US Sales and Use Tax: Understanding the nuances

Europeans familiar with VAT have a whole new language to learn as they try to understand US Sales and Use Tax (SUT). Both are indirect taxes, but they vary widely in scope and implementation, writes Michael Bernard, VP chief tax officer at Vertex

It is no surprise that European businesses looking to sell goods and services overseas continue to charge forward into the US market.

The country’s GDP continues to grow in consistent 2-4% annual increments, as it has done since World War II, and post-pandemic online sales are ramping up at a 7-9% clip. The opportunity is there. But challenges are there too for businesses crossing the pond that do not fully acquaint themselves with the complex nature of the US’s SUT regime.

VAT, of course, is collected by all sellers at each point of the supply chain. Suppliers, manufacturers, distributors and retailers all apply VAT on taxable transactions. Each of these parties, along with end consumers, also pay VAT on items and services they purchase. It’s up to businesses to keep track of the VAT they charge and pay to each jurisdiction along the way. Then they apply for credits at the end of the process.

Meanwhile, US SUT is collected once – by the seller when a sale is completed at the end of the supply chain. Consumers pay the final tax and sellers pay that tax revenue to the relevant jurisdictions when the process is complete.

The US is the only major global economy without a VAT. Instead, it relies on a much more complex distributed system. Not only do each of its 50 states have their own sales tax regime – some cities or counties also levy sales taxes. Each jurisdiction maintains its own tax rates and rules to serve its citizens and compete with other jurisdictions.

With over 13,000 taxing jurisdictions in the US, there are far more rate changes than there are in VAT systems. In 2023, there were approximately 400 rate changes in US states, counties, cities and tax districts alone. In the US, states grant sales tax exemptions in a wide range of situations. Purchases by not-for-profit groups are tax exempt, as are resale and export transactions along the supply chain.

One of the more common exemptions is based on use. For example, raw materials used to manufacture a product are generally exempt from SUT. Others exempt sales of unprepared food and offer sales tax holidays for items like children’s clothing and school supplies during the back-to-school shopping period. It is important for sellers to understand that exemptions at the state level normally will apply at all sub-jurisdiction levels (county, city and districts).

For both VAT and US Sales tax, taxation operates on what is called the destination-based principle. In other words, the tax is charged at the point of the destination of the consumer purchasing the good or service. In US interstate transactions, sales tax is collected in the state where a product is shipped or where the benefit of the service is incurred.

However, in many instances if a sale is made and goods or service delivered within the same state, origin-based tax rules apply. There are 12 states that apply origin-based tax rules, including California and Pennsylvania. In these states if your company is based in the same state as the shipping/customer location the tax must be collected and remitted according to the rules and rates applicable to the location of the seller.

A key distinguisher between US SUT collection and VAT collection is how it is triggered. In the US a business must establish ‘nexus’. For decades the US required businesses to collect taxes in states where they had a tangible ‘physical presence’ – a home office, a warehouse or a number of employees.

But in 2018, the landmark US Supreme Court ruling in 2018 in the South Dakota vs. Wayfair case established that states are free to apply what’s called an ‘economic nexus’. There is a compelling reason to do so. The growth in e-commerce has led to a sharp decline in tax revenue as purchases are increasingly made from ‘remote sellers’ – entities that make sales into a jurisdiction where they have no physical presence. Economic nexus is established if their sales or number of transactions rise above a certain threshold. With VAT there are established thresholds across countries or regions after which tax on sales becomes liable.

Businesses should consider the following compliance challenges before they embark on a significant sales campaign in the US:

• Establishing which states you may have triggered either physical or economic nexus, or both;
• Registering as a tax entity in each of these states for filing tax returns;
• Implementing a centralised system to track the validity of exemption certificates;
• Determining the correct product taxability of your goods or services;
• Managing tax items like ‘caps’, ‘thresholds’ and ‘sales tax holidays’;
• Keeping up with the volume of returns for the number of jurisdictions on a monthly basis.

It is important to understand the complex framework of US SUT rates and rules before venturing into the US market. With a system containing over 10,000 tax rates, tax automation software is critical to staying compliant and setting your business up for success in the US.