Managing sales tax is a significant pain point for any business, but it is an even bigger challenge for e-commerce businesses. The lack of boundaries in e-commerce business exposes it to a variety of tax structures of countries, states, and provinces it sells to.
Collecting, filing, and remitting sales tax is confusing and time-consuming, but it cannot be ignored. Taxes are a cost of doing business, but doing them incorrectly can be disastrous for your business. Every tax dollar you fail to collect from the customer is another dollar your company is responsible for paying your country's tax collector. The tax collector of your country, be it the IRS in the U.S. or the CRA in Canada, are very good at enforcing the tax laws.
Sales tax risks
As a small business owner, you, not your buyers, are responsible for the sales tax associated with online shopping. This means that every dollar of the sales tax you fail to collect is a dollar you will be held accountable for by state and local tax authorities. Beyond this, late payment penalties, interest, and collection fees may also be assessed. At the extreme, criminal charges may be brought if it is determined that tax evasion has taken place. If you haven't put the money aside, it could become an existential challenge for your business.
The complexity of establishing nexus.
A traditional brick-and-mortar store can charge the applicable local sales tax rate because the business and your customer are in the same country, state, or province. However, if you are an online business selling to customers worldwide, tax compliance can become incredibly complex.
In the United States, sales tax includes a combination of state, county, city, and district tax rates, which means rates can differ from city to city or district to district with the same state.
If that's not complicated enough, some U.S. states have 'origin-based' sales tax rates, and others have 'destination-based' sales tax rates. The state your business has nexus in dictates whether origin-based or destination-based tax rules would apply.
Understand where your business has nexus.
Nexus refers to a commercial connection to a state or local taxing jurisdiction, but it is not limited to a physical presence of your business. Nexus can be triggered by the location of your office, warehouse, fulfillment center, where your remote employees work from and even your referral source.
Therefore, it is crucial to know whether your business has a nexus in an origin-sourced state or a destination-sourced state. Most U.S. states and Washington, D.C., are destination-based, and about 11 are origin-based.
How does in-state origin-based and destination-based sales tax rate work?
- If your business has a nexus in an origin-based state and makes sales to customers in the same or different district of the state, you will charge sales tax based on your business's location (nexus), including any local and state taxes.
- If your business has a nexus in a destination-based state and sells to customers in the same state, but in a different district, you should charge sales tax based on your customer's location, including local and state taxes. For physical products, charge the tax rate of the ship-to place of the physical product. For digital products, charge the tax rate of the customer's billing address.
How does the out-of-state (remote) sales tax rate work?
- Origin and destination sourcing tax rules work differently if your business is in one state and your customer is in another state. A state considers you a remote seller if you have a sales tax nexus in that state but are not based there.
As a rule of thumb, if you are a remote seller in a state, you should be charging the sales rate at your buyer's destination.
- If you are selling to customers in a state where you don't have nexus, you don't have an obligation to collect sales taxes.
Canada's sales tax rules are less complex, but the sales tax rate differs from province to province. Most provinces charge a Harmonized Sales Tax (HST), which is an amalgamation of federal and provincial tax jurisdictions, and some provinces charge Provincial Sale Tax (PST) and Goods & Services Tax (GST) separately or only GST.
Place of supply (destination-based) rules
The CRA's 'place of supply' rules dictates which province's rate applies to your sale. As a rule of thumb, the province where your sales are made (destination) dictates the GST/HST rate you need to charge your customers.
- In-province sale: If your business and customers are in the same province, the province's sales tax rate applies.
- Out-of-province sale: If your business is in one province and your customer is in another, the place of supply (destination) province rates would apply.
For example, if a visitor from Alberta walks into your store in Ontario and buys a smartphone, Ontario's tax rate would apply. Still, if the same customer orders a smartphone from your online store and has it shipped to Alberta, Alberta's tax rate would apply.
- If your international customers make purchases while in Canada, they will have to pay sales taxes in that province but may be eligible to receive a refund.
- International customers are not charged sales taxes as long as they take the delivery of the goods or services outside of Canada.
When and how to start collecting sales tax
Consult a tax professional before you start collecting sales tax because what you're selling, your business's size, and where you have nexus can make a difference.
As a rule of thumb, it would be wise to start collecting sales tax on your first taxable sale, but first register to collect tax in your state or province.
Getting sales tax rates right
As the business grows and the more customers you have across states and provinces, tax compliance becomes a more complex and time-intensive task. If not managed diligently, it can result in a higher risk of sales tax audit, underpayment, or overpayment. To avoid this risk, it is better to deploy tax automation software like Avalara that is constantly updated with the latest rates and tax calculations, whether the sales tax is origin-based or destination-based.
In conclusion, we strongly advise you to consult a tax professional before your first sale as the risk is too high.