A wholesaler stores goods in Connecticut with an unaffiliated fulfillment company and drop-ships them to an out-of-state retailer's Connecticut customers -- must the wholesaler collect Connecticut sales tax, or does the fulfillment house exclusion relieve it?

Plain-English summary

A wholesale distributor headquartered outside Connecticut kept inventory in Connecticut with an unaffiliated warehousing and delivery agent. It sold that inventory to an out-of-state mail-order retailer with no Connecticut connection, and when the retailer made a sale, the wholesaler directed the warehousing agent to ship the goods to the retailer's Connecticut customer. The wholesaler asked whether it must collect Connecticut sales tax under the drop shipment rule, or whether the fulfillment house exclusion relieved it.

DRS held the wholesaler is responsible for collecting the tax, and the fulfillment house exclusion does not apply.

The drop shipment rule (§ 12-407(a)(3)(A)). Its second sentence provides that the delivery in Connecticut of goods, by an owner or former owner, to a consumer under a retail sale made by a retailer not engaged in business in this state, is a retail sale in Connecticut by the person making the delivery — who must include the retail selling price in gross receipts. The rule is a deliberate legal fiction: it lets Connecticut collect from a single, identifiable third party (the wholesaler/manufacturer that effects delivery) rather than chasing many individual customers of an out-of-state retailer with no duty to divulge them. The Connecticut Supreme Court acknowledged this "artificial" character in Steelcase, Inc. v. Crystal, 238 Conn. 571 (1996). So the wholesaler here is a drop shipper deemed a retailer and must collect tax on its Connecticut deliveries.

The fulfillment house exclusion (§ 12-407(a)(15)(C)) doesn't rescue it. That exclusion says a retailer not otherwise engaged in business in Connecticut isn't deemed engaged in business here merely by buying in-state fulfillment services (or owning goods on an unaffiliated fulfillment provider's premises). But the statute defines "fulfillment services" narrowly: the orders must be filled from an inventory of products offered for sale by the purchaser of the fulfillment services, and the provider must ship those orders to customers of the purchaser of the services. Here, DRS reasoned:

• The inventory is offered for sale by the out-of-state retailer, not by the wholesaler (the purchaser of the fulfillment services) — the wholesaler never offers the goods at retail.
• The goods are shipped to the out-of-state retailer's customers, not the wholesaler's customers. By the time delivery is complete, title has already passed from the wholesaler to the out-of-state retailer, so the warehousing agent is really fulfilling for the retailer, not the wholesaler.

Because those elements aren't met as to the wholesaler, the exclusion protects the out-of-state retailer (which isn't the party in question) but leaves the wholesaler on the hook for collecting tax on its drop shipments. DRS also noted a practical accommodation: it doesn't require such drop shippers to collect on the full retail price unless they have that information; instead they may use their wholesale selling price to the out-of-state retailer as the gross receipts on which tax is collected.

What this means for you

Wholesalers, distributors, and drop shippers

If you effect delivery in Connecticut of goods to a consumer for an out-of-state retailer that has no Connecticut tax duty, expect to be a deemed retailer who must collect and remit Connecticut tax on that delivery — even if your only Connecticut activity is warehousing through an unaffiliated fulfillment company. You generally can compute the tax on your wholesale price if you don't have the retail figures. Don't assume using a fulfillment house makes you a protected "retailer not engaged in business" here — the exclusion is written around the party whose inventory is offered for sale and whose customers are shipped to.

E-commerce businesses using third-party fulfillment

The fulfillment house exclusion is party-specific: it shields the retailer whose goods are being fulfilled and whose customers receive them, not an upstream supplier who is separately a deemed retailer under the drop shipment rule. Map who holds title at delivery and whose customers receive the goods before assuming the exclusion covers you.

Tax professionals

The interaction here is subtle: the same taxpayer can be a "retailer not otherwise engaged in business" for the exclusion's opening clause yet still fail the defined "fulfillment services" elements because the inventory-offered-for-sale and shipped-to-customers tests reference the purchaser of the fulfillment services. Note the ruling predates modern economic-nexus and marketplace rules — confirm current law for present-day facts.

Common questions

Q: Does a drop shipper have to collect Connecticut sales tax?
A: Yes, when it delivers goods in Connecticut to a customer on behalf of an out-of-state retailer not engaged in business here — that delivery is a deemed retail sale by the drop shipper under § 12-407(a)(3)(A).

Q: Doesn't using a Connecticut fulfillment house make the wholesaler "not engaged in business" here?
A: Not for these facts. The fulfillment house exclusion's defined elements aren't met as to the wholesaler, because the inventory is offered for sale by the out-of-state retailer and shipped to that retailer's customers — so the exclusion protects the retailer, not the wholesaler.

Q: On what amount does the drop shipper collect tax?
A: On the retail selling price in principle, but as a practical accommodation DRS lets drop shipper-wholesalers use their wholesale selling price to the out-of-state retailer when they don't have the retail figures.

Q: Who does the fulfillment house exclusion actually protect here?
A: The out-of-state retailer whose goods are warehoused and whose customers are shipped to — not the wholesaler that is a deemed retailer under the drop shipment rule.

Citations and references

Statutes:

• Conn. Gen. Stat. § 12-407(a)(3)(A) (drop shipment rule — delivery in Connecticut to a consumer under a retail sale by a retailer not engaged in business here is a retail sale by the person making delivery)
• Conn. Gen. Stat. § 12-407(a)(15)(C) (fulfillment house exclusion, and its definition of "fulfillment services")
• Conn. Gen. Stat. § 12-407(a)(12) (definition of "retailer" — which does not list drop shippers)

Cases:

• Steelcase, Inc. v. Crystal, 238 Conn. 571, 680 A.2d 289 (1996) (recognizing the artificial nature of the drop shipment rule and its imposition of tax liability on a former owner such as a manufacturer or wholesaler)

Source

• Landing page: Connecticut DRS Rulings
• Ruling: Ruling 2003-2

Original ruling text

Ruling 2003-2, Sales and Use Taxes / Drop Shipments / Fulfillment Services

FACTS:

A company headquartered outside Connecticut (the Company) is a wholesale distributor of a specialty item of tangible personal property throughout the United States.  The Company is registered with the Department for corporation business tax purposes due to the fact that it owns inventory within Connecticut.  The Company purchases inventory from an out-of-state manufacturer and ships the inventory to a warehousing and delivery agent in Connecticut.  The Company is not affiliated with the warehousing and delivery agent.  The Company then sells this inventory to an out-of-state mail-order retailer with no connection to Connecticut.  The out-of-state retailer sells the tangible personal property to customers in Connecticut and nearby states.  Upon being notified of a sale by the out-of-state retailer, the Company orders the warehousing and delivery agent to fill the order and ship the tangible personal property to the customer, either itself or by a common carrier.

ISSUE:

Whether the Company is deemed to be making retail sales of tangible personal property in Connecticut and is responsible for collecting sales tax on such sales under the “drop shipment rule” in Conn. Gen. Stat. §12-407(a)(3)(A), when it orders delivery of the property to Connecticut customers on behalf of the out-of-state retailer.

Whether, in using the warehousing and delivery agent’s services, the Company is purchasing fulfillment services in this state under the “fulfillment house exclusion” in Conn. Gen. Stat. §12-407(a)(15)(C), excluding it from being a retailer engaged in business in this state, and therefore relieving it from responsibility for collecting sales tax on the drop shipments to the out-of-state retailer’s Connecticut customers.

RULING:

The Company is deemed to be making retail sales of tangible personal property in Connecticut and is responsible for collecting sales tax on such sales under the “drop shipment rule” in Conn. Gen. Stat. §12-407(a)(3)(A) when it orders delivery of the property to Connecticut customers on behalf of the out-of-state retailer.

The Company’s responsibility to collect sales tax on its deemed retail sales under the drop shipment provision of Conn. Gen. Stat. §12-407(a)(3)(A) stands apart from, and is not affected by, the “fulfillment house exclusion” in Conn. Gen. Stat. §12-407(a)(15)(C).  Under the statute, for the exclusion to apply, the orders must be “filled from an inventory of products that are offered for sale by the purchaser of such services” and the fulfillment house must perform “the shipment of such orders to customers of the purchaser of such services.”  In this case the inventory of products is offered for sale not by the Company, but by the out-of-state retailer to which the Company has sold the goods, and the orders are shipped not to customers of the Company (the purchaser of the fulfillment services), but to customers of the out-of-state retailer.  The Company remains liable for collecting sales tax on its drop shipment sales to Connecticut customers of the out-of-state retailer.

DISCUSSION:

This ruling concerns the relationship between the “drop shipment rule,” which deems a person other than the retailer of tangible personal property to be making retail sales of goods under certain circumstances, and the “fulfillment house exclusion,” which establishes that a retailer is not engaged in business in this state (in other words, has no sales or use tax collection obligation) when its only contact with this state is that its property is located in Connecticut with an unrelated entity that fulfills retail sales of the goods for that person.

The Company asks the Department to find that because it uses a fulfillment company to warehouse and deliver tangible personal property, and because that is the Company’s only activity in Connecticut, it must not be engaged in business in this state.  If it is not engaged in business in this state, argues the Company, then it cannot be held liable for collecting sales tax on its deemed retail sales under the drop shipment rule.  While superficially compelling, the Company’s reasoning does not stand up to closer scrutiny within the context of the fulfillment house exclusion.

The second part of Conn. Gen. Stat. §12-407(a)(3)(A), the drop shipment rule, states:

The delivery in this state of tangible personal property by an owner or former owner thereof or by a factor, if the delivery is to a consumer pursuant to a retail sale made by a retailer not engaged in business in this state, is a retail sale in this state by the person making the delivery.  Such person shall include the retail selling price of the property in such person’s gross receipts.

The Company is a drop shipper under this statute, and uses a warehousing and delivery agent to assist it.  Under the drop shipment scenario in which the Company is involved, the following sequence of events takes place.  The Company wholesales tangible personal property (sells it on a resale basis) to an out-of-state retailer that has no nexus with Connecticut.  The out-of-state retailer sells the property to a Connecticut customer.  The out-of-state retailer then directs the Company to deliver the property to the customer on the out-of-state retailer’s behalf.  The Company does so using the Connecticut warehousing and delivery agent it has hired for this purpose.

The purpose of the drop shipment rule in Conn. Gen. Stat. §12-407(a)(3)(A) is to allow Connecticut to obtain sales tax from a third party not otherwise a retailer when the actual retailer is located outside the state and has no tax collection or payment obligation to this state, but directs the third party (usually the manufacturer or a wholesaler of the goods) to effect delivery of the goods to the retailer’s customer.  The drop shippers, of course, are not really retailers in the ordinary sense of the word.  Indeed, such drop shippers are not listed in the definition of “retailer” in Conn. Gen. Stat. §12-407(a)(12).  The tax could be (and sometimes is) collected from the retail customer as use tax, but the legal fiction that deems the drop shipment to be a retail sale achieves efficiency and accountability; it allows the state to collect tax from a single drop shipper rather than having to try to locate a number of individual retail customers of an out-of-state retailer that has no legal obligation to divulge the identities of those retail customers.

The Connecticut Supreme Court acknowledged the artificial nature of the drop shipment rule in Steelcase, Inc. v. Crystal , 238 Conn. 571, 680 A.2d 289 (1996), when it observed:

The second sentence of [§12-407(a)(3)(A)] clearly contemplates imposition of tax liability on a party other than the actual retailer and, by deeming a former owner who delivers the property to be the party making the retail sale for tax purposes, the act also contemplates the imposition of tax liability on a party, such as a manufacturer or wholesaler, who sells the property to the retailer for resale.

Id. at 583.  There are additional aspects of these deemed retail sales that make them unusual, as the court noted with regard to the plaintiff in Steelcase :

Steelcase was not a party to the sales contracts between the retailers and their customers.  The customers made no payment to Steelcase and it did not know what amounts were owed by the customers to the retailers, or whether any payments were made by the customers to the retailers.  Further, Steelcase did not know whether the customers had paid sales tax to the retailers, whether the customers had self-assessed a use tax, or whether the customers were exempt from the Connecticut sales and use tax.

Id. at 574-5.  In fact, in order to accommodate drop shippers that are deemed to be retailers, the Department does not require such drop shippers to collect and remit sales tax on the full retail selling price of the items unless the drop shipper has obtained that information from either the retailer or the customer.  Instead, the Department only requires drop shipper-wholesalers to use their wholesale selling price to the out-of-state retailers as the gross receipts on which tax must be collected and remitted.

These facts convincingly show that retail sales for purposes of the drop shipment rule in Conn. Gen. Stat. §12-407(a)(3)(A) are atypical, and are not retail sales in the ordinary sense of the term.  However, we must now closely examine the wording of the fulfillment house exclusion to determine if the Company has a valid claim that it should not be responsible for collecting and remitting tax on its drop shipments.

The fulfillment house exclusion, Conn. Gen. Stat. §12-407(a)(15)(C), states, in pertinent part:

A retailer not otherwise a retailer engaged in business in the state who purchases fulfillment services carried on in this state by a person other than an affiliated person, or who owns tangible personal property located on the premises of an unaffiliated person performing fulfillment services for such retailer shall not be deemed to be engaged in business in this state. . . . For purposes of this subparagraph, “fulfillment services” means services that are performed by a person on its premises on behalf of a purchaser of such services or an agent thereof, which orders are to be filled by the person from an inventory of products that are offered for sale by the purchaser of such services , and the shipment of such orders to customers of the purchaser of such services .  [Emphasis added.]

The overall issue is whether the Company’s activities, and those of its warehousing and delivery agent, comport with all the elements of the fulfillment house exclusion.  If we concede for the sake of argument that a retailer for the special purpose of the drop shipment rule is a retailer for all other sales and use tax purposes, then it does appear that the Company is a “retailer not otherwise a retailer engaged in business in this state.”  The facts presented by the Company are that its only retail activities in Connecticut are those of a drop shipper deemed a retailer because of a special statute.  Also, according to the facts, the Company purchases the services of a Connecticut warehousing and delivery agent unaffiliated with the Company.

The next question is whether the warehousing and delivery agent is “performing fulfillment services for such retailer,” namely, for the Company.  The answer is no.  If, as the Company states in the facts, the Company drop ships to Connecticut customers tangible personal property that has been sold at retail by the out-of-state retailer, then the warehousing and delivery agent is not performing fulfillment services for the Company (“such retailer”) but for the Company’s customer, the out-of-state retailer.  This is so because at some point between when the goods are taken out of the warehouse and when they are shipped or delivered by the warehousing and delivery agent, they have ceased to belong to the Company and have become the property of the out-of-state retailer.  By the time delivery is complete, even though it is completed on the Company’s instructions, the sale (the transfer of title to the goods) is from the out-of-state retailer to the customer, from both the out-of-state retailer’s and the customer’s points of view.  The Company must collect tax only because of the deeming provisions of the drop shipment rule, but it does not transfer title to goods to the retail customers, because it already has transferred title from itself to the out-of-state retailer.   In its capacity as a drop shipper, the Company deals in goods it does not own.

Now we must examine whether the Company’s warehousing and delivery agent is really performing “fulfillment services” as defined in the statute.  Again, the answer is no.  The orders are not filled by the warehousing and delivery agent “from an inventory of products that are offered for sale by the purchaser,” that is, by the Company.  The Company never offers the products for sale at retail—the out-of-state retailer does.  The Company maintains its wholesale inventory solely for the benefit of the out-of-state retailer.  Further, the warehousing and delivery agent does not perform “the shipment of such orders to customers of the purchaser of such services.”  It is the customers of the out-of-state retailer, not the customers of the Company, to which the agent ships the orders.

While the fulfillment house exclusion would certainly protect the out-of-state retailer to whom the Company wholesales its goods from being considered a Connecticut retailer (although that is not an issue here), it does not protect the Company.  That is because of the Company’s unique position, under the drop shipment rule, of being a wholesaler-deemed-retailer strictly for purposes of its responsibility to collect and remit tax on its deliveries.  In reality, the seller of the goods—the “retailer” for purposes of the fulfillment house exclusion—remains the out-of-state retailer.

LEGAL DIVISION

May 30, 2003