On the front line of the e-commerce tax are online travel companies, or OTCs, such as Expedia, Hotels.com, PricelineTravelocity and Orbitz. The issue is whether the OTCs should be collecting hotel room occupancy taxes on the difference in the price between what the OTC pays the hotel operator and the amount that customer pays to the OTC. For example, assume that an OTC in a jurisdiction with a 10 percent hotel room tax pays a hotel US$100 for a room night and then charges its customer $150. The OTC pays $10 in room taxes — but must the OTC collect a 10 percent room tax on the $50 markup? Increasingly, local tax authorities are saying that the additional tax must be paid.
The stakes are huge. On May 1, the San Francisco Tax Collector determined that Expedia owed $32 million in hotel room taxes, penalties and interest to the city. Expedia has filed a lawsuit to appeal this ruling, but this is just what a single city says it is owed by a single OTC in back taxes — albeit a city that is one of the top tourist destinations in the United States.
Still, it represents just a tiny fraction of the number of hotel rooms in the country — about three-quarters of one percent. At last count, there were 42 active lawsuits in which tax authorities assert that the OTCs owe what could ultimately amount to several hundreds of millions of dollars in back taxes, penalties and interest. In addition to these potential tax liabilities, a requirement that OTCs collect hotel room taxes in the future would increase their customers’ out-of-pocket costs and possibly impact the earnings of the OTCs.
The Nexus Problem
There are significant differences between the e-commerce tax issues faced by OTCs and those faced by etailers that sell goods, like Amazon. These differences work to the advantage of the e-commerce retail companies. First and foremost, is the issue of nexus.
The United States Supreme Court ruled in 1992 in the case of Quill Company v. North Dakota that in order for a state (the “taxing state”) to require a retailer to collect sales tax form its customers, the retailer must have a substantial physical presence in the taxing state. This required physical presence is known as “nexus.” So, if an e-commerce retailer is careful to avoid the presence of employees or independent contractors in the taxing state, and does not own or lease any assets in the taxing state, then it can avoid nexus for sales tax purposes, and not be obligated to collect taxes.
However, an OTC can not easily avoid nexus, because it essentially rents hotel rooms in the taxing state, and so owns a property right in the state, which satisfies the physical presence test. Even if the OTC were to argue that its arrangement with a particular hotel did not rise to the level of a property right, the on-site presence of an OTC’s employees to review or inspect a hotel’s facilities might be considered adequate to establish nexus with a state.
Since the United States Supreme Court has declined to hear any nexus cases since its 1992 decision in Quill, the issue of adequate nexus has been left to state courts to decide on a state-by-state basis. As a rule, state courts have tended to side with their state tax authorities, so the issue of nexus has not restrained tax authorities from going after the OTCs, even though they might be reluctant to go after traditional e-commerce retailers.
A second issue confronting OTCs that online retailers typically do not have to deal with is that many states allow their county or municipal governments to collect, administer and enforce hotel room taxes. This is different from levying a sales tax on retail merchandise, which is usually collected, administered and enforced at the state level.
Even in states that allow their local jurisdictions to impose a local tax on retail merchandise, these local option taxes are usually collected, administered and enforced at the state level, and the state tax authority then distributes the local taxes to the local governments where the retailer is located. This means that the centralized state tax authority must decide to pursue online retailers for sales taxes. However, in the case of hotel room taxes administered locally, it is up to the county or municipal taxing authority where a hotel is located to pursue the OTCs for back taxes.
A third problem for OTCs revolves around whom the tax authority can pursue. In the case of online retailers, the tax authority has two separate parties that it can go after to pursue sales tax. The first is the retailer. However, if the retailer is not liable for the tax because of lack of nexus, or if the retailer is no longer in business, then the tax authority can and will hold the customer liable for use taxes. This is a little known fact among consumers — that a customer of an online retailer is liable for use tax (equal to the amount of sales tax) even though the online retailer might not be obligated to collect the tax.
Many states now require individuals to report online purchases on their state income tax return and pay use tax. State tax authorities also can find out about online purchases through an examination of bills of lading from common carriers (UPS and Federal Express) to see if a consumer has made purchases from an online retailer, and then send a letter of inquiry asking if use tax was paid by the consumer. These factors allow a tax authority a chance to collect the sales tax on merchandise purchased from an online retailer from the customer.
This is not the case with the customer of an OTC, who usually does not even live in the same state. In addition, there have been no reported cases in which a tax authority has gone after the hotel operator for unpaid room taxes sold by an OTC. This is logical, because the hotel operator has no way of knowing how much the OTC is charging its customers for the hotel room. Some state tax authorities have gone so far as to issue published rulings that the hotel operator is not liable for the room tax on the marked-up amount that the OTC charges its customers. This leaves the tax authority with only one party to pursue for hotel taxes on the marked up amount the OTC charges its customer — the OTC.
Although it is theoretically possible that an OTC could collect the tax from its customers after the fact, this would be a practical impossibility for OTCs with a retail customer base. You can imagine what a typical OTC customer would do upon receipt of an invoice from an OTC for $50 in hotel room taxes two years after a vacation. The response from the customer would not likely be warm. It would cost the OTC much more to collect the tax from its customer then it could ever hope to collect.
Higher Rates, Higher Stakes
Fourth on the OTCs’ list of special problems is the actual hotel occupancy tax rate. The rate is typically much higher than that charged for retail merchandise.
A typical sales tax rate for retail merchandise is approximately 6 percent to 9 percent, depending on the state and city. However, the combined state and local hotel room occupancy rate will often exceed 15 percent, so the stakes are much higher for the OTCs.
One way to look at this is that if the potential hotel room rate is 15 percent, and the OTC’s net profit margin is 12 percent without paying the tax, then the net profit would turn into a 3 percent net loss if the OTC were found liable for collecting the tax from the customer.
Retail Tax-Free Zones
The fifth problem faced by OTCs that online retailers do not have to deal with is that a handful of states do not impose a sales tax on the sale of retail goods — Alaska, Delaware, New Hampshire, Oregon and Montana. So, online retailers never have to worry about avoiding nexus with these states (since there would be no liability to collect sales tax even if they had nexus in these states).
However, these states or local governments still impose a hotel room tax. So the OTCs still have to deal with the hotel tax issue in these states, even thought their online retailer counterparts do not have to deal with collecting sales tax there.
And Now, for the Good News
One last difference between the tax issues faced by the OTCs and online retailers is in favor of the OTCs (it seems about time for some good news for the OTCs). This has to do with the stakeholders in the controversy. In the case of the OTCs, the only stakeholder adverse to the OTC is the tax authority. However, in the case of online retailers, there are two additional groups with financial interests in having the online retailers collect sales tax on remote sales — brick-and-mortar retailers who must collect sales tax on retail sales (because they clearly have nexus), and the real estate investors who lease the retail space to the brick-and-mortar retailers.
This means that there are two powerful lobbying constituencies (in addition to the tax authorities) that want online retailers to have to collect sales tax, and these groups make certain that their voices are heard in the halls of Congress and state legislatures. The OTCs only have to battle politically with the taxing authorities.
Many local governments around the country have gone on the offense in an aggressive manner, choosing a novel litigation approach by doing an end run around normal administrative procedures in order to speed up the process. In a typical local tax controversy, first there is an audit, and then there is an opportunity to challenge the results of the audit with the auditor and the auditor’s supervisor. Then there is an internal administrative appeal within the tax authority to challenge to the findings of the audit, and only after that would there be a legal action to adjudicate the controversy in the courts.
This process is lengthy, and it can take well over a year to get the matter to a court. In the case of hotel tax controversies, however, the taxing authorities in many cities have ignored their typical administrative procedures and have gone directly to the courts, asking for a declaratory judgment that the OTCs owe hotel room taxes on the amount of their markup.
A second unique characteristic of these cases is that many of these taxing authorities are pursuing them by engaging private law firms rather then using staff attorneys. It appears that most, if not all, of these outside law firm engagements are on a contingent fee basis, which means the law firm gets paid only if it obtains a judgment in favor of the tax authority. Therefore, the governmental entities do not have to go out-of-pocket for legal fees. Where, in a typical tax controversy, a taxing authority might have some motivation to settle a tax controversy because of the resources required to litigate, this concern would not be present in a case litigated by attorneys who would not be paid until they were successful in the litigation.
A third characteristic that differentiates these cases is that many of them have been filed as class action cases, where a local government brings the case as the class representative of all of the local taxing jurisdictions in the same state. This unusual tactic is likely the result of the fact that they are contingency fee cases. A private law firm is willing to invest enormous resources into a class action case because the potential payoff can be very big if it hits the jackpot.
So, for example, if a single city could expect to reap $5 million if it won its case, this would yield about $2 million to the law firm on a typical contingent fee arrangement. However, if a class action resulted in 10 cities receiving a total of $50 million, then the law firm really hits a home run, taking home $20 million on what is essentially a single case. This dynamic has really changed the landscape in the tax controversy arena.
Marvin Kirsner is a shareholder with the international law firm of Greenberg Traurig, resident in the firm’s Palm Beach County South office. His practice is focused on state and local tax issues including e-commerce and telecommunication taxation.