State + Local Tax Insights: Winter 2013

Sales Tax Nexus Developments in California and Beyond: A Year in Review1

The battlelines have shifted once again in the disputes over sales tax nexus and we bring you this installment to cover the major developments in these issues over the past year. Our previous articles analyzed Amazon's and other online retailers' attempts to challenge the requirements for remote (largely Internet-based) sellers to collect the states' sales taxes.2 In our last installment, we reported on Amazon's efforts to take California's affiliate nexus law to the voters, which the company ultimately abandoned after reaching an agreement with the State to delay the effective date for one year, permitting Amazon time to lobby for federal legislation on the subject.3 Now, the one-year grace period has come and gone, federal legislation is still pending and California's new sales tax nexus statutes have gone into effect, as of September 15, 2012. In addition, Amazon is planning to build two large distribution centers in California and several in other states in order to shorten its shipping times.

In this article, we review the requirements of California's new law and analyze the proposed regulations recently issued by the State Board of Equalization ("SBE"), as well as bring you up to date on other sales tax nexus developments around the country. In addition, we provide an update on the status of pending federal legislation on this issue. Finally, we offer a few thoughts on the new direction this battle over sales tax nexus seems to be taking and the implications it might have for states and taxpayers.

California

California's statute, as amended last year, expands the definition of a "retailer engaged in business in this state" to include both: (i) any retailer that is a member of a commonly controlled group, of which another member "pursuant to an agreement with or in cooperation with the retailer, performs services in this state in connection with tangible personal property to be sold by the retailer;" and (ii) any retailer that has an affiliate in the state, that is, the retailer has entered into "an agreement or agreements under which a person or persons in this state, for a commission or other consideration, directly or indirectly refer[s] potential purchasers of tangible personal property to the retailer, whether by an Internet based link or an Internet Web site, or otherwise," if minimum thresholds are met for sales based on referrals from the agreement (i.e., $10,000) and for total sales by the retailer (i.e., $1 million).4 The statute expressly provides that advertising, whether on television, on radio, in print or on the Internet, does not trigger nexus, unless the compensation for the advertising service is by commissions based on the sale of tangible personal property.5 With respect to Internet advertisements, nexus is not triggered unless the person displaying the advertisement "also directly or indirectly solicits potential customers in this state through use of flyers, newsletters, telephone calls, electronic mail, blogs, microblogs, social networking sites, or other means of direct or indirect solicitation . . . ."6

The SBE's proposed regulations track the new statutory provisions, define a few key terms and provide examples that interpret the new statute in a manner that creates a safe harbor for certain types of Internet advertising relationships. First, the regulations expand on the term "commission or other consideration" by noting that this means any "consideration that is based upon completed sales of tangible personal property, whether referred to as a commission, fee for advertising services, or otherwise . . . ."7 Thus, "commission" does not, apparently, extend to fees paid to an advertiser based on the number of times viewers "click" on the advertisement or based on the number of times customers complete a sale through an affiliate referral.

Second, the regulations define "advertisement" as "a written, verbal, pictorial, graphic, etc. announcement of goods or services for sale, employing purchased space or time in print or electronic media, which is given to communicate such information to the general public."8 In addition, the regulations specifically address Internet advertising, noting that "[o]nline advertising generated as a result of generic algorithmic functions that is anonymous and passive in nature, such as ads tied to Internet search engines, banner ads, click-through ads, Cost Per Action ads, links to retailers' websites, and similar online advertising services, are advertisements and not solicitations."9 "Solicitation," on the other hand, is defined as "a direct or indirect communication to a specific person or specific persons done in a manner that is intended to and calculated to incite the person or persons to purchase tangible personal property from a specific retailer or retailers."10 In addition to these definitions, the SBE clarifies that much standard Internet advertising will not trigger nexus under the statute. For example, the proposed regulations specifically mention "Cost Per Action ads," which are advertisements for which the advertiser is paid a fee based on the number of specified actions by the viewer of the advertisement, e.g., clicks on the ad or sales made after clicking through the ad to the retailer's website. One could certainly interpret the SBE's definition of "solicitation" to extend to this type of advertisement. Indeed, if the "Cost Per Action" compensation arrangement were to trigger nexus under the statute, it would presumably bring much of the Internet advertising within the framework of affiliate nexus. However, the SBE is apparently not inclined to take that draconian approach and has, instead, created a safe harbor for a certain segment of the Internet advertising industry.

The regulations' examples confirm that the SBE does not consider click through advertisements paid based on commissions for sales to trigger nexus under the new statute. In one example, the regulations describe a remote seller that has an agreement with an in-state entity to place click-through advertisements or links on the in-state entity's website.11 The remote seller pays the in-state entity "commissions based upon the retailers' completed sales made to customers who click-through the ads or links . . . ."12 In addition, the in-state website posts reviews of the products sold by the remote-seller. However, the example notes that the in-state entity "does not engage in any solicitation activities in California that refer potential customers to the retailer . . . ."13 According to the example, nexus is not triggered for the remote seller by this relationship with the in-state website.14

In addition, the proposed regulations adopt New York's model for administration by specifying that a remote seller can establish that it does not have nexus based on its affiliate relationships by including certain terms in its contracts with in-state affiliates and obtaining an annual certification from those affiliates.15 In particular, the contract with the affiliate should prohibit the affiliate from "engaging in any solicitation activities in California that refer potential customers to the retailer including, but not limited to, distributing flyers, coupons, newsletters and other printed promotional materials or electronic equivalents, verbal soliciting (e.g., in-person referrals), initiating telephone calls, and sending e-mails . . . ."16 In addition, the affiliate's annual certification should provide that the affiliate has not engaged in any of the prohibited solicitation in California and must be signed under penalty of perjury.17 The retailer must accept the certification in good faith and have no "reason to know that the certification . . . [is] false or fraudulent."18

Assuming the proposed regulatory definitions of advertising and solicitation, along with the examples, are adopted, Internet sellers will be able to enter into contracts for quite a broad variety of online advertising without concern that those contracts will create nexus for the seller in California. This is consistent with our long standing view that basic advertising should not be enough contact with a state to trigger nexus.19 However, the California regulations take this a step further by expressly permitting online advertising with click-through ads that is compensated based on commissions for sales. We are encouraged by this indication that California apparently intends to adopt a measured approach in its new statutory definition of nexus.

We had previously noted our concern that California's new statute was broader in scope than other states, based on the fact that it bases nexus on agreements with any "persons" in the state, whereas other statutes are limited to agreements with "residents."20 Indeed, the SBE staff rejected requests made by interested parties during the rulemaking process to define "person" for this purpose as "an individual that is a California resident or a business legal entity that is commercially domiciled or headquartered in California."21 The SBE noted that "person" is broadly defined in the statute and that "an individual does not need to be a resident of California and a legal entity does not need to be headquartered or domiciled in California in order to perform services in this state."22

In addition, the proposed regulations specifically provide that the only activities of an affiliate that matter for the purpose of determining whether those activities create nexus for the remote seller are the activities that the affiliate undertakes in California.23 The SBE expressly noted that the affiliate nexus provisions apply only "when an individual solicits potential customers under the retailer's agreement while the individual is physically present within the boundaries of California . . . ."24 This resolves our concern that the statutory language could be construed more broadly to create...