State and local governments have seen sales tax revenues decline in recent years resulting from a shift in consumer habits. Trends involving frequency of online purchasing of services directly contribute to this decrease. In addition, states are more than ever acknowledging that an organization no longer needs to be physically located in a jurisdiction in order to access clients and markets in that jurisdiction. To that end, there is an increase in the number of states that impose an “economic nexus” standard.
The increase in states employing an economic nexus standard, combined with a change in our consumer habits referenced above, has opened the door for a migration toward market-based sourcing. Market-based sourcing is the idea of taxes being imposed on where the service is consumed, rather than the location where the service was performed. This growing trend is one that taxpayers, as well as investors, will need to monitor. Private equity (PE) and venture capital (VC) firms should consider how these changes will influence their tax obligations, because states have recently begun to favor the market-based approach, and are taking a more holistic view with respect to the imposition of income tax.
In 2018, the Supreme Court ruled that a physical presence in a state is not required for an entity to be subject to a state's sales and use tax requirements. South Dakota v. Wayfair overturned the physical presence standard set in the 1992 case, Quill Corp. v. North Dakota. The Quill case had established that requiring out-of-state vendors to collect sales tax without a physical presence violated the Commerce Clause, a Constitutional provision that gives Congress authority to regulate business activities. In overturning Quill, the Supreme Court held that the South Dakota v. Wayfair decision did not violate the Commerce Clause because economic activity satisfied the Commerce Clause’s “substantial nexus” requirement.
The precedent set in Wayfair sets the groundwork for the use of economic activity as a form of nexus for other types of state and local taxes, including net income and gross receipt taxes. This could affect investment fund managers, specifically as the states broaden classifications of economic nexus. PE/VC firms should be aware of the potential impact of the Wayfair decision, as well as states’ adoption of economic nexus and market sourcing rules.
PE/VC firms and fund managers should work with their tax service providers to quantify the potential changes in tax liability resulting from the transition to market-based sourcing and ensure that adequate business reporting and accounting practices are in place to accurately source revenue.
Various states have voted to change the rules for sourcing sales of services in their income apportionment formula, moving to a market-souring approach. In addition to increasing revenue, states like Massachusetts believe the new rules will mitigate disputes between the Department of Revenue and taxpayers, regarding the interpretation of the old cost of performance rules. Many other states have followed suit, even though these new market-based sourcing rules are not uniformly adopted.
States may differ on how to determine the marketplace for market-based sourcing. The apportionment formula is based on average factors involved with a business to determine what percentage of tax is paid in a particular state. In California, for example, this formula is based on receipts. For management companies, receipts may very well be attributed to states where the fund does not have a physical presence, yet the benefit of services could be classified as being “received” in multiple states. In California, a special look-through rule applies to regulated investment companies and a similar look-through rule has been more broadly proposed for asset managers. This could have a substantial impact in the PE/VC space. In general, the California look-through rule would source receipts derived from asset management services based on the average value of the interest in assets held by the asset’s investors or beneficial owners domiciled in California.
Fund managers need to be very careful in terms of understanding if their activities will be impacted by states that have both economic nexus as well as market sourcing rules, being especially cautious of scenarios where different sourcing rules are used, possibly resulting in double taxation. On the other hand, a tax benefit may be created for states that are also employing a single factor sales apportionment method as less than 100% of an entity’s revenue may be sourced to all jurisdictions.
Consequences for PE/VC Firms
Adoption of market-based sourcing rules, coupled with the implementation of a single-sales factor apportionment formula, have the effect of increasing the tax burden of out-of-state service providers. The use of market-based sourcing minimizes the importance of where costs are incurred, and instead places emphasis on where the market is located. Those with investments and receipts located in high-tax states that follow market-based sourcing rules are likely to see their tax bills increase.
States are currently electing to move from performance-based sourcing methods to market-based sourcing, which may prove difficult for PE/VC firms that will be required to allocate management fees to the home states of their investors rather than where they conduct business. The management company may be considered to have economic nexus in a state where its fund’s investors are located if management fees are allocated to those states and economic nexus thresholds are exceeded.
Economic nexus rules and market-based sourcing may also create state tax issues for where the PE/VC firm partners are required to file. Composite returns can possibly reduce the tax exposure for general partnership members. However, ultimate contingencies will be based on how funds and investments are classified, and the ownership structure of the firm. Exceptions for PE/VC funds and managers are not currently featured in wide-reaching provisions.
The activities of PE/VC firms are viewed in the industry as a dynamically different business activity than traditional consumer products and services, yet they will still be subject to standard state nexus rules. Firms should review their state tax filings to ensure the proper application of new market-based sourcing laws are applied.
For more information about state and local tax issues for your PE or VC firm, please contact a member of our team.
Published on December 28, 2020