Where States Will Turn for Revenue in Response to Declining Sales Tax Collections?

As I predicted in my March 25th post, Sales Tax Strategies During the Economic Disruption of the COVID-19 Outbreak, every state is revising its FY 2020 revenue forecasts in response to declining tax collections for March and April.  [https://www.ncsl.org/research/fiscal-policy/ coronavirus-covid-19-state-budget-updates-and-revenue-projections637208306.aspx ]  As reported by the National Conference for State Legislatures, some examples
of these shortfalls include:

• Florida:  Office of Economic & Demographic Research reported sales tax collection came in $12.4 million or .58% below monthly estimates.
• Illinois: Current fiscal year general fund revenues were revised to $2.7 billion below February estimates of $36.9 billion by the Governor's Office of Management and Budget (GOMB).
• Maryland: Comptroller Peter Franchot and the Bureau of Revenue Estimates outlined a shortfall of approximately $2.8 billion during the final quarter of FY 2020. The economic shutdown could also result in a loss of 59% of all sales tax revenue in a month, or almost $250 million.
• New York: In a letter to Governor Andrew Cuomo (D), State Comptroller Thomas DiNapoli estimated tax revenue would be between $4 billon and $7 billion below projections for fiscal year 2020. New York’s fiscal year ended on March 31.
• Pennsylvania: According to the Independent Fiscal Office (IFO), April revenue collections were down by $2.16 billion, or 49.8% less than projections released in August 2019. Sales and use tax collections fell short of estimates by $357.3, or 35.9%.
• Texas: Texas Comptroller Glenn Hegar reported April state sales tax revenue dropped by 9.3% from April 2019, the state's steepest decline since January 2010. Sales tax revenue accounts for 57% of all tax collections in Texas.

   “[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

Each states’ projected FY 2021 tax revenues were also adjusted downward, and these adjustment extend out for the next 4 years in most states.  For example, New York’s FY 2021 Enacted State Budget Financial Plan also estimates a $61 billion decline through FY 2024 as a consequences of COVID-19.

According to the July 1993 US Census Bureau’s Statistical Brief, Recessions Matter for State Tax Collections,  “[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.  In this article we explore state trends toward taxing digital and cloud-based products and services, and what taxpayers must do in response.

As an online gaming client recently confessed, as a result of people spending more time in their homes the past 2 months, the company has experiencing a doubling of revenues.  Certain industries that provide online shopping, gaming, entertainment, and online work facilities (for computing and communications) will continue to thrive during the current pandemic, and well after we have all been given the green light to safely resume human interactive experiences such as movies, pools and concerts.  This is due in large part because we will become accustomed to the use and convenience of these platforms, products and services.

As consumption shifts to cloud-based and digital goods and services, state revenue authorities will pivot to tax these services as well.

Digital Products and Services:  Currently, twenty-seven (27) states impose sales tax on some digital products, either classified as data processing, information, software, books, magazines, papers, cards, photos, apps, music, movies, other (e.g., video games, online courses, webinars, podcasts, ringtones, fonts).  Ten (10) of these states define and tax digital goods and seventeen (17) impose sales tax on some or all digital products, but in the absence of clear definition.  These states typically consider digital products and services to fall under the definition of tangible personal property, or a service that is already subject to taxation, such as communications, amusements, data processing or information services.

Software As a Service (SAaS) and Cloud-based Solutions:  Currently, seventeen (17) states impose sales tax on SAaS. These states typically consider SAaS to fall under the definition of tangible personal property (canned software), or a service that is already subject to taxation, such as data processing, information services or communications services.

As consumption shifts to cloud-based and digital goods and services, state revenue authorities will pivot to tax these services as well.  It is typically more efficient for states to simply expand their interpretation of existing tax code and rules to include new goods and services, than it is to ask the lawmakers to do so.  For example, the Maryland General Assembly recently passed legislation that would impose sales tax on nearly all digital goods and services (HB 932).  However, this legislation was vetoed by the governor and will only become effective upon 2/3 majority veto override vote in both chambers of the Assembly.  When taxing authorities simply expand their interpretation, it runs afoul of many of the basic tenets for sound tax policy, including transparency, no retroactivity, due process, equality, and simplicity.

For taxpayers, 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.

Furthermore, the most notable problems with imposing sales tax on digital and cloud-based products and services involve (1) the classification of products or services; (2) sourcing of sale to a jurisdiction, and; (3) bundled and mixed transactions.  Evidence of this can be seen in the recent decision of the Massachusetts Appellate Tax Board in J2 Cloud Servs., Inc. v. Comm’r of Revenue [No. C325426, 2019 Mass. Tax LEXIS 12 (Mass. App. Tax Bd. Feb. 27, 2019)]  The taxpayer’s service converts a traditional fax into a PDF file that is emailed to the recipient.  Though Massachusetts does not impose sales tax on data processing, information services, or digital goods and services, the Board found that the company’s eFax service constituted a telecommunications service inasmuch as “the critical component of the eFax service was transmission of messages or information”.  Likewise, the Texas Comptroller determined that a company’s subscription-based service in which it collected data from its customers (restaurants) and provided custom restaurant industry information to its customers, that allowed its customers to see specific data and competitive benchmarks, were both taxable data processing and taxable information services.  [Texas Comptroller, Decision No. 114,952 (September 5, 2019)]  In Texas, nontaxable information services include the sale of information that is gathered or compiled on behalf of a particular client that is of a proprietary nature to that client and may not be sold to others by the person who gathered or compiled the information.  See 34 Tex. Admin. Code § 3.342(a)(5).  There is no similar exclusion for data processing services.  As such, the sale of a service that involves both proprietary information services and data processing renders the entire transaction taxable.

State taxing authorities will begin and continue to aggressively audit and expand interpretation of their sales tax laws policies relating to digital and cloud-based products and services, in an effort to help bridge the budgetary gaps caused by declining tax revenues, and in recognition of the fact that we now live in a remotely accessible, digital world.

For taxpayers, 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.