Hawaii OKs economic nexus, market-based sourcing

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Hawaii Gov. David Ige recently signed legislation impacting Hawaii corporate and personal income taxpayers. The legislation creates economic nexus rules for income tax purposes,¹ adopts the use of market-based sourcing for sales other than sales of tangible personal property,² and updates Hawaii’s conformity to the Internal Revenue Code (IRC).³

Economic nexus Applicable to tax years beginning after Dec. 31, 2019, S.B. 495 creates an income tax economic nexus standard for taxing out-of-state persons on their income earned in Hawaii.⁴ A person that lacks physical presence in Hawaii is presumed to be systematically and regularly engaging in business in Hawaii and subject to income tax if, during the current or preceding calendar year: (i) the person engages in 200 or more business transactions with persons within Hawaii; or (ii) the sum of the value of the person’s gross income attributable to sources within Hawaii equals or exceeds $100,000.⁵ For purposes of Hawaii income tax, a “person” includes an individual, trust, estate, partnership, association, company or corporation.⁶

Market-based sourcing S.B. 394, applicable to tax years beginning after Dec. 31, 2019, adopts market-based sourcing for purposes of apportioning income from sales other than sales of tangible personal property.⁷ The market-based sourcing law provides that sales of intangible property are sourced to Hawaii to the extent the intangible property is used in the state, or, in the case of a service, to the extent the service is used or consumed in the state.⁸

For tax years beginning before Jan. 1, 2020, sales other than sales of tangible personal property are sourced to Hawaii if the taxpayer performs the income-producing activity in the state, or the taxpayer performs the income-producing activity both within and outside the state with a greater proportion of the activity performed in Hawaii than any other state, based on costs of performance.⁹

IRC conformity For tax years beginning after Dec. 31, 2018, S.B. 1130 updates Hawaii’s IRC conformity date to Dec. 31, 2018.¹⁰ Hawaii’s previous IRC conformity date was Feb. 9, 2018, for tax years beginning after Dec. 31, 2017.¹¹ The statute provides that conformity to the IRC is as of Dec. 31, 2018, as applicable to the determination of gross income, adjusted gross income, ordinary income and loss, and taxable income, except for provisions otherwise inapplicable or limited under Hawaii law.¹²

With respect to other IRC conformity issues, the legislation amends the definition of unrelated business taxable income (UBTI) to provide that IRC Sec. 512(a)(7)¹³ does not apply.¹⁴ The legislation also provides that Hawaii no longer decouples from Subchapter Z of the IRC, with respect to opportunity zones.¹⁵ Specifically, Subchapter Z is operative, except that for Hawaii income tax purposes, such qualified opportunity zones must be designated by the Chief Executive Officer of Hawaii.¹⁶

Commentary Hawaii is the first state to enact legislation that applies the economic sales tax nexus thresholds approved by the U.S. Supreme Court in South Dakota v. Wayfair, Inc.¹⁷ to an income tax context. In 2018, Hawaii enacted legislation that applies the Wayfair thresholds to the state’s general excise tax (GET).¹⁸ Therefore, Hawaii will now have somewhat similar nexus standards for both income tax and GET purposes. However, the income tax statute imposes nexus on out-of-state persons engaging in 200 or more business transactions with persons within Hawaii. The new law does not provide a definition of “business transactions,” and existing law does not define this term. The corresponding provision in the GET statute imposes nexus if the out-of-state person sold tangible personal property delivered in the state, services used or consumed in the state, or intangible property used in the state in 200 or more separate transactions.¹⁹ On in its face, the income tax statute requires 200 or more business transactions as opposed to 200 or more sales transactions. The income tax statute does not necessarily require that the business transactions consist of sales. This broad reading could impose income tax nexus on a remote entity that regularly purchases goods or services from a Hawaii business, conceivably causing an out-of-state business with minimal or even no sales in Hawaii to have nexus with Hawaii. Additional legislation or regulations are needed to clarify the meaning of “business transactions.”

Numerous states have enacted legislation that applies the Wayfair economic nexus standard to sales tax. There is a possibility that other states may follow Hawaii’s lead and extend the Wayfair economic nexus thresholds to income tax. Although the new economic nexus standard applies to income tax, remote businesses should continue to receive federally adopted protection from Hawaii income tax under P.L. 86-272 to the extent the activities of such businesses qualify for protection.²⁰

In replacing the existing cost of performance method for assigning income to the state, the Hawaii legislature noted that as intangible property and services have become a greater part of the economy, states have transitioned to market-based sourcing for intangibles and services.²¹ The legislation explains that the transition to market-based sourcing will ensure that Hawaii’s income tax is keeping up with the changing economy and will foster uniformity with states that have also transitioned to market-based sourcing. The change also will reduce inter-state complexity and simplify inter-state compliance. 

Additionally, Hawaii’s GET utilizes a version of market-based sourcing,²² so transitioning the corporation income tax to market-based sourcing could increase consistency and efficiency between the two taxes. However, there may be differences in the application of market-based sourcing between the tax types. For purposes of measuring market-based sourcing under the GET, gross income from services or intangible property generally is sourced to Hawaii in proportion to the benefit received in the state.²³ Hawaii will need to issue regulations to clarify the implementation of market-based sourcing for income tax purposes. If the Hawaii income tax market-based sourcing regulations are based on the extensive model regulations issued by the Multistate Tax Commission (MTC), there may be inconsistencies in market-based sourcing between income tax and the GET. For example, the MTC model regulations generally source income from services according to delivery location as opposed to the location where the benefit is received. The possible differences in market-based sourcing between income tax and the GET should be considered after the income tax market-based sourcing regulations are issued.

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1 Act 221 (S.B. 495), Laws 2019, enacted on July 2, 2019.
2 Act 96 (S.B. 394), Laws 2019, enacted on June 7, 2019.
3 Act 69 (S.B. 1130), Laws 2019, enacted on June 7, 2019.
4 The new statute will be codified in HAW. REV. STAT., Ch. 235, Part I. This chapter imposes the income tax and Part I contains the general provisions. Part III provides the personal income tax statutes and Part IV provides the corporate income tax statutes. Because the new statute will be added as a general provision in Part I, it presumably applies to both corporate income tax and personal income tax.
5 For a person that does business within and outside Hawaii, the second threshold is satisfied if the numerator of the person’s sales factor for Hawaii equals or exceeds $100,000.
6 HAW. REV. STAT. § 235-1.
7 HAW. REV. STAT. § 235-37.
8 Id.
9 Id.
10 HAW. REV. STAT. § 235-2.3. Note that Hawaii enacted legislation in 2018 that decoupled from many of the provisions of the Tax Cuts and Jobs Act, P.L. 115-97. Act 27 (S.B. 2821), Laws 2018. For further discussion, see GT SALT Alert: Hawaii Enacts Legislation Updating IRC Conformity Date, Decoupling from Many Federal Provisions.
11 Id.
12 Id.
13 IRC § 512(a)(7) provides for an increase in UBTI by the amount for which a deduction is not allowed under IRC § 274 (disallowance of entertainment and certain other expenses) and which is paid or incurred for a qualified transportation fringe, a parking facility used for qualified parking or any on-premises athletic facility.
14 Under existing Hawaii law, UBTI means the same as in the IRC, but HAW. REV. STAT. §§ 235-3 to 235-5 and 235-7 (except subsection (c)) apply.
15 The legislation deletes HAW. REV. STAT. § 235-2.3(b)(51). Subchapter Z is comprised of IRC §§ 1400Z-1 to 1400Z-2.
16 HAW. REV. STAT. § 235-2.45(k).
17 138 S. Ct. 2080 (2018). For a discussion of this case, see GT SALT Alert: Wayfair Ruling Overturns Quill Physical Presence Requirement.
18 Act 41 (S.B. 2514), Laws 2018. For more information on this legislation, see GT SALT Alert: Hawaii Enacts Economic Nexus Standards for General Excise Tax. In lieu of a traditional sales tax, Hawaii imposes a GET that is a privilege tax imposed on all business and other activities in the state.
19 HAW. REV. STAT. § 237-2.5.
20 P.L. 86-272, codified at 15 U.S.C. §§ 381-384, is a federal law that prohibits a state from imposing an income tax if the only in-state activity of the out-of-state person is the solicitation of orders for sales of tangible personal property where the orders are sent outside the state for approval or rejection and are filled by shipment or delivery from a point outside the state.
21 For an explanation of the purpose of this legislation, see S.B. 394, § 1.
22 See HAW. ADMIN. RULE §§ 18-237-29.53-01 – 18-237-29.53-13; 18-237-29.57-01.
23 HAW. ADMIN. RULE §§ 18-237-29.53-02; 18-237-29.57-01.

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