November 1, 2018
By Scott Rock, State and Local M&A Tax Principal, PwC
For decades, conventional wisdom was that a state could not require a business to collect sales tax if the business lacked physical presence within the state. However, in an era where e-commerce is booming, states began implementing legislation that sought to challenge the restrictions of the physical presence standard. South Dakota did just that by enacting Senate Bill 106 (“S.B. 106”), which required an out-of-state seller to collect and remit sales tax when that seller (1) delivered more than $100k of goods or services annually into the state or (2) engaged in 200 or more separate transactions annually within the state. When South Dakota’s action was met with a legal challenge, the US Supreme Court ruled in the state’s favor, in Wayfair v. South Dakota, No. 17-494 (2018), which removed the physical presence requirement after years of debate over the issue.
The Wayfair decision allows states to assert collection authority requiring out-of-state sellers (e.g., e-commerce businesses) to collect sales tax on taxable sales, to the extent substantial “virtual connections” between the taxpayer and the state exists (i.e., “economic nexus”). While many states have already planned to implement laws similar or identical to S.B. 106, companies, tax professionals and acquirers should continue to monitor issued or proposed guidance from each state to understand how the Wayfair ruling could apply to their business, portfolio companies, or acquisition targets. In other words, Wayfair opened the flood gates for more expansive state nexus actions.
Sales tax laws just got more complicated for M&A
Economic nexus adds additional nuance to understanding a company’s sales tax filing profile. This nuance could create additional complexity for both businesses and potential acquirers.
A company’s internal tax department and/or its outside tax professionals will be required to track and monitor required data (e.g., company’s customer base, location of customers, and the volume of transactions) to determine whether nexus was established in any given state to comply with their filing requirements.
Where nexus is created, companies will have to register, and start collecting and remitting sales taxes. Moreover, as sales tax nexus requirements have become a lot more complicated as a result of the Wayfair decision, some companies may be inclined to outsource their sales tax function and/or subscribe to tax software programs to monitor such information and comply with new laws, leading to additional business costs.
Particularly important for post-Wayfair diligence is an understanding of whether sales tax nexus has been established in a particular state. For targets that are slow to adapt to legislative changes in a state, the relevant information (e.g., customer base, location of customers, and the volume of transactions in each state) may not be readily available for acquirers to review. For these targets, non-filing issues may create cumulative historical sales tax exposures that could date back many years. Importantly, acquirers will need to determine the following:
- Whether an acquisition target’s noncompliance has created exposures akin to an indebtedness, reducing the equity value of the business.
- Whether, prospectively, the acquisition target will be responsible for sales taxes but unable to collect them from their customers which could reduce future profitability and cash flow.
- Whether incremental costs to comply with Wayfair-type legislation should be considered in the future earnings.
In making such determination, analysis regarding the ability to collect sales tax from customers, prospectively, and such collection’s effect on revenues will need to be evaluated.
Accordingly, the changing landscape will require many companies to reassess their sales tax filing profiles and perform, or update, sales tax nexus studies, internally or by engaging a tax advisor, or otherwise amend their sales tax policies and procedures in each state. Whether companies hire additional resources, outsource or receive assistance from tax professionals, or purchase third party software to help manage the sales tax function, companies will likely be expending additional resources in light of the Wayfair ruling.
Wayfair vs. South Dakota goes beyond sales tax
Outside the realm of sales tax, Wayfair may also have an impact on state income tax nexus. During diligence, inquiring into the magnitude of sales and volume of transactions will also be vital for income tax nexus purposes. In addition to the states that have already implemented economic nexus for income tax purposes, additional states will likely implement economic nexus for income tax purposes along with sales tax. Moreover, states may apply their existing authorities to find that more taxpayers have nexus in their states. Accordingly, we may see additional income tax filing obligations for companies that meet these thresholds and anticipate that companies may need to adjust their policies and procedures and consult with tax professionals to carefully monitor the magnitude of sales and volume of transactions as they begin filing in states where the company has established economic nexus.
Overall, based on the Wayfair decision, organizations should consider reassessing their historical and current nexus positions, as well as filing requirements for income tax purposes for all filing methodologies (i.e., separate, unitary and combined.) Meanwhile, purchasers of such organizations should consider the new potential exposures they are expected to see, such as debt or debt-like items, and effective tax rate implications. Moreover, entities organized as pass-through entities should consider economic nexus rules in light of the Wayfair decision might be applicable to their companies, potentially resulting in non-resident withholding and/or impact to investor’s filing profiles.
As mentioned above, the ruling may materially alter a company’s state filing profile. As such, certain companies may want to implement state tax planning in an attempt to address their tax profile post-Wayfair. While the method and result will vary for each specific company, as the Court’s decision is relatively new and states are evolving their rules from an income and sales tax perspective, acquirers will need to be diligent in determining the efficacy of such planning of their acquisition targets.
Consideration should also be given to the potential retroactive impact of certain state economic nexus laws on a corporation that has historically performed business in a state, since some states may retroactively impose economic nexus prior to Wayfair. While many states have affirmatively noted that they will not apply Wayfair retroactively for sales tax purposes, we are not aware of any that have indicated this for income tax purposes.
The Wayfair decision has sparked a comprehensive change to state nexus laws. The ongoing development in state guidance and legislation as a result of the ruling may require substantial investment (e.g., nexus studies and restructurings) for companies and should therefore be a cause for caution for strategic and financial buyers. In sum, they should consider:
- Tax professionals at companies or their tax advisers need to stay current with new legislation and interpretive authorities and spend time understanding where their companies conduct business, who their customers are, and where sales are made to fully understand their income and sales/use tax nexus profiles. This could result in additional business costs.
- Wayfair issues will involve more time during due diligence for collecting and analyzing information regarding a target’s profile. Potential buyers should consider this additional commitment in time, up front, in scoping their potential acquisitions.
- Potential buyers will likewise have to spend additional time identifying the risk and quantum of non-filing for sales/use tax and income tax in states that have current enactments, states that will apply their rules retroactively, and states that may apply existing non-economic rules broadly. Additionally, buyers will need to consider Wayfair in their financial models in order to accurately project their go-forward after-tax cash-flows.
- Should deals move to closing, buyers will need to determine how to deal with past non-filing exposure vis-à-vis taxing authorities (e.g., voluntary disclosure agreements), if at all.
- Finally, buyers that are working to close transactions will likely have to spend additional time drafting contractual protections to help ensure that they do not assume historical Wayfair-related exposures (e.g., via indemnity, escrow, purchase price reduction, etc.) The most challenging contractual issue that purchasers might address, in this regard, may well be from exposures that become ripe post-close, due to a post-close state change in the interpretation of a tax law, for pre-closing periods.
Concepts of state tax nexus have been turned on their head. Businesses and dealmakers will need to proactively deal with this new reality for their companies and acquisition targets. In a post-Wayfair world, dealmakers, especially, will have to exercise extra care in identifying the relevant tax issues, valuing the related after-tax cash flow effect of these issues, and contractually protecting themselves from related historic exposures.