not justify imposing the still-significant regulatory and compliance burdens associated with state and local sales and use tax collection that, in part, motivated the Supreme Court’s decision in Quill.  The proper solution to the ongoing complexity of state and local sales and use tax systems is true simplification, which H.R. 5660, unfortunately, does not provide.

What’s Next For Sales Tax (a/k/a Use Tax) On Direct Mail?

Direct marketers know that successful eCommerce strategies often depend upon reaching customers offline as well as online. Direct mail, including the distribution of catalogs, remains one of the most effective ways of driving traffic to a website. Indeed, given the reluctance of some consumers to give out their e-mail addresses, and the protections afforded consumers from unwanted solicitation under anti-SPAM, Do-Not-Call and other consumer privacy laws, traditional “snail mail” marketing techniques remain an important way for Internet sellers to communicate directly with customers.

Although several larger states (including California, New York, and Pennsylvania) provide exemptions from tax for certain types of direct mail, the vast majority of jurisdictions treat direct mail as taxable. And in all states, including those that provide exemptions, there are myriad other complex legal issues affecting taxability, including sourcing rules, taxability of postage, “direct mail” certificates, and nexus considerations, each of which make determining the proper sales tax treatment of direct mail transactions challenging. Add the fact that mailings go to recipients in many, if not all 50 states (and countless localities), each of which has its own tax law, and the difficulty of properly applying tax to any particular direct mail transaction multiplies exponentially.

Perhaps due to this complexity, states historically did not aggressively pursue audits or assessments on direct mail.  But, those days are gone. In recent years, states and localities have begun focusing more and more on sales and use tax application to direct mail, in part due to attention given the issue by the Streamlined Sales and Use Tax Agreement (“SSUTA”). Although it takes no position on whether direct mail should be subject to tax, the SSUTA project raised the issue’s profile by adopting provisions addressing the sourcing of direct mail transactions. Those provisions were amended in late 2009 to separate the treatment of “advertising and promotional direct mail” from other types of direct mail, such as invoices, notices, etc. But, the provisions do nothing to minimize (and, coupled with other provisions in the SSUTA, arguably aggravate) the complexity of taxation of direct mail.

In the last two years, many of the more aggressive states, particularly non-SSUTA states, began to put pressure on large printers and letter shops to collect the use tax on their sales of direct mail pieces, even on sales to clients that lacked any presence in the state. Internet and direct marketers began to receive unwelcome notices from their printers that they would have to pay tax on large print contracts, adding 7-10% to the already high cost of doing business for direct marketers

Given budgetary problems in states throughout the nation, revenue departments will likely continue to look for ways to boost tax collections from direct mail transactions. Direct marketers need to be aware of this issue prior to entering into any negotiation over print and other direct mail contracts; direct mail firms should understand their potential tax obligations and recognize that they may be able to take steps to minimize their tax exposure and thereby offer more competitive fees to their clients.