Many laws that govern taxation of interstate commerce have been slow to adapt to the economic realities of doing business in the digital age. One such federal law, Public Law (PL) 86-272, limits a state’s ability to impose a tax based on net income on out-of-state businesses with activity limited to solicit orders for sales of tangible personal property. In August 2021, the Multistate Tax Commission (MTC) revised its guidance of protected and unprotected activities for businesses with online activity.
The application of this guidance is far from certain, and it may have retroactive ramifications if not addressed currently. Buyers and sellers in the M&A marketplace should understand the potential impact on state income tax liabilities and the additional due diligence requirements necessary to manage transaction risk.
An introduction to the MTC and Public Law 86-272
The MTC is an intergovernmental state tax agency that promotes uniform and consistent tax policy among the states. A select number of states have incorporated the “Multistate Tax Compact” into state law, providing consistency on the interpretation of income tax rules, including the MTC’s definition of protected and unprotected activities. Other states have varying degrees of participation with the MTC’s Tax Compact and require additional legislative or regulatory action to incorporate the MTC’s revised definitions.
PL 86-272 was enacted in 1959 to exempt a business from state income taxes if its activity in the state is limited to the solicitation for the sales of tangible personal property. Based on historical definitions and guidance provided, no state could impose its net income tax when these three conditions are met:
- The only presence within the state consists of soliciting sales of tangible personal property.
- All sales are approved by an office outside of the customer’s state.
- The tangible personal property is shipped to the customer from inventory stored at locations outside of the state.
Since its enactment, states and businesses have questioned what “protected activities” are (those that don’t constitute a presence the state can tax) and what “unprotected activities” are (those that do create a presence that the state can tax).
The MTC’s August 2021 Statement on Public Law 86-272 is not only intended to interpret how PL 86-272 applies to certain online activity but also to provide notice to businesses that state income tax filing positions may be scrutinized. In short, the statement suggests a business’s website offering more than an ability to place an order has likely exceeded the protection of the federal law. The business may now be subject to additional state income tax filing requirements depending on the types of activities available on the website. The statement lists some examples of web-based activities that would be considered “unprotected,” including:
- Providing post-sale assistance to customers through electronic chat or email initiated via the website.
- Soliciting or receiving online credit card applications.
- Placing “cookies” used for product development or product management onto customers’ computers or other electronic devices.
- Providing extended warranty plans through the website to customers purchasing the company’s products.
- Allowing candidates to apply for open job positions.
In addition, the MTC’s statement seems to indicate this has been the intent of PL 86-272 since enactment, allowing for retroactive applicability by a state, though this interpretation may be the subject of lengthy legal challenges. In the meantime, state income tax due diligence procedures and transaction structures should consider the MTC statement and any state guidance issued.
Public Law 86-272 and transaction structures
The MTC’s updated guidance injects significant uncertainty and concern into transactions involving businesses that utilize a website to conduct regular operations. If a buyer thinks there could be additional SALT risk within the target company due to the MTC’s statement or guidance issued by the states, buyers may push for a lower purchase price or seek additional protections, including stronger indemnification clauses, larger escrow amounts, and longer holdback periods. In extreme circumstances, purchasers with low risk tolerance and an aversion to uncertainty may avoid the target company altogether.
Multistate businesses considering a future sale should analyze the impact of the MTC’s statement on their state income tax profile. An updated nexus study and exposure calculations will quantify potential tax liabilities, and voluntary disclosure agreements (VDA) should be considered to mitigate any historic tax risks and reduce the likelihood of post-transaction legal actions. Transaction planning can also include creating and updating a formal memorandum that describes all web-based activities, including the use of cookies and post-sale support functions.
The MTC statement on Public Law 86-272 is just the beginning
The MTC statement presents a potential fundamental shift in determining state income tax nexus for multistate businesses selling tangible personal property, and we’ve already seen California adopt similar guidance and New York move forward with potential legislation supporting this shift. Transactions, including potentially affected businesses, may require a closer examination of web-based activity as part of the state and local income tax review. Post-acquisition consideration may be given to managing web activities to avoid falling afoul of PL 86-272.
Participants in transactions need to understand that income generated in multiple states via websites will require closer examination by knowledgeable SALT specialists of everything from warranty offerings to cookie policies. There will be some inherent uncertainty on this issue for the foreseeable future, but buyers and sellers do have some options available to protect themselves.
If you have questions about how the MTC’s guidance could affect the state and local tax implications of a transaction, please contact your Plante Moran advisor to discuss your situation.
