One year ago, Arizona’s Legislature opened its 2019 Session to competing budget priorities—and important constitutional issues looming over Arizona’s transaction privilege tax system. This article discusses the tax issues facing Arizona leadership, the solutions they implemented, the political environment in which those solutions were forged, and the work left to be done.
Recent years have brought important changes to our nation’s tax system. In addition to income tax reform enacted by the Tax Cuts and Jobs Act1 in the summer of 2018, the U.S. Supreme Court made sweeping changes to our nation’s sales tax system when it overruled longstanding precedent that prevented state and local governments from imposing sales taxes unless a seller had a physical connection or “nexus” with the state.2
In South Dakota v. Wayfair, Inc., the Court determined that a seller/taxpayer can have sufficient constitutional nexus with a state based solely on its economic presence within that state, even if it has no physical presence therein, as long as the taxing scheme otherwise satisfies the requirements of the Commerce Clause of the United States Constitution.3 While Gov. Doug Ducey and key legislators negotiated water priority and teacher pay, other House and Senate leaders met with stakeholders and looked for practical ways to unify Arizona’s taxation of retail sales in a way that would pass constitutional muster and satisfy and support Arizona’s retailers.
Economic Nexus and Arizona’s Transaction Privilege Tax
The Standards
The Supreme Court’s Wayfair decision marks both the most sweeping expansion of states’ taxing reach in decades, and an overt recognition by the Court that legal principles must change with the times.
The Court considered a new statute enacted by the South Dakota legislature that allowed the state to impose sales tax on the sales of any company having within the state either: (1) $100,000 or more in sales, or (2) 200 transactions for the delivery of taxable goods or services. The state’s objective was to level the playing field between brick-andmortar stores and online sellers. In addition to the fixed overhead of maintaining a physical storefront, local merchants were at a competitive disadvantage because their sales were always subject to tax and the inevitable compliance audits, while online sellers who had no physical presence in the state were not required to pay collection sales or use tax, respectively, on sales to South Dakota residents, who, likewise, likely never or rarely reported use tax on items purchased.
The question for the Court was whether physical presence was the only way in which a state could satisfy the requirement that “a state tax must be applied [only] to an activity with a substantial nexus with the taxing state.”4
In Wayfair, the Court recognized that customers who purchase products provided by online sellers such as Wayfair enjoy the benefits provided by their state governments. As a result, the Court concluded that online sellers have a direct economic relationship to the services provided by their respective customers’ states of residence.
Moreover, in light of changed market conditions and the rise of online sales, the “physical presence test”—linking a state’s right to impose sales tax to a retailer’s physical location in that state—no longer represents our national economic reality. The Court decided that the physical presence standard “must give way to the far-reaching systemic and structural changes in the economy and many other societal dimensions caused by the Cyber Age. … The Internet’s prevalence and power have changed the dynamics of the national economy.”5 The Court found sufficient nexus with the state of South Dakota because the state limited its taxation to online retailers with a defined minimum dollar volume of sales or a minimum number of annual transactions. “Nexus is clearly sufficient based on both the economic and virtual contacts respondents have with the state.”6 The seller could not have met the statutory minimums “unless the seller availed itself of the substantial privilege of carrying on business in South Dakota.”7
Having determined that a state could demonstrate nexus by reference to a taxpayer’s economic activity rather than to its physical location only, the Court listed the factors in the South Dakota statute that ensured its compliance with the Commerce Clause of the U.S. Constitution. Those factors included:
- Safe harbor for small sellers (who did not meet the statute’s thresholds)
- Prospective application of the statute
- Single state-level tax administration
- Uniform definitions of products and services
- Simplified tax rate structures
- Uniform rules
South Dakota satisfied factors 3 through 6 by adopting the Streamlined Sales and Use Tax Agreement, a compact adopted by 43 other states. Arizona is not among them.
The Politics
Just as the movement toward the digital marketplace catalyzed South Dakota’s move to expand nexus rules, one of the largest online sellers took a lead role in proposing the bill that ultimately became Arizona’s answer to Wayfair. Large online retailers joined with the Arizona Retailers Association and the League of Arizona Cities and Towns to introduce legislation arguably designed to boost the business of large online sellers by allowing these “marketplace facilitators” to be responsible for collecting and reporting transaction privilege tax with respect to all sales occurring through their platforms.
Arizona retailers had long been under competitive pressure from online retailers, who paid no transaction privilege taxes and who did not have the expense of local brick-and-mortar stores. So, they were fully committed to enacting a law that removed this imbalance by making remote sellers subject to Arizona taxes. Opponents were concerned that this marketplace facilitator approach would encourage small sellers to abandon individual markets in favor of large established markets.
Among the most significant impediments to the simplified administration and unified tax rates and base required by the Court in Wayfair was Arizona’s complex transaction privilege tax system. At the state level, A.R.S §§ 42-5061 through 42-5076 prescribe 16 different categories of products and services subject to tax, each with unique rates and numerous exceptions and exemptions. At the local level, A.R.S. § 42-6051 et. seq. prescribes the adoption and maintenance of the Model City Tax Code, which all Arizona municipalities are obligated to use. However, while that code is a standardized document, it contains myriad alternative provisions from which municipalities can choose in adopting their individual tax codes. Moreover, each municipality has the flexibility to set its own rate structure. Each municipality adopts its version of the Model City Tax Code by voter approval.
Arizona retailers had long been under competitive pressure from online retailers, who paid no transaction privilege taxes.
So in addition to having to simplify (at least with respect to retail sales) one of the most complex transaction privilege tax statutes adopted by any state, legislators also had to face the problem of having over 90 local jurisdictions with voter-approved tax codes that were different. With revenue sources largely based on transaction privilege taxes, Arizona municipalities have historically fiercely defended their autonomy from the state government— particularly where tax issues are concerned.
The Solution: HB2757
By its adoption of HB 2757 on May 31, 2019, Arizona imposed tax obligations on both remote sellers and marketplace facilitators. A remote seller is any person that sells products for delivery into Arizona, and that does not have a physical presence or other legal requirement to obtain a transaction privilege tax license. A marketplace facilitator is any person that facilitates a retail sale by a marketplace seller in which the facilitator collects, directly or through third parties, funds from a purchaser and transmits the payment to the marketplace seller. A marketplace facilitator need not be compensated to be classified as a marketplace facilitator.
Nexus. Arizona has addressed the required nexus standard by adopting economic thresholds similar to those adopted by South Dakota. A.R.S. 42-5043 now taxes any remote seller who had sales of more than $200,000 in 2019, $150,000 in 2020, and $100,000 for all years thereafter. Marketplace facilitators, through which multiple sellers offer products, are required to report and pay tax if sales exceed $100,000 in any year. For purposes of these limits, all affiliated persons are aggregated. Unlike some states, which impose tax obligations based on prior year sales, Arizona measures that threshold based on the current year. Therefore, if a remote seller reaches the threshold at any time during a year, that seller must apply for a transaction privilege tax license and collect and remit tax from the first day of the month that starts at least 30 days after it first meets the threshold. Having met the threshold for any part of a year, a remote seller also must continue to collect and pay tax for the following year, even if sales fall below the threshold in the second year. The remote seller can discontinue tax collection and payment starting in the third year if it remains below the threshold.8
Commerce Clause Standards. Having chosen not to adopt the Streamlined Sales and Use Tax Agreement, Arizona has crafted its own statute that it hopes will satisfy the uniformity and simplicity standards established by the Court in Wayfair. The single most important aspect of Arizona’s legislation was the preemption of all city or town ordinances or other local laws insofar as the taxation of the retail classification of transactions.9 This means that, in general, Arizona now has a unified transaction privilege tax system. Thus, A.R.S. § 42-5061 now governs all retail sales transactions in this state, subject to a few necessary exemptions accorded to the local jurisdictions.
Cities may still separately tax food sales, required college textbooks, certain agricultural products if taxed prior to the Sept. 1, 2019, the effective date of the statute, and nonmetalliferous mined materials. The law also retains the current tax scheme for taxing automobile sales sold to out-of-state buyers or Native Americans if delivery occurs outside the state or reservation, respectively. Local jurisdictions may exempt from tax sales of paintings, sculptures or similar works for fine art if sold by the original artist. The applicable municipal tax rate that applies to marketplace sellers will be the same rate that applies to local retailers of tangible personal property. And a city can change that rate.
Part of the political quid pro quo for preemption was a commitment by the Legislature, recited in the legislative history of HB 2757, to not seek to preempt other classifications under the Model City Tax Code for a period of five years. This commitment likely ensures that Arizona’s complex transaction privilege and use tax system is likely to remain for some time to come. Nevertheless, state preemption of the regulation of the retail classification goes a long way to securing the constitutionality of Arizona’s statute.
Beyond preemption, it is still unclear whether the changes made by HB 2757 will pass constitutional muster. Multiple city tax rates still offer stumbling blocks specifically raised by the Court in Wayfair. The Court clearly indicated that not all economic nexus standards will pass constitutional muster. As with any major legislation with nationwide attention and controversial impact, legal challenges can be expected. So we should learn in the next few years how Arizona’s transaction privilege tax reform will hold up.
Into the Future
While Arizona accomplished much during the 2019 Legislative Session, additional debates about tax policy and legislation are doubtless in our future. Having addressed remote online sales, the next significant issue is to establish a distinction between goods and services in the digital world. Like most states, Arizona typically taxes sales of goods but not services. Some taxing jurisdictions, however, are trying to define all online content as taxable. Legislation defining the distinction for digital content will be important in coming years. And additional transaction privilege/use tax simplification—or perhaps statewide unification of our transaction privilege tax scheme—would be welcomed by many.
endnotes
1. Pub. L 97-115.
2. South Dakota v. Wayfair, Inc., 585 U.S. ___ (2018).
3. Earlier decisions had determined that physical presence was not required to establish minimum contacts required by the Due Process clause of the U.S. Constitution. See Quill Corp. v. North Dakota, 504 U.S. 298 (1992).
4. Complete Auto Transit v. Brady, 430 U.S. 274 (1977).
5. Wayfair, 585 U.S. at 18.
6. Id.
7. Id. at 23.
8. A.R.S. § 42-5042 provides detailed rules and protections applicable to marketplace facilitators, a discussion of which is beyond the scope of this article.
9. Id. § 42-6017(A).
Click here to read the article published in the March 2020 edition of Arizona Attorney Magazine.