COMMENTARIES. Technology. The E-Tax Man Cometh. The Battle Over Internet Taxation Makes Its Way Back to Washington. The Players.

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1 January 2002 Volume 3, Number 1 Technology COMMENTARIES The E-Tax Man Cometh The Battle Over Internet Taxation Makes Its Way Back to Washington Science fiction author William Gibson (the man widely credited with inventing the term cyberspace ) has written technological thrillers about bloody cyberwars being fought over the future of the Internet. In his books, the battles are fought by corporate giants and by rogue hackers, with the prize being the technological soul of the Internet as a medium and the public at large. The world Gibson envisioned has practically come to pass. Instead of vicious keyboard-toting, cybernetic implant-sporting computer hackers, the confrontation is being fought by accountants armed with calculators, politicians armed with images of school children and of empty coffers, and lawyers armed with copies of the United States Constitution. Welcome to the CyberTax Wars of the 21 st Century. President Bush signed an extension of the moratorium on certain new or discriminatory taxes and taxes on Internet access charges on November 28, shortly after the original moratorium imposed by the Internet Tax Freedom Act expired. Considering the acrimonious debate that accompanied this extension, this is likely the last time the moratorium will be extended. The clock is now running for the parties to arrive at a comprehensive, long-term compromise. This Commentaries outlines the history of this dispute and the stakes involved for the various combatants. Background Nexus. The seeds of the dispute over taxation of Internet transactions go back to laws and policies that long predate e-commerce. The biggest concern of the states has always been their inability to force remote sellers (that is, out-of-state companies with no in-state physical presence who sell to in-state customers) to collect state sales and use taxes on the sale of taxable items to customers within their state. States are also concerned about the limitations on their ability to compel remote sellers to pay in-state income taxes. The United States Supreme Court, interpreting the Commerce and Due Process Clauses of the United States Constitution, has long held that a remote seller that does not have a physical presence in a particular state also does not have sufficient contact there to be subjected to taxing jurisdiction. This elusive level of contact that subjects a company to taxing jurisdiction in a state is often referred to as nexus. The Players Brick and Mortar Sellers. Most retailers from the old economy already have stores, and thus nexus, in the states where they make sales. Since they are already required to collect sales tax on most transactions, these sellers generally favor no special treatment for mail-order sellers or Internet sellers, and they support legislation to impose sales or use tax collection responsibility on remote sellers. However, brick-and-mortar sellers also see the debate as a critical opportunity to force states to simplify sales taxes and therefore reduce state tax compliance burdens of all taxpayers. Internet Only and Mail Order Sellers. E- commerce businesses, already reeling from recent economic troubles and falling stock prices, view the 2002 Jones, Day, Reavis & Pogue. All rights reserved.

2 burdens and expense of state and local (or even international) tax compliance as a potential death blow to their businesses. Often operating on very slim margins, e-commerce businesses see the sales tax loophole (that companies lacking nexus in a state need not collect use tax on shipments into that state) as a means to offset their online sales transaction burdens of charging for shipping, a fee that a local retailer does not charge, thereby erasing any perceived price advantage by ordering online and escaping the sales tax. State and Local Governments. Many state and local governments rely heavily on sales and income tax revenue and see any tax protection for Internet and mail-order sales as a serious threat to their ability to provide essential services and to the fiscal stability of their state coffers. The growth of e- commerce has only heightened the concern, as more and more state and local revenues are lost, and more and more transactions with in-state residents go functionally untaxed. A Brief History of Internet Taxation Use Tax. Because of the physical presence limitation, a state s only historical recourse to tax in-state sales by out-of-state sellers is the so-called use tax assessed against the customer rather than the seller. Use tax is a complimentary assessment based on the use, as opposed to the sale, of a taxable item in the state. Use tax rates are usually the same as sales tax rates, and application of the two taxes is virtually identical. While use tax compliance reviews of businesses are easily undertaken during routine state audits of businesses that do have nexus in the state, taxing authorities do not have the manpower or the mechanisms to collect use tax from individuals or businesses that are not otherwise in the tax audit system. Many tax administrators are sensitive to the political consequences of auditing individuals for use tax, and this lack of enforcement capability has lead to the widespread but nonetheless mistaken belief held by much of the public that mail-order and Internet purchases are tax free. The Quill is Mightier than the Tax. The many years of bitter debate over taxation of sales by outof-state sellers with no nexus in a taxing state reached a pinnacle in 1992 when the United States Supreme Court issued its opinion in Quill Corp. v. North Dakota (504 U.S. 298 (1992)). In that case, North Dakota taxing authorities argued that the mail order industry had become so large and so profitable that states were losing out on significant revenue while placing in-state retailers (who do have nexus, and thus are required by law to charge sales tax) at a disadvantage. North Dakota proposed that a new taxing standard be established based on the concept of economic nexus. Under this principle, if a remote seller purposefully directed its economic activities toward a particular state (through advertising or similar means), that retailer should be required to collect state sales tax regardless of whether the seller had a physical presence there. The Quill court rejected this economic nexus approach. Taxation, it held, was a form of regulation of interstate commerce. The Commerce Clause of the United States Constitution reserves the power to regulate such commerce to the federal government. Therefore, the U.S. Supreme Court concluded that if a state wished to force a remote seller without physical presence to collect taxes on its sales into the state, it must seek approval to do so from Congress. The Standard for Mail Order No Nexus. Based on Quill and its predecessors, an out-of-state seller has no physical presence, and hence no nexus, with a state if the seller s only connections with the state in question are limited to the following: Sales are solicited via mail catalogs, general broadcast media, or phone centers from outside the state. Orders are taken via call centers located outside the state. Goods are shipped via common carrier and not company trucks. 2

3 Such sellers (often referred to as remote sellers ) lack nexus and can t be compelled to collect the state sales tax. Agency Nexus. However, some states do not believe that Quill requires that each seller be examined only on an individual basis. Some states believe that nexus is contagious, meaning that in certain circumstances, the actions of an in-state person or company can be attributed to the remote seller to give a remote seller nexus. For example, several states suggest that if a remote seller contracts with an in-state service provider or seller to provide service to in-state customers of the remote seller or otherwise to further the business of the remote seller, the nexus of the in-state contractor can be attributed to the remote seller. This controversial position (often referred to as agency nexus ) is best illustrated in a policy pronouncement issued by the Multistate Tax Commission, a public policy group comprising several state taxing authorities. The ruling, Nexus Program Bulletin MTC 95-1, states that a remote seller of computer hardware would nonetheless have tax collection and reporting responsibilities in a state if it contracted with an independent, in-state repair provider to perform its on-site warranty repairs. Twenty-five states follow the position taken in MTC California, which had originally adopted that position, rescinded its approval after a huge outcry from technology industry companies. Income Tax and P.L Nexus issues are further complicated by special federal limitations on imposing state income taxes on certain activities. A federal statute, Public Law ( P.L ), restricts a state s ability to impose state income taxes on businesses whose sole connection with a state is solicitation of sales of tangible goods (as opposed to intangible goods or services) in the state. What constitutes sales and solicitation has been the subject of much litigation, is far from a clear standard, and can turn on minute facts. Enter the Internet. While several bills were introduced in Congress after the Quill decision in 1992 to allow states to impose tax collection responsibilities on remote sellers, none of them passed. The issue remained on a back burner for a few years until a new technology took center stage, literally at the speed of light. Although the Internet s technology actually dates back to the 1950s, it wasn t until the mid-1990s and widespread use of the World Wide Web that businesses began to see the technology as a cheap and effective selling tool. Quill became the topic of conversation once again. Internet retailers have tremendous flexibility to limit their physical nexus yet still reach a great number of potential out-of-state buyers. Uncertain of how to apply traditional nexus rules to the electronic bits and bytes of e-commerce, states began passing a patchwork of contradictory and often confusing laws to deal with Internet sales and services. The Internet Tax Freedom Act and the Moratorium. In response to the confusion, Congress passed the Internet Tax Freedom Act (the ITFA ) in 1998 following extensive, often acrimonious debate. The ITFA placed a moratorium on new, expanded, or discriminatory Internet taxes. Much confusion has reigned in the public and the media about what the ITFA actually accomplished. In reality, however, the ITFA really only imposed a moratorium for three years on the following: New sales and use taxes on Internet access charges; Discriminatory and multiple taxes on Internet transactions; and So-called bit taxes based on the number of bits transmitted over the Internet. This last item is interesting because no state had ever imposed this type of tax. A very important provision of the ITFA grandfathered the laws of several states that already (in 1998) taxed Internet access or other activities over the Internet. 3

4 The ITFA established a commission to examine these complex issues and make recommendations to Congress as to how a well-thought-out e-commerce taxation system should work. This commission, the Advisory Commission on Electronic Commerce (the ACEC ) became a deeply divided, highly contentious media event. In the end, no substantive consensus was reached by members of the ACEC, and its report was issued to Congress in March 2000 with less than the required supermajority vote required by the ITFA. Without the requisite consensus, Congress failed to take any further action on the ACEC report. The Streamlined Sales Tax Project In response to the perception of failure of the ACEC, and the lack of any further action by Congress, and in recognition of the magnitude of the problem in dealing with so many different taxing systems, the states took the initiative. In late 1999, several states gathered to devise a new and simplified system of interstate sales taxation. Their idea was dramatically to simplify the sales tax collection burdens on remote sellers in return for Congressional authorization (openly invited by the Supreme Court in the Quill decision) to impose tax collection responsibilities on remote sellers. The group, calling itself the Streamlined Sales Tax Project (the SSTP ), identified several problem areas in the current system: The multiplicity of tax laws and local jurisdictions without common definitions, administration, practices, or customs. The multiplicity of rates and filing requirements for various state and local jurisdictions. The problems of remote-seller nexus when applying standard sourcing rules to determine the location of a sale, especially in the e- commerce context. Thirty-eight states are currently involved in the SSTP. Most of the work is being conducted through four work groups dedicated to (1) Tax Base and Exemption Administration; (2) Tax Rates, Registration, Returns, and Remittances; (3) Technology, Audit, Privacy, and Paying for the System; and (4) Sourcing and Other Simplifications. In 2000, the workgroups drafted model legislation for passage by state legislatures. However, this model legislation frightened some states as a possible abrogation of their sovereign authority by binding a state to programs and policies that were not yet developed. In early 2001, the National Conference of State Legislatures (the NCSL ) created its own SSTP model legislation. The NCSL version, while it acknowledged the work of the SSTP and agreed to its principles and goals, contained far fewer specific provisions and allowed state legislatures to implement the recommendations on a piecemeal basis and only as each saw fit. Stung by the criticism, the SSTP workgroups issued a revised model act that attempted to address many of the NCSL s concerns. Unfortunately, all three model acts went to various legislatures as viable options, and what started as an attempt to bring uniformity has digressed into a patchwork of three different model acts passed by 20 different states. In order to address these differences, the 20 implementing states or governing states have formed their own unified subgroup within the SSTP. In late November 2001, these implementing states elected two co-chairs to help hammer out the differences. Both co-chairs Utah State Tax Commissioner Bruce Johnson and Tennessee State Rep. Matthew H. Kisber (D) are highly respected for their extensive experience in both the public and private sectors. The new leaders will not have the authority to appoint committees but will generally develop the current plan of action as the implementing/governing states move forward. 4

5 The SSTP has also spawned a pilot project to test some of the group s recommendations, but until Congressional approval is obtained to impose collection responsibilities on remote sellers, the pilot project s work product is limited to very few states. The Problems of Internet Taxation Using Traditional Analysis The problems faced by law and policy makers attempting to fashion a taxing scheme for e- commerce transactions are challenging and many. A single Internet purchase taking only a few seconds can arguably touch several states, including the physical location of the buyer, the location of the buyer s Internet service provider, the location of the retailer, the location of the retailer s Web server, and the location of the bank issuing the credit card used to complete the transaction. Add into the mix the fact that goods purchased over the Internet can take digital, rather than tangible form, and the problems become clear. The lack of uniformity in state laws creates different answers for almost every different taxing jurisdiction. Making matters more complex, many industry groups are deeply divided between the various positions, rendering many of the groups official positions neutral on critical determinations. Impact of the Recent Extension Simplification. Although it eventually passed, the extension of the ITFA s moratorium was far from ensured. State and local governments, as well as 44 of the nation s governors, made a strong push to tie any extension of the moratorium to sales tax simplification and nexus legislation under Quill. In particular, proposals by Senators Dorgan and Enzi would have accomplished this, and until very late in the process, were still on the table. Various simplification techniques have been proposed, including limiting the number of different tax rates a state may maintain on transactions, the establishment of central filing systems to replace the thousands of separate filings currently required for local taxing jurisdictions, common definitions of terms for sales tax purposes, and possibly trusted third party collection systems that would allow third parties (such as credit card companies or other transaction-processing companies) to charge, withhold, and remit sales taxes for all states imposing sales taxes on behalf of remote sellers. Most brickand-mortar companies support such plans, and they will continue to be at the forefront of the debate despite the extension of the moratorium. Business Tax Nexus Bill. While ostensibly aimed at e-commerce nexus issues, other proposals being considered in the House of Representatives would change nexus standards for income-based taxes, including income, franchise, and occupation taxes. In the past, such taxability determinations relied almost entirely on P.L However, P.L does not apply for many Internet sellers because they do not sell tangible goods. Because of this limit in the scope of application of P.L , some states have aggressively attempted to impose income taxes on companies that merely (1) make a Web site available to in-state residents; (2) use an in-state ISP; (3) use or allow the use of a patent, logo, or trademark in the state; (4) lease any property in the state, even for less than one month; or (5) have employees in the state for a short period of time. These new Congressional nexus proposals, which are highly controversial, would federally preempt state laws attempting to assert income tax liability in such manner. While the first two sections clearly deal with Internet-specific nexus issues, the other three are aimed at reversing common state nexus standards for all sellers. 5

6 Conclusion The states are mobilizing to continue the process of simplifying sales tax systems. Recent issue papers issued by the SSTP are designed to aggressively move simplification forward during the 2002 legislative season. These papers, and the progress of the SSTP, can be tracked on the SSTP s excellent Web site, Further Information This Technology Commentaries is a publication of Jones, Day, Reavis & Pogue and should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general informational purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at its discretion. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship. For further information, readers are encouraged to contact their regular Jones Day attorney, the principal Jones Day coauthor of this Commentaries, David Cowling (telephone: 214/ ; decowling@jonesday.com), or Gregg Perry (telephone: 214/ ; gperry@jonesday.com). We invite you to visit our Web site at 6