California Releases Technical Memo over Sales of Digital Goods
The California Franchise Tax Board recently issued Technical Advice Memorandum 2022-01 to advise taxpayers regarding the state’s application of Public Law (P.L.) 86-272. The memo outlines examples of several common issues that arise with businesses operating in California in relation to P.L. 86-272. The examples mostly involve transactions that have arisen due to technological advances in recent years.
The examples provided are given under the following assumptions: (1) the business at issue makes sales to California customers, (2) the business is commercially domiciled outside of California, and (3) the business has no activities in California other than the activity mentioned in each example. The memo aims to provide clarity over whether California would consider the activity in each example to have exceeded the protection provided by P.L. 86-272. If a business’s activity is concluded to have exceeded the protection of P.L. 86-272, then the activity is taxable, and the business will have established a filing obligation and tax liability in the state.
The examples provided include businesses placing “internet cookies” onto computer devices, post-sale product assistance provided from out of state via telephone, and out-of-state businesses providing extended warranties.
One of the examples involves a business that contracts with California customers to stream digital goods—videos and music—to electronic devices for fees. The memo states that such an activity would disqualify a business from receiving protection under P.L. 86-272. The memo states that “streaming does not constitute the sale of tangible personal property for purposes of P.L. 86-272. The immunity provided by P.L. 86-272 only applies to sales of tangible personal property. Sales of digital video and music streaming are not sales of tangible personal property but rather are services and thus are not activities within the protection of P.L. 86-272.”
P.L. 86-272 was signed into law in 1959 and prohibits states from taxing sales of tangible personal property under certain circumstances as an extension of the Commerce Clause of the Constitution. The law was initially intended to protect interstate commerce by preventing states from taxing sales by out-of-state businesses whose activity in a state was minimal. Initially, states could not tax any sales made by a business whose only activity in a state included soliciting sales of tangible personal property. Over time, case law has elaborated on the specific application of the law, providing detail over what activities constitute solicitation of sales of tangible personal property and what activities do not.
The Supreme Court case Wisconsin Department of Revenue v. William Wrigley, Jr., Co. (1992) involved an Illinois chewing gum company that made sales in various states, including Wisconsin. The decision, along with clarification from the Multistate Tax Commission, provided a list of activities that would prevent a company from being eligible to receive protection from income tax liability under P.L. 86-272, along with a list of activities that are protected under the law. The vast increase in remote sales of digital and virtual goods and services in recent years has caused many of the directives included in the law to become less relevant.
The Supreme Court case South Dakota v. Wayfair, Inc. (2018) involved whether the state of South Dakota had a right to levy a sales tax on sales made by the company on sales to customers located there. The landmark decision overturned the previous standard included in the Supreme Court case Quill Corporation v. North Dakota (1992) and reversed what was known at the time as the “physical presence” standard, ushering in a new era for states’ ability to levy taxes on remote sales from online companies. Justice Anthony Kennedy wrote for the majority that an internet seller “may be present in a state in a meaningful way without the presence being physical in the traditional sense of the term.”
This decision gave rise to a new standard known as “economic nexus.” This standard involves the idea that a company can have a large presence and significant activity in a state without maintaining physical property or full-time employees there. The economic impact of a business is not necessarily tied to its physical location, and a business may be considered to have a large presence in a state where only the business’s customers are located. With the economic nexus standard in place, states are free to tax businesses that have never set foot in their state before—something they never would have been able to do prior to the Wayfair decision.
This memo provides a clear indication that out-of-state sellers of digital content should carefully track where subscribers are located and assume that sales into California will be taxable. The implications of this memo could have far-reaching effects for a wide variety of industries. The issue of state taxation of remote sellers of digital content represents a rapidly changing landscape, and businesses should keep close watch over states where they make sales. Failure to report sales and pay tax to various jurisdictions could result in steep penalties and interest.
If you or your client needs assistance reviewing sales and activities in California or you believe you may have established income tax nexus in the state, please reach out to our state and local tax services team. For additional guidance, contact your BKD Trusted Advisor™ or submit the Contact Us form below.