U.S. sales taxes: how it works and where sales tax applies

Changes to U.S. sales taxes can impact your business. Furthermore, the rules differ from state to state.

Quebec companies operating in the manufacturing, IT or distribution sector often have commercial ties with the U.S. Recent developments regarding U.S. sales tax laws can have a major impact on their operations–whether they have a physical presence in the U.S. or not.

Registration and fiscal obligations

In the U.S., sales taxes are mainly determined at the state level. Nearly all U.S. states have their own sales tax, with the only exceptions being New Hampshire, Oregon, Montana, Arkansas and Delaware (known as NOMAD).

In addition, states have authorized various local entities such as counties, cities, etc. to collect retail sales taxes. These local taxes are levied in the same way as state taxes, but increase the effective tax rate by a few percentage points. This means that the tax rates and rules vary greatly from state to state.

Physical or online presence?

When does a Canadian business selling in the U.S. need to worry about taxes? Traditionally, businesses that had a physical presence (e.g., a warehouse or subsidiary) in a particular state were required to collect and remit the applicable sales tax. However, e-commerce changed all this.

In the case of Wayfair v. South Dakota, in 2018 the U.S. Supreme Court ruled that states could require companies with no physical presence in the state to collect sales tax if they meet a certain sales or transactions threshold in the state. This paved the way for the concept of “economic nexus” in determining whether a business is required to collect sales tax in a given state.

Therefore, from now on Quebec businesses with online sales in the U.S. may be required to collect and remit sales taxes in a number of states due to their economic presence—even if they have no physical presence there. This means that cross-border tax compliance has become even more complex for a number of businesses.

It is also important to note that while the threshold is generally $100,000 in sales or more than 200 transactions per year¹, each state has its own rules and thresholds for collecting sales tax. Even if, at first glance, a business exceeds the economic nexus threshold it may not always need to register for the purpose of collecting sales tax in a given U.S. state. Certain types of businesses or transactions could be excluded in calculating the threshold, such as sales for resale (e.g., a wholesaler that sells to resellers) or the sale of manufacturing or farming equipment, which would actually be exempt. In addition, specific rules in one state could exclude other situations, particularly if the business operations in this state are considered to be occasional or isolated. States can have specific thresholds to determine what is considered to be “occasional”.

Most U.S. states also have “marketplace” rules whereby a business selling products via website—like Amazon or Best Buy—is required to collect and remit sales tax even though, legally speaking, online sales websites would generally be considered to act as agents for their clients to facilitate sales. It should be noted that sales tax rules in the U.S. governing sales websites are constantly changing and may vary from state to state as well as depending on the particular situation.¹Some states, such as New York and California, have a higher threshold ($500,000 per year) while several others have an annual threshold of $250,000.

Collecting and remitting U.S. sales taxes

Once a seller is registered or has a registration requirement, it must collect the applicable sales taxes from its customers and remit the amounts to the tax authorities.

If a seller fails to report sales, there is generally no statute of limitations period and states can demand payment for the amount of sales taxes beyond the normal three to four years².

It should be noted that the fact that a business is a registrant collecting sales tax does not increase the tax cost for its customers since they are required to self-assess and pay sales tax if the supplier has not collected the appropriate amount.²Some states have a longer statute of limitations period. The rules vary from state to state.

How the U.S. sales tax system works

Unlike VAT systems, retail sales taxes generally apply only to tangible personal property—not to intangible assets or real property. Moreover, services are generally not subject to retail sales tax, with the exception of specifically identified services or those that are specifically related to tangible personal property.

It is important to note the treatment that applies depending on the type of assets sold.

1. Sales of tangible personal property

U.S. sales tax generally applies to sales of material goods such as merchandise and manufactured products. The applicable rules and rates vary depending on the state. Quebec businesses selling tangible personal property in the U.S. must take into account the tax rate that applies in each state and make sure that sales taxes are being properly calculated and collected.

2. Professional services

In most U.S. states, sales tax does not apply to professional services, such as advisory, accounting and IT services. However, there are some exceptions and these types of services are taxed in some jurisdictions. Exceptionally, some states tax most services other than those that have been specifically identified. Quebec businesses that provide professional services in the U.S. must check the rules in each state to determine whether sales tax applies.

3. Services relating to tangible personal property

Services relating to material goods, such as maintenance, repair or installation services, may be subject to sales tax in some states. The distinction between services and the sale of goods may sometimes be more subtle. Quebec businesses that provide services relating to tangible personal property need to assess the rules in each state to determine whether sales tax applies to their specific services.

A transaction may be exempt from sales tax for different reasons. Exemptions vary from state to state and, in some cases, are based on economic criteria in the region. For further information, please see our article on exemptions.

4. Software and data processing

U.S. states can treat software differently, regardless whether in physical or downloadable format. Some states consider software to constitute material goods to which sales tax applies, while for others software is a tax-exempt service.

Under the SaaS model, software as a service is delivered via the cloud. Customers access software via the Internet rather than installing it locally on their own device. The taxation of SaaS services varies from state to state. Some states consider SaaS services to be taxable and require sales tax to be collected, while for others SaaS is a non-taxable IT service. Determining where the SaaS services are being sold can also be a complex matter.

The PaaS model provides a platform allowing developers to create, host and deploy applications. The taxation of PaaS services can also vary. Some states consider PaaS services to be taxable since they involve use of an IT infrastructure. The PaaS model can also involve taxable services (e.g., hosting the application) in addition to non-taxable services (e.g., supplying development tools). These considerations, as well as the wide array of services that can be provided, including development, implementation, configuration and data migration, can make fiscal obligations more complex.

Data processing services are often taxable, although the definition of what constitutes a data processing service varies from state to state. Some U.S. states consider these services to be taxable and require sales tax to be collected, while others consider them to be non-taxable professional or IT services. It is extremely important to know the position taken by the particular state in order to determine whether the data processing services are subject to sales tax. Some states may have exemptions for professional or IT-related services. However, these exemptions may differ from state to state and vary according to the specific data processing services being provided.

Mastering the complexity of state rules

If you are developing the U.S. market in different states, you need to master the complexity of state tax rules. Since each state has its own taxation criteria and exemptions, tax compliance may be harder to achieve. It is important to act quickly and have good advisors.

Moreover, due to the complexity of U.S. tax rules, many businesses opt for automatic collection and remittance. Specialized software solutions can be helpful in ensuring that tax rates are calculated properly based on a customer’s location and generating accurate tax returns.