A drop shipment is when a seller uses a third-party supplier to fill an order, and the supplier also delivers the merchandise directly to the seller’s customer. The Missouri Department of Revenue (“Department”) has issued several Letter Rulings regarding the tax consequences of drop-shipment sales. These Letter Rulings (Ruling 6271, May 20, 2010; Ruling 6203, April 2, 2010; and Ruling 5259, December 18, 2008) each dealt with the tax implications of sales of tangible personal property to Missouri customers by out-of-Missouri retailers, where the merchandise was drop shipped from a third-party supplier. During a recent conference call with Department leadership, Taxation Division Director Mr. Todd Iveson and General Counsel Mr. Trevor Bossert, provided the following position statements:
- Sales of property by out-of-Missouri retailers to Missouri customers where title to the property passes to the customer at the Missouri delivery address are subject to Missouri sales taxes rather than use taxes.
- When an out-of-Missouri retailer delivers tangible personal property to a third-party common or contract carrier for delivery to Missouri, title transfers in Missouri.
- When an out-of-Missouri retailer has property drop shipped to a Missouri customer, the out-of-Missouri retailer’s momentary ownership of the property in Missouri prior to transfer of the property to the customer constitutes a “physical presence” for purposes of determining nexus.
Typically, state tax departments consider drop shipments from out-of-state suppliers to be interstate sales subject to use taxes, not in-state sales subject to sales taxes. Missouri’s sales tax is a “seller privilege” tax structure, and the Missouri use tax is not imposed on transactions that are subject to the sales tax. Missouri law allows local taxing jurisdictions to implement a wide variety of local sales and use taxes, but many localities that impose local sales taxes do not impose local use taxes. Additionally, some exemptions apply to local use taxes but not local sales taxes. These factors, combined with the Department’s unique interpretation of the mechanics of drop-shipment sales, pose unique challenges for retailers and purchasers.
Compliance Challenges for Retailers
“Momentary Ownership” and Nexus
The Department’s position is that an out-of-Missouri retailer’s “momentary ownership” of the drop-shipped property between the time it leaves the supplier’s or common carrier’s vehicle and prior to receipt by the ultimate customer constitutes ownership of property in the state, which causes nexus for the out-of-Missouri retailer. The Department has not promulgated a regulation detailing what constitutes nexus for sales tax purposes, and the use tax regulations (in particular Regulation 12 CSR 10-114.100, “Determining When a Vendor has Sufficient Nexus for Use Tax”) do not address the impact of drop-shipment transactions. While the Department’s representatives indicated a single drop-shipment sale into Missouri during a three-year period would not in itself create nexus, repeated drop-shipment transactions would, in their view, constitute a “physical presence,” giving rise to nexus and a sales tax registration and collection responsibility. Out-of-Missouri retailers with no other physical presence (i.e., no employees, agents, offices, locations, inventory, or leased property, only the “momentary ownership” of goods drop shipped to Missouri customers) are considered to have nexus with Missouri and required to register to collect and remit state and local sales taxes.
Inventory Sales and Drop Shipments Taxed Differently
Out-of-Missouri retailers selling merchandise from both their own inventory and via drop shipment may be required to maintain a billing system capable of differentiating drop-shipment transactions from regular sales and capable of calculating both local sales taxes and local use taxes, depending on the type of sale. Orders where the tax was initially calculated and billed as a use tax transaction, which are subsequently filled through a drop shipment, may require a supplemental billing to collect additional local sales tax from the customer. On “split” sales, where a portion of the merchandise is coming from the retailer’s out-of-Missouri warehouse or other facilities and part of the merchandise is being drop shipped into Missouri by the retailer’s supplier, there would be two tax collection responsibilities. The retailer should bill, collect, and report Missouri vendors use tax for the sale of merchandise shipped from the retailer’s inventory, and the retailer should bill, collect, and report Missouri sales tax on the merchandise drop shipped to the ultimate customer’s location. If the drop-shipped merchandise is coming from a supplier’s location inside Missouri, the local tax would be sitused to that location; if the drop-shipped merchandise is coming from the supplier’s out-of-Missouri location, the retailer should collect and remit the local sales tax applicable to the tax jurisdiction where the ultimate purchaser received the merchandise.
Further, this distinction requires out-of-Missouri retailers selling merchandise from both their own inventory and via drop shipment to complete both a Missouri Vendors Use Tax Return reporting “regular” sales and also a Missouri Sales Tax Return reporting the drop-shipment transactions into each local tax jurisdiction and the resulting sales tax collections.
Purchaser’s Tax Compliance Challenges
Documentation and Transactional Analysis
Documents typically available to purchasers may not indicate whether the merchandise was shipped from the retailer’s inventory or was drop shipped from a supplier’s location. Many times, the only indication that a purchase was drop shipped may be in the packing slip accompanying the merchandise, which is not usually reviewed in the tax compliance process. Therefore, purchasers may not be able to determine if a transaction is a use tax transaction (which carries a legal burden to self-accrue and remit consumers use tax if the seller does not bill Missouri tax), or a sales tax transaction on which purchasers have no tax compliance responsibility in a “seller privilege” state.
Purchasers self-accruing state use tax and any local use tax on untaxed purchases may be erroneously remitting tax on sales tax transactions. One major purchaser reported being back-billed sales taxes by an out-of-Missouri retailer after the retailer was audited and assessed sales tax on drop-shipment transactions, even though it had already self-remitted use taxes on the purchases. Purchasers and the Department’s auditors may have significant difficulty determining whether purchase transactions were “sales tax transactions” or “use tax transactions” when planning audit procedures. This determination may pose challenges when analyzing transaction populations and selecting audit samples, and may alter the burden of proof responsibilities between taxpayers and auditors.
Enterprise Resource Planning (ERP) systems and tax compliance engines that calculate an expected tax amount may not be programmed to differentiate tax rates based upon whether the merchandise will be shipped by the retailer or drop shipped by the retailer’s supplier. This may cause system-projected tax liabilities to differ from the actual tax expense, impacting budgeting, procurement, and tax compliance processes.
Representatives of the Department indicated the Department is currently reviewing existing regulations and anticipates amending one or more regulations to address issues involving drop-shipment transactions. The regulation amendment process will take several months. In the interim, the Department advises taxpayers to use the following Letter Rulings as guidance:
- Missouri Letter Ruling 6271 (May 20, 2010)
- Missouri Letter Ruling 6203 (April 2, 2010)
- Missouri Letter Ruling 5259 (December 18, 2008)