What is ‘Economic Nexus’ and Why Do I Care?

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What is ‘Economic Nexus’ and Why Do I Care?

By - January 27, 2010

Under current law, many companies are not required to pay Washington’s B&O tax even though they do a significant amount of business in the state.  Governor Gregoire recently proposed to partially close this loophole.  If enacted, the Governor’s proposal would help level the playing field between in-state and out-of-state businesses. It would also generate a sizable amount of new resources that would help maintain core public services like health care and education throughout the downturn. However, because the standard would apply only to service-related businesses and royalty income, the Governor’s proposal falls short.  Legislators should consider applying the standard to all types of business activities performed in Washington.

A new nexus standard

The state business and occupation (B&O) tax only applies to companies with a significant presence (or “nexus”) in Washington State. Currently, a business has nexus and is therefore taxable only if it has a physical presence in Washington – that is, if it has any property, employees or agents soliciting sales in the state. Businesses that make significant sales in the state without a physical presence are not taxed.

The current system has three serious consequences: 1) out-of-state businesses have a competitive advantage over in-state business that are subject to the tax; 2) the state loses a substantial amount of badly needed revenue; and 3) under the physical presence nexus standard some businesses that benefit from Washington’s public structures – i.e. courts, roads, and other services that improve access to markets — are not required to help pay for their maintenance.  Taken together, these problems suggest that Washington needs a new nexus standard.

The Governor’s proposal would expand the definition of nexus to include companies that have a significant economic presence in the state—even if they don’t have a physical presence. In addition to the presence of property or payroll, nexus would be established if a business has more than $500,000 of receipts (sales) sourced to Washington State.

Economic nexus in other states

Economic nexus is used in other states with taxes similar to the B&O. It is consistent with the Multistate Tax Commission’s (MTC) “factor presence nexus” standard, which was developed specifically for state business activity taxes like the B&O tax.  Unlike the MTC’s suggested standard, the Governor’s proposal would apply only to firms engaged in service-oriented activities and that earn income from royalties.

Ohio’s Commerical Activities Tax, which is similar to the B&O, uses the MTC’s factor presence nexus standard as a means of determining which businesses are subject to the tax.  Similarly, the Michigan Business Tax (MBT) also incorporates an economic nexus standard for establishing tax liability.  In fact, under the MBT the threshold for economic nexus is $350,000 in receipts – significantly lower than the threshold advocated by Governor Gregoire.

Given the problems inherent with our current system and the need for new revenue, consideration should be given to following these states’ example and adopting economic nexus.

 

About Andy Nicholas, Senior Fellow

Andy specializes in state budget and tax policy. Since joining the Budget & Policy Center in 2009, he has served on a Legislative Task Force on Tax Preference Reform and has conducted numerous analyses of Washington state’s tax code.

Read more about Andy