On July 1, 2015, Washington Governor Jay Inslee signed into law Substitute Senate Bill 6138 (the “Law”). The Law expands the reach of Washington’s business and occupation tax (“B&O tax”) to wholesalers making sales to Washington customers, as well as to certain out-of-state retailers with referral sources in Washington. The B&O tax is applied against the taxpayer’s gross receipts attributable to various activities. Before the Law’s enactment, the B&O tax applied only to out-of-state taxpayers with “substantial nexus” with the state and apportionable income, that is, income from providing services, from royalties, and from a variety of particular industries (such as certain insurance and health care activities). In contrast, wholesalers were subject to the B&O tax only if they were physically present in the state.
The concept of “substantial nexus” has garnered a great deal of airtime with the United States circuit courts and Supreme Court, and is in some senses a moving target. The term “nexus” refers to the minimum connection between an out-of-state taxpayer and a state necessary to support the state’s imposition of a tax on the taxpayer. The nexus requirement derives from the Due Process and Commerce Clauses of the United States Constitution; this constitutional flavor has been the subject of significant scholarship and jurisprudence and continues to evolve. At the forefront of this evolution is the subset of nexus known as “economic nexus”: the establishment of a connection between the taxpayer and the state simply by virtue of the taxpayer’s participation in the state’s markets. Another offshoot of nexus is the concept of “affiliate nexus”: that a taxpayer can establish a taxable connection with a state by virtue of its affiliate’s activities. Each theory has found its place in Washington.
Economic Nexus and the Taxation of Out-of-State Wholesalers
Starting September 1, 2015, Washington began to apply its economic-nexus standard to both out-of-state retailers and wholesalers for B&O tax purposes. Again, this marks a clear shift in Washington tax policy, as the state looks outward to drive B&O tax revenues. By statute, Washington dictates that a taxpayer has economic nexus with the state if certain operational thresholds are met. Under the statute, a taxpayer has nexus with the state if in the immediately preceding tax year the taxpayer earns more than $267,000 of gross income in Washington, if the taxpayer has more than $53,000 of its payroll or property in Washington, or if more than a quarter of its total property, payroll, or income is attributable to Washington. RCW 82.04.067.
Because wholesalers with payroll and property in the state are likely already deemed to be present in Washington, and therefore subject to B&O tax, the economic-nexus standard really affects only out-of-state wholesalers with greater than $267,000 in gross income attributed to Washington. “Gross income,” in this instance, refers both to apportionable income (service income, royalty income, etc.) and to wholesale sales of goods delivered into Washington. The Washington Administrative Code dictates that tangible personal property will be included in gross income for the purpose of establishing economic nexus, if the property is actually delivered to a customer in Washington, whether by common carrier or otherwise and without regard to commercial delivery terms contained in the Uniform Commercial Code. See WAC 458-20-193(b). So wholesalers with significant levels of income from services, royalties, or sales to customers in Washington must be on alert.
Additionally, under its so-called trailing-nexus statute, wholesalers subject to B&O tax in the prior year will be subject to B&O tax in the following year even if they have no Washington income. RCW 82.04.220(2). For example, a Nebraska wholesaler of chinchilla collars sells $300,000 worth of its product to a single retailer in Washington on January 1, 2016. The sale floods the Washington market, and because of a precipitous decline in demand, the wholesaler is unable to sell a single chinchilla collar in Washington ever again. In 2017, the wholesaler will be deemed to have nexus with Washington and will be subject to B&O tax. Further, because the wholesaler was deemed to have nexus in 2017, it will be subject to B&O tax in 2018 as well.
It’s not all bad news for our hypothetical Nebraskan chinchilla-collar wholesaler, however. The B&O tax is levied against only the taxpayer’s gross income in Washington. Thus, in the example above, the out-of-state wholesaler would not have any tax liability in 2017 and 2018 because it would have no gross income in Washington. If instead the wholesaler’s Washington sales decreased from $300,000 in 2016 to $100,000 in each subsequent year, then the wholesaler would have B&O tax liability in 2016, 2017, and 2018—each of the years in which the wholesaler has nexus. In each of the following years, the wholesaler would not have B&O tax nexus because its Washington gross income would not exceed the $267,000 threshold amount.
Affiliate Nexus and the Taxation of Out-of-State Retailers
In addition to the economic-nexus standard for B&O tax discussed above, retailers are subject to an affiliate-nexus standard for sales and use taxes. This standard, also effective as of September 1, 2015, provides that retailers have substantial nexus with Washington, and must collect and remit sales tax, if they have entered into an agreement with a Washington resident, whereupon the retailer pays a commission to the resident for customer referrals, and the revenue associated with Washington customers exceeds $10,000 in the preceding calendar year.
The “traditional” conception of sales-and-use-tax nexus, as formulated by the United States Supreme Court, is a bright-line test based on physical presence. Therefore, under the traditional view of sales-and-use-tax nexus, any taxpayer physically present in Washington is subject to sales or use tax, while any taxpayer not physically present in the state would generally expect to not be subject to Washington’s sales or use tax.
By adopting the Law, Washington has used its affiliate-nexus rule to refine the physical-presence requirements adopted by the United States Supreme Court. In recognition of its slight departure from the accepted interpretation of Commerce Clause jurisprudence, Section 201 of the Law recites the physical-presence requirements and explains the legislature’s intent to interpret the physical-presence nexus standard in a manner more befitting the era of e-commerce. In fact, the types of referral agreements contemplated by the Law specifically include links on websites, making the nexus standard adopted by the Washington legislature not entirely different from the so-called click-through nexus standards adopted in New York, Colorado, and elsewhere in response to the widespread practice of an out-of-state retailer’s not collecting and remitting sales tax in jurisdictions in which the retailer has no physical presence.
The Law contains an exception for an out-of-state retailer whose referral agreement prevents the retailer’s referral sources from soliciting sales on behalf of the retailer, and that can establish that the referral sources have not engaged in solicitation. It is unclear what such an exempt referral agreement would look like, insofar as a passive link on a website alone and without any solicitous language is sufficient to create nexus under the Law. Fortunately, the Law also grants the Department of Revenue discretion to accept proof of nonsolicitation by other means, although relying on departmental discretion is at best a hollow victory.
Preventive Maintenance: Compliance and Recordkeeping
The Law presents new challenges to out-of-state wholesalers and retailers. To prevent these challenges from becoming expensive headaches, wholesalers and retailers should review their records for the immediately preceding tax year to determine whether they have substantial nexus with Washington. If they are subject to Washington’s B&O or sales tax regime, such wholesalers and retailers must ensure that they establish adequate recordkeeping policies to capture revenue-sourcing information on sales contracts, invoices, or bills of lading. Maintaining adequate records and actively performing nexus studies in Washington will avoid any unwelcome surprises from the Washington Department of Revenue.