Posted on November 15th, 2023

The California Department of Tax & Fee Administration (CDTFA) is responsible for allocating more than $9 billion of local sales tax to cities and counties each year. Along with property tax, local governments rely on sales taxes as a primary source of funding for critical services like police, fire, streets, parks, and libraries. Unlike property tax, though, sales tax is a fickle friend. Its ebbs and flows are much more closely tied to local and national economic trends. Accurately projecting future sales tax revenues is not only difficult, it's extremely important to the financial health of our cities.

It's hard enough when the ground isn't shifting beneath you, which is why the trend of CDTFA reallocations has become such a hot button issue. In recent years, most of California's local governments have received a notice informing them that portions of their sales tax revenues derived from online sales were going to be reallocated to other jurisdictions.

It might be easy to make CDTFA the boogeyman in this scenario, but the truth is a bit more complicated. And this problem is not isolated to California! Many states are dealing with similar issues resulting from the Wayfair ruling handed down in 2018. But California has a particularly quirky legal structure that makes resolving the question of online sales taxes even more challenging.

Several working groups have been convened over the years, so far with little to show. But momentum is certainly building inside the Golden State, and now's the time to find a palatable (and equitable) framework for handling the complexities of online sales tax.

How did we get here? 

Some of our dear readers might be interested in the full history of sales tax in California (if you're one of them, knock yourself out). But for our purposes, a condensed timeline will probably suffice:

  • 1933: California established statewide sales tax

  • 1945:  City of San Bernardino adopts first local sales tax

  • 1955: 174 California cities had implemented separate local sales taxes

  • 1955/56: California Legislature adopts Bradley-Burns Uniform Local Sales Tax Act establishing a centrally administered local 1% sales tax. State establishes that taxes will be based on the location where the sale occurs. 

  • 1993: California updates sales tax regulations to reflect that for out-of-state businesses, with warehouses located within the State, sales tax is assessed to the location where the item is delivered. 

  • 2019: California updates sales tax regulations after U.S. Supreme Court’s decision in South Dakota v. Wayfair opens the door for taxing online sales from out-of-state businesses without a physical presence in the State. Sales tax revenues for these online transactions are allocated based on where the item is delivered.

Let's key in on the 1993 changes. On the heels of Quill v North Dakota, which Wayfair effectively overturned, this well-intentioned legislative change provided a mechanism to create an influx of new revenues for cities. It wasn't long before localities found legal ways to partner with companies, allowing them to capture taxes from remote sales. While sales tax rebates are not as common in California as traditional retail incentives (unlike in other states, where they're used frequently), cities started agreeing to share a percentage of the local sales taxes generated from a specific retailer if that retailer would locate a warehouse in their city limits, or restructure their warehousing operations in a way that allowed sales taxes to be retained by the city. While these arrangements provide large revenue sources for the parties involved, they have had the effect of shifting revenue allocations away from other cities.

At this point, it's worth pointing out that in a pre-Wayfair environment, the amount of revenue actually being shifted to one city was probably not that much. Without these arrangements, most of the windfall would have remained uncollected anyway. It's not until Wayfair that these arrangements really start to be seen as inequitable. The world had fundamentally changed overnight, and it became clear that we'd need to find a middle ground.

But it's not just Wayfair causing the inequities. In 2021, CDTFA notified most of the cities in the State that they would no longer receive sales tax revenue allocations for online purchases made from Amazon.

It turns out that Amazon had changed their corporate structure: their warehouses and fulfillment centers would no longer be operated through an out-of-state company. Amazon purchases would therefore be considered an in-state purchase, and any associated sales taxes would be allocated to the location of the fulfillment center rather than the destination.

This modest restructuring resulted in most California cities losing Amazon revenue previously allocated to them, while a small number (those who have fulfillment centers) were allocated millions of dollars in new sales tax revenue.

Calls for change

Even before Wayfair, cities and some state legislators were calling for new rules to prohibit these sorts of sales tax rebate arrangements. Over the last decade the League of California Cities (Cal Cities) has established at least three working groups/task forces to examine this issue (and others related to the allocation of sales tax revenues).

In 2019, a bill was passed by the California legislature to prohibit these sharing agreements, but it was vetoed by Governor Gavin Newsom. He argued that the agreements are “an important local tool that captures additional economic activity, particularly in rural and inland California cities that continue to face significant economic challenges like high unemployment rates.” 

Shortly after the Amazon news, the City of Rancho Cucamonga - with the support of several other cities - submitted a resolution to Cal Cities. It called for the state legislature to pass legislation aimed at providing a more fair and equitable distribution of Bradley-Burns tax revenues from in-state online purchases.

The resolution was not approved when presented to the General Assembly at the 2021 Cal Cities Conference. However, Cal Cities established another working group to consider the issues surrounding sales tax sharing agreements and the equitable allocation of Bradley-Burns tax revenues. 

In June 2023, the working group presented their recommendations to Cal Cities’ Revenue and Taxation Policy Committee. The recommendations, summarized below, were approved by the Revenue and Taxation Policy Committee and later by the Cal Cities Board of Directors. 

  1. Recommendations Regarding Tax Sharing Agreements

    1. Any policy changes should be forward-looking and not affect existing agreements. However, current agreements should not be allowed to be renewed in perpetuity. 

    2. Limit the duration of agreements to 20 years.

    3. Cap rebates/tax sharing at 50% of the sales tax generated by the private business. 

    4. Require the state to create and maintain a database of all these agreements on a website.

    5. Exclude from county pool calculations the Bradly Burns tax revenues rebated to private businesses. 

  2. Recommended Equity Statement to Guide Exploration of Changes to Bradley-Burns Tax Allocations

    The equitable allocation of remote revenues from e-commerce recognizes both sides of the transaction and their contribution to sales tax generation. Allocation of the Bradley Burns 1 percent local sales tax revenue from in-state online purchases should proportionately benefit those communities that provide the infrastructure and incentives that facilitate the transaction and delivery of those goods and those communities that are the destinations for the goods. The regional impacts to infrastructure, land use, environmental quality, and public health stemming from e-commerce as well as the financial dependence of communities on the resulting revenues must be recognized. Changes to consumer behavior, which consists of more online shopping, must also be considered as to the fiscal sustainability of all cities. 

    City officials should account for these factors in the evolving marketplace and continuously strive for prospective fair and equitable revenue sharing based on data, as available. City officials should also employ their best judgment to support policies that benefit the sustainability of all cities.

Why is this such a tough question?

Recently, Bloomberg Tax reported that CDTFA has notified some cities with sales tax sharing agreements that significant portions of those cities sales tax revenues have historically been incorrectly allocated. The results of these reallocations could lead to a stunning 73% decrease in annual sales tax revenue, according to one city.

While taxpayer payment data is not public, some back-of-the-envelope math suggests that this estimate of revenue loss is definitely in the realm of possibility. This loss would equate to about 20% of general fund revenue. That's not necessarily "we're going bankrupt tomorrow" territory, but it is a Great Recession level shock to the system (and without the expectation of eventual recovery). It's nothing to sneeze at.

When the Texas Comptroller proposed a set of rule changes aimed at eliminating similar arrangements across the state, the pushback from cities that would be negatively impacted was swift and severe (including two separate legal challenges that are still pending).

The problem facing California (and other states) has less to do with the specifics of restructuring the legal framework around non-nexus sales tax than it does with the fact that the benefits of any change will be thinly spread out to a lot of cities while the harms will be heavily concentrated among a handful.

For example, one city has shared publicly that it could lose over $30 million annually, or about 32% of their entire General Fund budget from last fiscal year. If you assume a proportional distribution of those revenues divided over 39 million Californians, other cities would receive around $0.76 per resident. Based on data published by the State, the average Bradley-Burns city (population 72,502) would receive about $57,000 in additional sales tax revenues.

When the losses are so heavily concentrated, and the gains so diffuse, it's hard to arrive at a shared definition of "equitable".

Where do we go from here?

California has been struggling to address inequities within the State’s Bradley-Burns sales tax for decades. The difference today is that momentum is finally reaching a tipping point, so now is the time to strike a compromise: one that addresses the challenges while laying the groundwork to correct the inequitable distribution over time.

In the counterfactual scenario where Quill went the other way and states always had the ability to collect sales taxes without a physical nexus, it's almost certain that this sales tax would have been allocated to the ultimate destination of the purchase. In sales tax lingo, we call this "destination sourcing."

As a term, destination sourcing is pretty descriptive: wherever the item ends up is where the sales taxes are allocated. The only real problem with the term is that it stands in apparent opposition to the other primary allocation method, "origin sourcing," which is (not surprisingly) based on where the transaction originated.

The main problem here is that we have a distinction without much of a difference, because in both scenarios - destination and origin sourcing - sales taxes are due where the good changes possession. It's an unfortunate quirk of language that we have created fundamentally opposing mental models for two things that really aren't all that different.

But we don't live in a counterfactual... we got Quill, which prevented direct out-of-state sales tax collections and led to the hybrid system that everyone is now trying to unwind post-Wayfair.

Start with the sourcing question

While the working group's recommendations put addressing the agreements front and center, the attention should really be focused on addressing the sourcing question. Charles Bourbeau, chair of the Cal Cities Revenue and Taxation Committee, has admitted as much. "The rebate agreement stuff is irritating but it's peripheral," he said. "The big deal is where [online sales] tax goes."

Online sales tax should be sourced to the destination. It's simple, it's consistent, it's easy to explain (and it's actually pretty easy to enforce). There is no shortage of third-party services to calculate sales tax rates and jurisdictions based on the address of delivery. Even the smallest online retailer can avail themselves of them. And, as in brick-and-mortar retail, most online sales are run through major retailers or via marketplace apps like Shopify.

Solving the sourcing of online sales would effectively kill two birds with one stone:

  • It would prevent future sharing agreements from creating windfalls for individual cities at the expense of the rest of the state, since online sales taxes could no longer be artificially sourced to a warehouse.
  • It would make banning rebate agreements with online retailers a moot issue, solving one of the problems that Gov. Newsom cited with his veto.

However, that's not where the momentum is right now. And if politics is the art of the possible, it's not worth ruminating on the order of operations. The current framework under discussion has put the tax sharing agreements front and center, so let's start there.

Eliminate and Grandfather

These tax sharing agreements were largely the result of the liminal state that existed between Quill and Wayfair: we couldn't collect sales tax on all online purchases, but we could create a local mechanism to do it on a case by case basis.

In a post-Wayfair world, cities should not be able to grab sales tax destined for other localities especially when it means giving a lot of those revenues back to a business. The momentum is there to prevent this from happening in the future, and we should move forward with such changes.

But we can't ignore the fact that our friends, colleagues, and fellow Californians have come to rely on the revenue generated by these agreements. They may not be equitable anymore, but it's not fair to say they weren't equitable when they were adopted. Existing agreements should be grandfathered in a way that prevents them from being extended, and provides sufficient time for those cities to safely and reasonably wind them down over time.

Due to the potential to overcomplicate things, we recommend not slowly phasing out this revenue. Such an arrangement is likely to be extremely difficult to administer, both for the business and for the CDTFA.

If this kind of arrangement is necessary to reach a compromise, we should always prefer the simplest solution. For example, a city with a sharing agreement might send a slowly increasing portion of the affected revenue to the state to be re-allocated on a proportional basis across the state. This wouldn't be the most accurate way to reallocate this revenue, but it would be the simplest way to do it. It would also begin addresses concerns with the county pool allocations (which we'll touch on shortly).

Finally, we should be cautious about blanket bans on all sales tax rebate agreements. The working group's recommendations to ban most sales tax agreements might be too blunt a tool for this particular problem. Although sales tax rebates are not as common in California for traditional retail, they can be a valid and reasonable approach to economic development and recruitment when treated with caution. Throwing out the baby with the bathwater could have unintended consequences down the road.

In-state vs out-of-state online sales

While eliminating sharing agreements and allocating online sales to the purchase destination will go a long way to addressing these problems, it doesn't solve the Amazon issue.

The idea that a simple change of paperwork and corporate structure could have such a drastic shift in sales tax allocations should be considered untenable for the largest state in the union. These types of changes can happen independent of sharing agreements, and threaten to totally upend the financial health of hundreds of cities across the state.

This question is not unique to California, and we can reap the benefits of federalism to look for examples. In some states, for example, warehouses and distribution centers can only be considered nexus-generating places of business if they have an actual sales operation associated with them. It doesn't matter whether it's an in-state or out-of-state company, it doesn't matter whether the order is made online or in a brick-and-mortar store, a fulfillment center does not collect sales taxes without a legitimate sales operation.

This might not be the right model for California, but it could provide an off-ramp to exit the Corporate-Structure-Dictates-Sales-Tax-Allocations highway.

Do fulfillment centers put demands on local infrastructure? Sure! But they also generate significant property tax revenues (both secured and unsecured) that can help offset those costs. We don't need to change our mental model of sales tax nexus to accommodate them.

Some of the working group discussions have involved intricate formulas to split Bradley-Burns revenue between the location of warehouses and the ultimate destination. At this stage in the game, Conventional Wisdom suggest that we won't find a path toward compromise without some kind of equity split for this sales tax. While we get that, we still think it's an unnecessary complication.

After all, we're talking about the last mile of a much bigger process. There's a lot more to logistics than the location of the fulfillment center and the ultimate destination. If we're going to go down this road, it's unfair to ignore everything that happens before an item is checked into inventory at a warehouse. It's also completely impractical to accurately allocate sales tax to every bit of infrastructure involved.

This is true even if you wanted to limit revenue sharing to just the warehouse location and the ultimate destination. Should it be 50/50? 75/25?

Any compromise will just be based on political feasibility rather than actual infrastructure impacts, while making the Bradley-Burns pools even more complicated.

Keep it simple. Online sales should be sourced to their destination regardless of the corporate structure of the warehouse the merchandise sat in. If there's absolutely no way to get something done without splitting between warehouse and destination, the destination should be favored as much as practicable. We understand the equity argument being made; we simply don't believe it's strong enough to justify tacking on additional complexity.

Bradley-Burns Pools

Finally, the county pools have outlived their usefulness when it comes to online sales. Technology has advanced such that the "direct allocation" of local tax for online purchases is rarely impractical.

It's very easy to map a delivery address to a specific jurisdiction. There are myriad third-party services that allow you to calculate the correct tax when operating your own online point-of-sale; and marketplace facilitators like Amazon and Etsy are responsible for collecting sales tax on behalf of their vendors anyway.

The county pool is simply no longer needed for online sales, and can be phased out without legislative changes.

While we think this should be the long-term goal, it isn't feasible in the short-term. Unfortunately, the question of how to allocate county pool shares given the tax sharing agreements isn't going away. Any compromise that implicitly (or explicitly) acknowledges the unfairness of one city scooping up the revenue from other cities through a tax sharing agreement should also acknowledge the outsize benefits that accrue to county pool allocations.

In the short-term, removing all rebated amounts from the pool calculations seems like an easy move. If the revenue sharing agreements are slowly phased out (as discussed above), the remainder of this discrepancy will be slowly eliminated as well. When we get to that point, there will no longer be a justification to run online sales taxes through the county pools.

Keep it simple

Whatever we do, we should strive for simplicity. California has operated under a legal framework that became untenable as a result of Wayfair. It's tempting to want a fancy fix. But a fancy fix takes a fancy amount of time.

In life, there are no solutions; there are only trade-offs. We've got momentum to address some major problems. We should build on that momentum with small, simple changes that address the challenges and inequities without leaving our fellow Californians out to dry. We should ease into those changes where possible. And we should focus only on the problems that we're dealing with right now.

This is a humble yet strategic approach that should allow us to find common ground while we have the chance to do it. The more complicated and holistic we try to make this process, the more likely it is that we'll squander the opportunity we have.

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