On April 23, 2010, the Second Engrossed Substitute Senate Bill 6143 was signed into Washington state law adopting several business tax law changes that are now being implemented. Some of the more significant changes in the bill include:
- A business and occupation (B&O) tax rate increase for receipts taxed under the “service and other activities” classification;
- The adoption of a new “economic nexus” standard for imposing B&O taxes on “apportionable activities,” which most notably include activities subject to tax under the “service and other activities” classification and the “royalties” classification; and
- The adoption of a single factor receipts apportionment formula for apportionable activities, which requires a market-based sourcing methodology.
This article explains these new rules and how they could potentially affect your business.
Rate Increase for the “Service and Other Activities” B&O Classification
Effective May 1, 2010, through June 30, 2013, the B&O rate for service and other activities is 1.8 percent. Prior to May 1, 2010, it was 1.5 percent.
Effective June 1, 2010, Washington established factor presence nexus standards for B&O tax on “apportionable activities,” which most notably include activities subject to tax under the service and other activities classification and the royalties classification. A complete list of apportionable activities can be found in the Washington Administrative Code 458-20-19401.
These new standards, which are adopted by the Washington Department of Revenue under WAC 458-20-19401, state that a business has substantial nexus with Washington for apportionable activities for B&O tax purposes if, in any calendar year, it:
- Is organized or commercially domiciled in Washington;
- Is an out-of-state business with more than $50,000 of property in Washington;
- Is an out-of-state business with more than $50,000 of payroll in Washington;
- Is an out-of -state business with more than $250,000 of receipts from Washington; or
- Is an out-of-state business with at least 25 percent of its worldwide property, payroll, or receipts in Washington.
For purposes of calculating the amount of Washington-sourced receipts for determining if items 4 or 5 above have been met, the receipts sourcing methodology described under the new single factor receipts apportionment formula for income from engaging in apportionable activities is to be used. See the next section for a discussion on this new single factor apportionment formula and how receipts are sourced.
For purposes of calculating the property, payroll and receipt threshold amounts for the 2010 tax year, the entire 2010 calendar year is to be used. However, the actual B&O tax incurred will be calculated as beginning on June 1.
The nexus determination must be made separately for each legal entity. The state does not allow nexus determination on a combined or consolidated basis. However, the threshold amounts are calculated using amounts from all of a taxpayer’s apportionable activities. For example, if an out-of-state business has $50,000 of service income sourced to Washington and $220,000 of royalty income sourced to Washington in a given year, it has substantial nexus because it has more than $250,000 of receipts from all of its apportionable activities sourced to Washington. It does not matter that the amount of receipts under each of the different B&O tax classifications is not more than $250,000.
Once nexus has been established, it will continue as long as the taxpayer meets at least one of the thresholds, and for one year after the year in which the taxpayer no longer meets one of the thresholds. According to an Economic Nexus Q&A released by the Washington Department of Revenue on May 28, 2010, this one-year trailing provision, as of June 1, 2010, applies to all B&O tax classifications, replacing the previous five-year period.
These new nexus rules need to be examined closely by all service providers with multi-state activities, even those who did not previously have a Washington B&O tax filing requirement. Most likely to be caught by this new rule are out-of-state service providers who do not have a physical presence in the state but are now subject to B&O tax as a result of having more than $250,000 of receipts sourced to Washington.
However, a safe harbor has been created for service businesses that do have a physical presence in Washington but do not have enough property, payroll or receipts to meet any of the thresholds described in the new rule. If they were previously filing based on their physical presence in Washington, they may no longer need to file. For example, an employee visiting the state to solicit sales would have created nexus under the previous nexus standard for service businesses. However, under the new standard, the business will only have nexus if it meets one of the thresholds listed above.
The physical presence nexus standard that previously applied to all B&O tax classifications is still required for wholesaling, retailing and other non-apportionable activities. Thus, a business engaging in non-apportionable activities could meet the economic nexus standards in this new rule but, as long as it doesn’t have a physical presence, it would not be subject to tax. It should be noted that WAC 458-20-19401 clarifies that what has long been the Department’s nexus position is now applicable only to non-apportionable activities:
A person engaged in non-apportionable activities is subject to B&O tax on a non-apportionable activity only if the person has a physical presence in this state, which need only be demonstrably more than a slightest presence....A person is physically present in this state if the person has property or employees in this state. A person is also physically present in this state if the person, either directly or through an agent or other representative, engages in activities in this state that are significantly associated with the person’s ability to establish or maintain a market for its products in this state.
New Apportionment and Sourcing Method
To have the right to apportion the income from “apportionable activities,” a taxpayer must be taxable in another state. Washington defines “taxable in another state” for these purposes as meaning either:
- The taxpayer is actually subject to a business activities tax by another state on its income received from engaging in an apportionable activity; or
- The taxpayer is not subject to a business activities tax by another state on its income received from engaging in an apportionable activity, but the other state has jurisdiction to subject the taxpayer to a business activities tax on such income under the substantial nexus thresholds described above.
The recently enacted legislation adopts a single factor receipts apportionment methodology for apportioning service income (and other apportionable activity income) to Washington on or after June 1, 2010. Prior to that date, service income was apportioned under Rule 194, which required either “separate accounting” or “cost apportionment,” the latter of which is best described as a combination of a cost-of-performance method and a market-based method.
Under the new method, for any apportionable activity, the numerator of the receipts factor is the taxpayer’s gross annual income attributable to Washington from engaging in an apportionable activity. The denominator is the business’s gross annual income received worldwide from that same activity less amounts that are attributed to states where the taxpayer is not taxable and at least some of the activity is performed in Washington.
Separate factors must be calculated for each activity taxed under each separate B&O tax classification. The sourcing rules for royalty receipts are described in their own rule (WAC 458-20-19403). All other apportionable activities are sourced using the rules laid out in WAC 458-20-19402, which provides the following hierarchy of tests to determine where gross income is attributable or sourced:
- Where the purchaser receives the benefit of the services;
- If the benefit is received in multiple states, then where the benefit of the service is primarily received;
- If 1 or 2 do not apply, then to where the service was ordered;
- If 1 – 3 do not apply, then to where the bill is sent;
- If 1 – 4 do not apply, then to from where the customer sends the payment;
- If 1 – 5 do not apply, then to the customer’s address maintained in the seller’s records; and
- If 1 – 6 do not apply, then to the seller’s commercial domicile.
For purposes of excluding amounts from the denominator, a taxpayer is deemed to be taxable in a state as long as it would have substantial nexus in that state using the Washington-specific rules discussed above. It does not matter if the taxpayer is not actually subject to tax in the other state, nor does it matter if the other state has a business activities tax similar to the B&O tax.
Alvarez & Marsal Taxand Says:
Whether you’re a Washington domiciled business or an out-of-state business, these new nexus and sourcing rules need to be carefully examined to determine how they may impact your reporting requirements and the calculation of your B&O tax liability.
While this economic nexus standard may be challenged like so many others that have come about in recent years, because the B&O tax is not an income tax, the result of any challenge will not give us any additional insight into the long-running debate surrounding the physical presence requirement for income taxes. Since the vast majority of state cases addressing the issue have upheld economic nexus standards for business activity taxes, it is uncertain whether a challenge to this rule will be upheld.
Much like the move many states have made from a three factor apportionment formula to a single factor apportionment formula for apportioning income from sales of tangible property, this change to a market-based sourcing methodology for service income is likely to generally benefit in-state businesses and hurt out-of-state businesses. Out-of-state taxpayers may get “whipsawed” by this apportionment and sourcing change. If they perform the services in a cost-of-performance state and the customer is located in Washington, they may have to include the sale in the apportionment factor of more than one state.
Senior Director, Seattle
Mark Danbom, Senior Associate, contributed to this article
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