Congress Must Rein In California's Out-of-State Tax Grabs

I’ve written many times about the direct consequences of the Supreme Court’s decision in South Dakota v. Wayfair, which allowed states to impose sales tax obligations on out-of-state businesses so long as they exceed certain sales thresholds within the state — in other words, greatly increased compliance obligations for small businesses that suddenly needed to grapple with the differing sales tax regimes of states around the country. But unfortunately, one of the indirect consequences that critics of the Court’s decision in Wayfair feared is also beginning to come to pass.

Though the Court’s decision in Wayfair was limited to sales taxes only, one concern was that states would use its logic to expand their reach with other levies as well, like business income taxes. After all, if states could require businesses with no physical presence within their borders to collect sales taxes, what other parts of their tax system could they subject them to?

Ostensibly, states are largely prevented from doing that by P.L. 86-272, or the Interstate Income Act of 1959. This law bars states from imposing income tax obligations on out-of-state businesses if their only physical activity within the state is the solicitation of sales — in other words, if a New York business sends a catalog into California, and then ships any orders coming from California out from New York, California can’t claim income tax obligations.

Even though the internet has changed many things about our society, P.L. 86-272 has served as a limitation on states expanding their income taxes outside their borders. But organizations like the Multistate Tax Commission (MTC), an intergovernmental tax agency, have been pushing the boundaries of limits on state taxation steadily since the Wayfair decision came down. Last August, the MTC released a statement claiming that as a result of Wayfair, businesses lose the protection of P.L. 86-272 if they offer many forms of service beyond just the electronic sale. That includes services such as electronic chats and even allowing for cookies to be saved on customers’ computers.

Tenuous as that logic is, California, eager as it always is to try out any half-baked scheme to get more revenue, has taken up the argument wholeheartedly. On February 14, the state’s Franchise Tax Board (FTB) published a memorandum essentially announcing that it would apply the MTC’s interpretation to its business income and franchise taxes. 

In effect, this would impose California income tax obligations on businesses with websites that offer even basic services. Chat support and cookies are very common among businesses that are tailored towards e-retail. 

And what’s worse, businesses couldn’t even avoid these obligations by eliminating these services from their websites. California’s FTB announced that it would apply this new interpretation retroactively to all open tax years — for California, that means as many as four years backwards (or more, in the event of audits). In other words, online businesses across the country could soon find California’s FTB claiming that they owe taxes they weren’t subject to at the time the commerce was conducted.

As with all cases of states taxing and regulating outside their borders, the real danger is that more states take up the idea, creating an ever-expanding web of new compliance obligations for small online businesses without the accounting resources to keep up. Hawaii already assesses income tax obligations on the basis of economic nexus, while Colorado, Illinois, Oregon and Utah have all expressed interest as well. 

At the same time, just like other such cases, the problem can be fairly easily solved by Congress, the body empowered by our Constitution to prevent this kind of madness. The best solution would be the Business Activity Tax Simplification Act, or BATSA, which would prevent states from imposing business income taxes if the company in question has only a tangential connection to the state.

California’s actions show that BATSA is needed now more than ever. States’ drives to fill up their revenue coffers will likely continue unrelentingly until Congress puts its foot down and tells states to get back within their own borders.