How do payment plans affect sales tax collection?

Businesses are always on the lookout for options to make products and services more accessible to customers, and offering flexible payment plans is one of the best ways to achieve this. By allowing customers to spread the cost of a purchase over easy-to-pay installments, payment plans can increase sales. Traditionally available only for big-ticket items, these plans have changed over the years and are being offered for even smaller purchases for a wider range of products. 

Buy now, pay later (BNPL) has emerged as one of the fastest-growing payment options both in brick-and-mortar retail and ecommerce segments. Forecasted to grow at a CAGR of 25.3% to become a $115 billion market by 2032, BNPL is becoming a preferred financing option for consumers. Driven by benefits like higher conversion rates and increased average order value, businesses are embracing this service. 

While there are undeniable advantages for consumers, BNPL brings unique challenges for sellers, especially when it comes to sales tax management. Businesses need to understand the sales tax dynamics of BNPL transactions and have to collect, remit, and file taxes accordingly. In this blog, we delve into the details of the BNPL system and how automation can overcome the issues of BNPL tax obligations.

BNPL is a short-term financing option that allows customers to make a purchase by making a small down payment and pay the rest of the amount in fixed, equal installments over time. The installment payments are generally spread over a period of four to six weeks and might carry interest, depending on the service provider or payment terms. Additionally, late payments can incur fees, so it is important to stay on schedule with payments. 

A BNPL program works like layaway, but there is a key difference: immediate possession. In layaway, a customer can make a deposit with the seller who holds the item till the remainder balance is paid in installments. With BNPL, the customer can get immediate access to the product or service by making the initial down payment. 

Businesses, especially retailers and ecommerce platforms, are turning to BNPL for the numerous benefits it offers. 

• Increased conversion rates and sales: By offering a medium for customers to pay in small, manageable installments, BNPL supports more sales.
• Attracts younger customers: Easy access to products and services without stringent credit checks makes BNPL a preferred system for young customers.
• Improved cash flow: BNPL service providers typically pay the full purchase amount to businesses, thereby improving liquidity.
• Better customer experience: Flexible payment systems, instant access to products, and simplified checkout processes help improve customer experience.

While there are multiple advantages to using BNPL, there are some downsides that businesses must look into.

• Increased cost of transaction fees: BNPL service providers often charge businesses a transaction fee that can be higher than standard credit card processing fees, thereby reducing the profit margins.
• Risk of higher return rates: BNPL encourages impulsive purchases leading to higher return rates, which adds logistical costs.
• Dependence on third-party providers: Businesses must adhere to the payment terms and policies stated by the third-party providers, which may not always align with business needs.
• Regulatory challenges: Emerging regulations on the BNPL system for customer protection could pose challenges to businesses relying heavily on this payment method.

Managing sales tax for BNPL transactions can be really tricky. In general practice, sales tax is applied to the total amount of the purchase made by the customer, but in BNPL transactions, where the payment is deferred over a period, it can be difficult to determine the right application of taxes. 

Consider the following scenario: a customer buys a $1,000 wristwatch from an online retailer and opts to pay for it in four equal installments through a BNPL service provider. 

There are two ways in which the sales tax can be applied to this transaction:

1. The customer pays sales tax on the total purchase amount of $1,000 at the time of sale. Assuming the applicable tax rate to be 8%, the customer pays $80 as taxes to the seller.
2. The customer gets to pay a portion of the sales tax on each installment of $250.

Depending on the state in which the purchase was made, businesses need to either collect sales tax on the total purchase amount or a portion of it on every installment. 

BNPL tax regulations vary across states, and the onus of determining the correct application of sales tax lies with businesses, making it difficult to ensure compliance. Depending on the state, the tax may be applied to the full amount at the time of the initial purchase or to each installment payment.

Jeffrey Lutters, Director of Product Solution Engineering at Avalara, says BNPL is a new concept, so state tax law is still catching up. “Some states are grouping it with layaway rules; others are simply treating it as a straight sale, so all the tax is due up front.”

Here’s how some states tax layaway sales:

• Pennsylvania and the District of Columbia require sellers to report and remit sales tax on the entire sales amount at the beginning of the layaway, “when the sale, agreement, or other arrangement for transfer of the property from the vendor to the purchaser is made.”
• In Arizona, tax must be collected when “title or possession transfers to the purchaser or at the time receipts from the transaction are determined to be nonrefundable, whichever occurs first.”
• In California, “there is no taxable sale until the full purchase price is paid, unless the parties agree that title will pass at an earlier date.”
• South Carolina requires retailers to collect sales tax incrementally; payments are “taxable in the month during which such amounts are received.”

Tax automation can help overcome the challenges of sales tax management on BNPL transactions. It can help businesses with the correct collection, remittance, and filing of tax returns across jurisdictions, thereby reducing audit risk and making compliance easier. 

Avalara automates tax compliance for thousands of businesses. It provides immediate updates to tax rates, monitors nexus, manages exemption certificates, and keeps track of changing tax laws. Learn how Avalara can help simplify tax compliance for your business.