May 31, 2011, 5:31 PM

Next for Nexus?

With taxing web sales on the radar of many states, e-retailers may find it harder to avoid the tax man.

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It may be true, as Ben Franklin is purported to have said, that nothing is certain except death and taxes. But in the world of retailing and sales tax laws, certainty is in short supply.

Instead there is uncertainty and controversy—and an increasingly sharp debate over whether all online retail purchases should be subject to sales tax. At the center of this debate is an arcane legal concept known as "nexus," which in this case refers to whether a retailer has a physical presence in a state, such as a store, corporate headquarters or distribution center.

The U.S. Supreme Court first ruled in 1967 that states can only require retailers to collect sales tax if they have nexus in a given state; the high court upheld that finding in 1992 and, by extension, it has applied to online retailers since the early days of e-commerce.

But the debate over nexus is sharpening these days as cash-strapped states search for new ways to generate revenue. Fast-growing e-commerce is an inviting target.

That's leading some states to expand their definitions of nexus, for instance to include working with an affiliate web site—typically an informational or enthusiast site that hosts ads from e-retailers—as constituting a physical presence in the state and triggering the sales tax requirement. Some states are expanding the definition to encompass distribution centers owned by a retailer's subsidiary, even as other states offer tax breaks to win new fulfillment center projects.

"States interpret doing business differently," says Daniel Schibley, a state tax analyst for CCH Inc., a unit of Wolters Kluer that publishes tax and business information. "Some might say a distribution center is not the retailer directly doing business in the state because they want the retailer's business in their state."

No resolution is in sight, which means online retailers will have to closely follow the debate as they make decisions on where they position shipping facilities, what affiliate web sites they work with and whether they collect sales tax from customers in particular states.

Federal law?

Congress could clarify the issue by passing a law requiring online retailers to collect state and local sales taxes on all purchases. Legislators have proposed such a law in each of the five two-year congressional sessions of the last decade, and the same proposal, now called the Main Street Fairness Act, is expected to be introduced into the current session.

Some believe the bill has a better chance this year as some politicians view it as a way to provide state and local governments with much-needed revenue without passing or raising taxes—after all, they would just be requiring retailers to collect taxes already on the books. "States realize this would not be a new tax, but a way to ensure they would collect an existing tax that's largely uncollected now," says Scott Peterson, a former South Dakota tax official who now is executive director of the governing board of the Streamlined Sales Tax Project, or SST, a multi-state compact working toward a new tax system for Internet sales.

Even then, sales tax collection would not immediately be required. The proposed legislation would only require e-retailers to collect sales taxes in states that have simplified their sales tax rules as part of the SST. Twenty-five states now participate in the SST.

Web-only retailers like Amazon.com Inc. generally oppose such legislation, while retail chains, whose stores give them nexus in many states and thus force them to collect sales taxes, mostly support it. They argue that web-only retailers get an unfair competitive advantage by not having to collect sales tax on many purchases. But veteran observers note retail chains didn't always take this view.

"Just a few years ago, retailers now supporting the Alliance for Main Street Fairness were doing much the same thing Amazon is doing today," says Peterson. Retail chains, he says, often established their online operations as separate subsidiaries, contending that their retail web sites were separate from the stores the same retailer also operated, and, therefore, free from nexus requirements in many states.

But in recent years, as chains realized they stood to gain economically by operating more as multichannel retailers, such as by letting shoppers order online and pick up or return products at a store, they moved away from the strategy of separating offline and online operations for tax purposes, Peterson and others say. "Many realized it was not worth the effort to maintain a sufficient legal separation," says CCH's Schibley.

The web-only way

But many web-only retailers still see the value in trying to separate their online and physical operations to avoid sales tax collection, which they figure raises their operating costs and makes them less competitive by forcing them to charge a higher total price.

For some retailers that operate mostly in regional areas or are less focused on expedited delivery service, one option can be to place distribution centers only in states such as Oregon that don't have a sales tax and, therefore, present no nexus issue. Besides Oregon, the states with no sales tax are Montana, Delaware and New Hampshire; there is no state sales tax in Alaska but local governments can impose such a tax.

Building and expanding a nationwide web-only retail operation, however, can require the support of a fulfillment and distribution system capable of providing fast and efficient shipping services throughout the U.S. But the more physical facilities a web-only retailer deploys throughout the country, the more it creates in-state nexus and the need to adjust pricing to absorb not only the sales tax itself but the operational cost of collecting it and remitting it to states.

No retailer exemplifies this dilemma more than Amazon.com Inc., which says the cost of running a fulfillment network was a major contributor to its 33% year-over-year decline in first quarter income this year. With a fulfillment strategy built around offering fast deliveries—its Amazon Prime service, for example, offers two-day deliveries anywhere in the U.S. for a $79 annual fee—a broadly and strategically deployed distribution system is crucial to its success. The retailer operates about 60 fulfillment centers worldwide, including 28 in the U.S., according to investment bank Goldman Sachs. Amazon says it plans to build nine more distribution centers this year, about half in North America.

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