It’s not too soon for general counsel to think about complying — or not complying — with a policy shift in California that seeks to override a decades-old federal law protecting out-of-state companies from paying its state income tax.

The state’s Department of Tax and Fee Administration in February reinterpreted a 1959 statute, known by its Public Law number, 86-272, to say companies that provide to a California resident any service online in addition to selling tangible personal property must pay the state’s income tax if they’re not already doing so. Once it starts to implement its new tax policy, other states are likely to follow suit.

"California’s being out front on this will provide cover or make other states feel more comfortable about issuing similar guidance," Nikki Dobay, a California tax partner with Eversheds Sutherland, told Bloomberg Tax. 

Ecommerce rush

The shift in how the California agency understands PL 86-272 is an effort to get ahead of the rush to ecommerce in much the same way states did in 2018 following the landmark Wayfair ruling by the U.S. Supreme Court. In that ruling, the court established that online seller Wayfair must collect and remit sales tax to South Dakota, the plaintiff in the case, because its sales in the state gave it economic nexus. Other states quickly jumped on the bandwagon and set thresholds, by dollar volume and transaction number, establishing economic nexus. 

California’s new interpretation of PL 86-272, by saying companies are subject to the state’s income tax if they do more than just sell a product to a state resident, is using the same logic as South Dakota in Wayfair. 

Before it changed its interpretation, California took the consensus view that sellers outside its borders were exempt from its income tax by the federal law, which carves out an exception if companies are simply soliciting customers to buy their goods. Lawmakers at the time had catalog sales largely in mind. A company that sold through the mail would face a crushing burden having to pay income tax in potentially all 50 states if it targeted sales nationwide.

But in the wake of Wayfair, following the lead of the Multistate Tax Commission – a quasi-governmental body that sets tax standards for participating states – California views the federal law more narrowly by saying it only applies to sales. If the company also provides support of any kind to the customer – answering questions using an online chat function, for example, or installing a cookie on the customer’s browser to improve their experience – federal protection goes away.

Challenge expected

It’s only a matter of time before that narrow view is challenged in court, so general counsel would benefit by deciding now if they’re going to comply out of the gate or wait until the issue works its way through the courts, says Zach Gladney, an attorney with Alston & Bird. 

"The view among tax practitioners is that this is butchering the protections put in place by Congress," Gladney said in an interview. 

The Multistate Tax Commission, and by extension California, is arguing that Wayfair has shown that states are within their rights to collect tax from companies without physical nexus because of economic nexus, but there’s a big difference between Wayfair and PL 86-272, Gladney said. 

In Wayfair, the Supreme Court looked back on case law precedent in deciding in favor of South Dakota. In PL 86-272, given that Congress specifically created a carve-out, California is reinterpreting a federal statute. 

"I get why they’re doing it," Gladney said. "They’re emboldened by the state winning in Wayfair and economic nexus becoming the standard, so they’re saying, ‘Taxpayers, if you think you can beat us on this issue, have at it. Let’s litigate.’ That’s essentially what they’re communicating."

Resolution

It will probably take a year before California starts auditing companies for compliance and then assessing the income tax they owe. And since the state has said the new interpretation applies retroactively, to all open tax years, a company could be on the hook for not just the current year but two or three years prior as well. That’s when the lawsuits would likely start. 

"It may not take too long before someone gets assessed and a fight ensues," he said. 

Gladney expects a trade association to step in and help lead a lawsuit on behalf of its members, which would help spread the cost of the litigation to a broad class of potentially impacted companies. 

The Association of National Advertisers, whose members are companies that sell online, told Legal Dive it’s assessing its position. 

"The ANA does not have a POV on this issue at this time," the group’s director of communications, John Wolfe, said in an email.  

Another ecommerce group, the Direct Marketing Association, has been a part of ANA since 2018. 

Tactical considerations

If your company takes the conservative approach and pays the income tax before the issue is settled, you can expect a battle getting your money returned to you if California is ultimately shot down in the courts, Gladney said.

"It’s always harder to get money back from a state," he said. "We have some clients that are very conservative and just don’t want to deal with the issue. They’ll [probably] pay and hold on to the refund route."

Bureaucratic inertia is only one reason getting a refund can be hard. Another is tactical. A state can try to limit the facts companies can introduce in their case. "So, you could still end up having to fight the fight," he said. 

You also have to keep an eye on the statute of limitations. If it’s not still open, "you might have your fall off" in the years for which you can get a refund, he said. 

Companies that choose not to pay the tax until the legal question is settled can expect to pay back taxes for all open years as well as the interest that’s accrued on their assessment if the state prevails. But if it doesn’t, they’re off the hook. 

"If you’re confident that you’re going to prevail in the end, [accruing interest] doesn’t really matter," he said. 

Given the range of outcomes, companies can benefit now by choosing their course of action. It’s a decision the general counsel and chief financial officer should be in lockstep on before making a recommendation to the CEO. 

"The general counsel is responsible for thinking through the litigation risk, cost of litigation and these back-end concepts," he said. "But the GC has to think of what his or her CFO is saying. It’s a joint decision."