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Only You (and Your Department of Revenue) Know For Sure: State Notice and Reporting Laws Create New Issues for Direct Markets

08.12.2011

Background

If you shop (or sell) online or through a catalog, you know that sometimes sales tax is due on a purchase, and sometimes it is not. The reason: a decades-old determination by the United States Supreme Court that it is sometimes an “undue burden” on a retailer to collect sales tax from its customers and remit the tax to each customer’s home state. The “undue burden” exists because the retailer must keep track of the laws, rules, and regulations in 50 states. At present, there are more than 8,000 different taxing jurisdictions in the United States, comprised primarily of states, counties, and cities. Some states, counties, and cities do not charge a tax; others do, and the rates vary from jurisdiction to jurisdiction. To further complicate matters, states traditionally have not had uniform taxing structures. As a result, a sale that is taxable in New York City may not be taxable in Kansas at all.

The burden is deemed not to be “undue” if the retailer has a sufficient connection, or “nexus,” with the taxing state. The Supreme Court has traditionally found this nexus to exist when the retailer has a physical presence, in the form of property or persons, in the state. The reasoning is that in such instances the retailer has access to state-provided resources, such as roads to transport persons and property, and police and firefighters to protect them. In return, the state may ask for the collection and remittance of sales tax from in-state residents.

The last time the Supreme Court addressed sales tax nexus was in 1992, in a case involving catalog sales. In the subsequent 19 years, online shopping has emerged and exploded, but the application of the “physical presence” nexus test means that many of these sales are not taxed. Though estimates vary, it was commonly reported by news outlets in 2010 that the uncollected taxes from these transactions would have totaled $12 billion. Many state Departments of Revenue and state legislatures advocate abandoning the “physical presence” test in favor of a nexus standard that makes the retailer responsible for sales tax collection if it purposefully directs its activities at residents of the taxing state. Further, they argue that the “undue burden” no longer exists due to technological advances and efforts made by many states in the last ten years to simplify their tax structures. These states are aggressively passing legislation and taking actions designed to increase sales tax collection. Among the more controversial of the new measures are “reporting and notice” efforts designed to more directly reach the end user/consumer of the goods and services.

Reporting and Notice Requirements

Reporting and notice legislation requires retailers to notify their customers of their tax liability to the states, and in certain cases to report customer purchases to the states. The first reporting and notice statutes were passed in Colorado in 2010. H.B. 10-1193 imposed three notice and reporting requirements on out-of-state retailers who do not collect tax on sales to Colorado residents. First, the retailers were required to notify their Colorado customers that they (the customers) were obligated to pay use tax to Colorado on their purchases. (Note: use tax is the “flip side” of sales tax; customers who do not pay sales tax to the retailer are obligated under state law to pay the same amount, designated as a “use tax,” directly to the state. However, only a minority of consumers comply with these laws.) Secondly, the retailers were obligated to provide a report to their Colorado customers by January 31 of each year, detailing the customers’ purchases from that retailer in the previous calendar year and notifying each customer that the retailer was required to report the customer’s name and dollar amount of purchases to the Colorado Department of Revenue. Third, the retailers were obligated to provide a report to the Department of Revenue by March 1 of each year, setting forth the name, billing address, shipping address, and dollar amount of purchases for each Colorado customer for the previous calendar year.

The Direct Marketing Association, a trade association for online and catalog retailers (the “DMA”), immediately challenged H.B. 10-1193. The DMA argued that the legislation discriminated against out-of-state retailers, violated the right to privacy of Colorado residents, abridged the free speech of the retailers and their customers, exposed the confidential information of Colorado residents to risks of data security breaches, and deprived retailers of the value of their proprietary customer lists without compensation. In January 2011, a United States District Court judge in Colorado issued a preliminary injunction against the law, preventing its enforcement while the case was litigated. Colorado is reworking its statute in an effort to overcome the constitutional arguments. In the meantime, Oklahoma passed notice-only legislation during 2010, and South Dakota in 2011. California and Hawaii are actively considering notice and/or reporting statutes. (The Nebraska Department of Revenue has not announced any intention to follow suit at this time.) The Multi-State Tax Commission, an intergovernmental state tax agency that drafts model legislation for consideration by the various states, is working on a model notice and reporting statute.

Municipal efforts to collect such taxes are not necessarily being confined to legislation. During an audit of Amazon.com conducted during 2009 and 2010, the North Carolina Department of Revenue demanded that Amazon.com turn over “all information” related to purchases by North Carolina residents from 2003 to 2010. This information included names, addresses, and detailed information regarding the items purchased and the cost thereof. Amazon.com successfully challenged the request on, among other grounds, violation of the First Amendment and of a federal law requiring privacy measures to protect purchasers of video products. The Department indicated that it was only collecting this data in the event that it elected to allocate resources to use tax collection, and that it needed the information to accurately calculate Amazon.com’s sales tax liability. However, there is little doubt that this information would be examined, during or after the Amazon.com audit, to determine whether opportunities existed for additional revenue generation. This raises the question as to whether other retailers without Amazon.com’s deep pockets have already complied with similar requests, in North Carolina or elsewhere.

Considerations for Retailers and Purchasers

The notice and/or reporting efforts being undertaken by the various states place the online and catalog retailer in a dilemma: should it comply, and risk losing sales to competitors who choose not to comply (not to mention the loss of customer goodwill), or elect not to comply, and potentially be liable to the state for failing to do so? At a minimum, such retailers should educate themselves on the laws currently in place in Oklahoma and South Dakota, consult their tax advisors and trade associations regarding compliance with these laws, and monitor pending legislation and litigation in other states, such as Colorado. Likewise, online and catalog customers in these states should be aware that they are likely, at a minimum, to receive notices reminding them of their use tax liability. Further, their traditional expectations of privacy in their purchases may be in jeopardy, depending on whether the Colorado statute ultimately survives the challenges to its constitutionality and how many other states “jump on the bandwagon.”

For more information on the state activities profiled above or other recent state tax legislation, please contact Roberta Christensen in our Tax Practice Group.

By Roberta L. Christensen

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