California’s reinterpretation of an existing federal law may trap many businesses that have sold remotely into the state.
“What California has done is to reevaluate their interpretation of a decades-old law that was written to limit states’ authority over businesses that were doing nothing more than solicit sales,” explained Scott Peterson, vice president of U.S. tax policy and government relations at Avalara. ”This will add tens of thousands of out-of-state sellers to California’s income tax rolls.”
Public Law 86-272, also known as the Interstate Income Act of 1959, prohibits a state from imposing a net income tax on the income of a person “derived within the state from interstate commerce if the only business activities within the state are the solicitation of orders for sales of tangible personal property, provided that the orders are sent outside the state for acceptance or rejection, and, if accepted, are filled by shipment or delivery from a point outside the state.”
“The message from California to sellers is, ‘Some things you’re doing in our state now are more than just soliciting sales, so P.L. 86-272 protection doesn’t apply to you,'” Peterson warned. “Those things are so commonly used by online retailers that it is likely that anyone that does sell into California will be impacted.”
The decision to retroactively apply corporate income tax obligations to out-of-state ecommerce sellers is going to give ammunition to those who oppose the Wayfair Supreme Court ruling, he said: “No one argues that the state has an interest in interpreting Public Law 86-272, but doing so retroactively imposes an unexpected tax compliance burden already imposed on businesses — especially small businesses. It is likely that opponents of the Wayfair decision will use this as the latest example of complexity negatively impacting small businesses in their arguments against remote tax legislation. And, because California is the first state to take this step, it’s likely that other states will feel empowered to follow a similar path. If others follow suit, the struggle between advocates and opponents of remote tax laws will continue to grow.”
The Wayfair decision has incentivized the transition to a more sales-based approach to corporate income tax, according to Peterson. “When they modified their tax to conform to Wayfair, they made the thresholds for remote sellers the same for both sales tax nexus and income tax nexus,” he said.
A remote seller that stores property in a warehouse in California, such as an Amazon warehouse, already has physical presence, remarked Peterson: “In this case, the seller would be subject to both sales tax and corporate income tax. But for sellers that have no such presence, many will be unaware of their income tax liability.”
Legal opposition to the tax will likely assert that California has misinterpreted the statute, according to Peterson.
“There will likely be constitutional challenges, but first will be an assertion that California’s reading of the law is wrong,” he said. “If the courts say that California has interpreted the statute correctly they’ll have to decide whether to challenge its constitutionality.”
“A cautious attorney would advise a client that meets the threshold to complete the return, file it and pay any taxes owed under protest,” Peterson said. “If California loses the legal challenge, the taxpayer gets their money back, but if California wins, they have their back covered.”
“The corporate income tax return is not simple,” he observed. “The taxpayer has to show net income. Some businesses will go through the exercise but owe no tax, yet they still have to go through the administrative burden of completing returns — it’s an annual return, but it’s onerous.”
As of yet, the question as to retroactive application has not been officially addressed. However, reliable sources say that California intends to apply their new interpretation retroactively, according to Nikki Dobay, a partner at law firm Eversheds-Sutherland. “We can’t say specifically how that will play out. Their rationale for applying it retroactively is that P.L. 86-272 didn’t change — it’s been on the books for years.”
