The International Implications of Wayfair

“While nexus rules are clearly necessary, the Court should focus on rules that are appropriate to the twenty-first century, not the nineteenth.”¹

On June 21 the U.S. Supreme Court decided Wayfair.² It held in a 5-4 majority opinion written by Justice Anthony M. Kennedy that the states will generally be allowed to require out-of-state retailers to collect sales tax when they ship goods to in-state addresses, even when they lack a physical presence in the taxing state.³ The decision has important implications not only for U.S. state taxes but also for EU and international tax.

Since the Great Depression (which drastically reduced state income tax revenue), U.S. states have increasingly relied on sales taxes for their revenues. The tax applies to the final sale of goods (and some services) to an in-state consumer.⁴ Because the states have open borders with each other, all the states that have a sales tax also impose an identical use tax on products brought or shipped from out of state. However, other than in the case of cars that must be registered, such a tax must rely on the honesty of consumers to report their purchases, and not surprisingly self-reporting is exceedingly rare. The only way to meaningfully collect the use tax on individual purchasers is by requiring remote sellers to do so and remit the proceeds to the state governments.

In 1967, long before the invention of the internet and the rise of e-commerce, the Supreme Court decided in National Bellas Hess that states may not require a remote seller to collect use tax unless the seller has a physical presence in the state.⁵ The Court held that both the commerce clause and the due process clause of the Constitution prohibit the states from imposing such a burden on remote sellers. In 1992 the issue came up again in Quill, and the Court reiterated its previous holding, except it relied only on the commerce clause. The reason, as the Court stated, was to invite Congress (which has complete authority to regulate interstate commerce) to intervene.

Quill was also decided before the rise of e-commerce. However, soon thereafter the world wide web was created and e-commerce took off. Less than 2 percent of Americans had internet access in 1992; today that number is about 89 percent.⁶

In 1992 mail-order sales in the United States totaled $180 billion. Last year, U.S. e-commerce retail sales alone were estimated at $453.5 billion.⁷ Combined with traditional remote sellers, the total exceeds half a trillion dollars.⁸ Since the Department of Commerce first began tracking e-commerce sales, those sales have increased tenfold from 0.8 percent to 8.9 percent of total retail sales in the United States. And it is likely that this percentage will increase: Last year e-commerce grew at four times the rate of traditional retail, and its pace shows no sign of slowing.⁹

The combination of the rise of e-commerce and the physical presence rule has led to an increasing revenue shortfall faced by states seeking to collect sales and use taxes. In 1992 it was estimated that states were losing between $694 million and $3 billion per year in sales tax revenue because of the physical presence rule. Now estimates range from $8 billion to $33 billion.¹⁰

In the 26 years following Quill, there have been repeated attempts to pass legislation in Congress to overturn the physical presence rule.¹¹ However, these attempts have repeatedly failed. The reason is simple: The states are not represented in Congress, so Congress cares more about the remote sales industry with its powerful lobby than about state tax revenue. This shows the peril of a court assuming that the legislature will be able to fix its mistakes, with obvious lessons for the Court of Justice of the European Union.¹²

Now, finally, the Court has overturned the physical presence rule, which even the four dissenting justices admit was a mistake.¹³ The majority opinion by Kennedy explains that whether a remote seller has a physical presence in the state has nothing to do with how burdensome the collection of the tax will be on the seller:

The Quill majority expressed concern that without the physical presence rule “a state tax might unduly burden interstate commerce” by subjecting retailers to tax collection obligations in thousands of different taxing jurisdictions. But the administrative costs of compliance, especially in the modern economy with its Internet technology, are largely unrelated to whether a company happens to have a physical presence in a State. For example, a business with one salesperson in each State must collect sales taxes in every jurisdiction in which goods are delivered; but a business with 500 salespersons in one central location and a website accessible in every State need not collect sales taxes on otherwise identical nationwide sales. In other words, under Quill, a small company with diverse physical presence might be equally or more burdened by compliance costs than a large remote seller. The physical presence rule is a poor proxy for the compliance costs faced by companies that do business in multiple States.¹⁴

The Court goes on to eloquently state the rationale for allowing states to require remote sellers to collect tax. The market jurisdiction provides the benefits that are indispensable for the generation of profits by the remote sellers:

In essence, respondents ask this Court to retain a rule that allows their customers to escape payment of sales taxes — taxes that are essential to create and secure the active market they supply with goods and services. An example may suffice. Wayfair offers to sell a vast selection of furnishings. Its advertising seeks to create an image of beautiful, peaceful homes, but it also says that “‘[o]ne of the best things about buying through Wayfair is that we do not have to charge sales tax.’” What Wayfair ignores in its subtle offer to assist in tax evasion is that creating a dream home assumes solvent state and local governments. State taxes fund the police and fire departments that protect the homes containing their customers’ furniture and ensure goods are safely delivered; maintain the public roads and municipal services that allow communication with and access to customers; support the “sound local banking institutions to support credit transactions [and] courts to ensure collection of the purchase price,” and help create the “climate of consumer confidence” that facilitates sales.¹⁵ According to respondents, it is unfair to stymie their tax-free solicitation of customers. But there is nothing unfair about requiring companies that avail themselves of the States’ benefits to bear an equal share of the burden of tax collection. Fairness dictates quite the opposite result. Helping respondents’ customers evade a lawful tax unfairly shifts to those consumers who buy from their competitors with a physical presence that satisfies Quill — even one warehouse or one salesperson — an increased share of the taxes. It is essential to public confidence in the tax system that the Court avoid creating inequitable exceptions. This is also essential to the confidence placed in this Court’s Commerce Clause decisions. Yet the physical presence rule undermines that necessary confidence by giving some online retailers an arbitrary advantage over their competitors who collect state sales taxes.¹⁶

Therefore, the Court overruled both National Bellas Hess and Quill. Henceforth, states are free to require remote sellers to collect use tax — although not retroactively — if the seller has a “substantial nexus” to the taxing state (though the Court does not define substantial nexus, which will likely lead to more litigation).¹⁷

This sweeping language has broad implications for both EU and international tax. Importantly, the South Dakota law in question in Wayfair only imposed the duty to collect use tax on remote sellers that, on an annual basis, deliver more than $100,000 of goods or services into the state or engage in 200 or more separate transactions for the delivery of goods or services into the state.

A threshold based on sales revenue has been proposed repeatedly in the past 20 years (since the advent of e-commerce) as a substitute for the 19th-century permanent establishment rule, which is in more than 3,000 tax treaties and limits the ability of countries to impose income taxes on remote sellers.¹⁸ Recently, the European Commission has proposed precisely a “virtual PE” to supplement the existing PE threshold.¹⁹ Under the draft EU directive on taxation of digital services, a provider of digital services will be deemed to have a PE in the host member state insofar as “the proportion of total revenues obtained in that tax period and resulting from the supply of those digital services to users located in that Member State in that tax period exceeds EUR 7.000.000.”²⁰ That is similar to past academic proposals along similar lines and to one of the options considered by the OECD in the base erosion and profit-shifting project.²¹

As Eva Escribano has written, the EU proposal is the first genuine attempt to adapt the PE rule to 21st-century realities, and neither the OECD nor the U.N. are making progress:

The Directives proposed by the EC have been the first genuine normative proposals intended to address the tax challenges posed by the digitalized economy that have been raised at the international level and conceived for a multilateral implementation. Neither the OECD nor the UN, the driving forces of the two most influential model tax conventions, has gone beyond brainstorming and discussion of alternatives in this area. For its part, the OECD appears to be at a dead end. In its 2015 report, it only managed to put forward three proposals in an embryonic stage, barely specifying their content and scope and surely far from a minimally rigorous normative draft. More recently, it promised to deliver a consensus-based solution in 2020 while at the same time admitting the very diverse positions of the States participating in the debate. As far as the UN is concerned, the new article on technical services is today a reality, but it cannot be truly regarded as a targeted solution to the problems here discussed.²²

The problem, of course, is that the United States is adamantly opposed to these attempts to tax its digital giants and is blocking progress in the OECD, while China may be doing the same in the U.N. The EU and India, on the other hand, support the effort.²³

In the medium to long run, however, I believe that a virtual PE solution is inevitable. For the reasons eloquently set forth by Kennedy in Wayfair, the large market jurisdictions cannot tolerate the ability of remote enterprises to exploit their markets without paying a penny in tax because of a physical presence rule stemming from 19th-century realities and imported into 20th-century model tax treaties out of a desire to protect businesses from taxation.²⁴

The recent adoption of the base erosion and antiabuse tax by the United States follows many efforts by other large source jurisdictions to protect their ability to tax multinationals on income derived from providing goods and services into the source jurisdiction.²⁵ It is high time for the EU to adopt the virtual PE directive and for the OECD and the UN to follow suit.