We recently talked about the forthcoming rule changes being proposed by the Texas Comptroller, focusing mainly on the concern expressed by some cities that the Comptroller was using the single local tax rate and marketplace provider changes as a pretext to modify sourcing rules* across all local sales tax.
"Sourcing" refers to where a sale is considered consummated. Depending on the type of transaction, it may be "sourced" at the point of sale, where it is fulfilled, or where the item is delivered.
At the time, a draft copy of alleged rule changes was being circulated. As of this morning, the Comptroller's formal proposals have been released, and there are material differences between the formal proposal and the draft that was circulated. Here's what you need to know.
The rules do not change sourcing for all transactions
An email containing the alleged draft rules was sent to city officials across Texas along with a hypothetical analysis that calculated one possible option for reallocating all local sales taxes. The author of this email later clarified that it was meant to be hyperbolic, but it nevertheless concerned many that the Comptroller was intending to use new legislation related to online sales as a pretext to change sourcing rules across the board.
As we discussed in the ZacCast episode linked above, we do not believe the Comptroller has that authority. The changes to Internet based transactions may represent significant changes for a handful of cities, but taken as a whole the new rules do not appear to be an attempt to make sweeping changes beyond Internet based sales. It is a relatively targeted change, albeit one whose language may need some tidying up to avoid problems in the future.
Most of the changes are minor, and there are some good things for cities
As TML's legislative update from this morning explains, "[m]any of the changes will not significantly alter the collection of city sales and use taxes ... [and o]ther changes are quite beneficial..."
The formalization of the single local tax rate will open local sales tax to thousands of new remote sellers; the new marketplace rules will require online platforms like Amazon, Walmart, and others to collect sales taxes on behalf of third-parties who sell on their platforms; and changes to use tax collections put the onus on businesses (in some circumstances) rather than purchasers, which will make compliance more likely.
The Comptroller is not a fan of the exploitation of a particular loophole
Before Wayfair, Internet sales could be handled one of two ways: a) sourced to the destination, or b) sourced to a place of business in Texas. If no place of business existed, sourcing defaulted to (a). Some cities have use this rule to recruit businesses with substantial Internet sales to establish places of business in those cities. They've done so through the use of economic development agreements under Chapter 380 of the Local Government Code, which allows them to rebate a portion of the sales tax remitted by those businesses back to the businesses.
In some cases, these places of business provide actual business services and would otherwise qualify as a place of business. In other circumstances, they may function only as a place to consummate sales. The Comptroller is not a fan of the latter:
The comptroller also adds to the definition of "place of business of the seller - general definition" that an outlet, office, facility, or any similar location that contracts with a business to process certain orders or invoices is not a place of business of the seller if the comptroller determines that these certain locations are for the sole purpose to avoid tax due or to rebate tax to the contracting location. This change is made pursuant to the definition "place of business of the retailer" in Tax Code, §321.002(a)(3)(B).— Emphasis added
New in the formal proposal is language explicitly stating that the Comptroller is attempting to put an end to this practice. Existing agreements (made before September 1, 2019) may continue to operate until December 31, 2022, but no new agreements would be allowed.
What is the impact of these loophole arrangements?
First, it's important to understand that many of these arrangements, while reasonably classified as a loophole, were valid under the old rules.
Second, it's important to know that in the absence of these places of business, sales tax would (in most cases) have been remitted to the destination of these purchases, rather than to a central place of business created for these purposes, or not collected at all.
Third, it's worth noting that in the absence of the rebate agreements, the businesses would have had little incentive to participate in these arrangements; and although only a handful of the 1,000+ cities across the state have these agreements, any of them could have done so.
It is fair to state that these arrangements have benefitted some cities at the expense of everyone else. It's also worth stating that these arrangements were crafted within the bounds of the law, though one could argue not within the spirit of it.
This, most likely, is the impetus for the Comptroller's proposal.
Over the years, however, cities with these arrangements have most likely become dependent upon the revenue they generate. Although a portion of the revenue is rebated back to the businesses, in many cases the amount retained by the city is material to their operations. In some cases, the impact may indeed be significant.
Will my city be impacted?
If your city does not operate with an agreement like this, you probably don't have much to worry about. Indeed, you might benefit from these changes if online purchases from these vendors are sourced at the destination.
If your city is operating with one or more of these types of agreements, you might be in jeopardy of running afoul of these changes. Unless you can rework your agreement(s) to come in compliance with the new rules, you might lose all (or at least most) of the revenue the agreements are providing.
Although the Comptroller explicitly states in its commentary that its goal is to eliminate what one might call "shell places of business" that exist to avoid or rebate sales taxes, the language provided in the rules themselves might still provide opportunities to maintain existing agreements.
Call centers, showrooms, and clearance centers are still considered places of business of the seller, and in some cases so are distribution centers, manufacturing plants, storage yards, and warehouses (when they receive three or more orders from persons other than employees, contractors, and persons affiliated with the seller or if a sales office is co-located). Administrative offices (by themselves) are no longer considered places of business.
The rules for purchasing offices have not changed: "vital business services" must be provided to the contracting business, not just order processing.
The big addition to the place of business definition is as follows:
An outlet, office, facility, or any location that contracts with a retail or commercial business to process for that business invoices, purchase orders, bills of lading, or other equivalent records onto which sales tax is added, including an office operated for the purpose of buying and selling taxable goods to be used or consumed by the retail or commercial business, is not a "place of business of the retailer" if the comptroller determines that the outlet, office, facility, or location functions or exists to avoid the tax legally due under this chapter or exists solely to rebate a portion of the tax imposed by this chapter to the contracting business. An outlet, office, facility, or location does not exist to avoid the tax legally due under this chapter or solely to rebate a portion of the tax imposed by this chapter if the outlet, office, facility, or location provides significant business services, beyond processing invoices, to the contracting business, including logistics management, purchasing, inventory control, or other vital business services.— Emphasis added
In other words, there may be a way to keep your existing agreements by ensuring that the place of business that has been created is not just a shell, but provides tangible business services: Logistics, purchasing, inventory, fulfillment, distribution, etc.
What are my options?
We encourage you to work with your legal advisors and sales tax consultants to determine what options you may have. If your agreements can be brought in line with the new rules such that the Comptroller determines the place of business does not exist "for the sole purpose" of avoiding or rebating sales taxes, you might be able to continue as though nothing has changed.
If your agreements cannot be brought in line, you should begin preparing to lose revenue under those agreements after December 31, 2022. This may be an extremely difficult timeline for you, and we would encourage you to explain to the Comptroller how just two full budget cycles will not provide enough time to unwind these agreements. Although we do believe in principle that the changes better align the rules with the intent of the law, the exception timeline might be quite tight for cities who have become reliant on this revenue.
Comments to the Comptroller's proposals can be sent to Teresa G. Bostick, Director, Tax Policy Division, P.O. Box 13528, Austin, Texas 78711-3528 within 30 days of the rule publication (which was January 3, 2020).