Brief history
In a 1992 Supreme Court case known as the Quill decision, the Supreme Court held that an out-of-state mail order business was not required to collect sales and use taxes on goods sold into a state. While Quill Corporation purposefully availed itself of the state’s economic market, the corporation did not have substantial nexus in the state due to its lack of physical presence. The Court held that the imposition sales tax collection on a remote seller, such as Quill , created a burden on interstate commerce that violated the Commerce Clause of the U.S. Constitution. The Court will be reconsidering the Quill precedent in the South Dakota v. Wayfair Inc. case currently before it, which could impact any seller with remote sales.Initially, states and taxpayers interpreted Quill to require commonly understood examples of physical presence, such as a salesforce or a retail outlet in the state. Over time, states creatively broadened their interpretation of the level of contact that will create nexus. For example, courts have ruled that online retailers who allow returns through a related local business or that market the retailers’ goods through websites of third-party businesses located within a state would be sufficient to create nexus and require the out-of-state retailer to collect and remit taxes on goods sold into the state.
More recently, multiple states have passed legislation that establishes sales tax nexus through an economic presence without any physical connection, in direct and acknowledged violation of the Quill decision. This spring, the Supreme Court will hear a case brought by Wayfair, Inc. against South Dakota. The state enacted a 2016 law establishing nexus if an out-of-state seller’s sales into the state exceed $100,000 or 200 transactions in a year. The case has been heard by the South Dakota courts and the decisions have stated South Dakota’s law is unconstitutional because of the physical presence standard determined in Quill. Most tax professionals expect the court to address Quill and possibly change the historical physical presence standard allowing laws such as South Dakota’s to prevail.
What does this mean for M&A?
Effective tax due diligence has always included a close look at the sales and use tax obligations and compliance of the seller, but the Wayfair case adds a new layer of complexity to the review. Businesses currently considering a transaction should evaluate the impact that a reversal of Quill would have on the transaction.
Many states have already passed legislation establishing nexus through economic bright-line thresholds of annual sales or transactions with customers in the state. If South Dakota prevails, a state may more aggressively enforce its economic nexus law based on the effective date of the enacted law. Further, states without an economic nexus statute might even attempt to enforce a broad finding that economic nexus is constitutional on a retroactive basis to all open tax years.
Another area of concern relates to how states may define the economic standard if Quill is overturned. If South Dakota prevails and the physical presence standard no longer applies, most tax professionals agree that other states will quickly hop on the bandwagon and pass similar legislation. Many states may take an aggressive stance on what gives rise to nexus through an economic means. For instance, Hawaii just introduced a bill that would create sales tax nexus similar to South Dakota’s but the in-state threshold for sales would be defined as sales of items or services delivered to Hawaii customers that exceeds $5,000 per year, whereas, South Dakota’s law requires at least $100,000 in sales before nexus is established.
The uncertainty puts dealmakers in the unusual position of forecasting the possible retroactive impact of a change in some state laws or tax enforcement that the parties could not have foreseen until recently.
What happens next?
Oral arguments before the Supreme Court in Wayfair are scheduled for April 17 and the Court could release its decision in the Wayfair case before the end of June. If the Supreme Court finds in favor of South Dakota, businesses that meet the bright-line thresholds in states that have enacted economic nexus laws could be liable for taxes on sales based on the laws’ effective dates.
Additionally, many states that impose sales and use taxes have become increasingly expansive in their interpretation of existing nexus rules in recent years. It seems likely that those states would make economic nexus legislation a high priority if the Supreme Court rules in South Dakota’s favor. Further complicating the issue, each state could be free to set its own economic thresholds for establishing nexus.
As far back as the Quill decision in 1992, the Court noted that the issue could be resolved with federal legislation. Bills have been introduced and referred to committees in both chambers of Congress, but action seems unlikely to occur before the Court rules. However, depending on what the Court holds, federal legislators might consider action to create a consistent nationwide threshold for economic nexus to limit the uncertainty taxpayers would face should states take different positions about what does and does not give rise to economic nexus.
What to do now?
Potential buyers and sellers considering an M&A transaction should understand the implications of how Wayfair may affect the transaction and the magnitude of the potential exposure. The buyer and seller should include protections in the transaction documents. Further, buyers should place a stronger emphasis on obtaining tax clearance certificates to reduce the risk of successor liability being imposed on a buyer.Evaluate sales and use tax compliance under both Quill and Wayfair. If the target company is a retailer selling into a state with an economic nexus law on the books, due diligence procedures should determine if the business is in compliance and, if not, what its exposure is. The impact and risk should be considered when determining the valuation of a target company and the purchase agreement should allocate the risk of a possible tax underpayment between the parties in the purchase agreement.
As always, the individual facts and circumstances of the parties are the most important considerations when negotiating a merger or acquisition. If you have questions about how the Wayfair decision could affect current or future transactions, please contact us.
