On June 21, 2018, the U.S. Supreme Court issued its decision in South Dakota v. Wayfair, Inc., et al,1 overturning the sales tax physical presence nexus standard established under Quill Corp. v. North Dakota,2 and opening the door for the states to require remote sellers to collect and remit sales tax based solely on a seller’s economic contacts with the state’s market. Not surprisingly, this outcome is being hailed as the ultimate equalizer between Main Street and E Street, and a panacea for the states’ revenue problems. But, is it? Given the U.S. model for state tax enforcement, the near-global application of the revenue rule, and the portability of many E businesses, there is a strong possibility that the answer is “no,” and that the ultimate impact of the Wayfair decision will be to trigger the flight of U.S. E businesses, particularly those on the cutting edge and with the highest growth potential.
The U.S. model for state sales tax enforcement and Wayfair
In general, the U.S. model for state sales tax enforcement in relation to remote sellers is fairly straightforward. When a remote seller has nexus with a state, the state can require the remote seller to collect sales tax from its in-state customers and remit the tax collected. If the remote seller fails to properly collect and remit the tax due and declines to respond to audit notices, the state can issue a jeopardy assessment, and sue the remote seller in state court seeking a tax judgment. Assuming the state wins the tax judgment and the remote seller has no in-state property to take an enforcement action against, the taxing state can sue the remote seller in its state of legal and/or commercial domicile for enforcement, and, pursuant to the Full Faith and Credit Clause of the U.S. Constitution,3 the court in the secondary forum state is required to enforce the prior tax judgment of the taxing state.4
In this chain of events, the lynchpin for whether collection and remittance of the sales tax is the responsibility of the remote seller is whether the seller has nexus with the taxing state. No nexus. No Full Faith and Credit. No sales tax. And, under Quill, nexus meant having a physical presence in the taxing state; a standard that most remote sellers, particularly E retailers and sellers of digital goods and services, could mitigate with a minimum amount of planning and due care. Advantage, E Street. Disadvantage, Main Street and state revenue collection.
With the Wayfair decision, the U.S. Supreme Court turned this calculus on its head. Now, a state can assert sales tax jurisdiction over a remote seller that has engaged in substantial economic activities directed at the state’s market, such as having a more than de minimis number of in-state customers or revenue derived from in-state transactions. Physical presence is no longer necessary. Accordingly, in the post-Wayfair world, unless we’re talking about a very small seller, remote sellers will have to collect and remit sales tax to the same extent as local sellers. Main Street and E Street live happily ever after in perfect harmony and state revenue shortfalls are cured forever, right?
Not so fast, there’s still the revenue rule
Unfortunately, while the enforcement calculus discussed above applies to U.S.-based remote sellers, foreign-based remote sellers might have nexus but still won’t have to collect and remit state sales tax. This disparity is due to the problem that on the international stage the prevailing approach to transnational tax enforcement is quid pro quo, and the long-standing controlling principle is that “no country ever takes notice of the revenue law of another.”5 What this means is that, as a rule of thumb, no foreign court will enforce a state sales tax judgment, particularly against the foreign country’s domiciliaries, unless the foreign country’s tax imposition decisions would be enforced by that state. Where lies the United States and the various states on the spectrum of tax enforcement reciprocity? It’s not a good answer for the states.
To start with, while the Full Faith and Credit Clause requires the courts in one state to enforce the tax imposition decisions of another state, it does not apply to the judgments of foreign courts.6 Instead, the generally applicable rule in the United States, commonly called the revenue rule, mandates exactly the opposite result, and, pursuant to the U.S. Supreme Court decision in Pasquantino v. United States, U.S. courts are actually prohibited from enforcing the tax judgments of foreign courts, except where otherwise allowed by the law.7 And, other than in certain types of criminal cases, both federal and state law have nearly uniformly acted to perpetuate the revenue rule rather than provide exceptions to it.
From a federal standpoint, the U.S. model tax treaty does not include any provisions allowing the enforcement of foreign tax judgments in U.S. Courts.8 And, while five of the currently active U.S.-foreign tax treaties require tax judgment enforcement reciprocity,9 none apply to state and local taxes.10 Similarly, although the United States is a signatory to the OECD Convention on Mutual Administrative Assistance in Tax Matters, it specifically does not participate in the reciprocal tax collection provisions, which would have superseded the revenue rule.11
The federal approach to foreign tax judgment enforcement has largely been mirrored at the state level. From a model statute perspective, both the Uniform Foreign Money-Judgments Recognition Act (UFMJRA) and the Uniform Foreign-Country Money Judgments Recognition Act (UFCMJRA) provide that foreign money judgments are generally enforceable in state courts, with the explicit exception of tax judgments.12 To date, approximately two thirds of the states, as well as the District of Columbia, have adopted variations on either the UFMJRA or the UFCMJRA. The remaining states have adopted the American Law Institute’s Restatement (Third) of Foreign Relations Law, which provides that the enforcement of foreign tax judgments is allowed but not required.13 However, the application of this more permissive approach is questionable following the Pasquantino decision.
Taken altogether, U.S. courts are unlikely to enforce the tax judgments of foreign courts, and foreign courts are highly likely to respond in kind. Accordingly, in relation to the sales tax landscape post-Wayfair, foreign-based remote sellers may have nexus with a state based upon their purely economic activity directed at the state’s market, but, in practice, the imposition of a sales tax collection and remittance responsibility on those sellers may be unenforceable. This enforcement issue yields a completely different calculus for foreign-based remote sellers than is applicable to U.S.-based remote sellers. Nexus? So what? Not my problem.
The potential for E flight
As a result of this toxic combination of the model for U.S. enforcement of state tax judgments and the application of the revenue rule, foreign-based remote sellers will continue to enjoy an advantaged status post-Wayfair. To begin with, foreign-based remote sellers will not have to incur the not-insignificant expense of the people, processes, and software necessary to comply with the sales tax laws of the approximately 10,000 state and local sales tax jurisdictions in the United States, many of which require separate returns and have their own characterization, taxability, and sourcing rules. Next, foreign-based remote sellers will continue to benefit from the misapprehension of consumers that the lack of a charge for state sales tax is a price discount.
These are the same advantages that U.S.-based remote sellers lost in order to equalize them for sales tax purposes with U.S. brick and mortar stores. Therefore, while there is essentially no long-term competitive issue for U.S.-based remote sellers vis a vis the U.S. market considering only domestic actors, there is a clear disadvantage in the global marketplace. How long can U.S.-based remote sellers survive the increased costs associated with implementing sales tax economic nexus, while being pressured by foreign businesses? That depends on the business model. For traditional large E retailers, the answer may be that it isn’t a real issue, as they continue focusing on using hyper fast shipping to drive a convenience shopping model that foreign-based remote sellers can’t match. However, for highly mobile, innovative businesses in the digital goods and services space, where physical plant is limited and delivery is instantaneous over the Internet, the answer may be to move out of the country. This represents a particularly difficult problem, as digital goods and services represent a rapidly growing portion of consumer spending, and carry a high potential for future disruption of traditional production and retail streams.
Can or should something be done?
While the risk of overall dissatisfaction with the results of the Wayfair decision is high because of the practical immunity of foreign-based remote sellers from the effect of the implementation of sales tax economic nexus, there is a significant question whether the issue and potential for E flight can be feasibly fixed. For example, Congress could legislatively overturn Wayfair by codifying the physical presence sales tax nexus standard, and restore the pre-Wayfair status quo. Alternatively, Congress could legislatively eliminate the revenue rule as applied to state and local transaction taxes. However, each of these solutions would require Congressional action, which has been historically hard to come by in relation to state taxes, and would come at a significant cost. Other potential solutions, such as authorizing U.S. Customs to require U.S. purchasers to pay use tax on packages coming from out-of-country if the foreign shipper indicates that sales tax has not been collected and remitted, are equally unpalatable or ineffective
However, a better question might be whether something should be done at all. The United States, after all, is still the United States, and the benefits of relocating overseas might not be attractive enough to drive behavior for other powerful business reasons. For example, access to U.S.-educated workforce, infrastructure, and capital may outweigh reduced compliance costs and the perception of consumer-friendly pricing. Additionally, while the states may not be able to enforce the requirement to collect and remit sales tax on foreign-based sellers, the tax liability does exist and continues to accrue, transaction after transaction, plus penalties and interest. This accrued liability may present significant financial statement issues, and could represent an insurmountable roadblock if the foreign-based seller ever wishes to attract a U.S.-based purchaser or open a U.S. location. These issues are not small things and would potentially discourage relocation out of the United States in the first place.
Clearly, only time will tell. However, before the Wayfair decision, the E flight question did not exist. Instead, the focus was on slowing the downturn in bricks and mortar retail. This shift in the nature of the issue and what it means for the United States as a player in the future of the digital economy as an innovator rather than just a consumer should not be ignored.
