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Retail Industry Braces for a Major Legislative Disruption

Brick-and-mortar retailers in the United States have been under enormous pressure due to having too many stores, high levels of debt on their balance sheets, and the rise of digital retailing. But, the Supreme Court of the United States (SCOTUS) may be about to hand them a rare win, thanks to a case known as South Dakota v. Wayfair, 17-494.

The case being argued this week has to do with the treatment of sales tax, and relates to another court case — Quill Corp. v. North Dakota — that was argued before the Supreme Court in 1992. In Quill Corp. v. North Dakota, the Supreme Court ruled that a business must have a physical presence in a state for that state to require it to collect sales taxes, setting a crucial precedent for future retailers.

At the time of the 1992 ruling, which involved a mail-order company, American retail was booming, and strip malls and supercenters were on the ascendant. Online retail was barely an idea on the horizon. Then 1995 ushered in the dotcom era, Google and Amazon, all of which would eventually facilitate merchants’ ability to conduct business remotely online, disrupting the retail industry in a massive way. Quill Corp. v. North Dakota proved pivotal in that, to this day, online merchants are only required to collect and remit sales tax in states where they have a physical presence — like stores, warehouses or fulfillment centers.

But, with more shopping moving online, many physical stores are struggling to remain viable, and e-tailers’ ability to generate sales in an outside state without collecting sales tax is taking a toll on local municipalities. Today, states may be losing between $8.5 billion and $13 billion in annual uncollected taxes, per the U.S. Government Accountability Office. Given the seismic impact of e-commerce on the retail industry and the economy, and heeding calls from traditional retailers and dozens of states, SCOTUS is now hearing arguments to determine whether the 26-year old Quill ruling is still relevant and may decide to overturn it.

The case came to fore because South Dakota passed a law in 2016 with an eye toward overturning the Quill decision, and asked that retailers with more than $100,000 in annual sales in the state should pay a 4.5% tax on purchases. After enacting that law, South Dakota filed suit and asked the courts to declare the measure constitutional. Wayfair, Overstock and Newegg said the court should reject the appeal and leave it to Congress to set the rules for online taxes. The Supreme Court’s decision to take up the case suggests the Quill ruling may be on shaky groundThree of the nine current justices — Clarence Thomas, Anthony Kennedy and Neil Gorsuch — have already expressed doubts about the precedent.

Overturning the ruling would be a win for traditional retailers, as it would help level the playing field somewhat. The growing popularity of online retail has created pricing disparities that has benefited online merchants for the most part, particularly in this age of bargain shopping. That’s because consumers comparing an identically-priced product sold by a physical retailer and an online retailer may opt for the online retailer to avoid paying the sales tax.

Dropping the Quill ruling would put pressure on internet retailers and marketplaces that don’t always collect taxes — including Overstock, Wayfair, Newegg, EBay, Etsy, and thousands of smaller merchants across the nation. Amazon is less directly affected: The company has warehouses all over the country, giving it a physical presence in most states, so it already pays sales tax in the majority of states. But merchants that sell on Amazon.com do not. And they represent about 50% of the products sold on Amazon.

Not only would online merchants lose some of their pricing competitiveness if they had to collect sales tax, they would also face the complex task of complying with new rules for thousands of products in thousands of cities, counties and airports that serve as their own taxing jurisdictions. Implementing software to calculate taxes across some 12,000 nationwide taxing jurisdictions is expensive, burdensome, and could threaten the existence of many small businesses. To address this potential headache, Amazon is proposing a nationwide approach that would relieve retailers from having to deal with a patchwork of state laws.

If SCOTUS ultimately overturns Quill Corp. v. North Dakota, large e-tailers like Wayfair and Overstock are better equipped than many smaller companies to handle the potential costs of collecting sales tax. In fact, it could be extremely disruptive for small retailers and marketplace sellers. They may end up with fewer sales and greater costs, with some possibly going out of business. For Amazon, that could mean a loss of revenues from Amazon Marketplace sellers whose businesses are negatively impacted.

As for traditional retailers, there are several reasons to be more optimistic about their prospects. E-commerce represents just 9% of the $5.7 trillion American consumers spent at retailers in 2017. The remaining 91% of that spending occurred at brick-and-mortar stores, so even though their share of the pie is shrinking, it is still quite large. In the meantime, physical retailers are fighting back against the online threat with innovating experiments, Virtual Reality and Augmented Reality technologies to create experiential stores that appeal to modern shoppers. Also, bankruptcies and store closings are helping whittle away at their overcapacity problem, and the industry is beginning to reduce its debt levels. This year, $1.9 billion of high-yield retail debt is set to mature, and an average of $5 billion per year between 2019 and 2025, according to Fitch Ratings. Furthermore, retailers could get a boost from an accelerating economy, rising wages for consumers, and the benefits to retail from the new tax law.

Until it is resolved, MRP will continue to follow the Supreme Court case relating to South Dakota v. Wayfair, Inc. Oral arguments were scheduled for April 17, 2018, and a decision is expected by the end of the current term in June 2018.

Investors can gain exposure to the changing retail landscape through a couple of ETFs that focus on the Clicks-versus-Bricks trend, such as the ProShares Long Online/Short Stores ETF (CLIX) or the ProShares Decline of the Retail Store ETF (EMTY). The CLIX combines long positions in retailers with leading online businesses and short positions in companies that rely principally on revenue from physical stores. The EMTY provides short exposure to the Solactive-ProShares Bricks and Mortar Retail Store Index, which consists of retailers that rely principally on revenue from physical stores.

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