Dropshipping is a way of selling products in which the seller takes a customer’s order but has the product shipped to the customer via a third party. The third party ships the product directly to the customer. The seller does not keep any inventory. Instead, the seller instructs the third party to fulfill the order.
This third party, acting as a drop shipper (usually a manufacturer or distributor), then ships the goods directly to the U.S.-based customer. For example, when a manufacturer acts as a drop shipper, it may produce and ship goods directly to a U.S.-based customer on behalf of the foreign seller.
The drop shipping business model delivers significant benefits to foreign sellers in lowering their inventory and supply chain costs while driving increased sales.
In this business model, the sales transaction involves the following:
In short: the foreign seller makes the sale, but a U.S. partner handles the actual fulfillment. This ensures the customer receives faster delivery.
These transactions, while related, are treated separately for sales tax purposes and can be quite complex, especially when the seller is a foreigner and the transactions cross international borders.
Next, let’s understand the drop shipping model through a simple example.
Assume Foreign Company A, a German luxury handbag retailer, sells handbags through its online store to customers throughout the United States. The company has no offices, employees, or inventory in the United States.
A customer in California, Customer B, orders a designer handbag for $600,000 from Foreign Company A’s website. But Foreign Company A does not stock products in the U.S., so it immediately purchases the handbag from New Jersey Vendor C, a U.S.-based supplier that keeps the handbag in inventory. Vendor C then ships the handbag directly to Customer B in California on behalf of Foreign Company A.
From Customer B’s perspective, there is only one purchase of the handbag from Foreign Company A. However, to complete that sale, Foreign Company A also purchases the handbag from Vendor C, who fulfills the order by delivering it directly to Customer B.
Accordingly, the arrangement consists of one commercial transaction involving two related sales:
Step 1: Foreign Company A sells the handbag to California Customer B; and
Step 2: To fulfill that sale, Foreign Company A purchases the handbag from New Jersey Vendor C, who ships it directly to Customer B.
The above steps may have different sales tax treatments. Let us analyze the sales tax implications of each of these steps separately.
First, let’s understand the sales tax implications of the sale of the handbag from Foreign Company A to California Customer B
The first part of the transaction is the retail sale made by Foreign Company A to California Customer B. Foreign Company A sells the handbag to the California customer for $600,000 through its website.
The primary sales tax issue is whether Foreign Company A has sufficient nexus with California to be required to register, collect, and remit California sales tax.
California applies an economic nexus standard. A foreign seller should register and collect California sales tax once its annual sales into California exceed $500,000, regardless of whether it has a physical presence in the state.
In the present case, Foreign Company A’s sale to Customer B is $600,000, which exceeds California’s economic nexus threshold. As a result, Foreign Company A would generally be required to register with the California Department of Tax and Fee Administration (CDTFA), collect California sales tax from Customer B, and remit the tax to the state.
Unlike some states, California bases its economic nexus solely on the value of sales into the state rather than the number of transactions. Therefore, a single large transaction exceeding $500,000 can create nexus just as easily as many smaller transactions.
It is also important to note that California is a seller-privilege-tax state. This means the seller and not the customer is generally responsible for collecting and remitting sales tax. Accordingly, California Customer B would ordinarily not be responsible for paying use tax on this purchase if Foreign Company A is responsible for the sales tax.
However, completing the above sale also requires Foreign Company A to obtain the handbag from Vendor C. The sales tax treatment of that purchase is different because Vendor C is selling the handbag to Foreign Company A for resale rather than to the final consumer.
Next, let’s understand the sales tax implications for the next part of the transaction: the purchase of the handbag by Foreign Company A from New Jersey Vendor C.
To fulfill Customer B’s order, Foreign Company A purchases the handbag from New Jersey Vendor C, who then ships it directly to the California customer. B
Although Vendor C physically delivers the handbag to Customer B, Vendor C is not the retailer dealing with the customer. It is supplying the product to Foreign Company A so that Foreign Company A can complete its retail sale.
The key sales tax issue here is whether Vendor C should collect sales tax when selling the handbag to Foreign Company A.
Generally, because Foreign Company A is purchasing the handbag solely for resale, the transaction may qualify as a sale for resale. If so, Vendor C ordinarily would not collect sales tax, provided Foreign Company A furnishes a valid resale certificate.
Whether Foreign Company A can provide a valid resale certificate depends on its California registration status.
If Foreign Company A has exceeded California’s $500,000 economic nexus threshold and has obtained a California seller’s permit, it can generally issue Vendor C a valid California resale certificate. Vendor C may then treat the sale as exempt from sales tax, while Foreign Company A remains responsible for collecting and remitting California sales tax on its retail sale to Customer B.
If, however, Foreign Company A is not registered with the CDTFA and therefore cannot issue a valid California resale certificate, the result may be different. In that situation, California’s drop shipment rules may treat Vendor C as the retailer responsible for collecting and remitting California sales tax on the shipment to Customer B. Importantly, Vendor C’s tax liability may be measured by the retail selling price charged to Customer B rather than the wholesale price paid by Foreign Company A.
Next, let’s understand how the sales tax implications for sales under Step 1 and Step 2 differ, even though they are part of the same customer order.
Although both sales under Step 1 and Step 2 occur within the same customer order, they serve different purposes.
The sale from Foreign Company A to Customer B is the final retail sale. The focus is on whether Foreign Company A has sufficient nexus with California to collect and remit sales tax.
By contrast, the sale from New Jersey Vendor C to Foreign Company A is not a retail sale. Foreign Company A is purchasing the handbag solely for resale to Customer B. As a result, this sale may qualify for the resale exemption if the required documentation is provided. If a valid resale certificate is unavailable, California’s drop shipment rules may instead shift the responsibility for collecting sales tax to Vendor C.
Accordingly, even though both sales arise from the same order placed by Customer B, they are analyzed differently. This is because one is a retail sale to the end customer, while the other is a wholesale sale made for resale. This distinction is what makes dropshipping transactions one of the more complex areas of U.S. sales tax compliance, particularly for foreign sellers.
Next, let’s understand what a resale exemption certificate is and the role it plays in exempting foreign sellers from sales tax.
A resale exemption certificate is a document that a buyer gives to a seller to show that the goods are being bought for resale, not for personal use. If the seller accepts a valid certificate, they usually do not charge sales tax on the sale.
For example, a retailer can buy inventory from a manufacturer without paying sales tax if the retailer provides the manufacturer with a valid resale exemption certificate. Later, when the retailer sells the goods to the final customer, they collect and pay the sales tax if it applies.
One common example of a resale exemption certificate is the Texas Sales and Use Tax Resale Certificate (Form 01-339). The certificate can be used to show that the purchase qualifies for the resale exemption. Most states have similar forms, but the details and rules can vary.
It is essential for the foreign seller to have a valid resale exemption certificate when purchasing goods from a U.S.-based drop shipper to resell them to U.S.-based consumers. Without it, the transaction between a foreign seller and a U.S.-based drop shipper may be classified as a retail sale instead of a resale. As a result, the foreign seller may be liable to collect sales tax from buyer and remit to the appropriate state. However, if the foreign seller is not subject to a registration requirement, this burden could shift to the drop shipper. This may create an additional burden on the drop shipper.
Resale exemption certificate procedures differ from state to state. Many states will accept an out-of-state resale certificate, a multijurisdictional form (e.g., the Multistate Tax Commission uniform sales and use tax resale certificate or Streamlined Certificate of Exemption), or alternative documentation in a drop-shipping situation.
Further, the foreign seller should continually assess their sales activities in each U.S. state. Reaching sales or transaction thresholds could establish an economic nexus, necessitating registration and collection of sales tax.