State and Local Taxes: Drop Shipments and Flash Title

Establishing sales tax nexus in complex commercial transactions.

September 2009
by Cara Griffith and Stephanie Stewart/The Tax Adviser

As businesses evolve to meet the needs of customers in an increasingly instantaneous and borderless commercial environment, transactions are inevitably becoming more complex. Business models have increased in complexity with the use of e-commerce, supply chain management, dual branding, and multi-chain retailers. State tax codes, while arguably complex, have largely failed to keep up with the evolution of commercial transactions. Many state tax codes are still based on the premise that a sales transaction involves only two parties: a seller and a buyer. Modern transactions can involve far more than two parties. In addition, transactions involving remote sellers raise sales and use tax issues, including whether a remote seller has  nexus with a state if its only connection to that state is the presence of a retailer or manufacturer that supplies goods to the seller’s customers.

Other common commercial transactions include drop shipments and flash title transactions. Drop shipments involve a customer in one location who places an order with a retailer in a second location, which requests that a supplier in yet another location fill the order and ship the item directly to the customer. The sales and use taxation of drop shipments can be complex because not all states treat drop shipment transactions the same. Another type of transaction involves something called a “flash title.” This occurs in a transaction where an out-of-state entity holds legal title to an item in the stream of interstate commerce but the item is in the control of a third party (typically a common carrier). During the course of shipment, title passes at a contractually agreed upon point at which neither the seller nor the purchaser has business operations and thus theoretically no nexus. However, some states have attempted to use flash title to assert sales and use tax nexus over a remote seller.

This column first provides an overview of the theories surrounding substantial and attributional nexus and then examines how nexus is asserted for sales and use tax purposes in drop shipment and flash title transactions.

Substantial Nexus

Before a state can impose a tax on an interstate business, the tax must overcome the limitations of the Commerce Clause, which the U.S. Supreme Court has interpreted in a number of important cases. Most notably, in 1977, in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the Court established a four-prong test that a tax must pass to withstand Commerce Clause scrutiny. One of those prongs, the Court explained, is the requirement that a challenged tax is applied to an activity with a substantial nexus with the taxing state.

This article has been excerpted from The Tax Adviser. View the full article here (PDF).