As more and more companies conduct business in multiple states they are discovering that they are required to file and pay taxes in a state where they have absolutely no physical presence. It’s called factor based nexus, and it is hitting companies with significant and unexpected costs.
What is Nexus?
Nexus is the term for whether or not state governments can legally impose tax on a business. Historically, states only have the ability to tax a business if that business has either property or employees in that state, also referred to as physical presence nexus. States using a factor based nexus standard, are subjecting companies to tax in their state if one of the company’s apportionment factors (property, payroll, or sales) exceeds the state’s statutory threshold. In other words, actual physical presence is not required if the company has sales that exceed the threshold.
Why the Switch to Factor Based Nexus?
The increase of consumers doing business without borders via the internet has taken a toll on state tax collections. It’s this loss of revenue that is pushing states to adopt new standards that expand their taxable reach. More and more states are restructuring their corporate tax rules, including a broadening of nexus standards. This expanded interpretation of “presence” allows a state to justify business income tax on companies whose only connection with a state is virtual. As more states adopt this standard, taxpayers find themselves facing tax filing obligations in states where they traditionally have not.
The Double Dipping Scenario
To make things even more complicated, the lack of a universal state standard to determine nexus can create some interesting scenarios. Several states that have adopted a factor based nexus standard have also adopted a market-based sourcing approach. A business could find itself in the middle of a double taxation situation depending on the combination of states involved.
The combination of sales factor based standards and market-based sourcing for receipts from sales of services can create significant problems for service companies. Although only a handful of states have enacted both sales factor presence and market-based sourcing, more are expected. The key here is to ensure that your tax planning efforts are taking these situations into account.
Some state courts are seeing litigation related to factor presence nexus, including a recent ruling in Ohio where the Supreme Court decided that physical presence is not a necessary condition for imposing its commercial activity tax. If this verdict is any indication, factor presence nexus is not only here to stay, but will likely experience an uptick in the number of states adopting it.
For businesses with multistate activity, it is vital to understand how contact with other states can trigger tax obligations.
The bottom line, states will continue to aggressively look for ways to expand their taxing authority. Don’t be caught off-guard, watch our on-demand webinar, The High Price of Exposure: What You Don’t Know About State and Local Tax, where we discuss nexus and other state and local tax issues that can impact your business.