The California Office of Tax Appeals (OTA) reversed the Franchise Tax Board’s (FTB) determination that an out-of-state limited liability company (LLC) had taxable nexus with California solely because it held an ownership interest in an LLC operating in the state that ranged from 1.12% to 4.75%. California imposes an annual $800 tax on LLCs “doing business” in the state, with “doing business” defined by statute to mean “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” Cal. Rev. & Tax. Code § 23101(a). Relying on a Court of Appeal decision which held an out-of-state corporation with a 0.2% ownership interest in a California LLC investment fund was not “doing business” under the same definition, the FTB argued “0.2% is deemed to be the threshold between actively doing business and passively doing business” and because the out-of-state member’s interest in the LLC doing business in California was “well beyond the 0.2% … limit,” it too was doing business in the state. The OTA rejected the FTB’s “bright line” test and instead engaged in a more thorough inquiry of the relationship between the out-of-state member and the in-state LLC. The OTA concluded the out-of-state LLC did not have any ability or authority to influence or participate in the management or operation of the LLC doing business in the state based on such facts as: the LLC doing business in California was manager-managed; the out-of-state company had no power to manage the LLC or bind or act on its behalf in any way, and the out-of-state company had no interest in any specific property in the LLC. Accordingly, the OTA held the out-of-state LLC was not “doing business” in California.

Appeal of Jali, LLC, OTA Case No. 18073414 (July 8, 2019) (pending precedential).

The Eversheds Sutherland SALT Team is always excited to see what kind of pets our clients and friends have. Our team features a different pet at the end of every month, and we want to feature YOURS! Featured pets will receive a fun prize from the SALT Team. The deadline for September submissions is Friday, September 27.

To submit your pet to be featured, visit the Eversheds Sutherland SALT Shaker App, click “Pet of the Month” in the drop-down, then click “Submit A Pet.”

Don’t have the app? It is available for download in the Apple App StoreGoogle Play and the Amazon Appstore.

The Texas Comptroller adopted a proposed decision issued by an Administrative Law Judge (ALJ) finding that a company owed sales tax on its sales of online gaming services to Texas residents. The company, who had at least one employee in Texas, developed and maintained online interactive social gaming experiences for its registered users, including those allowing for the adoption of virtual pets. The ALJ determined that the company had sufficient nexus with the state and that the company provided taxable amusement services in Texas because in-state residents used its website services. The ALJ rejected the company’s argument that its services were provided at its out-of-state headquarters, and not where the Texas residents used the service. Instead, the ALJ ruled that an electronic game amusement service transaction “is consummated where the amusement service is provided or delivered, not at the seller’s place of business,” and that the company provided taxable amusement services in Texas.

Petitioner v. Texas Comptroller of Public Accounts, SOAH Docket No. 04-19-3723.26 (July 19, 2019)

The court held that the taxpayer, a freight broker, could deduct freight and delivery charges, which it received from its customers and remitted to third-party delivery providers, from gross receipts before calculating a city’s business privilege tax. A local regulation provides an exemption for freight delivery or transportation charges “paid by the seller for the purchaser.” The court rejected the city’s argument that the freight broker was not a “seller” eligible for the exemption, because the broker only procured services, but did not sell goods. Instead, the court held that the term “seller” could be read broadly to encompass the freight broker’s activities. The court noted that the exemption regulation was ambiguous and construed it in favor of the taxpayer. S&H Transport, Inc. v. City of York, 210 A.3d 1028 (2019)

The California Department of Tax and Fee Administration (“CDTFA”) issued two new special notices addressing marketplace facilitators and its new registration and filing requirements effective October 1, 2019.

In Special Notice L-694, the CTDFA reiterated that effective October 1, 2019, a marketplace facilitator is generally required to pay sales tax or collect and pay use tax on all retail sales by marketplace sellers to California customers facilitated through its marketplace. It was also noted that the new requirements are in addition to any other sales or use tax liabilities a marketplace facilitator is responsible for reporting and paying on retail sales of its own tangible property through its marketplace.

More importantly, Special Notice L-694 stated that if a marketplace facilitator is responsible for tax on retail sales in California facilitated its marketplace, the marketplace seller is no longer liable for the tax on those transactions. The marketplace facilitator should notify all of the marketplace sellers that it is registered with the CDTFA and will be collecting and paying the tax due on marketplace sellers’ sales to California customers facilitated through the marketplace beginning October 1, 2019.

In Special Notice L-700, the CDTFA also noted that marketplace sellers are not responsible for reporting and paying sales and use tax to the CDTFA on retail sales of tangible merchandise facilitated through a marketplace facilitator that is registered or required to be registered with the CDTFA as a retailer. Therefore, a marketplace seller that sells through a marketplace facilitator that is registered and collecting California sales tax does not have to report these sales to CDTFA.

Next Monday: Sourcing of Marketplace Sales

The quarterly Eversheds Sutherland SALT Scoreboard tallies significant state and local tax litigation wins and losses. In this Bottom Line videocast, Eversheds Sutherland attorneys Charles Capouet and Justin Brown discuss the results from the first two quarters of 2019, including:

  • how taxpayers have fared in litigation in the first two quarters of 2019 compared to 2016, 2017 and 2018
  • three of the main cases from the second quarter of 2019: North Carolina Department of Revenue v. Kimberley Rice Kaestner, Franchise Tax Board of California v. Hyatt, and Department of Revenue v. Agilent Technologies, Inc.
  • the recent Cook County Circuit Court decision, Mercury Sightseeing Boats, Inc. v. County of Cook, in which the court determined that the Department of Revenue violated the taxpayer’s procedural due process rights.

Check out our videocast here.

Consistent with a prior decision of a sister appellate court, Texas’ Texarkana Court of Appeals held that the sale of telecommunication products and signals constitutes the sale of a service for purposes of Texas’ franchise tax. The taxpayer sold electrical, light and radio signals to customers through copper wire, fiber-optic cable and leased telephone lines. At trial and on appeal, the taxpayer argued it sold tangible personal property because the signals were perceptible to the senses and, because it sold tangible personal property, it was entitled to a deduction for costs of goods sold from its taxable margin. The taxpayer also argued that although it sold signals, it did not provide a telecommunications service because it did not have the infrastructure to deliver, transmit, or convey the signals. Like the trial court before it, the Court of Appeals found these arguments unpersuasive, concluding first that leasing “the means by which it made its signals available to customers did not transform its business” to anything other than transmitting, conveying, or routing its signals to customers. The court also held it was “bound by the precedent” of a sister court, NTS Commc’ns, Inc. v. Hegar,1 which “already decided that provision of telecommunications products constitutes the provision of services, not goods.” Consequently, the taxpayer was not entitled to a costs of goods sold deduction.

Metro. Telecommunications Holding Co. v. Hegar, No. 06-19-00016-CV, 2019 WL 3938496 (Tex. App. Aug. 21, 2019).

1 NTS Commc’ns, Inc. v. Hegar, No. 03-16-00771-CV, 2018 WL 2728065, at 2, 4-5 (Tex. App. June 7, 2018).

The shift in tax collection responsibility to marketplace facilitators raises issues regarding which party will bear the burden of any additional sales tax liability resulting from a state audit of marketplace transactions. These issues include the extent to which marketplace facilitators can rely on information provided by marketplace sellers, and to what extent marketplace sellers remain subject to audit for transactions facilitated via a marketplace.

Audit Liability Relief for Marketplace Facilitators

Some states provide broad audit protection for marketplace facilitators where the failure to collect and remit the correct amount of tax is a result of incorrect or insufficient information provided by a marketplace seller, so long as the marketplace seller is not an affiliate of the marketplace facilitator. For example, Arkansas provides relief for marketplace facilitators who do not collect and remit the correct amount of tax “to the extent that the failure was due to incorrect or insufficient information given to the marketplace facilitator by the marketplace seller.” Ark. Code Ann. § 26-52-111(f). In Arkansas and similar states, where a marketplace facilitator seeks relief based on a marketplace seller’s provision of incorrect or insufficient information, the marketplace seller becomes subject to audit with respect to its marketplace sales. E.g., Ark. Code Ann. § 26-52-111(e)(2).

Exception – Liability for Sourcing Errors

A number of states exclude errors related to sourcing of transactions from their marketplace facilitator relief provisions. Indiana, for example, requires a marketplace facilitator to show to the department’s satisfaction that the failure to collect sales tax was not due to an error in sourcing the transaction in order to qualify for relief. Ind. Code § 6-2.5-9-3.5(b) (applicable to transactions occurring before Jan. 1, 2022). Similarly, Utah provides relief for marketplace facilitators where the failure to collect tax “was due to a good faith error other than an error in sourcing.” Utah Code Ann. § 59-12-107.6(7)(a)(iv). Massachusetts, on the other hand, expressly provides relief to marketplace facilitators from liability if the error is due to reasonable reliance on incorrect information provided by the marketplace seller or purchaser regarding the proper sourcing of an item or transaction, so long as the marketplace facilitator can show that it made a reasonable effort to obtain accurate information from the seller or purchaser. Mass. Gen. Laws ch. 64H, § 34(i).

Limitations on Relief for Marketplace Facilitators

Further, certain states provide for a cap on the amount of protection accorded to marketplace facilitators, limiting the amount of uncollected and unremitted taxes to a certain percentage of total sales or the total amount of tax that should have been collected. In Arizona for example, for calendar year 2019, relief for marketplace facilitators where the failure to pay the correct amount of tax is due to an error other than an error in sourcing, but not due to incorrect information provided by the marketplace seller, the amount of liability relief is limited to five percent of the total tax due on taxable sales facilitated by the marketplace facilitator on behalf of a marketplace seller and sourced to Arizona. Ariz. Rev. Stat. Ann. § 42-5043(A), (B). The amount of relief drops from five percent to three percent of total tax due for calendar year 2020, and for calendar years 2021 and later the relief provision is eliminated. Id. at (B).

Contractual Relief

Other states do not provide for similar broad relief for marketplace facilitators, but instead clarify that marketplace facilitators are free to contract with their marketplace sellers for the recovery of sales tax and any related interest or penalties to the extent that such tax is assessed by the state in an audit of the marketplace facilitator and where the marketplace facilitator has relied on incorrect or incomplete information provided by the marketplace seller. E.g., Utah Code Ann. § 59-12-107.6(6)(b). As a result, in states such as Utah, the contractual agreements between marketplace facilitators and their marketplace sellers will determine which party bears the risk of additional tax being assessed as a result of an audit.

Why this is important: State rules regarding audit liability and relief from liability will be significant for marketplace facilitators who have been forced to comply with state marketplace collection laws in over half of the states with limited time to implement procedures for collection, reporting and documentation. In order to take advantage of these provisions, it will be important for marketplace facilitators to carefully document: (1) information received from marketplace sellers regarding characterization of the product, and (2) sourcing determinations. Marketplace facilitators may also want to consider contractual indemnification provisions with their marketplace sellers. Marketplace facilitators may also want to consider more frequent state audits or self-audits in order to more timely understand any collection issues.

What to prepare for: Marketplace facilitators should review state marketplace collection laws to inform their potential exposure and defenses in case of an audit, to determine which aspects of accurately reporting and remitting sales tax to prioritize, and to determine the tax responsibility language to include in their contracts with marketplace sellers so as to minimize their potential exposure.

Next Monday: Sourcing of Marketplace Sales

In this post-Labor Day update, we wanted to highlight the following marketplace discussions to watch for this fall:

  • Northeastern States Tax Officials Association Annual Meeting September 9th through 12th in Providence, Rhode Island. There will be a panel discussion on what states are doing to tax online marketplaces.
  • Multistate Tax Commission (MTC) Marketplace Facilitator Work Group Teleconferences:
    • September 19th
    • October 3rd
  • Fall MTC Committee Meetings November 4th through 7th in San Antonio, Texas. It is expected that the Marketplace Facilitator Work Group will make recommendations for certain revisions to state tax marketplace collection laws.
  • California Marketplace Interested Parties Meeting expected in October regarding draft marketplace regulations.

Next Monday: Audits of Marketplace

Eversheds Sutherland’s newest SALT associate, Peter Hull, recently joined our New York office and brought along the latest addition to our SALT pet family, Luna.

An adorable, but sometimes troublesome, two-year-old golden retriever, Luna has a knack for mischief – including the time she became “that dog,” and ate Peter’s law school notebook at the end of the semester. Her hijinks don’t end there. Luna will often wait for Peter to leave home and jump on his bed to nap on his pillows. While she thinks she’s sly and can jump off the bed right when he gets home, the dog hair on the pillow is a clear giveaway.

If she’s not at home, you can generally find Luna at the dog park, where she is the life of the party. Always on the lookout for a mud pit to roll around in, Luna spends most of her mornings running around and playing with the other dogs, usually tiring herself out for the nap as mentioned above.

We’re pleased to welcome both Peter and Luna to the Eversheds Sutherland SALT family, and excited to feature Luna as our August pet of the month!