Will the push for origin-based sourcing derail SST?

The main goal of streamlined sales tax (SST) is to simplify sales and use tax collection and administration in such a way that compliance with multiple state sales and use tax regimes will not create an undue burden on interstate commerce. To accomplish this goal, the drafters of the Streamlined Sales and Use Tax Agreement (SSUTA) required uniformity in state and local sales and use tax rules and administration. In addition, the drafters recognized that, for practical purposes, sales should be sourced based on where the taxable property would be used. Indeed, since its inception, the SSUTA has provided for destination-based sourcing of taxable sales, with origin-based sourcing a default method where destination cannot be determined. Specifically, according to Section 310 of the SSUTA, the retail sale of a tangible personal property will be sourced:

1. To the seller's business location, when the product is received by the purchaser there;

2. To the location where receipt by the purchaser (or the purchaser's donee, designated as such by the purchaser) occurs, when the product is not received by the purchaser at the seller's business location;

3. To the location indicated by an address for the purchaser that is avail able from the seller's business records, when the first two scenarios do not apply;

4. To the location indicated by an address for the purchaser obtained during the consummation of the sale, when the first three scenarios do not apply; and

5. Finally, to the location from which tangible personal property was shipped, if none of the previous sourcing rules apply (including instances in which the seller is without sufficient information to apply the previous rules).

For taxable interstate transactions, the concept of destination-based sourcing has not caused significant controversy; most states and businesses recognize the practicality of sourcing sales and collecting tax based on the situs of the purchaser or where the purchased items ultimately will be used. Nevertheless, the effect of destination-based sourcing on local sales and use tax administration has raised significant practical concerns, leading some states to advocate the use of origin-based sourcing for intrastate taxable sales.

In states that provide for the imposition of local sales and use taxes, destination-based sourcing for intrastate sales can create significant burdens for sellers. Namely, smaller businesses that currently collect and remit state sales taxes based on a single rate (as determined by their location) under an origin-based system would be required to determine, collect and remit taxes based on the rates in their customers' localities using a destination-based system. The potential for resulting administrative burden has caused many businesses to petition their state governments to change the rules or to abandon the SST effort altogether.

Utah Responds

Several states that are contemplating membership in SST--most notably Texas, Illinois and California--apply origin-based sourcing for intrastate sales. Although not currently a member, Texas has expressed its concern within the SST that it would be unable to substantially comply with the SSUTA. Texas has expressed the belief that the administrative burden on local governments caused by destination-based sourcing and the corresponding burden on in-state businesses (many of which conduct no interstate business) constitute insurmountable barriers and render the SSUTA unworkable. Other SST member states (most notably, Kansas) have expressed similar concerns about applying destination-based sourcing for local sales and use taxes.

In an attempt to overcome the perceived obstacle of destination-based sourcing for intrastate sales, Utah (on behalf of Texas) submitted a proposal to the SST Governing Board to amend the SSUTA to give member states the option of sourcing local sales taxes under their own state laws. Specifically, the proposal would allow states to exclude intrastate sales of goods (including digital goods and services) from the Section 310 destination-based sourcing rules. The proposal defines intrastate sales only as those sales of goods or services sold from a point within a state, and shipped, delivered or provided to a purchaser within the same state. Utah, in a sense, forced the issue by introducing legislation in January 2006 (2006 Utah S.B. 233) to conform its sales and use tax code to the proposal. The legislation quickly passed and, on March 17, 2006, Gov. Huntsman signed the bill into law. Subsequently, on April 17, 2006, the SST "Implementing States" voted 17 to 7 against adopting the proposed amendment, thereby calling into question Utah's "substantial conformity" with the SSUTA.

Ohio's Attempt at Compromise

Ohio also has struggled with the switch to origin-based sourcing and, like Utah, attempted to address the concerns of its in-state business community--as well as to maintain the momentum in expanding SST membership--by introducing a proposal to the Governing Board that would have simplified local tax rate structures and eliminated many of the concerns caused by the move to destination-based sourcing. The draft proposal, released in early February 2006, sought to allow states with local option sales and use taxes to adopt their own sourcing rules for intrastate sales, subject to certain limits. Specifically, if a state chose to adopt its own sourcing rules for intrastate sales, the state also would have been required to adopt a single statewide rate option for sales made from outside the state to customers within the state. Out-of-state sellers then would have had the option of sourcing sales to customers within the state under Section 310 of the SSUTA (i.e., based on destination) or following the state-specific sourcing rule and collecting the single statewide rate.

The proposal also afforded some protection to consumers. Specifically, if the applicable local rate where the consumer received the property or services sold was higher than the single statewide rate, no additional "makeup" tax would have been charged. Conversely, if the single statewide rate was higher than the local rate, the consumer would have been given one year to file a refund claim with the state, which would have then been required to issue a refund to the consumer for the difference in tax. As with the Utah/Texas proposal, Ohio's draft proposal was rejected by the SST "Implementing States" on April 17, 2006, by a vote of 19 to 5.

The Small Matter of the Commerce Clause

There is some question whether any scheme that differentiates between interstate and intrastate sourcing is constitutional. Specifically, by allowing an in-state seller to source a sale based on origin and collect sales taxes determined by the local origin rate, the tax paid may be lower than the tax paid on a sale made by an out-of-state seller of the same item and to the same customer. Such a distraction between sales made by in-state and out-of-state sellers has the potential to be considered unconstitutional discrimination against interstate commerce.

Commentators on both sides of the issue cite the 2005 Missouri Supreme Court case Kirkwood Glass Co. v. Director of Rev., 166 SW3d 583 (MO 2005), cert. denied, 126 S.Ct. 803 (2005), which challenged Missouri's origin-based sourcing rules. Under Missouri law, sales are sourced for local tax purposes based on origin but, as a safeguard, no purchase made from an out-of-state seller may be subject to a higher tax burden than a similar purchase made from within a taxpayer's local jurisdiction. In Kirkwood Glass, the taxpayer argued that the scheme still violated the Commerce Clause because a purchase made from an out-of-state vendor still could be taxed at a higher rate than a similar purchase made from an in-state vendor in a Missouri locality other than the taxpayer's locality. As an example, the taxpayer in Kirkwood Glass noted that under the Missouri scheme, it would pay a 4.725% origin-based sales tax rate on purchases made from Williamsburg, Missouri (a locality other than that of the taxpayer), but would pay a 5.475% destination-based use tax rate on identical purchases made from an out-of-state seller. Because a higher tax was paid on purchases made from out-of-state sellers, the taxpayer contended the law impermissibly burdened interstate commerce.

The court rejected this argument, concluding that "[s]o long as, within each taxing jurisdiction, an item purchased from an out-of-state vendor will never be taxed at a higher tax than would be charged had the item been purchased from a vendor in that locality, there is no undue burden on interstate commerce." In other words, the court held that in determining whether Missouri's scheme created unconstitutional discrimination against interstate commerce, the proper comparison classes were not in-state sellers, as a general group, and out-of-state sellers, but were sellers within a local jurisdiction and out-of-state vendors selling to the same local jurisdiction. When comparing these two classes, Missouri's sales and use tax law clearly did not have a discriminatory effect. Based on this decision and the subsequent denial of certiorari by the U.S. Supreme Court, many of those involved with the SST who oppose destination-based sourcing felt that the door may have been open for the origin-based option. However, based on the April 2006 rejection of the Utah and Ohio proposals--as well as the assertion by some commentators that Kirkwood is "bad law" (i.e., the selection of the comparison classes was too narrowly defined), it is doubtful that any further push to revert to origin-based sourcing for intrastate sales ultimately will succeed.

The Business Community Weighs In

Despite the potential for increased compliance burdens for smaller, single-state businesses, some members of the business community have noted their strong opposition to any compromise allowing states to adopt origin-based sourcing for intrastate sales. While acknowledging that smaller businesses would suffer some hardship under a destination-based sourcing scheme, these businesses have asserted that any move away from administrative uniformity on matters such as sourcing runs counter to the SST's stated goals--namely, simplification.

These same businesses also have raised the issue that any compromise allowing origin-based sourcing will cream an entirely different set of obstacles, no less formidable than those raised under a destination-based scheme. For example, if a single-state seller maintains warehouses in multiple local jurisdictions, under destination-based sourcing its intrastate transactions with a single customer (that maintains a single, in-state location) would be taxed at the same rate. However, under an origin-based system, there is the potential for taxing sales of the same items to that same customer at different rates based on the location of the seller's warehouse from which the items are shipped. The potential for such a result demonstrates that origin-based sourcing is not the panacea claimed by some states, and underscores much of the business community's opposition to any compromise that would involve origin-based sourcing.

As an alternative to origin-based sourcing, many SST-participating businesses have indicated support for a proposal calling for a single state/local rate, and encourage states to impose specific revenue distribution mechanisms to offset any local financial hardship. At present, this proposal has not found significant support within the Governing Board.

Conclusion

As noted earlier, it is unlikely that any origin-based sourcing proposals will gain traction with a majority of the member states. Kansas, a full-member state that struggled significantly with the issue of destination-based sourcing, has expressed some criticism of the compromise efforts. Other states, such as Washington, which have been making slow, but steady, progress with SST legislation, fear a compromise on one of the key elements of the SSUTA could stall momentum or result in a complete re-evaluation of all potentially controversial provisions. Essentially, states may begin to question the need for conforming their state laws to a uniform agreement that can be amended based on one state's objections. While the proposals (and actions) of Texas and Utah, allowing these states the option of origin-based sourcing for intrastate sales, seem innocuous, such actions do not bode well for the SST, as another bedrock principle of sales and use tax simplification is reopened for debate.

Ultimately, each state will need to determine whether the sacrifices required in the move toward conformity are sufficiently offset by the prospect of potentially being able to compel collection of sales and use taxes by out-of-state, nonnexus sellers. For states that have already endured the sometimes painful process of amending their laws--both from a political and business standpoint--the trend toward compromise on the more difficult SST issues is frustrating. At the same time, the practical concerns of small businesses, which may face extreme compliance burdens under a destination-based sourcing scheme, cannot be ignored or marginalized. However, if the ultimate goals of sales tax simplification and uniformity are to be achieved, some compromise likely will be required, and the efforts of states that are working to achieve consensus on the issues ultimately may hold the key to the SST's success.

Editor's note: Mr. Salmon is the chair of the AICPA Tax Division's State & Local Taxation Technical Resource Panel. For more information about this column, contact Mr. Nicolas at [e-mail].

Editor: Scott Salmon, CPA, M.Acc.

Partner

KMPG LLP 

Washington, DC

Author: Karl Nicolas, Esq.

National Tax Department--State & Local Taxation

Ernst & Young LLP

Washington, DC