Public Law 86-272’s Thin Veil of Income Tax Protection is Getting Thinner

Since Congress adopted Public Law (P.L.) 86-272 in 1959, the retail world has changed dramatically — and the ways a company obtains customers, approves orders, and ships goods have all changed along with it. After the Wayfair decision — which imposes sales tax nexus due to a significant economic presence — states took an aggressive approach to taxing out-of-state businesses, and may do the same in relation to potential changes in the application of P.L. 86-272.

P.L. 86-272 prohibits states from imposing a net income tax on income derived from interstate commerce if the only business activity within the state is the solicitation of orders of tangible personal property. The orders must be sent outside the state for approval or rejection. If accepted, the orders must be filled from a point of shipment outside the state. If any services are provided along with these transactions, then P.L. 86-272 protections do not apply.

However, P.L. 86-272 does not explicitly define what “solicitation of orders” means, and states have taken different positions over the years to interpret it. As retail sales have shifted to the internet, this definition has become even less clear.

On August 4, 2021, the Multistate Tax Commission (MTC) issued model language for this definition — along with several examples. California was the first state to issue official guidance adopting this language, and other states have started to follow — which might require businesses to file additional income tax returns.

California may set the tone for more taxes

On February 14, 2022, the California Franchise Tax Board (FTB) issued Technical Advice Memorandum (TAM) 2022-01. The TAM provides numerous new fact patterns more common in today’s economy. These changes will require businesses with nexus previously claiming protection under P.L. 86-272 to file income tax returns and pay income tax.

TAM 2022-01 provides several examples of internet-based activities that either exceed protections or retain them. The examples assume the business:

• Makes sales to California customers
• Is commercially domiciled outside of California
• Has no activity in California other than those mentioned in the specific fact pattern

Consider the nuances of protection in these instances

Example 1: Answering customer questions electronically

• Exceeds protection — A company regularly provides post-sale assistance to California customers via electronic chat or email initiated by clicking on an icon on the business’s website.
• Retains protection — A company provides post-sale assistance to California customers by posting a list of static frequently asked questions with answers on the business’s website.

Example 2: Using internet “cookies”

• Exceeds protection — A company places internet “cookies” on the computers or other electronic devices of California customers, and the cookies gather customer search information used to adjust production schedules and inventory amounts, develop new products, or identify new items to offer for sale.
• Retains protection — A company places internet “cookies” on the computers or other electronic devices of California customers, and the cookies gather customer information used only for purposes entirely ancillary to solicitation, such as remembering items in the customer’s shopping cart or reminding customers of previously viewed products.

Example 3: Selling products online

• Exceeds protection — A company contracts with an online marketplace that facilitates the sale of a business’s products. The facilitator maintains inventory for the company at fulfillment centers in various states where the business’s customers are located.
• Retains protection — A company offers for sale only items of tangible personal property on its website, which enables customers to search for items, read product descriptions, select items for purchase, choose among delivery options, and pay for items. The business does not engage in any other in-state business activities.

Additional examples address topics such as remote fixes or upgrades, extended warranty plans, video and music streaming, and employment and credit card applications.

What we know now

These modifications are not a certainty. California’s updated P.L. 86-272 guidance has not yet been enacted through the legislators and has not been challenged through the judicial system. Additionally, the Massachusetts Appellate Tax Board recently held that — for sales tax purposes — Massachusetts could not impose tax duties on a California online seller under the state’s internet-based cookie nexus rule.

That said, the New York State Department of Taxation has indicated it will also conform with the MTC guidance regarding internet-based income tax nexus-creating activities. It seems likely that more states may follow California’s and New York’s lead and begin to formally announce adoption of the MTC’s position.

How we can help

An analysis of P.L. 86-272 protection can determine whether a business’s activities create state income tax nexus — and whether those activities would be protected under P.L. 86-272. Also, refund claims may be available for certain California taxpayers that have used P.L. 86-272 as protection from filing in other states and have been throwing back sales to California for sales factor purposes.

CLA’s state and local tax professionals understand the complex tax laws in each state and jurisdiction where your company does business and can evaluate your multistate sales to assess your tax reach, analyze your readiness, and evaluate your exposure.