By: Matthew Dyment, Aftab Jamil, Eric Fader and Steve Oldroyd, BDO USA, LLP
This is the second part of the effects of Wayfair for business with multi-state operations. You can read Part I here.
A year later, the business world continues to pull at the thread of the Wayfair decision, unraveling its implications from income tax obligations and M&A repercussions, to financial reporting changes and new marketplace facilitator tax laws. As with most matters concerning taxes, these issues seem straight-forward but can be very complex.
It is important for business owners to understand how the Wayfair decision might alter their total tax liability. Some the less obvious but equally important effects of the Wayfair decision include:
State Income Tax Obligations Triggered
The tax implications of Wayfair extend beyond sales and use taxes. The Supreme Court held that an activity is subject to a state’s power to tax when “the taxpayer [or collector] ‘avails itself of the substantial privilege of carrying on business’ in that jurisdiction.” As such, Wayfair lifts the constitutional barriers to states imposing state income/franchise tax filing obligations on remote sellers, too.
Many businesses have been anticipating states will pass laws that codify not only their entitlement to sales taxes, but state income taxes, too. However, from the state income tax perspective, this generally has not happened. Most states already have a general nexus provision in their statutes that allows them to levy income taxes to the fullest extent allowed under the U.S. Constitution.
As a next step, states will likely clarify and/or enforce their preexisting laws. Massachusetts, for example, issued a proposed regulation indicating that if a remote seller’s sales volume exceeds the state’s sales tax safe harbor threshold, barring Public Law 86-272 immunity, the company will have an income tax filing obligation, too.
Rather than proactively preparing to address any income tax exposure, many companies are delaying action until they receive a notification from state taxing authorities that says they need to file income tax returns. For obvious reasons, this isn’t the best way to manage potential tax exposure. To determine whether you may be required to pay state income taxes, first look at the composition of your sales. Are you selling tangible property or a service?
If you are selling tangible property, then you may still be protected under a 1959 federal statute, Public Law 86-272, which prevents states from levying income tax on out-of-state companies if their activities within the state are limited to soliciting orders for the sale of tangible personal property and if the orders are approved and filled from outside the state.
However, if you are selling a service or tangible property that is installed by a company employee or contractor, these sales, by definition, contain a service element, which precludes Public 86-272’s applicability, unless the unprotected activities are de minimus. Companies should also be aware of the possibility that while states may not seek to apply an economic nexus standard for sales and use taxes for periods prior to the June 2018 Wayfair decision, they may do so for other tax liabilities.
Financial Statement Obligations
Wayfair will also have an impact on financial accounting under GAAP, namely, Accounting Standards Codification (ASC) 450 for sales taxes and 740 for state income taxes.
ASC 450 outlines the accounting and disclosure requirements for loss contingencies. This GAAP rule provides that an estimated loss from a loss contingency must be accrued as a charge to income if both the amount of the loss can be reasonably estimated and if information indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements.
Under ASC 740, existing income tax positions must be reassessed at each balance sheet date to determine whether an income tax benefit should be recognized, or continue to be recognized and, if so, how much of the benefit should be recognized based on new information. Depending on a corporation’s specific situation, an analysis should be performed to determine if state income tax exposure exists in non-filing states due to economic nexus or factor presence rules. Given that a company may have taken a historic position in reliance on constitutional arguments that a physical presence was required before a state may impose an income tax, this position will now need to be re-evaluated in light of Wayfair.
For example, in a July 13, 2018, announcement, Wells Fargo disclosed a $481 million income tax expense mostly related to state income taxes and the Wayfair decision. Overall, companies should be prepared to justify their financial reporting decisions (both sales tax and income tax) to their external auditors, taking into account the Wayfair decision.
Full Impacts on M&A To Be Seen in 2020
Because Wayfair was decided in June 2018, its impact on deal making won’t be fully understood until after 2019 and beyond as potential buyers evaluate the consequences of Wayfair on financial metrics and potential contingencies.
For instance, deals involving foreign buyers may be delayed as these entities seek to understand how remote sales tax collection might affect their business. For foreign companies, Wayfair proves a bit of a paradox: On the one hand, they may see the benefit in striking a deal with a U.S.-based company that has a better grasp on the sales and use tax system, but on the other, the complexities around Wayfair and the amount of education required to understand the U.S. sales tax system may prove too intimidating for a prospect to tackle, even with a U.S. deal partner.
Of course, the nature of being a U.S. domestic company doesn’t mean being automatically endowed with all the knowledge required to be in compliance with Wayfair. Given the potential complexity, even companies with knowledge of their sales and use tax requirements may not be able to easily comply with their obligations.
Take, for example, a U.S. company being acquired by a private equity firm. Though the company had implemented a robust sales tax determination engine for the 35 states into which it made sales, it hadn’t employed subject matter experts to verify whether its products were correctly mapped to the proper code for the purpose of determining whether sales were subject to tax in a given state. Incorrect mapping resulted in a material historical sales tax liability prior to the acquisition, necessitating pre-close clean-up and precious time spent before the deal was closed.
If you are considering a sale and believe you may have uncollected sales and use tax exposure in a state, there are paths to remediation. To avoid a liability and payment of interest and significant penalties for failure to file, companies should engage a professional service firm to anonymously reach out to states with material exposure amounts by participation in a VDA, whereby the company acquiesces to payment of the historical liability while having the benefit of a limited lookback period (often three years) and a penalty waiver.
Some companies have chosen to file on a prospective basis, thereby ignoring the historical nexus and related exposure. This has resulted in sales tax assessments for prior years, by preventing their ability to negotiate a limited lookback period, since most voluntary disclosure programs are not available for a current registered taxpayer. For companies that have been making sales for seven, eight, or more years, this means their liability (and interest and penalty payments) may double or triple what they would otherwise have been required to pay had they qualified to enter into a VDA with the ability to take advantage of a limited lookback period.
The complexities and far-reaching effects of the Wayfair decision cannot be understated. Sales and use tax exposure is just the tip of the iceberg. From tangible goods to services, and state income/franchise tax to financial reporting, Wayfair has unleashed a formidable amount of change to the most basic tax operations of your business. Contact us today for more information and guidance.