Sales tax exposures in tech business acquisitions

Many target technology businesses that have grown rapidly but are unaware of their sales tax obligations or have not invested the time and resources to address them. As a result, those companies often do not collect or remit sales tax and do not file the required returns. Depending on the size of the target business and technologies involved, sales tax exposure in the technology space can present material risks to buyers.

The potential exposure has substantially increased as states have imposed sales tax on new and growing technologies, such as cloud computing and other digital services. And it has exploded exponentially in the wake of the U.S. Supreme Court’s 2018 decision in South Dakota v. Wayfair, which changed the sales tax landscape by eliminating the physical presence nexus requirement as the sole standard for nexus and permitting sales tax nexus based solely on sales in the state.

Sales tax considerations

Increasing target business complexity has exploded the significance of sales tax exposure to potential buyers, particularly in the technology industry, where the rate of change in the sales tax law has been very high. While some target technology businesses are aware of their sales tax collection responsibilities and have complied accordingly, many others have never considered their broader sales tax obligations, often because what they sell is not subject to sales tax in the state where they began doing business. Given the ease of cross-state transactions in the technology space and the economic nexus standards quickly enacted in the wake of Wayfair, these companies are likely to have undercollected and underreported sales tax, causing significant problems for the buyer in pursuing an acquisition.

However, Wayfair economic nexus standards are just the tip of the iceberg. While Wayfair may have replaced the constitutional physical presence standard, physical presence in a state still establishes nexus for sales tax purposes. Starting with click-through nexus provisions that seek to assign the presence of an independently commissioned advertising host within a state to an online seller, states have aggressively targeted the technology space from a physical presence standpoint. New approaches, such as software cookie nexus in Massachusetts and inventory nexus for Fulfillment by Amazon sellers, continue to arise regardless of a state’s ability to assert jurisdiction solely on economic grounds. The pandemic has only exacerbated this problem, particularly with the rapid expansion of remote workforce in the technology space.

Once nexus is established, the sales tax problem for technology businesses becomes one of classification and taxability. Particularly in relation to digital goods and services, how a state classifies what a technology business really does makes all the difference in the world. For example, a business may view its primary offering as software as a service (SaaS). But based on advertising, contract language, invoicing and other factors, it may be treated by the states as physical software, professional services, telecommunications, data management or processing, or something else entirely. Each of these might be subject to different taxability rules in a given state and are certainly subject to a wide variety of rules from state to state.

During this time, sourcing comes into play, and technology businesses commonly have sales tax problems in relation to both intrastate and interstate sales. From an intrastate perspective, some states opine that while interstate sales are subject to destination sourcing, intrastate sales are sourced to the origin of the transaction. For a technology business, the origin may be difficult to identify, and depending on the state, it could be determined based on headquarters, invoicing address, server location, sales office location or a variety of other options. This determination may have an immense impact on exposure or refund potential, as the origin of the transaction indicates the applicable local sales tax rate. From an interstate perspective, destination sourcing is generally applicable, but determining the destination may not be easy for digital goods and services transactions.

In general, the destination is deemed the location of first use by the customer, but state definitions of “first use” vary significantly. Possibly more important, though, purchasers may intend digital goods and services, such as enterprise cloud software, for multiple use points. There are opportunities for relief, including direct pay permits and multiple points-of-use certificates. However, these are generally not obtainable retroactively and should not be considered a panacea by an acquiring company.

Addressing sales tax exposure

When a buyer identifies a sales tax exposure at a target but still wishes to go forward with the deal, the buyer has a number of options to address the situation. One approach is to estimate the exposure amount, negotiate a purchase price reduction and move forward with the transaction with the understanding that the exposure will likely have to be rectified later. However, purchase price reduction negotiations can be difficult, and, in many cases, may not end up at a point that would cover the buyer for all taxes and costs if the worst-case scenario were to occur.

Accordingly, buyers often layer on or turn entirely to contractual indemnification provisions, offsets or clawbacks for future payments or against rollover equity, escrows to cover additional costs that will be released to the seller when all identified liability is extinguished, and representations and warranties insurance to cover unidentified risks. Each of these options has benefits, issues, and complexities that must be resolved and negotiated between the parties, and often, a combination approach best insulates the buyer against risk.

Ultimately, however, a buyer will have to address sales tax exposures with state or local tax authorities in order to close off potential liabilities before contractual protections, like indemnifications, lapse. To do so, a buyer should consider taking advantage of state tax amnesty programs, when available, or seeking to enter into a voluntary disclosure agreement (VDA) directly with each state or with a group of states through an organization like the Multistate Tax Commission. In order to enter into a VDA, the company, or in some cases the buyer or a successor entity, must proactively approach a state, generally through an intermediary on a no-name basis, and reach a negotiated settlement to pay prior-year unpaid taxes.

Each state has its own requirements to participate in its VDA program, and navigating these requirements can be complicated. By entering into a VDA, a business can obtain a limited look-back period, typically three or four years, abatement or reduction of penalties, and a clean slate with the state going forward. The limited look-back period, in particular, is very important for buyers, as many sellers in the technology industry have never collected and remitted sales tax and have an open statute of limitations for all back years.

Buyers have a real incentive to take advantage of state amnesty and VDA programs in order to remediate historic liability while still contractually protected and before registering with a state and collecting and remitting sales tax prospectively. At first blush, sellers may be less enthused. Paying tax through an amnesty or VDA program is still paying tax. However, the benefits of the amnesty or VDA process for sellers can also be very valuable, particularly in the technology space where the combination of complex products and services and uncertain tax law creates unique settlement opportunities.

By working with buyers, sellers can have a voice in the amnesty or VDA process, helping to create the certainty and closure buyers crave while reducing ultimate liability. While buyers and sellers have issues and conflicts regarding the amnesty or VDA process, they have much to gain by collaboration, and through careful negotiation of contract language, they can promote and protect both of their interests.

Final considerations

In the context of an acquisition, buyers often focus on identifying historical sales tax exposures and the cost of remediation. However, particularly in the technology space where a business may be significantly increasing its sales tax compliance post-closing, the ultimate cost of going-forward sales tax compliance may be more powerful than historical issues on the economics of a deal. Buyers need to consider the elasticity of the price point of the target’s offerings and gauge the extent to which the requirement to collect and remit sales tax going forward will affect future earnings and cash flow.

If the business has pricing power in the marketplace, their customers will likely bear the sales tax economically. Conversely, in a more competitive marketplace with limited perceived price elasticity, the business may bear the economics even though the sales tax is technically a “pass-through” tax collected from purchasers. Compliance process and technology implementation, necessary business model changes, and customer relations costs may also impact the overall going-forward profitability of the business in relation to its pre-close, non-compliant state. A buyer should consider the impact of these issues on their current valuation of the target and expected future benefit.

Reproduced with permission. Published April 27, 2021. Copyright 2023 Bloomberg Industry Group +1 800 372 1033. For further use, please visit Bloomberg's site.