Drop shipment transactions, under which a retailer transmits orders to a manufacturer that then ships the product to the customer, have become an integral part of e-commerce operations. Another common player in the e-commerce arena are marketplace sellers, which are businesses that sell goods through a marketplace facilitator's internet platform. For purposes of sales and use tax collection requirements, California law does not currently distinguish between drop shippers, who are generally required to collect sales and use tax, and marketplace sellers, who are not. As a result, marketplace sellers run the risk of being erroneously required to collect tax. Fortunately, a proposed regulatory amendment is pending that would clarify that marketplace sellers are generally not engaged in drop shipment transactions and, therefore, are not subject to California sales and use tax collection requirements. Instead, sales and use tax collection remains the responsibility of the marketplace facilitator.

This article explains how a gray area in California's sales and use tax laws could adversely impact marketplace sellers and why a regulatory amendment is needed to clarify that they are not subject to the same sales and use tax collection requirements as drop shippers.

Proposed Regulatory Changes

In September 2021, the California Department of Tax and Fee Administration (CDTFA) proposed to amend the California Code of Regulations, title 18, Reg. 1706 (California Reg. 1706), to reflect the legislation enacted under Assembly Bill (AB) 147. Under the proposed amendment, the CDTFA clarifies that marketplace sales are usually not drop shipment transactions.

To understand the proposed amendment, we must examine the law. In 2019, the California Legislature enacted AB 147, which added the Marketplace Facilitator Act (MFA) to the California Revenue and Taxation Code. Under the MFA, a marketplace facilitator is considered the seller and retailer for each sale facilitated through its marketplace for purposes of determining whether the marketplace facilitator is required to register with the CDTFA for a seller's permit or Certificate of Registration. The MFA also provides that a registered marketplace facilitator who facilitates a sale of tangible personal property on behalf of a marketplace seller is the retailer making the sale of the tangible personal property sold through its marketplace. The marketplace seller is generally not responsible for the tax. As a consequence of AB 147, a marketplace seller may not be required to register with the CDTFA for a seller's permit or Certificate of Registration.

Under California Reg. 1706, a drop shipment is defined as a delivery of tangible personal property by an owner or former owner (or their agent), to a California consumer pursuant to the instructions of a true retailer. A true retailer is defined as a retailer who is not engaged in business in California and who makes a sale of tangible personal property to a consumer in California. A retailer engaged in business in this state means and includes any person who is required to collect use tax. A drop shipper is defined as an owner or former owner (or their agent), who makes a drop shipment of tangible personal property.

A drop shipment usually involves two separate sales, where the true retailer (1) contracts to sell tangible personal property to a consumer, and (2) contracts to purchase that tangible personal property from a drop shipper. The true retailer then instructs the drop shipper to ship the tangible personal property directly to the consumer. A drop shipper who is engaged in business in California is reclassified as the retailer and thus, is liable for the collection of sales and use tax. When more than two separate sales are involved, the person liable for the applicable tax as the drop shipper is the first person who is a retailer engaged in business in the state in the series of transactions beginning with the purchase by the true retailer.

Impact on Marketplace Sellers and Suppliers

Under the proposed amendment, when a marketplace facilitator is the retailer for the retail sale of tangible personal property to a California consumer by a marketplace seller, the marketplace facilitator is not a true retailer. If the marketplace seller contracts to purchase the tangible personal property from a supplier and instructs the supplier to deliver the tangible personal property to the consumer, the supplier is not a drop shipper. The CDTFA proposed adding an amendment to clarify that such marketplace sales are not drop shipments. The proposed rules are distinguishable from traditional drop shipment rules as they involve two separate transactions where: (1) the true retailer contracts to sell tangible personal property to a consumer; and (2) the true retailer contracts to purchase property from a supplier and then instruct the supplier to ship the tangible personal property directly to the consumer. In this traditional transaction, the supplier is a drop shipper. This difference between the CDTFA's proposed amendment and the traditional drop shipment transaction rules will have a significant impact on marketplace sellers and suppliers.

The proposed amendment provides an example under which ABC Co. is a marketplace seller and not a retailer engaged in business in California. On December 1, 2019, a marketplace facilitator that is registered with the CDTFA for a seller's permit or Certificate of Registration – Use Tax, facilitates a retail sale of tangible personal property to a California consumer by ABC Co. through its online marketplace. ABC Co. then contracts with XYZ Inc. to purchase the tangible personal property and instructs XYZ Inc. to ship the property directly to the California consumer. XYZ Inc. is not a drop shipper liable for the applicable tax as the retailer. The marketplace facilitator is the retailer and is liable for the applicable tax.

The Takeaway

The CDTFA's proposed rule clarifying the difference between marketplace sales and drop shipments are even more needed due to the passage of AB 147. Failing to distinguish between marketplace sales and drop shipments, marketplace sales could result in marketplace sellers being erroneously required to collect sales and use tax.

Contact an Andersen SALT advisor to discuss how these issues may impact your business.