The Supreme Court recently ruled that a physical presence in a state is not required for a state's sales and use tax requirements. In response to South Dakota vs Wayfair, states are rapidly updating their policies to collect state sales taxes from companies that conduct business remotely.
Internal accounting departments may be focused on complying with the tax changes (and rightly so), but there are also financial reporting considerations that come into play with sales and use taxes. Companies that owe additional sales taxes will also need to ensure they update their accounting under ASC Topic 450, Contingencies: Loss Contingencies.
Brief Summary of Sales Tax Changes
For more than 50 years, physical presence has been the standard for whether a state can impose sales and use taxes on businesses. The principle behind the physical presence standard is tied to an interpretation of the Commerce Clause, a law that allows Congress to prohibit states from placing "excessive burdens on interstate commerce without congressional approval."
Technology advances allow companies to do more business remotely. E-commerce has led to a significant loss in potential tax revenue to the tune of $8-33 billion per year. Many states, including South Dakota, have tried to capture revenue from remote sellers and challenge the physical presence standard by implementing tax policies based on "economic nexus" — thresholds for an amount of transactions (or dollar amount of transactions) that would make remote sellers subject to state sales taxes.
Wayfair involved whether South Dakota's "economic nexus" standard violated the Commerce Clause. The Supreme Court ruled that the physical presence mandate is "an arbitrary, formalistic distinction" disavowed by modern precedents to the Commerce Clause. Further, it determined that preventing states from collecting taxes from remote sellers "creates rather than resolves market distortions" and that physical presence "is not a necessary interpretation" of whether a business has nexus within a state.
Although the decision only applies to South Dakota's tax policies, the decision opens the door for states with similar requirements to South Dakota's law to collect state sales taxes from remote sellers.
How Sales Tax Affects Financial Statements
Sales and use tax law changes will do more than affect where companies register, collect and remit sales taxes. Accounting for sales taxes will also need to be updated, and companies will be required to estimate their potential sales tax liabilities as part of their financial statement reporting.
Because sales tax is not based on income, it is generally accounted for as an obligation that arises from the collection of sales tax from customers that must be remitted to a state or in the same manner as an expense, accrued when incurred. However, in some instances there is uncertainty as to whether a sales tax is due, or when fines and penalties may be assessed because they may be contingent upon enforcement activities of applicability under the law. When there is such uncertainty, the definition of loss contingencies under ASC Topic 450 is applied. Accounting for loss contingencies has different rules based on the likelihood of the contingency occurring: probable, reasonably possible, and remote. If a loss contingency is probable to occur, the reporting entity estimates the loss as a charge to income at the date of the financial statement issuance. If a loss contingency is reasonably possible, the reporting entity discloses the nature of the contingency, and estimate of the loss.
Wayfair introduces uncertainty to the accounting for sales tax this year because the incurrence of a loss will be contingent on the outcomes of laws and enforcement actions of individual states. It is not yet clear whether states that have existing laws that are based on economic nexus will now enforce those laws, or whether states will pass new laws that will either be retrospective or require remitting sales taxes prior to entities being able to put the process in place to collect them from customers. As a result of the changes that may come about as a result of Wayfair, entities will need to consider whether they have potential loss exposure due to a failure to collect sales taxes for individual states in their upcoming financial statements. These potential losses and liabilities will be assessed under ASC Topic 450.
Determining When to Adjust Accounting for Wayfair
One of the largest challenges involved with the Wayfair decision involves timing. Effective dates and thresholds vary based on state, with some imposing sales tax changes for 2018 and others waiting until 2019 to begin using the "economic nexus" standard. Although early indications are that states will pursue sales taxes based on economic nexus prospectively, the Wayfair decision also does not limit the economic nexus standard to prospective use. States may be able to retroactively impose an economic nexus sales tax standard, however trying to collect sales tax from previous years may be an "excessive burden" to companies under the Commerce Clause.
Working with an experienced accounting provider can help your company meet its requirements and navigate the changes to policies and guidance that are coming out in the wake of the Wayfair decision. For more information on how accounting for your business may be affected, please contact us.
Published on July 17, 2018