This Alert has been updated to address questions regarding the application of the Wayfair decision to accounting for state income tax nexus positions under ASC 740. None of the original discussions or conclusions contained herein related to ASC 450 have been modified.

On 21 June 2018, the US Supreme Court (Court) issued its ruling in South Dakota v. Wayfair.¹ In a 5-4 decision, the Court held that physical presence in a state was not a necessary element to create taxable nexus for sales and use tax purposes. This decision effectively overturns two long-standing US Supreme Court decisions (Quill ² and National Bellas Hess ³), which have historically provided a bright-line nexus standard based on physical presence. In its opinion, the Court found the physical presence nexus standard in those opinions to be "unsound and incorrect."

Having rejected the physical presence nexus standard, the Court intimated that the protections in South Dakota's sales tax nexus statute — including sales threshold limitations, limits on retroactivity and Streamlined Sales Tax (SST) membership — were sufficient to limit the burdens on interstate commerce. Nevertheless, the Court did not opine directly on the constitutionality of the law, choosing instead to vacate and remand the case back to the South Dakota Supreme Court, where any other US Commerce Clause questions might be raised.

As a result of the Court's decision, additional states may now begin requiring all remote sellers to register, collect and remit sales and use taxes on transactions with in-state customers regardless of the seller's physical presence within the state, provided that they do so in a manner that does not otherwise violate the US Commerce Clause by discriminating against or imposing undue burdens on interstate commerce.

Question of retroactive application

One of the most pressing questions raised by the Court's decision is whether states will now attempt to assert liability for uncollected taxes on a retroactive basis. While several states have informally indicated that they will not do so, and a few states have enacted legislation specifically prohibiting retroactive assessments, most states do have laws on the books — some dating back to the 1970s — that apply an economic/minimum contacts nexus standard that could conceivably be used as a basis to assert a claim for a period before the Wayfair decision.

While the Court's ruling did not opine directly on the constitutionality of South Dakota's law, it did provide guidance that protections in the law, including limits on retroactivity, were sufficient to limit the burdens on interstate commerce. Specifically, the Court held that, " … [South Dakota's] Act ensures that no obligation to remit the sales tax may be applied retroactively." This was provided as a feature that, in the Court's opinion, "appear[s] designed to prevent discrimination against or undue burdens upon interstate commerce." As such, it is possible to infer that, if another state were to pass new legislation and attempt to impose a liability on a remote seller's activity before June 21, 2018 (the date of the Wayfair decision), such an imposition may in fact be found to discriminate against interstate commerce by imposing undue burdens on taxpayers.

Accounting implications

ASC 450, Contingencies

While the Court's decision will certainly have future sales tax implications for remote sellers that do not have physical presence in a taxing jurisdiction, a question has been raised as to whether the decision results in immediate financial statement recognition and/or disclosure of a loss contingency in accordance with ASC 450.⁴

Sales taxes are not based on income and are accounted for as part of pre-tax income. ASC 450 categorizes loss contingencies, including taxes not based on income. Loss contingencies are categorized using three terms based on the likelihood of occurrence:

— Probable — the future event or events are likely to occur
— Reasonably possible — the chance of the future event or events occurring is more than remote but less than likely
— Remote — the chance of the future event or events occurring is slight

ASC 450 requires an estimated loss to be accrued by a charge to income if it is both probable that a liability has been incurred (or an asset has been impaired) at the date of the financial statements and the amount of the loss can be reasonably estimated.

ASC 450 also requires disclosure of the nature of a contingency when there is at least a reasonable possibility that a loss or an additional loss may have been incurred. For contingencies that meet the threshold for disclosure, companies are required to disclose:

— The nature of the contingency
— An estimate of the possible loss or range of loss or a statement that such an estimate cannot be made

Informal indications from various states suggest that they will look to enforce the ruling on a prospective basis only (e.g., for taxable transactions occurring after June 21, 2018). It is also not clear whether and when each respective state might attempt to assert enforcement or a liability prospectively (i.e., on or after June 21, 2018).

Even if a state were to attempt to assert a liability for transactions before June 21, 2018, there is mixed precedent as to whether such an attempt could withstand challenge under the Due Process Clause. In addition, statements made by the majority in Wayfair imply that retroactive application could also present undue burdens on interstate commerce in violation of the US Commerce Clause. As such, significant uncertainty exists as to whether states' assertions on retroactive application of the Wayfair decision would be upheld upon challenge. Such uncertainty is even more pronounced in states that have not yet attempted to enforce collection efforts on remote sellers. Based on information currently available, it may not be probable that the Wayfair decision will be applied on a retroactive basis. However, each company's facts and circumstances should be reviewed with respect to the laws of the jurisdictions in which they operate to assess the possibility of retroactive application.

While a small number of states, for example Ohio and Massachusetts, have previously attempted to enforce their sales tax statutes on remote sellers, we are presently not aware of additional states that intend to try and enforce their sales tax statutes for transactions prior to the Court's decision as a result of the Wayfair decision. We will continue to monitor the states' reactions for indications on their intentions.

ASC 740, Accounting for income taxes

Additional questions have arisen as to whether the Wayfair decision affects the accounting for state income tax nexus positions for companies that have not previously filed state income tax returns based on the physical presence standard held in Quill. While the Wayfair opinion addresses nexus considerations for state sales and use tax purposes only, some companies may determine that the Wayfair decision changes their judgement regarding their particular facts and circumstances related to economic nexus for state income tax purposes. Those companies may conclude that a re-valuation of the measurement of their tax positions for state income tax nexus may be warranted.

ASC 740-10-35-2 states: "subsequent measurement of a tax position meeting the recognition requirements ...shall be based on management’s best judgement given the facts, circumstances, and information available at the reporting date." As a reminder, a change in tax positions due to a change in judgement that results in the subsequent recognition, derecognition or change in measurement of a tax position taken in previous annual periods should be treated as a discrete items in the period in which the change in judgement occurs. Changes in judgement related to a tax position reflected in a prior interim period within the same fiscal year should be reflected in accordance with interim reporting guidance in ASC 740.

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¹ South Dakota V. Wayfair, Inc., Dkt. No. 17-494 (U.S. S. Ct. June 21, 2018).

² Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

³ National Bellas Hess, Inc. v. Illinois Dept. of Rev., 386 U.S. 753 (1967).

⁴ Accounting Standards Codification ASC 450 Contingencies (ASC 450) defines a loss contingency as: an existing condition, situation, or set of circumstances involving uncertainty as to possible loss to an entity that will ultimately be resolved when one or more future events occur or fail to occur. The term loss is used for convenience to include many charges against income that are commonly referred to as expenses and others that are commonly referred to as losses.