Sales Tax Strategies During the Economic Disruption of the COVID-19 Outbreak

As we all hunker down or at least change our daily routines to include working from home and social distancing amidst the COVID-19 outbreak, the economy struggles to adapt to the acute and devastating change in business and consumer spending.  While the U.S. and global economy is dynamic and will undoubtedly adapt and recover from the impact, for purposes of this discussion, we reference the impact that recessions have on state tax revenue collections and what states have done to address reduced tax revenue.  We then consider the proactive measures companies should be taking now to enhance sales tax compliance processes and minimize risk and liabilities.   

the effect of a recession on state tax collections, therefore, often translates into one or more of the following policy alternatives: 1) Raise the tax rate, 2) Change the tax base, 3) Seek additional funding sources

According to the July 1993 US Census Bureau’s Statistical Brief, Recessions Matter for State Tax Collections, sales tax accounts for the largest portion of state tax revenue collections.  According to the Bureau, “[t]he 1990-1991 recession was particularly challenging for State government finances.  For fiscal 1991, States experienced only a 3.3 percent rate of tax growth – the smallest rate of increase since ... the 1957-58 recession.”  The report goes on to note that “[r]ecessions are events with ‘big time’ consequences for State tax growth rates and revenue totals through their effects on retail sales and personal income.”   The 1990-91 recession was also marked by a lack of inflation, which meant lower prices and even less sales tax collections on retail sales.  This makes sense, as consumer spending and retail sales fall, and prices drop (rather than rise), sales tax remittances plummet.

The report concludes that “[t]he effect of a recession on state tax collections, therefore, often translates into one or more of the following policy alternatives”:

1. Raise the tax rate
2. Change the tax base
3. Seek additional funding sources

While the first alternative is typically politically unattractive – as legislators do not prefer to raise taxes on constituents – the latter two alternatives are typically employed, and often in tandem.  We address each of these latter two in turn:

Change the Tax Base

After the most recent recession began in October 2008, states experienced a tax revenue decline of eleven percent (11%), the largest decline in the post World War II era.  The states responded by a combination of these alternatives, the most notable of these efforts targeting Amazon and online retailers via “click-through” and affiliate nexus provisions.  In addition, New York and North Carolina specifically enacted legislation imposing sales tax on goods purchased over the Internet, and Tennessee extended the sales tax to include software maintenance contracts and limited a sales tax exemption on computer software.  Vermont extended the sales tax to digital downloads and Wisconsin entered the multi-state Streamlined Sales and Use Tax Agreement (SSUTA) — a compact that simplifies sales tax collections for participating businesses.

Even in the absence of new tax legislation expanding the sales tax base, state tax administrators are tasked with expanding the interpretation of existing tax codes to expand the types of products and services subject to sales tax and minimize exemptions.  This can be done formally through the administrative rule-making process or - more often – informally through policy and enforcement.  For example, a state taxing authority that historically imposes sales tax on electronically delivered software, but not Software As a Service (SAaS), can redefine its position to impose sales tax on SAaS by expanding its interpretation of electronic delivery to include remote access.

As more people remain “sheltered in place” during the COVID-19 pandemic, online gaming and cloud-based service activities are surging to all-time highs.

Seek Additional Funding Sources

The most politically amiable approach to raising sales tax revenues is to target out of state taxpayers, as they are not voting constituents.  State tax administrators can hire more sales tax auditors and guarantee multiples in increased tax revenues, through audits if in-state taxpayers, in which they focus on their purchases from out-of-state (or remote) and unregistered sellers who put “feet on the ground” in the state through installations, repairs, maintenance, training and support.  State tax audit and nexus teams will send nexus questionnaires, demand notices to file tax returns and audit notices to these out-of-state and unregistered sellers.  The prominent incentive of these measures is to increase sales tax revenues by increasing the number of compliant taxpayers. 

In the wake of the U.S. Supreme Court’s decision in South Dakota v. Wayfair, which eliminate the requirement of physical presence nexus before a remote seller must register to collect sales tax, all but two states are enforcing economic nexus thresholds.  We can certainly expect states to more aggressively pursue physical presence nexus, even before such economic nexus thresholds are crossed.  Just look at Massachusetts’ “cookie nexus” provision, which establishes that physical presence is created by the bits of information online sellers store on their Massachusetts customer’s computers.  The Wayfair Court left this opportunity open by extending that nexus may be established by “economic and virtual contacts”.

Maryland passed HB 932 (now on Governor Hogan’s desk), which imposes sales tax on digital products delivered electronically, including video/ electronic games. 

While it is normal to want to hunker down and protect during a recession or period od economic downturn, one of the primary means that a business can protect itself is to minimize risk by taking stock of its multistate sales tax nexus footprint and compliance protocol.  Now is the time to work with your sales tax experts to identify multistate nexus, develop a taxability matrix of your products and services, register for and automate sales tax compliance where appropriate, and seek opportunities to minimize audit risk relating to your contracts, invoices and website ... your audit trail.  Taking these proactive measures will: 

• minimize tax liabilities, and compliance costs,
• centralize and increase internal efficiencies related to the compliance process, as fewer resources will need to be committed to the compliance and audit process, and
• demonstrate to taxing authorities that the Company has proactively taken the steps expected of a reasonable person in regards to their sales & use tax obligations.