The Sourcing Tail Wagging the Nexus Dog

August 20, 2015

There is a growing list of states that have adopted a more aggressive income tax nexus standard.  On August 11, 2015, Alabama added itself to the group of states that impose their income tax on out-of-state businesses solely based those businesses a certain level of sales to customers in the state.  The trend is a natural response to the impact that technology has had on the ability of businesses to provide their services on a national (or even global) scale without having an expansive physical presence.

The legislation enacted in Alabama (H.B. 49), which will take effect for tax years beginning after December 31, 2014, is commonly known as a “factor presence” or “bright-line” nexus test.  Under Alabama’s the new nexus rule, a business organized outside the state will have an income tax filing obligation if:

  • Its in-state property exceeds $50,000;
  • Its in-state payroll exceeds $50,000; its in-state sales exceeds $500,000; or
  • 25 percent of its total property, payroll, or sales are attributed to Alabama.

In the last year, New York and Tennessee have also adopted similar nexus rules.  Other states that have a factor presence nexus rule for their income tax (or other business activity tax) include California, Colorado, Connecticut, Ohio, and Washington.

For years, state tax practitioners would typically advise their clients that they did not have an income tax filing obligation in a state unless they had a physical presence in the state.  Thus, the fact that a state applied a destination-based sourcing rule for sales of services was irrelevant because the business did not have the requisite nexus with the state to have a filing obligation.  Under a factor presence nexus rule, sourcing is front and center.  An out-of-state business will have a filing obligation in the state by merely making sales to customers in the state.  Service providers should pay close attention to this trend, as states that adopt a factor presence nexus rule typically change their rules to consider a sale of a service to be an in-state sale when the customer is located in the state.  Thus, the location from which the service is performed is largely irrelevant in determining if the business has a filing obligation in the state.  The result is that companies with very small physical footprints could have a much larger tax compliance footprint.

While the list of states imposing a more aggressive factor presence nexus rule is still relatively small, the fact that three states have enacted such a rule in the last year suggest that more will follow suit.  Service providers should know where their large customer bases are located, and monitor legislation in those states to ensure they are in compliance.

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