Multistate Taxpayers, the Aloha State Welcomes You: Three New Laws Will Bring Your Tax Dollars to the Islands

Hawaii recently enacted several major tax changes that will impact multistate taxpayers. First, the state became the first to adopt the Wayfair economic nexus thresholds for state income tax purposes. Hawaii also changed its rules for determining if a multistate taxpayer’s gross receipts from the sale of intangibles or services are subject to Hawaii’s income tax. Finally, the Aloha State imposed mandatory withholding requirements on partnerships, trusts and estates with nonresident taxpayers who receive a distributive share of Hawaii-sourced income.

Income Tax Nexus

Although 14 other states have some form of economic nexus for income taxes on their books, with its new law, Hawaii becomes the first state to implement the same economic nexus standards for both income and sales tax purposes.

For sales tax, prior to the U.S. Supreme Court’s 2018 decision in South Dakota v. Wayfair, the states could only impose sales tax collection duties on a vendor that maintained a physical presence within their jurisdiction. The Wayfair decision removed the so-called physical presence requirement for purposes of sales tax nexus determinations. Activities such as owning property in the state or having employees work there are examples of a physical presence.

In doing away with the physical presence requirement, the Court upheld a South Dakota statute that imposed sales tax collection obligations on a remote vendor that annually sold more than $100,000 of goods or services in the state or engaged in 200 or more separate transactions for the delivery of goods or services in the state.

For income tax, the U.S. Supreme Court has never explicitly held that the physical presence requirement applies to income tax nexus determinations. As a result, over the past 20 years many states have successfully enforced income tax liabilities against businesses that lacked a physical presence within their jurisdiction. Hawaii’s new income tax nexus statute is notable because it takes a similar approach to the South Dakota sales tax nexus statute that received the U.S. Supreme Court’s tacit approval in Wayfair.

Hawaii’s new income tax nexus statute (Hawaii S.B. 495) states that a person that lacks in-state physical presence is presumed to be systematically and regularly engaging in business in the state and subject to Hawaii’s income tax if they (1) engage in 200 or more business transactions in Hawaii and (2) have gross income from the state of $100,000 or more, which includes the numerator of the sales factor equaling or exceeding $100,000. The provision is effective for tax years beginning after December 31, 2019, with thresholds based on activity either in the current or preceding year. It should be noted that federal law (P.L. 86-272) still protects an out-of-state business from being subject to net income tax on its business activity in Hawaii if the entity limits its business activity to the solicitation of sales of tangible personal property.

At this point, only Philadelphia has added a Wayfair threshold to its City Business Income and Receipts Tax and Gross Receipts Tax respectively. Oregon toyed with adding Wayfair provisions to its income tax laws but ultimately rejected them. However, it is expected that other states may explore following Hawaii’s lead by enacting Wayfair-style thresholds for income tax purposes in coming years.

Market-Based Sourcing

Another significant change to Hawaii’s income tax laws alters the sourcing rules that businesses operating in Hawaii and at least one other state must use for determining if the gross receipts from a sale of other than tangible personal property are subject to Hawaii income tax. Under Hawaii’s new law (S.B. 394), the state will adopt a market-based sourcing approach for sales of intangible personal property and services. Based on the provision, which is effective for tax years beginning after December 31, 2019, sales of intangible property will be sourced to Hawaii to the extent that the property is used in the state. Sales of services will be sourced to Hawaii to the extent the service is used or consumed in the state. Hawaii follows a long line of states that have moved from cost-of-performance sourcing (where the gross receipts are taxable in the jurisdiction in which the costs are incurred) to market-based sourcing (where sales of services and intangibles are sourced to where the market is located). The move to a market-based approach means tax will be imposed on transactions involving intangibles or services that are used or consumed in Hawaii. It should result in a lower sales factor for companies that have been selling intangibles or performing services in Hawaii for use elsewhere because the receipts will no longer be sourced to Hawaii.

Mandatory Withholding for Nonresident Partnerships and Trusts

Partnerships, trusts, or estates with nonresident owners receiving a distributive share of income from Hawaii sources must withhold income tax on the share. The withholding rate is equal to the highest marginal tax rate applicable to nonresident taxpayers (currently 11% for individuals) multiplied by the nonresident taxpayer’s distributive share of income attributable to Hawaii. Although the law was supposed to be retroactive to tax years beginning after December 31, 2018, the Department of Taxation extended the implementation date to tax years beginning after December 31, 2019.

The Takeaway

Hawaii has enacted three measures that effectively ensure multistate taxpayers with significant activities in the state will owe income tax. The state’s nexus law sets the stage for the state to impose nexus for income tax purposes on businesses that make sales to customers in Hawaii, regardless of whether or not the firms have a physical presence (i.e., property or employees) in the state. The change to Hawaii’s sourcing rules for sales of intangible property and services means gross receipts from their use or consumption in Hawaii will be subject to Hawaii’s income tax. Service providers will be greatly affected and could unwittingly be subject to the business entity taxes in Hawaii if they are transacting business with customers there. An early evaluation of the effects of this law will ensure proper compliance.