California Says Federal Income Tax Prohibition No Longer Applies to Remote Vendors Conducting Certain Online Activities in the State

When California issued Technical Advice Memorandum 2022-01 (February 14, 2022) (TAM 2022-01), it became the first state to adopt a tax policy that significantly weakens Public Law 86-272 (P.L. 86-272), which prohibits states from imposing income tax on certain out-of-state businesses that sell tangible personal property. California’s policy shift follows a revised interpretation of P.L. 86-272 adopted last year by the Multistate Tax Commission (MTC)―a U.S. intergovernmental state agency whose mission is to promote uniform and consistent tax policy and administration among the states. Public Law 86-272, also known as the Interstate Income Act of 1959, prohibits a state from imposing income tax on an out-of-state business engaged in interstate commerce if: (1) its business activity within the state is limited to the solicitation of orders for the sale of tangible personal property or activities that are ancillary thereto, (2) the orders are approved outside the state, and (3) delivery of the property originates from an out-of-state location.

How Andersen Can Help

Changing the interpretation of P.L. 86-272 provides a new framework within which to review our clients’ state tax profile. Refund opportunities may be available or additional tax exposure may exist for all open years in states that follow MTC guidance like California. Remote sellers relying on P.L. 86-272 should review the MTC’s interpretation of P.L. 86-272 as well as California’s recently issued guidance to consider whether they may be deemed subject to tax in other states. These taxpayers should also understand the impact of P.L. 86-272 as it relates to the Joyce/Finnigan and throwback rules discussed in more detail below. Andersen’s State and Local Tax (SALT) team can assist you in determining how these recent developments and additional factors may affect your business.

Multistate Tax Commission Amendments

On August 4, 2021, the MTC adopted revisions to the Statement on P.L. 86-272 for recommendation to the states. In general, the MTC considered how P.L. 86-272 applies to modern business activities and was limited to statutory interpretation, not policymaking. It primarily focused on business activities conducted by remote sellers over the internet and specifically considered to what extent the solicitation of orders covered activities that neither explicitly nor implicitly propose a sale.

The MTC’s revisions to the Statement on P.L. 86-272 generally conclude that if a remote seller interacts with a customer via the business’s website, the remote seller would be engaged in an activity with that customer’s state. A remote seller’s website that only presents static text or photos would not be sufficient to be an activity within a taxing state. The revisions include 11 factual scenarios, 10 of which provide that the remote seller’s website alone violates the protection of P.L. 86-272. For examples of unprotected activities, see this Tax Release).

Following the MTC’s adoption of the amendments, the California Franchise Tax Board (FTB) announced that it had revised its interpretation of P.L. 86-272 and issued TAM 2022-01. The TAM includes the 11 factual scenarios as provided in the MTC’s revision but also adds that a taxpayer with an employee who telecommutes on a regular basis from within California and performs tasks beyond those limited to solicitation of orders for sales of tangible personal property or that are entirely ancillary to solicitation, would be disqualified from P.L. 86-272 immunity. For example, a remote business with an employee who telecommutes from within California and also performs business management, accounting or any other non-sales activity may no longer be protected from California income taxation.

Basis of Authority

Although the FTB’s examples mirror those of the MTC’s revised statement, it does not rely explicitly on the MTC as the authority for its changes. Instead, the FTB cites the U.S. Supreme Court’s landmark 2018 decision in South Dakota v. Wayfair. In that case, the Court when construing the Commerce Clause of the U.S. Constitution, concluded that an internet seller “may be present in a State in a meaningful way without that presence being physical in the traditional sense of the term.” Although the Court was not interpreting P.L. 86-272 in Wayfair, the FTB applies the Court’s analysis to the question of whether a seller is engaged in business activities in states where its customers are reached via virtual contacts for purposes of P.L. 86-272.

Throwback Rule

An expanded reach of income tax jurisdiction presents an opportunity for sellers of tangible personal property that ship from a high-tax state and employ a sales factor throwback rule including California. The new FTB guidance. may serve to reduce the income apportioned to the ship-from state in certain circumstances.

When corporate income is apportioned among the states for tax purposes, some income may be sourced to a state that lacks the jurisdiction to tax the corporation. The income arising from such transactions may be nowhere income in that no state imposes a tax related to the transaction. To avoid this result, some states apply a throwback rule that permits a state from which the sale originates to include the sale in the numerator of the origination state’s sales factor in cases where the destination state lacks jurisdiction to tax the company.

Beginning with the 2013 tax year, most taxpayers apportion income to California using a single-sales factor apportionment method. The numerator of the sales factor is comprised of sales made in California, while the denominator is comprised of sales made everywhere. Tangible property sales are sourced to the customer’s location where the property is delivered or shipped.

California applies a throwback rule that requires the inclusion of receipts from tangible personal property in its numerator if “the property is shipped from an office, store, warehouse, factory, or other place of storage in this State and (1) the purchaser is the United States Government or (2) the taxpayer is not taxable in the State of the purchaser.” A taxpayer is deemed taxable in a destination U.S. state if the activity in the state exceeds the protection of P.L. 86-272, regardless of whether the taxpayer files a tax return or pays a tax in the destination state. As a result of TAM 2022-01, California sellers engaged in internet-based activities directed to states may be unprotected by P.L. 86-272 in such states. Sales to these states should not be subject to California’s sales factor throwback rule. While the TAM was issued in 2022, it is interpretive guidance without prospective application. Accordingly, taxpayers should consider revising the sales factor based upon TAM 2022-01 for all open tax years and claim refunds.

The states take different approaches to taxing a combined unitary group of corporations that is comprised of some affiliates that are protected by P.L. 86-272 and others that are not. Some states apply the Joyce rule under which individual corporations that are protected by P.L. 86-272 do not have to include sales attributable to the state in the numerator of the sales factor of the combined unitary group, even if an affiliate corporation has nexus with the state. Other states apply the Finnigan rule under which a corporation does not have to throwback sales that are made to a particular state if one of its unitary affiliates has nexus with the destination state.

California applies the Finnigan rule. As a result, TAM 2022-01 has a broad reach. California sellers engaged in internet activities in other states that are not protected by P.L. 86-272, as interpreted by California, should not be subject to California’s sales factor throwback rule for the entire combined group.

The Takeaway

Every taxpayer selling tangible personal property across state lines should consider the impact of P.L. 86-272 and its reinterpretation by the states. The Andersen SALT team can review any taxpayer’s facts to identify risks and opportunities presented by this evolving area of the tax law.