YOUR TAXES: US state and local sales and use taxes: Bad news, good news

Israeli businesses fall into each of these categories of noncompliance, and it is primarily to these businesses and their advisers that the remainder of this article is addressed.

money (photo credit: REUTERS)
(photo credit: REUTERS)
Thousands of American subnational governmental units (states and localities) impose taxes. These taxes include “sales taxes,” which are imposed on sales to end users of goods and certain services, and “use taxes,” which are imposed on such purchases when sales tax applies but was not collected. Across the US, combined state and local tax rates are about 8 percent of the amount of a retail sale.
Sales and use taxes generate far more tax revenue for states and localities than do corporate income taxes. Businesses in the United States know that the subnational governments jealously guard their sales-tax base, and these businesses go out of their way to avoid the under-collection of these taxes. Recently, there have also been “whistle- blower” lawsuits brought by private parties against non-compliant businesses. The private parties are eligible for large financial rewards if taxes are collected as a result of their efforts.
Despite the risks of noncompliance, anecdotal evidence suggests that many businesses headquartered abroad are not complying with their obligations to collect sales taxes.
Some are not doing so because of a lack of understanding of the American tax system, others are hoping that the states will not notice them, and others (including very large businesses) are relying on the advice of local financial accountants who are not state tax experts.
Israeli businesses fall into each of these categories of noncompliance, and it is primarily to these businesses and their advisers that the remainder of this article is addressed.
First, the bad news: States treat vendors as being liable for collecting tax on their sales even if a tax treaty protects those businesses from having to file a federal income-tax return. For example, the temporary presence in a state of a vendor’s employees, or even of independent contractors selling the vendor’s goods, can be sufficient to require the vendor to collect sales tax. Failure to collect sales taxes exposes the vendor, as well as its management and financial employees (“responsible persons”), to liability for the uncollected taxes, interest and penalties. Make no mistake: Sales-tax noncompliance converts the small liabilities of a business’s many customers into a large liability of the business itself.
And even worse news: Earlier this year, a US Supreme Court justice wrote that he is prepared to end a half-century’s worth of precedent conditioning a requirement that vendors collect a state’s sales tax on the vendor’s physical presence in that state. Such a change will directly impact Israeli vendors (and their responsible persons), potentially including those with no property, employees or representatives in the US. Under current law, such vendors generally are not responsible for the collection of state and local sales taxes.
Now the good news: Twenty-four states are members of the Streamlined Sales Tax Governing Board, which provides uniform definitions for sales-tax concepts. These states’ cooperation has simplified the process of determining taxability of sales of goods and services. And more good news: Currently, seven states have active or upcoming tax amnesty programs applicable to sales taxes, under which participating businesses will generally receive a waiver of liability for some back taxes, waiver of liability for all penalties and waiver of liability for some or all interest on the taxes and penalties. In addition, three other states are considering sales-tax amnesty programs.
Even more good news: Even states and localities that are not offering tax amnesty permit non-compliant taxpayers to come forward voluntarily and make special arrangements to become compliant. Such arrangements generally include the waiver of some back taxes and a waiver of all penalties. In some cases, it is possible to obtain a shorter period of back-tax liability than is available through the amnesty programs. In general, interest is not waivable when a business makes a voluntary disclosure.
Significantly, the voluntary disclosure process is a negotiation between a tax jurisdiction and a tax professional on behalf of his unidentified client. The client’s identity is not disclosed until the terms of the voluntary disclosure are agreed upon.
And the best news: Ultimately, sales-tax responsibilities are dependent upon the characterization of what is being sold. Not all goods and services are taxable, nor (when they are taxable) are all goods and services taxed at the same rate. For example, items characterized as “medical devices” (a favorite merchandise category for Israel-based vendors) may be taxed at reduced rates in some states and exempted from sales tax in other states. Likewise, some states impose sales taxes on the sale of prepared foods but not on the sale of unprepared foods.
Moreover, looking to the “essence of a transaction” may reveal that what is being sold is a nontaxable service rather than taxable tangible personal property. A classic example is the purchase of legal services that involve drafting a will; while purchasers, of course, want the paper manifestation of the legal advice they received, their real desire is for legal advice. The difference in characterizations is significant because most states impose sales tax on sales of paper, but most do not impose sales tax on the sale of legal services.
Characterization planning has been and will continue to be the most highly valued sales-tax planning service that state tax lawyers provide.
The smoke from a distant fire Efforts are under way in several very populous states to greatly expand the types of services that are subject to sales taxation.
For example, Pennsylvania Gov. Tom Wolf has proposed an expansion of the state’s sales tax to services, and on March 18, 2015, the Pennsylvania Department of Revenue issued a bulletin identifying types of services that will be newly subject to sales tax. These include accounting and legal services. And California is considering legislation that potentially makes sales of all types of services taxable in California.
Of course, identifying where the benefit of a service is received is difficult when the purchaser is a multistate or multinational enterprise. For example, because financial accounting and tax advice benefit an organization in its entirety, how would one determine where a benefit of such advice is received? Nevertheless, in April, the California State Board of Equalization (the state agency responsible for administering its sales tax) estimated that a tax on services would generate $122 billion for the state in 2016. Put in context, that figure is astounding considering that during 2014 all states combined collected a total of $866b. from all taxes. It is certain that the California Legislature will have difficulty restraining itself from tapping into such a revenue stream, as will the legislatures of other states.
Israeli businesses will be directly and significantly affected by the trend toward the taxation of services if the physical presence requirement is eliminated. For that reason, although the smoke from this fire is presently barely discernible, it merits vigilant monitoring.
Some closing remarks State and local tax liabilities matter. They may impact on a liquidity event, and the tax world is getting smaller and more transparent. The US-Israel tax treaty does not cover state taxes.
And the domestic foreign tax-credit rules in the Israeli Income Tax Ordinance only relate to income taxes, not sale and use taxes. So check it all out.
As always, consult experienced tax advisers in each country at an early stage in specific cases.