United States: Above-The-Line Considerations For Your Company

States and localities are continuing to experiment with different above-the-line tax systems, nonuniform methods of taxing similar items and taxes on out-of-state entities that have relationships with in-state contacts. San Francisco has decided to revamp its local tax regime by switching from a payroll to a gross receipts base. More generally, an issue of multistate importance has developed over the taxation of software as a service (SaaS). Finally, states have enacted click-through and affiliate nexus legislation, which has become the most pervasive trend in sales and use taxation over the past several years. Knowledge of these developments will allow multistate businesses to consider potential new filing obligations and adjust their software systems to support compliance.

San Francisco's shift from a payroll tax to a gross receipts tax

While the California corporate income tax garners substantial attention from taxpayers doing business in California, cities in the state, such as Los Angeles and San Francisco, also impose entity-level taxes on businesses. It may be tougher to comply with these local business taxes than you imagine, requiring analysis of numerous variables, including industry classification, payroll size, gross receipts and apportionment rules for in-city and out-of-city activities.

In San Francisco, a change in the way the city measures its entity-level tax on businesses is about to occur. Currently, the San Francisco gross receipts tax (SFGRT), despite its name, is actually based on a taxpayer's payroll, not gross receipts. The SFGRT is imposed on companies doing business in San Francisco whose payrolls exceed $250,000 annually. The SFGRT is computed as 1.5% of the taxable payroll expense, which includes all compensation paid to individuals for services performed in San Francisco. However, effective Jan. 1, 2014, San Francisco will begin a five-year phase-out of the SFGRT in conjunction with a phase-in of the San Francisco business tax (SFBT). The SFBT will be measured by a taxpayer's gross receipts from business activities attributable to San Francisco in excess of $1 million. Businesses with gross receipts in San Francisco for the preceding tax year of $1 million or less will be exempt from the SFBT but subject to higher annual business registration fees. Certain taxpayers will see their San Francisco tax liability substantially change as a result of the shift in tax base from payroll (as required by the SFGRT) to gross receipts (as required by the SFBT). Companies must understand how the SFBT will work to take steps to mitigate potential San Francisco tax increases before the actual shift in the measurement of the city's business tax base from payroll to gross receipts.

Multistate sales tax treatment of SaaS

For revenues from the sales tax to consistently grow from year to year, the sales tax base likely will have to expand from taxing tangible personal property with a selected group of services, to a broader tax base that accounts for newly created products of the digital economy. These include SaaS, cloud computing and technical support activities. The sales tax base has started expanding through new legislation and regulatory or administrative clarifications or case law interpretation of existing legislation. So far, however, the legislation and other SaaS-related guidance released by states has been contradictory and often vague, making it difficult to determine whether SaaS transactions will be taxed in a particular jurisdiction and, if so, how such sales will be sourced.

States are considering the threshold question of whether the sale of SaaS is subject to the sales tax base. States need to determine whether to characterize the sale of SaaS as the sale of a software license, the sale of an information service, the sale of database access or another enumerated item that is classified as either taxable or exempt. In doing so, states often conclude that the sale of SaaS is the sale of tangible personal property, the sale of a service, the sale of an intangible or a mixed transaction. If the transaction is considered to be mixed, states typically follow either a "true object" or "incidental to services" approach. States that follow the true-object test should determine the identity of the true object — the software provided or the data processing involved in the provision of SaaS. This determination will affect whether SaaS is taxable in these jurisdictions. Other states follow an incidental-to-services test that classifies items like SaaS as a taxable or an exempt service, with incidental amounts of tangible personal property being provided. The complex nature of many SaaS arrangements, which often include the provision of additional tangible personal property that may be taxable,makes it wise to require an itemized bill showing taxable and nontaxable components.

If the transaction is considered taxable, the second issue is whether the sale is sourced to that state. Again, guidance is not entirely clear or uniform. States are taking varied approaches, often looking to the location of (i) the seller, (ii) the user of the SaaS or (iii) the server. To the extent states tax SaaS according to where the end customer is using the SaaS, companies will need to be able to accurately track that location. Given that much of this guidance is included in state tax authority letter rulings and other publications that are not regulations, the positions may be narrowly tailored to the taxpayer requesting such guidance. A regulation promulgated later could provide a completely different result on both the taxability and sourcing questions.

Click-through and affiliate nexus

Current law requires remote (out-of-state) sellers to collect and remit sales tax in only the limited number of states where the sellers have created some form of physical presence. Click-through nexus legislation typically establishes nexus or a presumption of nexus when a remote seller pays a commission to an in-state resident for referrals that result in a certain threshold of sales to in-state customers. Affiliate nexus legislation typically establishes nexus or a presumption of nexus when the remote seller's in-state affiliate performs certain activities that benefit the remote seller.

Since 2008, numerous states have followed New York's lead and enacted or implemented click-through nexus rules, including Arkansas, California, Connecticut, Georgia, Illinois, Kansas, Maine (effective Oct. 9, 2013), Minnesota, Missouri (effective Aug. 28, 2013), North Carolina, Pennsylvania, Rhode Island and Vermont. For Vermont, the legislation goes into effect if and when 15 or more other states have enacted similar legislation. The states that have enacted affiliate nexus legislation or implemented affiliate nexus rules are Arkansas, California, Colorado, Georgia, Illinois, Iowa, Kansas, Maine (effective Oct. 9, 2013), Missouri (effective Aug. 28, 2013), New York, Oklahoma, Pennsylvania, South Carolina, South Dakota, Tennessee, Texas, Utah, Virginia (effective Sept. 1, 2013) and West Virginia (effective Jan. 1, 2014).

In addition, pending federal legislation deals with the remote seller issue and is designed to impose collection and remittance responsibilities on remote sellers. On May 6, 2013, the U.S. Senate passed the Marketplace Fairness Act of 2013 (MFA), which would allow states to require remote sellers to collect and remit sales and use tax on sales to in-state residents even if the retailer has no physical presence in the state. Under the MFA, a member state of the Streamlined Sales and Use Tax Agreement (SSUTA) could require the collection of tax beginning 180 days after it publishes notice of its intent to exercise its authority (but no earlier than the first day of the calendar quarter that is at least 180 days after the legislation is enacted).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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