Internet Law and Practice1
Chapter 5 -- Taxation
§ 5.1 Scope
Numerous excellent treatises and other reference sources already exist to inform serious students about the general rules of taxation. This chapter will not attempt to add to that existing body of literature. Rather, it will assume that the reader is either an experienced tax professional, that he is advised by one, or that he has access to a “regular” tax library.
The first portion of this chapter will provide the historical background to help the reader understand the development of the tax law that is unique to electronic commerce, and to place that history into its proper political context. Of necessity, the authors’ perspective will affect the history, since we were all involved representing our business-sector clients, either on the NTA Tax Project’s Steering Committee, or in some other way, in lobbying for and interpreting the Internet Tax Freedom Act.
The remaining portions of the chapter, primarily aimed at corporate tax directors and the lawyers and accountants who advise them, will address the tax issues unique to electronic commerce businesses. As tax rules and tax planning ideas affecting electronic commerce are developed, implemented, audited and litigated, our objective is to report them. It is intended that this chapter will be updated periodically, as both technology and the law develop.
1 Portions of this chapter are based on articles by Ken Silverberg and Mark Foster that appeared in the Journal of Multistate Taxation and Incentives, titled “The Internet Tax Freedom Act: Will It Be a Success or a Failure?,” 9 JMT 4 (July 1999); and “ACEC’s Report to Congress on Electronic Commerce – Mission Accomplished?,” 10 JMT 6 (August 2000), published by Warren, Gorham & Lamont, a division of RIA, copyright (c) 1999 and 2000, respectively, RIA. Used with permission.
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§ 5.2 Historical Context -- The 1996 Boston Conference
Most observers agree that the first time U.S. tax professionals demonstrated serious awareness that the advent of electronic commerce would challenge their traditional paradigm was the so-called “Boston Conference” in November 1996. The Conference on Taxation of Telecommunications and Electronic Commerce was sponsored jointly by the Federation of Tax Administrators, the Multistate Tax Commission, the National Conference of State Legislatures, and the National Tax Association.
Unlike many such continuing education conferences, there were probably more experts in the stated subject matter seated in the audience than there were on the various panels. Most of the scheduled speakers were from the world of academia, or were involved in the governmental side of tax administration, and these individuals had the charge of framing the issues, most of which had recently been “discovered” by a handful of legislators and tax administrators.
The audience, however, was dominated by corporate tax directors, attorneys, accountants, and others who were employed by companies already engaged in electronic commerce. These individuals had already encountered the need to adapt traditional tax compliance rules to their evolving businesses, and many were well aware of the issues. Their management and shareholders had already inspired them to progress to the next step of the process – tax planning.
The business participants in the Boston Conference represented several telecommunications service providers, Internet service providers, financial institutions, traditional retailers, publishers, recording studios, the print and broadcast media, and others whose employers were already generating electronic commerce revenue. Their companies were concerned that they not be surprised by either of two types of tax liabilities.
First, they were unsure whether electronic presence in a jurisdiction would make them subject to income or franchise taxes (herein, “business activity taxes”) to which they had not previously been exposed. The traditional tax paradigm required some income tax nexus, which was usually conferred by the physical presence of employees, agents or property, in a remote state or a foreign country, before businesses would be subjected to income or franchise taxes. Now, these businesses had an electronic presence which enabled them to earn revenue from the - - 3 - - residents of those remote states and foreign countries. Applying the traditional tax nexus paradigm to their activities, they found they could generate this revenue without being subject to the tax regimes of these remote jurisdictions. Their objective was to participate in the electronic commerce debate and help preserve the exemptions from these business activity taxes.
The second concern was the potential duty to collect sales, use or value-added taxes (herein, “transaction taxes”) from their customers, and remit these taxes to the remote state or foreign country. Again, the traditional paradigm required the jurisdiction to prove that the remote business entity had tax nexus before it could impose a duty to collect transaction tax. The businesses already participating in electronic commerce were generally exempt from this duty, and wanted to maintain that status. However, there was great concern that the governments that impose transaction taxes might attempt to change the paradigm retroactively, by means of audits, assessments and litigation, and thereby make the business and its shareholders subject to the transaction tax, which should rightfully have been the burden of the customer, if collected contemporaneously. Further, these businesses were aware of the administrative burden involved with transaction tax collection in multiple jurisdictions, and their representatives were there to prevent that burden from being multiplied, making them subject to the sales tax collection rules of potentially thousands of states and localities.
Another group of businesses was represented in the audience that day in Boston – the direct mail, or catalog sales, industry. Even though electronic commerce was still in its infancy in 1996, some of the most active participants in that industry got there by migrating from the world of catalog retail sales. After all, how much different was it for a customer to place his order by calling the toll-free telephone number printed in his catalog, as opposed to logging on to the Internet from his desktop computer? Even though the human interface was missing from the electronic commerce version of the transaction, the tax paradigm was the same. Remote vendors who did not maintain a physical presence in a state or a country did not have nexus for either business activity taxes or for the duty to collect transaction taxes, and they wanted to preserve the status quo.
The direct mail industry had been fighting and winning the tax nexus battle for years. These businesses did not want their successes to be undermined by some new paradigm invented - - 4 - - to deal with electronic commerce. If any new paradigm was to be invented, the direct mail industry representatives wanted to be at the table as it happened.
By the end of the Boston Conference, an unprecedented cooperative spirit seemed to emerge from the business, government and academic sector participants. The explicit consensus was that electronic commerce presented new issues that could not adequately be addressed by the existing paradigm, and that the tax professionals from these three worlds were the most qualified to address the issues and resolve them. Informal pledges of cooperation were the order of the day. As it developed, the National Tax Association would soon assemble these informal pledges of cooperation into one of the most extraordinary tax study venues ever created.
§ 5.3 -- The National Tax Association Communications and Electronic Commerce Tax Project (“NTA Tax Project”)
During the months following the 1996 Boston Conference, much follow-up discussion took place, culminating in the organization in September 1997, of the NTA Tax Project. The National Tax Association served as the neutral convener of a Steering Committee composed of sixteen representatives of the business community, sixteen representatives of state and local government, and seven “other” representatives of academia, professional organizations, and the federal government.
The NTA Tax Project embarked on the daunting task of framing the issues raised by the clash of the existing tax paradigm with electronic commerce. It had as its principal purpose to consider alternative policies that could be implemented to deal fairly and sensibly with those issues.
The work of the NTA Tax Project centered on transaction tax issues, and its participants immediately turned to identifying a practical method of enabling remote sellers to collect transaction taxes for all states and localities to which their products were delivered. The Steering Committee intended its September 1999 final report to provide a blueprint for reform of the transaction tax systems of state and local government.
Although the recommendations contained in the NTA Tax Project’s final report have not to date become a part of any federal legislation, most of these substantive recommendations are - - 5 - - embodied in the report of the Advisory Commission on Electronic Commerce and included in the Simplified Sales Tax Project, both discussed infra. This is consistent with the strong preference of the state and local government representatives on the Steering Committee. Many of them had first-hand experience with the fairly recent federal pre-emption of one tax that had previously been within the exclusive jurisdiction of states and localities, through their participation in implementing the Interstate Fuel Tax Agreement (commonly known as “IFTA,” which is not to be confused with the common acronym for the Internet Tax Freedom Act, “ITFA.”) Regardless of the many differences among the states, and the different needs of state government compared to those of local government, they all agreed that federal pre-emption was undesirable.
By contrast, most of the business members of the Steering Committee were skeptical of the practicality of relying on voluntary parallel state action to implement a series of reforms. They had seen the uneven adoption by the states of UDITPA, and several failed attempts by the Multistate Tax Commission to achieve enough consensus among the states to create any meaningful uniformity. They believed that pre-emptive federal legislation was the only means of achieving the necessary radical simplification.
As a result, the NTA Tax Project’s final report discusses both federal legislation and cooperative state action as possible means of implementing the necessary reforms. The debate over the efficacy of our traditional concepts of federalism continues to flourish.
§ 5.4 --- Recommendations of the NTA Tax Project
One Rate Per State. The NTA Tax Project found that the multiplicity of state and local transaction taxes, roughly 7,500 at the date of the report, was an impediment to any system that would impose a transaction tax collection burden on remote sellers.
National catalog and electronic commerce retailers could hardly be expected to collect tax at 7,500 different rates, using 7,500 different definitions of a taxable sale, and filing 7,500 different returns. If remote sellers were to be burdened with collecting sales taxes on every transaction, there had to be radical simplification. However, legitimate fiscal issues were raised by any attempt to eliminate the authority of localities to regulate their own transaction tax - - 6 - - systems. Numerous localities had issued bonds guaranteed by the stream of revenue from certain local taxes. Other localities, like New York City, had fiscal needs that were vastly different from those of the other localities in their state, and intrastate variations in their transaction tax rates were a practical necessity.
The resulting compromise recommendation reflected the balance of business and governmental interests on the Steering Committee:
There should be one tax rate per state which would apply to all commerce involving goods or services that are taxable in that state. Provision must be made to ensure protection and equitable distribution of revenues to local jurisdictions. The details of how to encourage or require states, local governments, and businesses to participate in this new system need further study.
The other recommendations of the NTA Tax Project similarly reflected a balance between the business constituency on one side, which demanded radical simplification as the quid pro quo for their cooperation and support, and state and local governments on the other, each of which had to grapple with their own fiscal and political issues.
Uniform Definitions of Goods and Services. One type of simplification advocated by the NTA Tax Project was the adoption by all taxing jurisdictions of a common lexicon, or taxonomy, by which businesses and consumers could easily comprehend which products were taxable and which were not. Instead of having hundreds of inconsistent definitions of a category (e.g., the definitions of the terms “snack food” and “groceries” were different from state to state, and many states did not use the terms at all) there would be a single definition. A retailer selling a product (e.g., shelled salted peanuts in 8 oz. packages) would know with certainty which category covered his products, and need only determine which jurisdictions taxed that category of goods.
Uniform Treatment of Business Purchasers. Most jurisdictions provide an exemption for certain business purchases to avoid the potential “cascading” of transaction taxes at several different levels of the production process. The NTA Tax Project advocated standardizing the treatment of these common transactions: (1) sales for resale; (2) products that become components of another product; (3) items used or consumed in the manufacturing process; and (4) agricultural equipment and supplies. - - 7 - -
Sourcing of Transactions for Tax Purposes. Much of the reason that the existing tax paradigm clashes with the reality of electronic commerce is that transaction taxes in this country have historically been imposed at the destination of the sale, rather than at the source of the product. By contrast, most countries employing value-added-tax regimes impose the tax at the source, making it much simpler for the tax authorities to deal with vendors located in a single jurisdiction who ship products to customers in multiple remote jurisdictions.
Admittedly, our transaction tax system is an anachronism, harkening back to the day when one had to go to a store in order to make a purchase. Over time, however, complex political systems had become fiscally dependant on the revenue stream generated by applying transaction taxes to purchases made by the local citizens, i.e., taxing purchases at their destination. Regardless of how ill-suited this sourcing regime is for the world of electronic commerce, state and local governments cannot afford the uncertainty implicit in scrapping the present system and replacing it with something more easily administered and more consistent with transaction taxation in other countries.
Thus, the NTA Tax Project forged the following compromise resolution, intended to preserve the fiscal status quo:
For sourcing of transactions for sales and use tax purposes, the following principles should be followed:
Transactions should be sourced only to the state level; sourcing to a sub-state level should not be required.
Transactions should be sourced to the state of use or destination to the extent that adequate information is available in a practical, unobtrusive and efficient manner. Transactions for which such information is not available should be subject to one or more default rules, to be developed.
Procedures should be developed dealing with audits and recordkeeping.
Simplified Transaction Tax Administration. Several “nuts-and-bolts” aspects of tax administration typically present multi-state vendors with unnecessary complexity, and the NTA Tax Project advocated harmonizing these administrative features. No detailed procedures were adopted, but the issues were identified for use in future tax reform efforts. - - 8 - -
· Uniform vendor registration form;
· Uniform sales and use tax return, increasing the ability to electronically file such returns and decreasing the frequency with which such returns are filed;
· Uniform state laws for bad debt deductions and use of direct pay permits;
· Uniform exemption certificates and other simplifications in the administration of exemptions; and
· Simplified audit, assessment and appeal procedures for multi-state sellers.
Most observers believe that the NTA Tax Project reached the end of its useful life when it became impossible to solve the dispute regarding business activity tax nexus. The business members of the Steering Committee believed that part of the necessary quid pro quo for agreeing to transaction tax simplification was to extract a similar type of simplification for the income tax nexus questions that had plagued early electronic commerce companies. Thus, they proposed a number of “business activity tax nexus safe harbors” that would identify activities in which businesses could engage without fear of acquiring income tax nexus. The business members of the Steering Committee felt this was a long-overdue update of Public Law 86-272; 15 U.S.C. § 381 et seq. (“Public Law 86-272”), necessary to recognize the realities of electronic commerce.
The state and local government members of the Steering Committee had quite a different view of the potential for expansion of the NTA Tax Project into business activity tax nexus issues. They believed that Public Law 86-272 was an ill-considered, as well as an outdated, concept. They had worked for years to circumscribe its limitations on income tax nexus in their jurisdictions, and had no intention of supporting any twenty-first-century version of this unwelcome intrusion by the federal government into state sovereignty. They had come to believe that the entire scope of the NTA Tax Project would be limited to domestic transaction tax simplification, and accused the business members of the Steering Committee of inappropriate opportunism, and worse! - - 9 - -
Thus, the Project effectively reached impasse at a meeting in Snowbird, Utah, in July 1999. The next few months saw the completion and release of the Project’s final report, but no further progress.
In retrospect, the NTA Tax Project seems to have been an effort that was far ahead of its time. It identified a number of issues that require political solutions, but it had no political authority to implement its findings. The Steering Committee negotiated several compromises between the competing demands of businesses and government entities, but it remains unclear whether its compromises will shape the ultimate tax reform effort. By the time tax reform occurs, it may be necessary to replicate all the study and negotiation that took place between 1997 and 1999.
The congressional staff who attended some of the NTA Tax Project meetings were apparently favorably impressed with the agenda of the Project, if not its ultimate accomplishments. So much so, that they found a way in drafting the Internet Tax Freedom Act (“ITFA”) during 1998, to draw attention to the work of the NTA Tax Project. The ITFA, in creating the Advisory Commission on Electronic Commerce (“ACEC”), directed the ACEC to make its findings consistent with the NTA Tax Project’s report. Of course, once the Internet Tax Freedom Act was passed and the ACEC began to function, the issues moved beyond the reach of the state and local tax administrators and the business sector’s tax professionals.
§ 5.5 Political and Legislative Context -- The Internet Tax Freedom Act
In late 1998, Congress passed the Internet Tax Freedom Act and President Clinton signed it as a part of the fiscal 1999 omnibus budget legislation. 2 Generally, the ITFA imposed a three- year moratorium on various types of state and local taxes on electronic commerce, and called for the creation of an advisory commission to study the state and local, as well as federal and international, tax treatment of Internet transactions. Following the study, the ACEC was to issue a report to Congress, including the possible recommendation of tax- and technology-neutral legislation.
2 Title XI of the Omnibus Consolidated and Emergency Appropriations Act of 1998, P.L. 105-277, October 21, 1998. - - 10 - -
Rep. Christopher Cox (R-Cal.), the original sponsor of the House bill, explained the impetus for the enactment of the ITFA as follows:
The Internet Tax Freedom Act is needed not just to give the Net room and time to grow. It is also needed because the Net is inherently susceptible to multiple and discriminatory taxation in a way that commerce conducted in more traditional ways is not. The very technologies that make the Net so useful and efficient, notably its decentralized, packet-switched architecture, also mean that several States and perhaps dozens of localities could attempt to impose a tax on a single Internet transaction. The Internet Tax Freedom Act will protect commerce conducted over the Internet from being singled out and taxed in new and creative ways, and will give Americans the reassurance they need that they will not be hit with unexpected taxes and tax collecting costs from remote governments. 3
Passage of the ITFA gave taxpayers several new defenses against some types of state and local taxes, but these weapons have yet to be tested in the courts. It is more significant that additional new taxes have not been enacted on electronic commerce since the moratorium became effective. Still, it is useful to explore some of the defenses created by the ITFA.
§ 5.6 -- Moratorium on Taxation of Internet Access
The ITFA imposed a three-year moratorium on certain state and local taxation of Internet access services, and on multiple or discriminatory taxes on electronic commerce. The three-year moratorium began on October 1, 1998, and was extended for two additional years by Public Law 107-75 (extending the moratorium until November 1, 2003). In addition to the moratorium, the ITFA declared that the Internet should be free of federal taxes, and established the ACEC to study the domestic and international taxation of electronic commerce and to recommend to Congress policies regarding the taxation of such services.
The first category of taxes4 covered by the moratorium was any “taxes on Internet access” that were not “generally imposed and actually enforced” prior to October 1, 1998. The legislation contained various detailed operational rules by which one could determine whether a tax was
3 H.R. Rep. No. 105-570, 105 th Cong., 2nd Sess., pt. 1 (1998). 4 Taxes, as defined by ITFA, do not include “any franchise fee or similar fee imposed by a State or local franchising authority, pursuant to section 622 or 653 of the Communications Act of 1934 (47 U.S.C. 542, 573), or any other fee related to obligations or telecommunications carriers under the Communications Act of 1934 (47 U.S.C. 151 et seq.).” - - 11 - -
“generally imposed and actually enforced.” Many of these provisions enable a taxpayer who is protesting a tax assessment to make the initial assertion that the tax is barred, and, in effect, shift the burden of proof to the tax authority to demonstrate that its tax still may be levied despite the ITFA.
As a practical matter, few states or localities want to expend the enforcement and litigation resources necessary to demonstrate their entitlement to the benefit of the grandfather clause. Thus, this provision has effectively shut down numerous new tax assessments that otherwise might have been applied to the revenue from Internet access services.
§ 5.7 -- What Internet Access Taxes are Prohibited
The ITFA and its extension prevent a state or political subdivision from imposing any non-grandfathered tax on Internet access. The ITFA defines “Internet” to collectively include “the myriad of computer and telecommunications facilities, including equipment and operating software, which comprise the interconnected world-wide network of networks that employ the Transmission Control Protocol/Internet Protocol, or any predecessor or successor protocols to such protocol, to communicate information of all kinds by wire or radio.” Therefore, the key to the definition of “Internet” is the use of the TCP/IP, or any predecessor or successor protocols, by the medium involved, whether by telecommunications, cable networks, or satellite.
Furthermore, “Internet access” is defined as “a service that enables users to access content, information, electronic mail, or other services offered over the Internet, and may include access to proprietary content, information and other services as part of a package of services offered to users. Such term does not include telecommunications.”
The exclusion of “telecommunications” was based on the ITFA’s fundamental premise that Internet access services are separate from the underlying telecommunications infrastructure on which they currently depend. Therefore, the ITFA did not affect any taxes imposed on an Internet user or provider based on the use of the underlying telephone service. An Internet access - - 12 - - tax would be limited to a tax on the monthly fee that an Internet user pays to an Internet service provider.5
This provision was intended merely to prevent new and creative types of state and local taxes from being applied to Internet access charges collected by Internet access providers. Some companies other than traditional Internet access providers furnish services to which this portion of the moratorium applies. Others undoubtedly expected to be brought on-line during the moratorium period. Examples of protected transactions include:
· Cable modem services provided by cable operators, wireless carriers, electric utilities, and others.
· Sales of digital products or information services that may be accessed via the Internet (even if they also may be accessed by other, non-Internet methods), so long as the sale is “bundled” with Internet access.
When other services or products were bundled with Internet access, a state or locality was not prohibited from imposing a tax on the portion of the revenue attributable to the products or to the services other than Internet access. Nevertheless, it was unlikely that a jurisdiction would choose to impose taxes that raise the additional issue of unbundling, or allocation of purchase price. Unless the tax evasion was egregious, the tax authorities were more likely to defer any such assessments until after the moratorium ends. This “chilling effect” on tax assessments
5 The House Report accompanying an earlier version of ITFA (H.R. 3849) discusses Internet access service providers: In recent years, we have seen a significant growth in the number of service providers offering consumers access to the Internet. Such services are known as Internet access services. The service providers could be pure access providers (such as Erols), access providers that also offer content services (such as America Online), or other service providers that have begun to offer Internet access in conjunction with other regulated or unregulated activities (such as a telephone or cable company that offers Internet access in conjunction with the provision of telephone or cable service). Internet access providers and online service providers operate in a competitive marketplace and consumers have significant choice regarding how they access the Internet and how they obtain information. Recent data indicates that there are approximately 6,300 Internet access and online service providers in the United States.
H.R. Rep. No. 105-570, 105 th Cong., 2nd Sess., pt. 1 (1998). - - 13 - - created opportunities for some businesses to offer tax-free products or services during the moratorium period merely by bundling them with Internet access.
§ 5.8 -- What Internet Access Taxes Were Allowed — The “Grandfather Provision”
The moratorium on Internet access taxation applied only to taxes that were not “generally imposed and actually enforced” prior to October 1, 1998. Thus, under the ITFA, the only taxes that a state or political subdivision may impose on Internet access during the moratorium are those that were authorized by statute enacted before that date. In addition, for a tax to be deemed “generally imposed and actually enforced,” either of the following had to have occurred before that date:
· The appropriate administrative agency of the state or political subdivision had to have issued a rule or other public proclamation such that the service provider had a reasonable opportunity to know that the agency interpreted and applied the tax to Internet access service.
· The tax on charges for Internet access generally had to have been collected by the state or political subdivision.
At least eleven states and the District of Columbia sought to impose some form of a tax on Internet access prior to October 1, 1998.6 Some of these states taxed Internet access as a telecommunications service, while others taxed such access as an information- or data- processing service. Eventually, some of these states abandoned their efforts. Currently, only North Dakota, Ohio, South Dakota, Tennessee, Texas, and Wisconsin impose some form of sales tax on Internet access charges.
6 These states include: Connecticut, Iowa, Nebraska, New Mexico, North Dakota, Ohio, South Carolina, South Dakota, Tennessee, Texas, and Wisconsin. The authors express herein no opinion on whether the imposition of tax on Internet access by these states would satisfy ITFA’s requirement that the tax be “generally imposed and actually enforced” prior to October 1, 1998. - - 14 - -
§ 5.9 -- General Moratorium on Taxation of Electronic Commerce
The second category of taxes covered by the ITFA moratorium is much broader than the first. The ITFA prohibited any state or political subdivision from imposing any “multiple or discriminatory” tax on “electronic commerce.” Electronic commerce was defined to include much more than the mere provision of Internet access, and thus it was much more likely that taxpayers other than Internet access providers would benefit from this provision. Under the ITFA, electronic commerce is “any transaction conducted over the Internet or through Internet access, comprising the sale, lease, license, offer, or delivery of property, goods, services, or information, whether or not for consideration, and includes the provision of Internet access.”
When electronic commerce is implicated in connection with any product or service, the ITFA provided a defense to any tax that is “multiple or discriminatory.” Such a levy could include not only income and franchise taxes but also property and sales and use taxes, as well as a vendor’s obligation to collect and remit sales taxes. Most types of excise taxes also would be included. The ITFA, however, specifically excluded any franchise fees imposed by a state or local authority, and the universal service fee and certain other telecommunications fees.
The ITFA defined “discriminatory tax” and “multiple tax,” but not with a great deal of precision. It was clear that Congress had certain types of activities in mind for protection, but it could not effectively predict every means by which a state or local tax might discriminate against electronic commerce. Accordingly, taxpayers have plenty of leeway to assert that specific taxes are either discriminatory or multiple when applied to particular types of revenue.
§ 5.10 --- Discriminatory Taxes
The incidence of discriminatory taxes most familiar to state tax practitioners is a levy that favors local commerce over interstate commerce. But the term should be read more broadly to include any unequal application of a particular tax to transactions that should be taxed equally.
The ITFA found the imposition of a tax to be discriminatory if the tax disadvantaged electronic commerce when compared to similar commerce conducted through any other means. This discrimination could result from either the coverage of the tax or the application of differential tax rates. - - 15 - -
A state or local tax on electronic commerce would be found discriminatory if the tax was not “generally imposed and legally collectible”7 in transactions involving similar property, goods, services, or information accomplished through other means. The ITFA also prohibited a state or local government from taxing electronic commerce in a manner that would result in the imposition of a different tax rate on electronic commerce (unless the rate was being phased out by the state or locality).
Example. State A attempts to impose a sales tax on the purchase of clothing over the Internet, but it does not tax clothing purchased via telephone or mail-order catalog. Clearly, this tax is discriminatory and thus prohibited. The same result would occur if state A generally imposes and legally collects sales tax on the purchase of clothing via telephone or mail-order catalog but at a rate lower than that applied to such purchases conducted over the Internet.
§ 5.11 --- Tax Imposed on a Different Person
A state or local tax law also would be discriminatory if, in an electronic commerce transaction, it imposed a tax-payment or tax-collection obligation on a person or entity different from the person or entity subject to the tax in transactions involving similar property, goods, services, or information provided through other means.
Example. State A imposes a sales tax collection obligation on vendors (either in- or out-of-state) selling tangible personal property over the Internet and shipped to a customer in the state. The state does not impose such an obligation on vendors conducting similar transactions via telephone or mail-order catalog. Thus, the requirement to collect and remit such tax will be prohibited as discriminatory.
§ 5.12 --- Tax Imposed at a Higher Rate
While a tax on an Internet access provider might have been permitted under the grandfather clause, it still could have run afoul of the prohibition on discriminatory taxes. Thus, a state or local tax on Internet access service would be discriminatory if it established a
7 ITFA does not provide a definition of “legally collectible” nor is it clear why this term is used in place of the term appearing in the grandfather clause “actually enforced.” If a tax is not legally collectible, there would seem to be little need to temporarily outlaw it by federal legislation such as ITFA. Presumably, aggrieved taxpayers would have an adequate, and more permanent remedy under state law or under the Due Process Clause of the U.S. Constitution. - - 16 - - classification of Internet access provider or online service provider in order to impose the tax on such providers at a rate higher than the rate generally applied to providers of similar information services delivered through other means. The full scope of this analogy is unclear. Nevertheless, states and localities would seem to have been barred from classifying an Internet access provider as a public utility for the purpose of applying a higher tax rate on the service.
The more common application of this prohibition probably will prove to be in the area of sales of goods, either tangible or intangible, involving electronic commerce. These electronic sales compete with traditional retail sales, as well as with mail-order sales and other types of remote commerce for which states have long attempted to impose tax-collection duties on vendors. The ITFA’s ban on discriminatory taxation effectively precludes states from applying some type of blended statewide rate to transactions conducted by means of electronic commerce, unless the same blended rates were applied to all sales. It would be permissible, however, to apply a lower rate to electronic commerce, i.e., to discriminate in favor of such commerce.
§ 5.13 --- Electronic Nexus; Agency Nexus
The ITFA also was intended to protect out-of-state electronic commerce vendors from being unfairly burdened with the obligation to collect sales taxes that are not applied to mail- order and other remote sellers. Thus, for example, a “discriminatory tax” included a sales tax collection obligation that was based on (1) the ability to access a remote seller’s Web site by computer (“electronic nexus”) or (2) the theory that an Internet service provider was an in-state agent of the seller (“agency nexus”).
It is somewhat clear,8 for purposes of the moratorium, that Congress did not consider that an out-of-state vendor’s use of an in-state computer server to create or maintain a site on the Internet would constitute the “substantial physical presence” required by Quill Corp. v. North
8 This principle is only somewhat clear because of the curious language employed by ITFA. Part of the definition of discriminatory tax is a tax “if . . . the sole ability to access a site is considered a factor in determining a remote seller’s tax collection obligation.” Does “sole ability” mean something like exclusive access to a Web site, so that sites accessible by multiple users simultaneously are outside of this provision? The more likely intended meaning is that in and of itself, the fact that a remote seller’s Web site could be accessed in-state is insufficient to constitute substantial physical presence. - - 17 - -
Dakota.9 It is less clear whether Congress would make such a sweeping generalization for purposes of permanently applying the Commerce Clause to electronic commerce. This question undoubtedly will be tested in the courts if Congress fails to address it at the end of the moratorium. The courts’ answer can then be expected to either incite or stifle the development of an industry of offshore computer service providers, and providers situated in states that have no sales or use tax.
States and localities also were prohibited from treating a provider of Internet access or online services as an agent of a remote seller that uses the service.
Example. Vendor C, conducting business from state B, sells tangible personal property over the Internet using a computer server in state A. C has no physical presence in state A. Under the ITFA, any attempt by state A to impose a sales tax collection obligation on C based on the vendor’s use of a server in state A will be prohibited.
Example. The facts are the same as in the prior example except the server is in state D and is owned by an Internet access provider in state A. The provider uploads C’s site to the Internet, or processes customer orders for C through the use of its server in state D. Under the ITFA, although the Internet access provider has nexus with state A, that state may not impose an obligation on the provider to collect the tax as C’s agent.
§ 5.14 --- Different Views on One “Discriminatory” Tax
One “real life” example of a tax that would seem to have been barred as discriminatory under the ITFA is the application of the Chicago Personal Property Lease Transaction Tax to purchases of information services. Since 1989, Chicago has consistently applied this tax to all charges for the use of a computer and its software, including database search charges. 10
In the city’s Lease Transaction Tax Ruling #13, issued 9/18/92, the Director of Revenue ruled:
Where possession of a computer is not transferred, use of the computer is deemed to occur at the location of the access device used to access the computer.
9 Quill Corp. v. North Dakota, 504 U.S. 298 (1992). 10 In Meites v. The City of Chicago, 184 Ill. App. 3d 887 (1989), the City’s application of this tax to the plaintiff’s Lexis/Nexis charges was permitted. - - 18 - -
Therefore, if the user’s access device is located in the City of Chicago, the Chicago Transaction Tax applies to all charges for the use of the computer and its software, including, but not limited to, the running or execution of computer programs. . . . Unless charges for the use of the computer include charges for services performed by the computer-provider’s personnel at the time of the transaction, the transaction is considered to involve charges solely for the use of personal property and not for the sale of a service. . . . Thus, charges imposed on the user for the user’s access to, or retrieval of information from, a computer or its database are charges for the use of personal property and not charges for the sale of a service.
During the congressional debates on the ITFA, Chicago’s chief assistant corporate counsel was reported to have stated that if Congress were to enact such legislation, city officials feared losing as much as $15 million per year from the 6% tax that the city imposes on database use. Referring to the ITFA grandfather clauses then being debated in House and Senate committees, the Chicago counsel stated: “We are worried they won’t cover our tax.” 11
As the legislative process turned out, the Chicago tax was not grandfathered. If the tax is applied to information obtained online and not to information acquired through conventional means, it is discriminatory in the sense specified in the ITFA. Thus, since October 1998, the city’s collection of the tax has been barred by federal law. 12 Nevertheless, informal contact with the Chicago Law Department indicates that the city continues to assess and collect the tax on purchases of information services, believing that the tax is grandfathered by the ITFA. The Department had no response to the suggestion that the ITFA does not grandfather discriminatory taxes.
Some other examples of discriminatory taxes that one might encounter include:
(1) Sales tax on downloads of digital products or information that are not taxed in tangible form (e.g., books, magazines, newspapers, floppy disks, CDs, or videotape).
11 Don’t Touch Internet Tax, City, State Say: Publishers Lobby for Moratorium; Millions At Stake, Crain’s Chicago Business, January 5, 1998. 12 The authors note that they accessed Crain’s Chicago Business on the Lexis/Nexis service from their office in Washington, D.C. Had they instead done so within the city limits of Chicago, they might have become the plaintiffs in the first case to be brought under ITFA. - - 19 - -
(2) Differential sales tax rates applied to electronic vs. tangible versions of the same product or information.
(3) A sales tax collection obligation asserted against a different entity in electronic vs. tangible commerce (e.g., credit card companies in electronic commerce vs. retailers in conventional commerce).
(4) Gross receipts or business license taxes that apply to electronic and conventional commerce in different ways or at different rates.
(5) Personal property taxes applied to equipment used in electronic publishing, while conventional presses used to print the same content in magazines, newspapers, or books are exempt under manufacturing or other special exemptions.
(6) Income taxes applicable at higher effective tax rates to electronic commerce than to conventional commerce, because of some nexus or apportionment rule.
§ 5.15 --- Multiple Taxes
Some taxpayers also may be able to claim the ITFA defense against a “multiple tax,” which is any tax imposed by a state or locality on essentially the same electronic commerce that is also subject to another tax imposed by another state or locality (other than sales or use taxes imposed by a state and its own political subdivisions), whether or not at the same rate or on the same basis, without a credit (for example, a resale exemption certificate) for taxes paid in other jurisdictions. This provision is intended to avoid double taxation of the same transaction or service in either the same taxing jurisdiction or two or more taxing jurisdictions. The following example illustrates one instance of a multiple tax.
Example. State A classifies Internet access services as telecommunications services. Also, the state taxes the underlying telecommunications service that is used to provide Internet access, but does not provide for a credit or other mechanism to avoid the double taxation of the access service and the means for its delivery. Under the ITFA, state A’s tax scheme will be prohibited as a multiple tax because, as a levy on both the service and the means of delivering that service, it taxes the same service twice. - - 20 - -
Multiple sales or use taxes will rarely occur because of the general availability of resale exemptions for vendors, and because of the credit typically allowed against “compensating use taxes” for prior payment of sales taxes. The ITFA also makes it clear that localities in a state may add a local surcharge to transactions taxed at the state level without resulting in multiple taxes.
The multiple-tax rules could have some application with regard to income, gross receipts, or franchise taxes paid by certain taxpayers. If some electronic commerce sales were subject to different income or franchise tax apportionment regimes in two jurisdictions, a portion of the sales might be taxed in both jurisdictions. In that situation, the levy should be deemed a multiple tax.
It seems unlikely, however, that Congress intended to create an ITFA defense to be used by taxpayers subject to apportioned income taxes in, for example, one state applying single- factor apportionment and another using a double-weighted sales factor, but a reasonable case could be made that the rules apply in that situation. Some business with a significant liability for a potential multiple income tax undoubtedly will attempt to test the limits of this provision.
§ 5.16 --- Exceptions to the Moratorium
The ITFA offers several exceptions that would allow states to impose taxes despite the moratorium.
Harmful to Minors. The ITFA’s moratorium on Internet taxation may not be used as a defense by any taxpayer that knowingly and for commercial purposes communicates material that is obscene or otherwise harmful to minors.13 The exception to the moratorium may be
13 ITFA provides the following definition of material that is harmful to minors: The term “materiel that is harmful to minors” means any communication, picture, image, graphic image file, article, recording, writing, or other matter of any kind that is obscene or that— (i) the average person, applying contemporary community standards, would find, taking the material as a whole and with respect to minors, is designed to appeal to, or is designed to pander to, the prurient interest; (ii) depicts, describes, or represents, in a manner patently offensive with respect to minors, an actual or simulated sexual act or sexual contact, an actual or simulated normal or perverted sexual act, or a lewd exhibition of the genitals or post-pubescent female breast; and (iii) taken as a whole, lacks serious literary, artistic, political, or scientific value for minors. - - 21 - - avoided, however, if the taxpayer employs procedures such as requiring the use of a verified credit card, debit account, adult access code, or adult personal identification number in order to restrict access to such material by persons under age seventeen. The exception also does not apply to (1) telecommunications carriers providing telecommunications services, (2) providers of Internet access services or Internet information location tools, and (3) persons engaged in transmitting, storing, retrieving, hosting, formatting, or translating (or any combination thereof) a communication made by another person, without selecting or altering the communication.
Screening Software. In connection with agreements entered into after April 20, 1999 between Internet access service providers and their customers, the ITFA requires that the service provider offer “screening software,” i.e., software that will permit the customer to limit access to material on the Internet that is harmful to minors. The service provider may charge a fee for the software. Service providers failing to comply with this requirement were exempted from the moratorium on discriminatory or multiple taxes, as well as taxes on Internet access.
Bundled Services. The moratorium applies only to that portion of the medium that is used to provide Internet services. Thus, consider for example a cable network that provides Internet access employing the Transmission Control Protocol/Internet Protocol. The same network also provides cable television programming, which does not employ TCP/IP or any predecessor or successor protocols. Accordingly, the ITFA moratorium applies to only the Internet access service, i.e., the service using TCP/IP. Although the Internet service and the underlying medium can be distinguished in theory, it may be much more difficult to separate them in practice. For instance, a state or locality may impose its personal property tax on the value of the coaxial cable used by a cable television operator. The cable operator also provides its residential customers with Internet access over the same coaxial cable. In applying the personal property tax, it is not clear how the value of the coaxial cable will be apportioned between the different services. Still, it would seem that the ITFA might provide a defense against all or part of the property tax assessment in such a situation.
Liabilities and Pending Cases. The ITFA does not affect either a taxpayer’s liability for any taxes accrued and enforced prior to October 1, 1998, or ongoing disputes relating to any taxes. Accordingly, any taxpayer litigating the imposition of a state or local tax on Internet - - 22 - - access or on electronic commerce at the effective date could not use the ITFA as a defense in such proceedings.
§ 5.17 The Advisory Commission on Electronic Commerce
As noted above, in addition to imposing the moratorium, the ITFA established a temporary commission, the Advisory Commission on Electronic Commerce, to study Internet taxation. The ACEC consisted of nineteen appointed commissioners, including the Secretaries of Commerce and Treasury and the U.S. Trade Representative (or their respective delegates). In addition, the ACEC included eight representatives of state and local government and an equal number from the electronic commerce industry, telecommunications carriers, local retail businesses, and consumer groups.
The ACEC was directed to conduct a thorough study of international, federal, state, and local taxation of Internet access and transactions conducted on the Internet. The issues to be examined were to include the following:
· Foreign market barriers for U.S. vendors engaged in electronic commerce.
· The imposition of consumption taxes on electronic commerce.
· The impact of the Internet and Internet access on the revenue base.
· Model state legislation that would provide tax uniformity and neutrality.
· The effects of taxation on interstate sales, including transactions using the Internet.
· Ways to simplify taxes imposed on the provision of telecommunications services.
The ACEC was to report its findings to Congress, including any legislative recommendations necessary to address those findings, within eighteen months of the enactment of the ITFA.
The ACEC’s work was disappointing from the perspective that the heavily negotiated decision-making mechanism of the ACEC required too great a degree of consensus to get much done. The Report reveals that the ACEC reached the required consensus (two-thirds majority) on - - 23 - - only three of the many issues addressed. And these three issues were of minor importance to the taxpayers and regulators who had hoped for guidance. They were:
Digital Divide Issues. The ACEC Report defined “digital divide” to mean “the disparity between individuals with access to a computer (or other evolving technologies, such as wireless, etc.) hardware, infrastructure and critical information and those without such access . . . .” The ACEC recommended that Congress clarify federal welfare guidelines expressly to permit the states to spend Temporary Assistance to Needy Families Program surpluses (unobligated balances) to provide needy families access to computers and Internet use. In addition, the ACEC recommended that states and localities be encouraged to partner with private technology companies to make computers and the Internet widely accessible for needy families, libraries, schools, and community centers and to train needy families how to use computers and the Internet. The ACEC suggested that incentives for such partnerships might include federal and state tax credits and federal matching funds for state and local expenditures. Finally, the ACEC encouraged the Clinton Administration and Congress to continue gathering data for empirical research that would inform federal, state and local policymakers on measures leading to the reduction, and eventual elimination, of the Digital Divide by empowering families in rural America and inner cities to participate in the Internet economy.
Privacy Implications of Internet Taxation. The ACEC Report recommended that Congress explore “the privacy issues involved in the collection and administration of taxes on e- commerce, with special attention given to the impact that any new system of revenue collection may have upon other values that U.S. citizens hold dear, and the steps taken in systems developed to administer taxes on e-commerce to safeguard and secure personal information.” The ACEC Report also cautioned Congress to exercise care in creating online privacy laws to avoid endangering U.S. leadership in worldwide e-commerce.
Although few would argue with the preservation of the rights of privacy, this finding is not an insignificant one. It represented a substantial victory for the financial institutions, which had been actively involved in the legislative effort and the ACEC.
During the debates at both the NTA Tax Project and the ACEC, it became clear that access to the data underlying e-commerce was necessary in order to apply any new scheme of - - 24 - - taxation to remote transactions. Attention quickly turned to those who were in possession of that data – the banks, credit card issuers and other financial intermediaries. These organizations in turn, spoke up early, often and loudly to make the point that this data was not theirs to disclose, even if requested by proper state and local taxing authorities. They further objected to the alleged oversimplification of the technological problem of access to that data. The financial institutions claimed that the data could not be accessed for tax administration purposes without incurring substantial capital costs for new hardware and software. The financial institutions wanted it to be made clear that their industry should not be saddled with some type of “unfunded mandate” to produce and format the data for the use of a tax collection agency.
International Taxes and Tariffs. The final ACEC formal recommendation to Congress was to support implementing and making permanent a standstill on tariffs at the earliest possible date.
The ACEC Report contained clear statements of the opposing positions on several issues, and the clarity with which it addressed those issues undoubtedly improved the quality of the subsequent legislative proposals.
Perhaps of greatest importance was the ACEC’s “Majority Policy Proposals.” Although these proposals did not receive the required two-thirds vote to become official recommendations of the ACEC to Congress, they did represent a source of substantive input with greater official standing than those of the NTA Tax Project.
The most striking new proposals of the ACEC majority were:
Coverage of the Moratorium on Sales and Use Tax. The ACEC majority suggested that the current moratorium provided under the ITFA be extended for an additional five years and that the scope of the moratorium be expanded to prohibit taxation of sales of both digitized goods and products and their non-digitized counterparts.
It sounded straightforward enough, continuing the moratorium and leveling the playing field among competing products. Furthermore, the latter portion of this recommendation seemed to represent a major victory for many in the bricks-and-mortar business sector. This provision would have brought into the sales-tax-free zone, for example, books, magazines, newspapers, - - 25 - - recorded audio and video products – anything that could also be downloaded in digital form. A good compromise, right?
But other observers correctly saw this compromise as fool’s gold. By expanding the scope of the original ITFA moratorium to non-digitized goods and services, the fiscal stakes attached to the moratorium were suddenly multiplied. And raising the stakes may prove to be a very unwise strategy for the e-commerce business sector. Now, large portions of existing state and local sales tax revenue would suddenly be preempted by federal action. This would undoubtedly wreak havoc on the budgets of many state and local government units, not to mention their bond ratings.
This expansion provision would have altered the merits of the future moratorium debate, no doubt encouraging some previously disinterested parties to join those who opposed continuing the moratorium. The potential fiscal impact of this measure could now be said to endanger the provision of necessary state and local government services. In fact, it was suggested by some that this expansive language was actually proposed by the defenders of the status quo, who realized early along that the fiscal impact of this proposal doomed it to near-certain death.
As explained more fully below, the moratorium extension bill did not expand the scope of the moratorium.
Sales and Use Tax Simplification. In order to address the need for consistency and certainty and to alleviate the tax collection burden and liability of sellers, the ACEC majority proposed that Congress clarify by legislation the factors that would not, in and of themselves, create sufficient nexus with a state to permit that state to impose collection obligations on remote sellers (these are often conveniently referred to as “sales tax nexus safe harbors”). Moreover, state and local governments were encouraged to work with and through the National Conference of Commissions on Uniform State Laws (“NCCUSL”) in drafting a uniform sales and use taxation system that would create and maintain parity of collection costs (net of vendor discounts) between remote sellers and comparable single-jurisdiction vendors that do not offer remote sales.
The majority also proposed a simplified sales and use tax system, which would include: - - 26 - -
(a) uniform tax base (i.e., a uniform system of product definitions and classifications), vendor discounts, sourcing rules, audit procedures, tax returns/forms, electronic filing and remittance methods, and exemption administration rules; (b) one sales and use tax rate per state and uniform limitations on state rate changes; (c) a methodology for approving software that sellers may rely on to determine state sales tax rates; and (d) a methodology for maintaining revenue neutrality in overall sales and use tax collections within each state to account for any increased revenues collected from remote sales.
Finally, the ACEC majority saw a need to establish a new advisory commission responsible for oversight of the progress of NCCUSL’s efforts to create a uniform sales and use tax act.
Business Activity Tax Nexus Safe Harbors. In an attempt to supplement and modernize Public Law 86-272, the ACEC majority proposed that Congress clarify the circumstances that determine whether a seller has sufficient nexus with a state to be required to pay business activity (i.e., income and franchise) tax.
This represented another major expansion of the e-commerce tax debate, namely, getting into income tax issues. Many observers believe this to be the highest priority agenda of the business sector. The reasons for this are clear. In the view of many business people, sales tax is the consumers’ tax, not theirs. So long as the system is simple enough that businesses can avoid making procedural mistakes in carrying out their duty to collect and remit the tax, it’s not their tax. And so long as the tax is imposed fairly and uniformly to their competitors, no one will receive a competitive marketing advantage by virtue of how they are organized or accessed by the customer. Income taxes, however, are not directly passed along to the consumers. They are an overhead cost of the business, and eventually drop right to the bottom line of the shareholders. If these taxes could be reduced, for example by eliminating a business’s tax nexus in several states, thus permitting more “nowhere sales” for apportionment purposes, businesses are interested. - - 27 - -
According to the majority proposal in the ACEC Report, the following factors would not be taken into account in determining nexus for income or franchise tax purposes:
(a) a seller’s use of an ISP that has physical presence in a state;
(b) the placement of a seller’s digital data on a server located in that particular state;
(c) a seller’s use of telecommunications services provided by a telecommunications provider that has physical presence in that state;
(d) a seller’s ownership of intangible property that is used or is present in that state;
(e) the presence of a seller’s customers in a state;
(f) a seller’s affiliation with another taxpayer that has physical presence in that state;
(g) the performance of repair or warranty services with respect to property sold by a seller that does not otherwise have physical presence in that state;
(h) a contractual relationship between a seller and another party located within that state that permits goods or products purchased through the seller’s Web site or catalogue to be returned to the other party’s physical location within that state;
(i) the advertisement of a seller’s business location, telephone number, and Web site address; and
(j) a seller’s sales and use tax registration with that state and/or a seller’s collection and remittance of use taxes for that state.”
Note that many of these proposed income tax safe harbors differ from the list of sales tax safe harbors, supra. Even more significant is the difference between the two in how the safe harbors would be applied. For sales tax purposes, the ACEC majority proposed that Congress clarify by legislation the factors, which would not, in and of themselves, create sufficient nexus with a state to permit that state to impose collection obligations on remote sellers. By contrast, for income tax purposes, the factors would not be taken into account in determining nexus at all. This is another indication that the income tax issues were considered of paramount importance to the business interests. - - 28 - -
Taxes Imposed On Internet Access Charges. Another ACEC majority policy proposal would make permanent the current moratorium on any transaction taxes on the sale of Internet access, including taxes that were grandfathered under the Internet Tax Freedom Act. This came as no surprise, considering that most of the business representatives to the ACEC either already provided Internet access to customers, or else intended to do so soon.
Taxation of Telecommunications Services and Providers. The present 3% federal excise tax on communications services was initially established in 1898 to assist with financing the Spanish-American War. This tax is typically applied to local or long distance telephone system calls, including those that are used to reach ISPs.
Throughout the Internet tax debates, one of the principal objectives of the regulated telephone companies was to have this tax repealed. Because the excise tax does not apply to certain competing technologies that customers may use to reach their ISPs (e.g., cable modem, direct broadcast satellite modem, etc.), the regulated telephone industry claimed that the tax was an anachronism, suited only to those bygone days when monopolies provided nothing but pure telephony. In a competitive environment, they claim the excise tax places them at a severe competitive disadvantage.
The ACEC majority agreed, and proposed to eliminate the federal excise tax on communications services. In order to address the disparity between telecommunications companies and other businesses at the state and local level, the ACEC majority also suggested that excess tax burdens on telecommunications property be eliminated. This has been another long-standing complaint of the regulated telephone companies. State and local tax assessors, by adhering to the so-called “unit valuation method,” have in effect imposed ad valorem taxes on the goodwill of those businesses for many years. The ACEC majority further urged state and local governments to work with and through NCCUSL in drafting, within three years, a uniform and simplified state and local telecommunications excise tax act.
Since the release of the ACEC Report, no fewer than six bills have been introduced which would repeal the federal excise tax on communications. To date none have been successful. - - 29 - -
International Taxes and Tariffs. The ACEC majority also proposed several policies regarding international taxes and tariffs, including supporting the formal, permanent extension of the World Trade Organization’s current moratorium on tariffs and duties for electronic transmissions, and recognizing the OECD’s leadership role in coordinating international dialogue concerning the taxation of e-commerce. The final ACEC majority policy proposal states that Congress should increase its oversight of the international ramifications of domestic Internet commerce decisions.
§ 5.18 The Internet Tax Freedom Act Extension
The original ITFA moratorium expired in October 2001. The terrorist attacks on the United States occurred on September 11, 2001. In those frantic days just after September 11, most of the regular business of the country simply stopped, and Internet taxation was one part of that regular business that was placed on Washington’s back burner, while more important issues were occupying our attention.
In November 2001, the Internet Tax Nondiscrimination Act was signed into law, extending the ITFA moratorium on new Internet access and multiple and discriminatory taxes through November 1, 2003.14 The ITNA made no changes to the existing ITFA other than to simply extend the expiration date.
The version of the bill signed by President Bush was a compromise of several concerns. Many of the bills introduced in the House and the Senate contained permanent extensions of the moratorium. However, pressure from state representatives successfully reduced the moratorium to two years. Some bills sought to eliminate the grandfather clause in the ITFA that preserves existing state taxes on Internet access. These amendments were also shot down. Finally, there were discussions to amend the definition of “Internet access services” to address the “bundled” services concern of states and some telecommunications providers. This concern was also not alleviated by the passage of the ITNA.
14 H.R. 1552, 107th Cong. (2001) (enacted). - - 30 - -
§ 5.19 The Streamlined Sales Tax Project
The work of the NTA Tax Project and the ACEC had identified the types of simplification that would make the collection duty a reasonable burden to impose on direct mail and electronic commerce vendors. There was great concern among state legislators and tax administrators that this simplification agenda would be forced on them by Congress if they did not take voluntary steps to adopt it themselves.
Indeed, the enactment of the Internet Tax Freedom Act, with its temporary moratorium on certain state and local taxes, sent a very strong message to state and local government. Certain members of Congress believed the present Byzantine system of state and local taxes would stifle the commercial growth of the Internet, and they were prepared to pre-empt the field with federal legislation in order to permit the free flow of interstate and international commerce. Many observers regarded the ITFA’s moratorium as Congress’ means of assigning to the states and localities the job of putting their houses in order, and giving them a calendar deadline in which to accomplish the work. If insufficient progress was made by the time the moratorium expired, Congress might have taken action.
The Streamlined Sales Tax Project (“SSTP”) was organized in March 2000 by many of the state and local government agencies and representatives who had served on the NTA Tax Project Steering Committee. Their objective was to take the process of transaction tax reform to its next level – a formal, voluntary agreement among the states that would make it practical to require remote vendors to collect sales taxes for all the states.
In order to accomplish this objective, the SSTP will attempt to simplify state and local sales and use taxes; standardize the administration of such taxes among the states; and identify computer software and financial transmission systems to implement the collection of use taxes on out-of-state sales without imposing a prohibitive cost burden. The SSTP has created four working groups to address various issues: (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. - - 31 - -
The SSTP acknowledges that the key elements of a simplified sales tax system are: uniform definitions within tax bases; simplified administration for exempt transactions; rate simplification; uniform sourcing rules; and uniform audit procedures. 15 The SSTP also asserts that states should assume the responsibility for implementing the streamlined sales tax system in order to reduce the financial burden on sellers.
The process to implement the streamlined sales tax system can be categorized by three distinct steps: (1) state enactment of model legislation authorizing the state to participate in multi-state discussions and to enter into a multi-state compact that contains specified simplification provisions; (2) state adoption of specific sales and use tax amendments conforming each state’s tax laws with the simplification provisions; and (3) the SSTP’s governing body granting the state entrance into the compact.16
To date, thirty-nine states and the District of Columbia are participating in the SSTP. Of these, thirty-four states and the District of Columbia have enacted the legislation necessary to make them voting participants in the SSTP. Unfortunately, forty-five states and the District of Columbia impose transaction taxes. Can one system effectively serve the needs of thirty-nine jurisdictions, leaving direct mail and electronic commerce vendors to fend for themselves in the other six? It is doubtful that any such limited proposal would receive the support of the business community.
There is some hope on the part of the SSTP participants that their effort will produce so much simplification that Congress will enact legislation permitting their system to be imposed nationwide. If those six – or any other states – elect not to participate, Congress would prevent them from imposing a duty to collect transaction taxes on any business lacking substantial physical presence in the jurisdiction. In other words, the hope is that Congress will repeal the Quill case for any state or locality that participates in the SSTP. Such an “incentive” would be similar to the method by which the states are induced to participate in the Interstate Fuel Tax Agreement. Could it happen? Possibly.
15 Streamlined Sales Tax Project, Executive Summary (March 1, 2001). 16 Arthur R. Rosen and Susan K. Haffield, “The Streamlined Sales Tax Likely to Affect All American Businesses,” LEXIS 2001 STT 251-21, December 10, 2001. - - 32 - -
However, the SSTP has other problems. First, there are two versions of the model legislation. The SSTP’s version of the legislation, known as the Model Uniform Sales and Use Tax Act (SSTP Act), refers to numerous simplification/uniformity provisions recommended and approved by the SSTP’s voting states in December 2000. However, when the NCSL executive committee considered the SSTP’s proposals in January 2001, it determined that many of the proposed simplification/uniformity items would be too politically controversial to address during the 2001 legislative sessions. The NCSL version of the model legislation is known as the Simplified Sales and Use Tax Administration Act (NCSL Act) and refers to a compact that would contain fewer simplification requirements/provisions. The NCSL apparently is based on the belief that removing the controversial items would encourage a greater number of states to participate. Because each of the model acts contains different simplification provisions, there are also two versions of the multi-state compact. The SSTP’s compact, the Uniform Sales and Use Tax Agreement, contains all of the SSTP’s simplification provisions. The NCSL compact, the Streamlined Sales Tax Agreement, contains all of the NCSL’s simplification provisions.
At the time of this writing, thirty-five states and the District of Columbia had passed some version of the model legislation. The SSTP Act was approved in Arkansas, Kentucky, Maine, Minnesota, Nebraska, North Carolina, Rhode Island, South Dakota, Wisconsin, and Wyoming. The NCSL Act is law in the District of Columbia, Florida, Illinois, Indiana, Maryland, Michigan, Missouri, Nevada, Ohio, Oklahoma, Rhode Island, South Carolina, Tennessee, Texas, Washington, and West Virginia. A modified or hybrid version was enacted in Alabama, Arizona, Iowa, Kansas, Louisiana, Nebraska, New Jersey, North Dakota, Virginia, and Utah. Minnesota, North Carolina, and Wyoming have not only passed the SSTP Act, but have also changed their sales and use tax laws to conform to the provisions contained in the SSTP Agreement.
The second problem deals with strict conformity. At the June 2002 meeting of the SSTP, the issue of strict conformity to the model statutory language was considered. As is to be expected, the representatives from the various states each had their own precedents and procedures to observe, and the SSTP concluded it was impractical to expect each participating state to enact the identical statutory language. Instead, the delegates are leaning in favor of requiring “substantial compliance” with the model statute. This would be defined as a variation - - 33 - - permitted for a particular state that does not place an undue burden on a seller who is required to comply. How many states would be allowed to employ tax schemes with permitted variations? How much of a burden constitutes an “undue” burden? From the business’s perspective, do twenty or thirty “reasonable burdens” add up to an “undue burden”?
Unless a single system is in place that eliminates the need for a business to research the laws of the fifty states to identify the state-by-state variations, the business community can be expected to complain that the burden on interstate commerce is still “undue.” As such, the authors confess to a high degree of skepticism that the SSTP will achieve the objective sought by its participants. As of this date, the SSTP’s progress is not encouraging. Even though several basic principles have been the subject of preliminary agreement, it seems unlikely that the necessary simplification will be achieved through this medium.
Despite statements from the SSTP and some state tax officials that the simplification efforts will not be used to extend new sales tax jurisdictional rules to business activities taxes (income tax, franchise tax, business and occupation tax, etc.), some businesses are justifiably skeptical. The basis for this skepticism lies in the growing number of states willing to impose income taxes on business merely because they have customers in the state or have some mere irregular, occasional presence there. Assurances by the SSTP that this is not the case seem somewhat hollow considering the focus placed on “economic nexus” by organizations such as the MTC, which advises states on such matters.
§ 5.20 The Politics of the Passage of the Internet Tax Moratorium -- 1996 to 2001: The Stock Market Boom Years
To look at Washington and its treatment of technology issues during the “bubble” years, when the possibilities of technology seemed infinite, one has to recall the climate of those times and the rose-colored glasses most of society was wearing with respect to the promise of the technology industry. Politics and politicians were no different than investors in their fascination with this exciting new industry.
A quote from Raymond C. Sheppach, Executive Director of the National Governors’ Association, leading the opposition in 1998 to the first bill imposing a three-year moratorium, - - 34 - - amply demonstrates how most top officials in state government viewed the treatment being accorded technology –
The Internet is like motherhood and apple pie now.
But was the success and glare of that industry the full explanation of why Congress moved, and of how fast it moved on this issue? To answer that question, we’ll look at the congressional process and the factors that propelled two successive moratoria on new Internet access taxes to final passage in the U.S. Congress, first in 1998 and later again in 2001.
Having set the tone for a political discussion, it should be noted that many observers believe that the basic issues being confronted throughout this debate are often overlooked. Headlines continually used by the press referred to the ongoing congressional debate on the moratorium using words such as “Free the Internet” and “Tax-Free Internet.” This characterization of the dialogue perhaps presented the issues too simplistically and did a disservice to the real concerns for the corporate world – then and now. These issues fundamentally have not been resolved by the imposition of a moratorium and will be the topic of discussion globally and in the Congress for years to come. Some of the primary issues include (1) non-discriminatory treatment of online and offline sales and (2) a uniform standard for “business activity tax.”
These issues are touched upon in other sections of this chapter and shall be also be revisited at the end of this section. The politics and the players in the U.S. Congress who contributed to the passage of the original moratorium and a successive two-year “extender” at the height of the technology industry’s explosive growth period are the principal focus.
§ 5.21 -- The Power of the Technology Industry – How Two Moratoria Got Passed
In 1996, Congressman Chris Cox and Sen. Ron Wyden (R.-Ore.) drafted the ITFA, with its three-year moratorium, describing it as potentially saving consumers $16 billion or more in 2002 alone, and preventing the high-tech economy from being strangled by as many as 30,000 state and local tax systems. - - 35 - -
The daily diary for political “junkies” of how this process played out in Congress is best reflected by reference to the document included in the Addendum to this Chapter, a “Detailed Legislative History of the Internet Tax Freedom Act.”17
Was there precedent for such congressional action, which in essence, circumscribed state and local taxation to ensure that it did not interfere with interstate commerce? The proponents pointed to taxes on interstate motor carriers, where in 1995, Congress prohibited state and local sales tax on interstate motor transportation service. Taxes on satellite television 18 and taxation of the pension income of individuals who do not reside in that state had also been prohibited by the Congress.19
But – the principal question is – were the politics skewed in favor of the technology industry and unfairly against the legitimate interests of the states? One must focus on the political players and political climate in the years 1997-1998 and later in 2001.
The Speaker of the House in the mid-nineties was Newt Gingrich (R.-Ga.), and his leadership team included Dick Armey from Texas. Gingrich and Armey had strongly-held views on a conservative philosophy for the conduct of fiscal and monetary policy. Their views on free market forces had been espoused for years and were well-known by the business and consumer interest groups in Washington.
With the Republicans ascending to the Majority in Congress in 1994 after a forty-year term politely referred to as “minority” status, their enthusiasm for achieving passage of legislation reinforcing their strongly held principles was, understandably, very high. The Republicans were, very simply, in 1997, enjoying to the full their leadership status. At the same time, the technology industry seemed to be the very embodiment of free enterprise, with its focus at the policy level on “self-regulation.” The support this industry also provided, in terms of keeping the individual parties’ campaign coffers full, was also not unnoticed by the leadership of both parties in Congress.
17 We are indebted to the Office and staff of Congressman C. Christopher Cox, principally his Chief of Staff Peter Uhlmann, for providing us with this chronology of the bill. 18 See H.R. 4869 IH, introduced on June 5, 2002 by Rep. Tom Davis (R. – Va.). - - 36 - -
Very early on, Congressman Christopher Cox approached his Republican House leadership, including Newt Gingrich and Dick Armey, and his then-Chairman of the Energy & Commerce Committee, Tom Bliley (R.-Va.), for their support. They embraced his efforts on this legislation from the outset.
After laying the groundwork with leadership, Cox took on the jurisdictional battles. The support he had garnered from his leadership would ultimately prove decisive. The outcome of these early jurisdictional battles often determines whether a bill will be successful in making its way through the congressional process. The Internet Tax Moratorium bill was no exception. The signals were positive from the start.
The House leadership ensured that the Energy & Commerce Committee, on which Congressman Cox was a very senior member of the Majority, emerged as the committee with primary referral. The Judiciary Committee, to whom issues involving states rights questions, such as this, are often referred, was relegated to “second chair,” and Ways and Means, the principal tax committee in the House, was given a peripheral consultative role.
To clarify, however, the Ways and Means Committee does not have claim to Commerce Clause collisions with states rights in the area of sales and use taxes. Further, the language of the bill as originally drafted, had contained provisions related to the Federal Communications Commission, to bolster Energy & Commerce’s “claim” to the bill.
Those who have worked on or around Capitol Hill for any length of time know that a good working knowledge of parliamentary procedure has always been important for any member of Congress. However, many long-time participants in the process also understand that these same rules can be interpreted to lead to more than one conclusion or direction, and in this case, the stakes were high enough that certain “safeguards” were provided to ensure a favorable outcome. Energy & Commerce achieving jurisdiction was no accident.
Did the clout of the technology industry dictate “special” treatment for this bill? Was the House Republican Leadership so anxious to favor the industry that it threw out all the rules?
19 H.R. 394, 104th Cong. (1996) (enacted). Signed by President Clinton in January 10, 1996. - - 37 - -
There’s no question that at the time the technology industry was receiving its share of favorable attention in Washington.
On the other hand, Rep. Cox was the original sponsor in the House, a senior member of the Majority, and a knowledgeable player on the topic. Further, he had convinced his leadership and the Chairman of the Energy & Commerce Committee that this bill was important and would lead to strong incentives for free market forces. Mr. Cox had another, and perhaps critical, source of support – four key governors of the so-called tech states.
These were the governors from the State of California, Pete Wilson; the State of Virginia – initially George Allen and later Jim Gilmore; the Commonwealth of Massachusetts, Bill Weld, and the State of New York, George Pataki. These governors held key roles in the National Governors Association, chaired the principal committees within that organization, and ultimately, ensured the NGA would be unable to present a united front against the legislation.
The bill passed by unanimous 41-0 vote out of Energy & Commerce on May 14, 1998, with Judiciary Committee following suit a month later. On June 23, the bill went to the House floor, where it passed by voice vote.
§ 5.22 -- Onto the U.S. Senate
Sen. Ron Wyden (D.-Ore.), the original co-sponsor with Congressman Cox, had considerable opposition to contend with in the Senate – on the Commerce Committee itself and on the floor from specific pro-sales and use tax states. Sen. Wyden got help from Senate Finance Committee Chair Max Baucus, who was able to move the bill through Senate Finance. Consideration was delayed on the Senate floor for several months while proponents lined up support.
When the debate finally took place on the floor, Sen. Bob Graham of Florida and Sen. Dale Bumpers of Arkansas, representing two states looking for the revenue from an overturn of Quill and taxation on all Internet merchants, forced two cloture votes. In addition, senators like Tim Hutchison (R.-Ark.) lined up with many retailers who strongly objected to what they saw as discriminatory treatment in favor of online retailing. With Wyden and John McCain (R.-Ariz.) - - 38 - - leading the charge, however, on October 8, the bill passed by the amazingly lopsided final vote of Senate 96-2.
These votes in both the House and Senate are substantially one-sided, and clearly reflect a strong interest by individual members of Congress to have their names in the column supporting the technology industry. As we suggested earlier, however, in order to balance this argument, the substantive issues in this case also have merit, and need to be mentioned.
The process of getting a bill through Congress to final passage is long and demanding. This is always viewed as a good thing in our political process, to protect against ill-conceived proposals, and historically, gives all interested parties more than sufficient opportunity to review and advise on proposed statutory language – before it becomes law. The point here being that if the basic issues and arguments made on the proponent side of this bill were not valid, no amount of skilled lobbying nor political influence could have achieved the final successful outcome.
One of the fundamental arguments of the debate involved the 1992 Quill decision, where the U.S. Supreme Court ruled that the Commerce Clause barred the states from requiring an out- of-state mail-order company to collect taxes on sales made to customers inside the states unless the company had a substantial presence (referred to as “nexus”) within the state. The Court said Quill had no outlets or sales representatives or other significant presence within the State of North Dakota, so it did not have to collect the tax.
The physical nexus arguments relied upon by proponents of the moratorium are also strong and valid considerations. Physical “nexus,” often referred to globally as “permanent establishment,” has for a long time been used as the litmus test allowing a company to sell to customers in another country without having a physical presence there. Long before the rise of e- commerce, a business could make contact with customers via television, mail order, or telephone. These rules have not been modified in response to the growth over time of even these “traditional” modes of communication. - - 39 - -
§ 5.23 -- Internet Non-Discrimination Tax Act (H.R. 1552)
The moratorium “extender” will expire November 1, 2003. The politics of this legislation were far more complicated in many ways than the original bill. Rep. Chris Cox and Sen. Ron Wyden remained key players in the bill’s introduction and ultimate passage, but many new elements had been added since the original 1998 imposition of the moratorium.
First of all – how did the Advisory Commission on Electronic Commerce, mandated under the provisions of the original ITFA, fare? Given the mandates laid down by the statutory language relating to the make-up and scope of the Commission, were the hopes for its success unrealistic from the outset?
The Commission was to consist of nineteen members representing the U.S., state and local governments, the electronic commerce industry, telecommunications carriers, local retail businesses and consumer groups. The report from the Commission was due eighteen months after the date of enactment.
The Commission was divided from the start, with the various factions equally divided between the states rights forces and the no new taxes without simplification elements of industry. The result was that none of the final recommendations ultimately sent to Congress by the Commission could claim a “consensus” vote of support. Congress was given a set of suggestions at the end of the Commission’s tenure, but the political in-fighting that burdened this effort from the start greatly impacted the weight given to the final report by all the various interests.
More important at this point and in the passage of the moratorium extension was a change of tactics by the states. Some background here: Sen. Byron Dorgan (D.-N.D.) served as Revenue Commissioner of the State of North Dakota in 1992 – at the time the Supreme Court ruled against the state in the Quill decision. As a result, Sen. Dorgan had and continues to have a very strong stake in the outcome of this debate and in the overturn of Quill.
The states realized in the second round of debate on a moratorium that if they were to prevent another defeat, they needed to change their tactics. Their overall goal was still to overturn Quill, but the new approach was to partner with the tech industry temporarily to buy - - 40 - - sufficient time to see if the states could conceivably work toward a uniform “one-rate per state” simplification proposal that industry could accept.
Thus far the effort at simplification has been ongoing (outlined supra), but could not be described as anywhere near completion. Business had an easy decision – given the win-win position it was in. The moratorium was extended to November 2003, and the states were at least initiating an effort to simplify the tax system.
Sen. John McCain, working with Sens. Dorgan, Enzi, Kerry, and Ron Wyden, was able to achieve sufficient support for passage a second time. The politics post-9/11 were also a contributing factor and hard to define. But this was still a significant accomplishment in this climate.
The issues that motivated the Congress to twice pass a moratorium on new Internet taxes have not been resolved and have not gone away. The states are still working on a simplification effort, and they will have a different climate when they next approach the Congress. With individual state treasuries in deficit, and the Congress still reeling from recent corporate scandals, a more receptive forum may well present itself for for the states. The first year of the next Congress could be the year in which the serious discussions are held on the basic issues, i.e., one rate per state and “business activity taxes.”
§ 5.24 What Does A Business Executive Need To Know About Internet Taxation? --The Current Tax Paradigm.
Most business managers – CEO’s, COO’s, CFO’s, general counsel – have a reasonably good idea of the tax environment in which they operate. They may not always know, in statutory or case law terms, the reasons why a particular type of income is taxed a certain way, or why there is a duty to collect sales and use taxes on a particular type of transaction. However, they know how their business, their competitors, and their industry usually deal with certain tax issues.
Electronic commerce now makes it possible to do business in ways that were simply never imagined when the existing tax enforcement paradigm was invented. The rules that for years determined who paid tax and who collected tax don’t clearly define these duties in the - - 41 - - electronic commerce medium. Therefore, the more experienced an executive may be with the current tax paradigm, the more likely he will be to make incorrect assumptions about how his e- commerce business should be taxed.
When e-commerce transactions arise, the first presumption of many business executives is that there usually is a requirement to pay federal income tax on the income that the business derives from the new activity. This is because we have been conditioned to assume that all income is subject to federal income tax unless it is covered by some special exemption.
The executive’s second presumption would normally involve state income or franchise taxes (“business activity taxes”), and it is usually the exact opposite of the first. Executives of multi-state businesses have been conditioned to assume that a state’s income tax is only due when business is clearly conducted in that state. They frequently enjoy the benefits of what the business’s tax director probably calls “nowhere sales.” The term refers to the phenomenon of having less than 100 percent of the income of the business being subject to state income tax “somewhere.” There is a feeling that states are only entitled to levy their income taxes on certain revenues, and that unless part of one’s business clearly falls within the state’s jurisdiction, the business has a right to operate free of state income tax.
The third presumption involves whether the business has a duty to collect sales, use or value-added tax (“transaction taxes”) from its customers. Most executives will generally assume that on-site transactions involving the sale of tangible property give rise to a duty on their part to collect transaction taxes and remit the collections to the state or local government on a periodic basis. However, if the transaction is conducted by long-distance telephone, over the Internet, or by correspondence, the presumption shifts. The business executive will assume that his business can’t possibly be expected to collect the sales tax if it isn’t physically located there. The presumption also shifts when the business sells an intangible product or sells its services – the executive will generally assume that these transactions are simply not subject to sales tax, regardless of whether the business is located in the taxing jurisdiction.
These three sets of presumptions compose the current tax paradigm, and they are generally based on correct application of the law. Let’s see whether the paradigm works in the e- commerce medium. - - 42 - -
§ 5.25 How E-Commerce Fits Within The Current Paradigm -- Businesses Dealing In Tangible Personal Property
The maturity of the direct mail, or catalog sales industry, has created a subset of expectations for dealers in tangible property. If the business has no plant, warehouse, office or other location in a jurisdiction, its executive expects to it be exempt from business activity tax, and expects it to be exempt from the duty to collect transaction tax.
These expectations are generally appropriate for tax at the federal and international level, since the concept of taxing only those businesses that have a “permanent establishment” in a country is still the general rule among nations, and is still the basis for most bilateral tax treaties whose purpose is to prevent any potential double taxation of the citizens of one treaty country by the government of the other treaty country.
At the state and local level, a political tug-of-war has been waging for decades between the direct mail industry and the brick-and-mortar retail industry. The battleground is whether the retailer must collect state and local transaction taxes on business-to-consumer (“b2c”) sales made from a remote location. This is usually not an issue in business-to-business retailing (“b2b”), because most businesses are required to file a regular “direct-pay” use tax return, which self- assesses the transaction tax, and that return provides an easy paper trail for the state tax authority to audit. But very few consumers who are not charged sales tax on a purchase will ever self- assess the transaction tax, regardless of how convenient the state might make it. And the practical reality is that states rarely enforce sales and use taxes at the consumer level, because the enforcement would cost more than the amount of tax revenue it would generate.
E-commerce has raised the financial stakes in this tug-of-war. As Internet b2c sales continue to grow, draining more business away from the brick-and-mortar retailers, e-commerce retailers of tangible goods find themselves allied with the direct mail industry, collecting sales tax only if they have a physical presence in a state. On the other side, state governments are trying to pierce the protective veil provided by the Quill and National Bellas Hess precedents (discussed below). More and more states are attempting to impose a duty to collect their transaction tax on out-of-state retailers who have less substantial contacts in the jurisdiction. State tax administrators believe that if they can’t get the Supreme Court or Congress to repeal - - 43 - - these transaction tax nexus protections for business, the least the state can do is to interpret the protections very narrowly, and aggressively assess retailers that have even the slightest level of contact not protected by Quill and National Bellas Hess.
A retailer maintaining a Web site that can be accessed by a citizen from his home can be said to be maintaining a kind of “electronic presence” in a state that simply wasn’t possible, even as recently as 1992, when Quill was decided. Who can say what the Supreme Court would have thought of the electronic presence argument? Quill merely dealt with a catalog merchant, and the states that feel the Quill case robs them of legitimate tax revenue, deny that the case applies to any business that does not strictly adhere to the Quill facts.
These states may have even a better argument when they attempt to impose their duty to collect transaction taxes on the so-called bricks-and-clicks retailers. These retailers typically maintain a traditional retail store within the state selling similar goods, although the store may be owned and operated by a separate corporation or a franchisee. Is it an unconstitutional violation of the Due Process Clause or the Commerce Clause for a state to impose the duty on these companies? Many attorneys general would like to argue the case before the U.S. Supreme Court and become known as the attorney for the state that “overturned Quill.” Certainly, no rational business executive wants his business to be the defendant in that case.
How can a business executive avoid becoming that defendant? The answer is simple – collect sales tax on each and every b2c retail sale. Some large bricks-and-clicks retailers actually do just that. Others have made the business decision to charge no transaction tax, and remain at risk in the event a state or locality attempts to assess the tax against the business itself. They believe it would place their products at a competitive disadvantage to add the transaction tax to their price, and do so only when the product is being shipped to a state in which it is impossible to deny their tax presence. Still other businesses refuse to deal with any of the transaction taxes imposed by remote jurisdictions, citing the overwhelming complexity of attempting to comply with all the various laws and file all the required forms.
The authors expect to see a dramatic increase in the number of tax audits and litigation related to these taxes as soon as the ITFA moratorium expires. Many states want to test the limits of the Quill decision, but without the additional impediments raised by the ITFA. - - 44 - -
§ 5.26 Recent Developments Affecting the Concept of Nexus for Businesses Dealing In Tangible Personal Property
The authors expect to see a dramatic increase in the number of tax audits and litigation related to these taxes as soon as the ITFA moratorium expires. Many states want to test the limits of the Quill decision, but want to do so without the additional impediments raised by the ITFA. Two recent nexus cases dealing with retailers of tangible property are discussed immediately below.
§ 5.27 -- In the Matter of Borders Online, Inc.20
In Borders Online, Inc., the taxpayer was a corporation headquartered outside California that made online retail sales through the Internet, primarily of books, videos, music and gift items, which were then delivered by common carrier from outside California. The taxpayer was an affiliate of Borders, Inc. (Borders), a corporation that sold similar good in stores throughout California. The Sales and Use Tax Department informed the taxpayer that it was a retailer engaged in business in California, and was therefore obligated to collect use tax from its California customers. The Department based its conclusion in part on certain representations published on the taxpayer’s Web site. These stated that purchasers could return unwanted items they had purchased on the Web site to any store owned by Borders, as long as the purchaser presented a valid packing slip. In fact, the taxpayer’s California customers could receive cash refunds from the Borders’ stores, despite the fact that individuals who purchased merchandise directly from Borders’ stores could only receive store credit.
The issue for decision was whether the taxpayer was under a use tax collection obligation because it was a “retailer engaged in business in this state and making sales of tangible personal property for storage, use, or other consumption in this state.” The relevant statute defined “retailer engaged in business in this state” as any “retailer having any representative, agent, salesperson, canvasser, independent contractor, or solicitor operating in this state under the authority of the retailer or its subsidiary for the purpose of selling, delivering, installing,
20 In the Matter of the Petition for Redetermination under the Sales and Use Tax Law of Borders Online, Inc. , SC OHA 97-638364, California State Board of Equalization (Sept. 26, 2001). - - 45 - - assembling, or taking of orders for any tangible personal property.” The taxpayer was found to be acting through a representative because the taxpayer’s Web site expressly stated that Borders was the authorized representative for the purpose of accepting returns from the taxpayer’s California customers. Additionally, it was concluded that, when accomplished through an authorized representative, the taking of returns constitutes “selling” under the relevant statute because the term is inclusive of all activities that are an integral part of making sales. The court explained:
When out-of-state retailers that make offers of sale to potential customers in California authorize in-state representatives to take returns, these retailers acknowledge that the taking of returns is an integral part of their selling efforts. Such an acknowledgment comports with common sense because the provision of convenient and trustworthy return procedures can be crucial to an out-of-state retailer’s ability to make sales. This is especially evident in the realm of e- commerce.
The court then examined the “substantial nexus” requirement outlined in Quill21 and concluded that the taxpayer had substantial physical presence in California through the many places of business and employees of Borders, the taxpayer’s authorized representative in California for the purpose of selling tangible personal property.
§ 5.28 -- State of Louisiana v. Quantex Microsystems, Inc. 22
Quantex Microsystems, Inc. (Quantex), a New York corporation with its principal place of business in New Jersey, sold computer products via mail, the telephone, and the Internet. It solicited business through national publications and on the Internet, but did not specifically direct any advertisements to Lousiana. Quantex had no offices, property, bank accounts, or direct employees in Louisiana. During the years 1995 through 1997, Quantex made computer sales of
21 Supra note 9. 22 State of Louisiana and Secretary of the Department of Revenue and Taxation v. Quantex Microsystems, Inc. , 809 So.2d 246 (La. Ct. App. 2001). - - 46 - - approximately $7,480,000 for delivery in Louisiana. As part of the limited warranty provided with the purchase of computer products, Quantex represented to its customers that it might, at its sole discretion, provide on-site service for the replacement of defective hardware parts for one year from the date of purchase. Quantex claimed that this service was provided by the manufacturer of the computer products and not by Quantex.
In 1997, the Louisiana Department of Revenue and Taxation filed suit against Quantex seeking payment of unpaid use, income, and franchise taxes related to the sale of computer products. The Department alleged that Quantex had “established a physical presence in the State of Louisiana” by providing for “repairs, service and/or support for products purchased for use in Louisiana through the use of agents, employees and/or independent contractors operating in Louisiana.” Quantex filed a motion for summary judgment on the grounds that it did not have a physical presence in Louisiana. The trial court granted Quantex’s motion and the Department appealed, contending that the trial court erred in finding that “an out-of-state corporation’s use of independent contractors to provide on-site computer repair services in Louisiana cannot constitute [a] substantial nexus” to support state taxation. The Louisiana Court of Appeals reversed and remanded the case.
The court of appeals phrased the issue as whether Quantex’s activity in Louisiana had a “substantial nexus” with Louisiana to warrant the imposition of taxation. The court noted that the boundaries of the “physical presence” requirement have been the subject of much judicial debate in the years since the Supreme Court decided National Bella Hess, Quill, and Complete Auto. The court of appeals stated that the crucial factor governing nexus is whether the activities performed in the taxing state on behalf of the taxpayer are significantly associated with the taxpayer’s ability to establish and maintain a market in the taxing state. On the basis of the facts before it, the court found that there were disputed factual issues regarding whether Quantex itself provided on-site service, the extent of the on-site service actually performed, and whether that activity was significantly associated with Quantex’s ability to establish and maintain a market in Louisiana. The court explained that federal and state jurisprudence indicates that the parameters of the “physical presence” requirement have not been sufficiently developed to determine whether on-site service performed by independent contractors on behalf of Quantex, or the extent of such service, would be adequate to support taxation in that case. Thus, like the court of - - 47 - - appeals in America Online, Inc., the court refrained from applying a bright-line test requirement that the out-of-state company have an actual physical presence in the taxing state.
Another development is the legislation on sales tax nexus recently passed in Arkansas, Ark. Code Ann. § 26-53-124. In 2001, Arkansas amended a statute which imposed on certain out-of-state “bricks-and-clicks” vendors the duty to collect transaction taxes. The amendment, effective January 1, 2002, states:
(3) The processing of orders electronically, by fax, telephone, the internet or other electronic order process, or the processing of orders by non-electronic means, by mail order, fax, telephone, or otherwise, does not relieve a vendor of responsibility for collection of the tax from the purchaser if both the following conditions exist:
(A) The vendor holds a substantial ownership interest, directly or through a subsidiary, in a retailer maintaining sales locations in Arkansas, or is owned in whole or in substantial part by such a retailer, or by a parent or subsidiary thereof; and
(B) The vendor sells the same or substantially similar line of products as the Arkansas retailer under the same or substantially similar business name, or the facilities or employees of the Arkansas retailer are used to advertise or promote sales by the vendor to Arkansas purchasers.
(4) For purposes of this section, “substantial ownership interest” in an entity means that degree of ownership of equity interests in an entity that is not less than that degree of ownership specified by Section 267 of the Internal Revenue Code of 1986, as in effect on January 1, 2001, with respect to a person other than a director or officer.
The new law effectively forces an out-of-state company with no employees or property in Arkansas to collect sales tax on each sale made to customers of the state if the company is related, within the meaning of section 267 of the Internal Revenue Code, 23 to a retailer in Arkansas and the two related parties provide similar products or the facilities or employees of the Arkansas retailer are used to advertise or promote the out-of-state company’s sales products. Thus, it is possible that a company located outside of Arkansas may be required to collect sales tax despite the fact it has no employees and property in the state, it is run independently of the related Arkansas retailer, and the Arkansas retailer does not provide services in the state on the
23 26 U.S.C. § 267 deals with losses, expenses, and interest with respect to transactions between related parties. The statute provides specific rules for determining when parties are related. - - 48 - - company’s behalf (i.e., accepting returns from the company’s Internet sales to customers in Arkansas). This last point distinguishes the Arkansas statute from the situation in Borders Online, Inc., and raises serious constitutional questions in light of the Supreme Court’s holdings in this area.
§ 5.28 -- Businesses Dealing With Both Tangible And Intangible Property
Many businesses sell information, database access or the right to use intellectual property. The method of delivery of the product has historically determined the seller’s exposure to a duty to collect transaction taxes. For example, most states impose their transaction taxes on sales of tangible products. Thus, if a computer software program is purchased on a CD, the state treats it as the sale of a tangible product. However, if the program is downloaded from the author’s or retailer’s Web site, there is no tangible product involved, and most states’ transaction taxes will not apply.
This leads to some anomalous results. What happens in the case of a downloaded digital product (software, music, e-book, etc.) when the vendor also ships a backup copy, or a user’s manual, in tangible form? Is the portion of the purchase price allocated to the tangible component subject to transaction tax, and the price of the downloaded portion exempt?
The political and economic anomaly inherent in this situation is that similar products are taxed differently, depending on their delivery medium. However, our transaction tax systems have tolerated this anomaly since the earliest days of mail-order catalogs.
§ 5.28 -- Businesses Dealing Solely In Intangible Property
As Internet access speeds increase, more and more products will migrate from the form of software delivered on a CD and loaded on the consumer’s hard drive, to interactive Internet applications. Many companies selling database access have already converted to interactive products, and their experience has been routinely favorable. This should, in time, allow most consumers to use relatively “dumb” Internet terminals to access all their sophisticated software, which in turn will be stored on the vendor’s servers. - - 49 - -
Currently, such transactions may only be taxable in the City of Chicago.24 The Chicago approach implies an analogy to the bygone days of time-sharing computer services. In effect, the City’s position is that the remote computer is being leased and used within the City limits, and as such, it is actually tangible personal property which is temporarily present, albeit by electronic means, in the City. This analogy gives the City the nexus to impose a transaction tax on the local user. To date, the authors are not aware of instances in which the City has sought to impose a duty to collect this tax on an out-of-state business.
§ 5.29 -- Service Businesses
Most states and localities do not impose transaction taxes on professional or personal services. Florida experimented with taxing services and found it to be highly unpopular when citizens learned that many magazines, publishers and broadcasters simply withdrew from the Florida market, rather than gear up to comply.
§ 5.30 -- Internet Service Providers
Tennessee, one of the states whose transaction tax on Internet access is grandfathered by ITFA, also apparently chose to assess America Online (“AOL”) for its business activity tax. Quite apart from questions of the moratorium, the assessment had to pass muster under the four- pronged Commerce Clause test of Complete Auto. AOL objected to the assessment on several grounds, including the claim that it had no physical presence in Tennessee, and thus the assessment could not satisfy the “substantial nexus” prong of the Complete Auto test.
The Tennessee Court of Appeals, in America Online, Inc. v. Johnson,25 dealt with this issue in a very strange way, actually appearing to render more of a political decision than a constitutional one.
AOL is a Delaware corporation that provides various Internet and online services, including electronic mail and Internet access. Its principal office is in Virginia where its main computer facilities are located. AOL does not own or lease any real property in Tennessee, and it
24 See the discussion of Chicago’s Personal Property Lease Transaction Tax at §5.14, supra. 25 America Online, Inc. v. Johnson, 2002 Tenn. App. LEXIS 555 (July 30, 2002). - - 50 - - does not have any regular employees in that state. AOL sells its services through the mail or by magazine inserts. The promotional materials include printed brochures and a floppy disk containing the necessary information to access AOL’s data center in Virginia. By using the disk, customers can sign up online and become an AOL member by agreeing to the terms and conditions of the offer. Some of AOL’s members in Tennessee were designated as “remote staff.” These members were unpaid persons working from home and trained by AOL to moderate real time conferences. They were subject to call at any time to enforce AOL’s rules, but they did not solicit business in Tennessee.
The Commissioner of Revenue claimed that AOL’s activities in Tennessee gave it a sufficient nexus to subject it to business activity taxes. The Chancery Court of Davidson County disagreed, and granted summary judgment to AOL by employing a bright-line test requiring an out-of-state company to have a “physical presence” in Tennessee in order to have substantial nexus. The Court of Appeals reversed.
The Court of Appeals rejected the lower court’s interpretation of the Court of Appeals’ own decision in J.C. Penney Nat’l Bank v. Johnson,26 that an out-of-state company must have “physical presence” in a state in order to have a substantial nexus. The court reasoned that such an interpretation would simply substitute “physical presence” for “nexus” as the first prong of the Complete Auto test.27
The court rejected the argument that AOL neither owns or rents real property in Tennessee, nor does it have offices or employees in the state. The court chose instead to cite the U.S. Supreme Court’s transaction tax Due Process decisions, Quill,28 and National Bellas Hess,29 to address the Commerce Clause nexus questions. From these cases, the court concluded that the
26 J.C. Penney Nat’l Bank v. Johnson, 19 S.W.3d 831 (Tenn. Ct. App. 1999), cert. denied 531 U.S. 927 (2000). 27 In Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977), the Supreme Court stated that a state tax would not violate the Commerce Clause “when the tax is applied to an activity with a substantial nexus with the taxing State, is fairly apportioned, doesn ot discriminate against interstate commerce, and is fairly related to the services provided by the State.” Id. at 279. 28 Supra note 9. 29 National Bellas Hess v. Department of Revenue, 386 U.S. 753 (1967). - - 51 - - only safe harbor, or situation in which substantial nexus does not exist, is one in which the taxpayer’s only contact with the state is by the Internet, mail and common carriers.
The court noted that there are a substantial number of network service providers operating in the state, helping make the AOL service available to Tennessee customers, including one which is a subsidiary of AOL. The court felt that this presence, that of the “remote staff,” and the large number of AOL floppy disks and CDs present in the state constituted substantial nexus.
It is too early to tell whether other courts will follow the Tennessee Court of Appeals in blurring the line between substantial nexus for income tax and sales tax purposes. The only conclusion the authors suggest is that in Tennessee, some combination of “agency nexus” and “garbage nexus”30 are substantial.
§ 5.31 -- Businesses Dealing In Optical Fiber
Internet service providers (“ISPs”) are the principal consumers of optical fiber, and at the turn of the century it seemed as if every urban street in the country was the recipient of the typical 18-inch-wide trench into which the fiber was laid. Fiber was bought and sold, sometimes “lit” and other times “dark” (referring to whether it had been placed in service.) It was also “swapped,” and the financial accounting treatment of those swaps has figured prominently in some of the highly publicized accounting scandals of 2002.
The tax characteristics of optical fiber use and ownership have yet to be clearly defined. The typical swap transaction proceeded as follows: the original owner of the fiber was normally the company that laid it under the city streets. These companies then bought and sold optical fiber capacity with similar original-owners through transactions call “indefeasible rights of use,” or “IRU’s.” The ostensible purpose of all the IRU-swapping transactions was to acquire the
30 This term is not intended in any way to denigrate the Tennessee court’s decision. It was first used, to the authors’ knowledge, by commentators who referred to one of the arguments advanced by the attorney general of North Dakota during the U.S. Supreme Court oral argument of Quill. “Garbage nexus” refers to the extent to which an out-of-state vendor purposefully avails itself of the garbage-removal services of the jurisdiction by flooding local residents with material that must eventually be disposed of. In Quill it was numerous catalogs and a few floppy disks. In AOL, it must have been the ubiquitous “free 100 hours of AOL” CDs. - - 52 - - capacity to carry data between different geographic points to provide nationwide, or worldwide connectivity.
Each IRU was a unique contract conferring certain rights of use on the holder. The original owner of the fiber typically retained title to the fiber, as well as the risk of loss or damage caused by the trench in the street into which the fiber had been laid. That original owner, the IRU-seller, promised the IRU-purchaser to carry a certain amount of data across the fiber for a certain number of years into the future. The magnitude of the IRU was denominated in the number of terabytes of data that would be carried, but no commitment would be made regarding which specific strand of fiber would “belong” to the IRU-purchaser. The IRU-seller retained the right to substitute strands, and even to substitute routes, so long as the data was delivered from point A to point B in Internet real time. IRU’s were the technological equivalent of time-sharing, conferring the right of carriage without specific ownership.
IRU-purchasers usually depreciated the rights they acquired as if they were property, sometimes using accelerated tax depreciation methods normally reserved for tangible personal property. They also assumed the obligation to pay property taxes on the fiber, even though it was often unclear at the time of the swap to which political subdivision those taxes might eventually be payable. The tax benefits of the depreciation and the costs of the property tax were rarely determined in an IRU swap – the parties merely decided whether the buyer or the seller would bear the ultimate cost or receive the ultimate benefit. Tax indemnification clauses were usually included, many with parties that have since become insolvent.
The optical fiber IRU swaps were a short-lived phenomenon of the technology boom at the turn of the century. Lawyers and accountants will be sorting out the consequences of the swaps for many years. In retrospect, it is unclear whether IRUs were property rights or service contracts. It may be some time before the appropriate tax and financial accounting treatment of these transactions is finally known.
§ 5.32 Federal Tax Provisions
Generally, for federal taxation purposes, there are no special exemptions for transactions conducted over the Internet. The federal income tax rules apply to Internet services or electronic - - 53 - - commerce in the same manner that they apply to any other provision of goods or services. Thus, income received by any business, whether or not the receipt of that income is associated with the use of the Internet, is includible in that business’ income for federal income tax purposes.
In addition, access to and transactions conducted on the Internet are subject to generally applicable federal excise taxes, such as the communications tax. Present law imposes a three- percent excise tax on certain communications services (i.e., local and long distance telephone service). Thus, amounts paid for telephone service connecting users to the Internet are subject to this excise tax in the same manner as other payments for telephone service. Charges for actual Internet service are not subject to this tax, as long as the service provided does not otherwise fall within the statutory provisions governing the communications excise tax (e.g., voice quality local or toll service).
§ 5.33 State and Local Taxation
A state or local government may impose taxes on sales that occur within its jurisdiction or on the use of property within its jurisdiction under the U.S. Constitution. Forty-five states and the District of Columbia impose sales and use taxes. 31 Approximately 7,500 local jurisdictions impose these taxes.32
State and local sales taxes are levied on final purchasers, but are collected primarily through vendors. Use taxes commonly are complimentary taxes to sales taxes, imposed where vendors cannot be required to collect and remit sales tax. Use taxes typically are imposed on and collected from purchasers (who are expected voluntarily to report their use tax liability).
The authority of a state or local government to impose its sales or use tax extends to mail order sales by out-of-state vendors to residents of the state.33 There are, however, limitations on the methods state and local jurisdictions may employ to collect sales and use taxes.
31 The five states that do not impose state sales taxes are Delaware, Montana, New Hampshire, Oregon, and Alaska. In all but Alaska, no local sales taxes are imposed either. See, Congressional Research Service, RL30667, Internet Tax Legislation: Distinguishing Issues (January 11, 2001), note 6. 32 Id. at 3. 33 See, e.g., McLeod v. J.E. Dilworth Co., 322 U.S. 327 (1944). - - 54 - -
States are generally prohibited from requiring many out-of-state businesses to collect sales or use taxes by federal law and the U.S. Constitution. The three cases frequently cited as providing guidance on state tax collection prohibitions are National Bellas Hess v. Illinois, 386 U.S. 753 (1967); Complete Auto Transit Inc. v. Brady, 430 U.S. 274 (1977); and Quill Corp. v. North Dakota, 504 U.S. 298 (1992).
In National Bellas Hess, the Supreme Court held that a mail-order company could not be required to collect use taxes if the company’s only in-state activity consisted of shipping catalogs and goods from out of state by common carrier. Citing to both the Due Process and Commerce clauses of the U.S. Constitution, the Court held that sellers can be required to collect use taxes only for states where they maintain a level of physical presence known as “taxable nexus.” For purposes of sales and use taxes, taxable nexus generally requires substantial physical presence, such as property, equipment or employees located in that state. However, taxable nexus can also be found if the out-of-state business has a contractual relationship with a business that is in the state. For instance, if the out-of-state business contracts for the services of an in-state sales company to market products in that state, the out-of-state business could be liable for tax collection if the activities performed on its behalf are necessary for it to establish and maintain its market in that state.34
In Complete Auto Transit Inc. v. Brady, the Court clarified the level of nexus necessary to satisfy the requirements of the Commerce Clause. However, this case did not discuss the Due Process Clause and is typically applied to income, not use, taxes. Nevertheless, there is no reason why the Court’s analysis in Complete Auto cannot be applied to use tax cases. The Court employed a four-part test in determining when the application of a tax will satisfy Commerce Clause requirements. According to this test, any state tax must: (1) be applied to an activity with “substantial nexus” in the taxing state; (2) be fairly apportioned; (3) not discriminate against interstate commerce; and (4) be fairly related to the services provided by the state.
In Quill Corp. v. North Dakota, although the Court reaffirmed National Bellas Hess, it considered the nexus question separately under the Commerce and Due Process clauses. The
34 See Scripto Inc. v. Carson, 362 U.S. 207 (1960); and Tyler Pipe Industries Inc. v. Washington Department of Revenue, 483 U.S. 274 (1977). - - 55 - -
Court held that due process is satisfied whenever the out-of-state business’ efforts are “purposefully directed” toward the residents of another state.35 Advertising in a local newspaper or soliciting orders from the residents of a state can amount to purposeful direction. Accordingly, physical presence is not longer required to satisfy due process under Quill. Nevertheless, the Court continued to require physical presence in order to satisfy the Commerce Clause. The significance of this distinction is found in the difference between the Due Process Clause and the Commerce Clause. The Due Process Clause is a constitutional limitation on the power of government and reducing the level of that protection would require a constitutional amendment. The Commerce Clause, however, is an affirmative grant of power to the federal government. Therefore, Congress can alter the Commerce Clause by statute. Consequently, many observers view the Court’s analysis in Quill as an invitation to Congress to exercise its power to clarify the standards for remote-commerce taxation. In fact, the Court in Quill concluded by stating that “the underlying issue is not only one that Congress may be better qualified to resolve, but also one that Congress has the ultimate power to resolve.” 36
35 Quill at 298. 36 Quill at 318. - - 56 - -
Addendum Detailed Legislative History Of The Internet Tax Freedom Act Drafted and Published by the Office of Rep. C. Christopher Cox
This pulls together into one place information on the legislative history of the Internet Tax Freedom Act.
June 1996: The Idea Is Hatched Fresh off the successful February 1996 enactment of the first Cox-Wyden collaborative legislative effort, the Internet Freedom and Family Empowerment Act, Rep. Cox in June 1996 identifies the emerging issue of Internet taxation as a possibile topic for another legislative initiative. Although Internet taxation has not yet become an issue that engenders much media attention, Cox clearly sees what the future holds: the prospect of the Internet’s growth being stifled by a confusing patchwork of 30,000 state and local taxing authorities. After reading a U.S. News & World Report article entitled “Shaking Down the Net: Local Governments Seek to Tax Internet Sales and Services,” the idea is born: on June 25, Cox directs his legislative staff to put together “a bill preventing states (and feds) from taxing the Internet.”
March 1997: The Unveiling After months of preparation, Cox and Wyden are ready to unveil their bicameral and bipartisan legislation. On March 13, 1997, the two lawmakers introduce the Internet Tax Freedom Act in their respective chambers. The House bill is desginated as H.R. 1054; the Senate bill, S. 442. At the heart of the legislation is a national moratorium on Internet taxes, barring any state or local government from imposing “any tax or fee directly or indirectly on the Internet or interactive computer services or on the use of the Internet or interactive computer services.”
Cox and Wyden hold a press conference to announce their collaboration on this latest pro-Internet initiative. Cox explains that the legislation is needed not just to give the Internet time to grow and mature; he also points out that the Internet’s very technology – its decentralized, packet-switched design – makes it especially vulnerable to multiple or discriminatory taxation from 30,000 state and local taxing authorities. Wyden echoes these themes, too, in his statement: “Allowing a chaotic, helter-skelter approach to taxing electronic commerce could harm hundreds of thousands of businesses and millions of consumers.”
In a significant show of support for the legislation – and in a surprise blow to tax collectors across the nation – Cox and Wyden are joined at the press conference by a prominent state tax collector, Ernie Dronenburg, the Chairman of the California Board of Equalization, who is on hand to express support for the cause of Internet tax freedom. Dean Andal, another member of the BOE, endorses the ITFA in a separate statement. A week later, with the leadership of these two members, California’s tax board votes unanimously to give their full support to the ITFA. Cox praised the board members for their vision in willingly endorsing legislation that would preclude them from imposing new Internet taxes. - - 57 - -
Early Summer 1997: Congressional Hearings Support for the Internet Tax Freedom Act grows quickly. The bill is endorsed by dozens of consumer and taxpayer advocacy groups, Internet activists, and service and trade associations representing businesses involved in the Internet community. A significant number of far-sighted state and local officials also endorse the legislation. In April, California Gov. Pete Wilson (R) endorses the legislation, becoming the first governor to do so. In June, New York Gov. George Pataki (R) and a majority of state lawmakers in the California Assembly go on record in support of the federal ITFA.
Cox and Wyden spend the spring and summer months educating their colleagues about the legislation. By Memorial Day, Cox has gathered nearly fifty Democrat and Republican co- sponsors, including key lawmakers such as Rep. Billy Tauzin (R-LA), the Chairman of the Subcommittee on Telecommunications. On the Senate side, Wyden has gained the support of several key lawmakers, including Conrad Burns (R-MT), the Chairman of the Subcommittee on Communications.
On May 22, Burns’ subcommittee holds the first legislative hearing on the Internet Tax Freedom Act. In a notable step forward, Sen. John McCain (R-AZ), the Chairman of the full Commerce Committee, makes a surprise appearance at the hearing to endorse the bill and indicate his plans to mark up the legislation as soon as possible. The subcommittee takes testimony from Rep. Cox. In addition, the Clinton administration offers – for the first time – public support for the legislation. The administration witness, Deputy Treasury Secretary Larry Summers, tells the panel that the administration “fully supports the goals and underlying objectives of this Bill.”
The White House also incorporates support for the Cox-Wyden “no-Net-tax” approach in its “Framework on Global Electronic Commerce,” which is released on July 1. The White House report, authored by aide Ira Magaziner, expresses concern about “possible moves by states and local tax authorities to target electronic commerce and Internet access” and concludes that “no new taxes should be imposed on Internet commerce.”
On July 11, the House Subcommittee on Telecommunications holds hearings on the Internet Tax Freedom Act. In an opening statement, Commerce Committee Chairman Tom Bliley (R-VA) declares his support for the bill, explaining that “we intend to make sure that state taxing authorities do not adopt policies that burden interstate commerce.” Subcommittee Chairman Tauzin warns that “The power to tax involves the power to destroy. We should take every effort not to destroy the promise of the Internet.” In addition to taking testimony from Wyden and other supporters of the bill, the panel also hears from Texas tax director, Wade Anderson, who attempts to defend his efforts to aggressively target the Internet with new taxes. Still, the hearing shows the growing bipartisan support for the bill, as Rep. Bart Gordon (D-TN), Rep. Eliot Engel (D-NY), and other committee Democrats join with Cox in supporting the bill.
Less than a week later, on July 17, a second House subcommittee – the Judiciary Subcommittee on Commercial and Administrative Law, chaired by Rep. George Gekas (R-PA) – holds a hearing on the ITFA. Sen. Wyden and Rep. Bob Matsui (D-CA) testify in support of the bill. Jack Valenti of the Motion Picture Association of America explains that ITFA is needed, because without it “overburdensome taxation has the potential to inhibit global commerce and - - 58 - - obstruct the development of the Internet.” Another witness testifies that the bill is needed to “avoid the morass of inconsistent and incomprehensible taxation by the 30,000 localities that have the power to tax.”
Fall 1997: Committee Action Begins After Congress returns from its annual August recess, House and Senate committees are ready to begin substantive action on the Internet Tax Freedom Act. During the summer months, support continues to grow for the legislation. By Labor Day, the House bill has nearly 100 co- sponsors. And several additional state officials, including Massachusetts Gov. Bill Weld (R) and Virginia Gov. George Allen (R), have gone on record in support of the legislation’s call for a national time-out on Internet taxes.
The House acts first. On October 9, the legislation is approved by the two subcommittees which held hearings on the legislation in July – the Commerce Subcommittee on Telecommunications and the Judiciary Subcommittee on Commercial and Administrative Law. In response to the testimony and advice given at the July hearings, Rep. Cox is ready to make improvements and technical changes to the bill. He proposes a substitute amendment, which is offered and unanimously adopted in both subcommittees. Cox explains that the substitute amendment solves many of the questions raised at the hearing and contains technical changes to ensure a more precise and targeted moratorium. Most significantly, whereas the original bill would have imposed a moratorium of indefinite duration, the revised bill adds an explicit end- date to the moratorium of up to eight years.
Senate action follows less than a month later. On November 4, after a full day of debating the issue, the Commerce Committee reports out an amended version by a 14-5 vote. The revised bill adopts many of the same changes included in the House subcommittee bill, but shortens the moratorium end-date to five years.
February 1998: Clinton Endorsement Support continues to grow in the winter of 1998 for the Internet Tax Freedom Act. In the first few months of the year alone, the bill earns the endorsement of dozens of newspapers and magazines, including the Seattle Times, Los Angeles Times, Business Week, Columbus Dispatch, Wall Street Journal, Forbes, Orange County Register, Journal of Commerce, Rocky Mountain News, Washington Times, Orange County Weekly, Savannah Morning News.
On February 11, House Majority Leader Dick Armey (R-TX) joins as a co-sponsor of the ITFA, and announces that the legislation will be included on the House leadership’s list of high- priority legislation to be considered during 1998. On February 26, Virginia’s new governor, Jim Gilmore (R) endorses the Internet Tax Freedom Act, stating that lawmakers must “foster the economic growth of the Internet rather than thwart it with a patchwork of burdensome tax policies.”
Prospects for the enactment of the Internet Tax Freedom Act are further buoyed by President Bill Clinton’s express endorsement in a February 26 speech to high-tech leaders in San Francisco, California. “I support the Internet Tax Freedom Act now before Congress, because it takes into account the rights of consumers, the needs of businesses, and the overall effect of - - 59 - - taxation on the development of Internet commerce. . . We can’t allow unfair taxation to weigh [the Net] down and stunt the development of the most promising new economic opportunity in decades.”
Several days later, on March 2, Senate Majority Leader Trent Lott (R-MS) indicates that the ITFA will be considered by the full Senate in 1998: “I’m a fan of the Internet, and I never met a tax I liked.”
March 1998: Consensus With The NGA And The “Big 7” On March 10, Cox holds a press conference with senior lawmakers from California’s State Legislature who endorse the federal Internet Tax Freedom Act, and talk about the progress of a similar state statute called the California Internet Tax Freedom Act.
On March 19, Rep. Cox wins new converts to the cause of Internet tax freedom – the National Governors’ Association, National League of Cities, National Conference of State Legislatures, U.S. Conference of Mayors, and other state and local government organizations (the so-called “Big 7”), who hold a press conference to endorse a revised version of the Internet Tax Freedom Act. This is the culmination of four months of direct negotiations with state and local leaders, which began back in November 1997 with a meeting between Rep. Cox and Utah Gov. Mike Leavitt (R).
In order to get state and local officials to drop their opposition, the ITFA is changed in several respects: the legislation has a shorter moratorium (three years); state and local governments are permitted to keep any taxes they may have already collected on Internet access; and an advisory commission on which state and local officials will serve is created to provide advice to Congress on Internet tax issues. Notwithstanding these compromises, Cox notes that the bill’s fundamental purpose remains intact: to ensure that the “Internet is not a place where the tax vultures will descend and start creating new ways to collect money that don’t presently exist.”
Spring 1998: The ITFA Moves Through The House In the wake of the March 19 endorsement by state and local leaders, the ITFA can move more quickly through the legislative process. The first House committee to act on the revised legislation is the House Commerce Committee, which is chaired by Rep. Tom Bliley (R-VA) and on which Rep. Cox serves. Chairman Bliley strongly supports the bill, declaring that “[a]s electronic commerce emerges as the new marketplace for the 21st century, it’s important that we keep the Internet free from unnecessary taxation and regulation.” With Chairman Bliley’s leadership, the revised version of the ITFA is approved by the Commerce Committee on May 14 by a unanimous 41-0 vote. On June 17, the Judiciary Committee is ready to follow suit, and approves virtually identical legislation by voice vote.
To resolve jurisdictional differences that have arisen between the two committees, Rep. Cox introduces a new bill, H.R. 4105, that combines the two separate, yet substantively indistinguishable, bills into one unified whole. On June 23, with the support of both committee chairmen, this consensus legislation is brought up on the House floor. During debate, there is no vocal opposition to the bill; all sixteen speakers express support for the measure, and as a result - - 60 - - the bill is approved by voice vote. In his floor statement, Rep. Cox aptly sums up the aim of the bill: “As we enter the Information Age, the digital age, we are establishing in law a very important principle; that information should be made available as freely and widely as possible throughout the world – it should not be taxed.”
The same day as the House vote, former British Prime Minister Margaret Thatcher gives a speech to the World Congress on Information Technology warning against government taxation of information technology and the Internet.
Late Summer 1998: One More Hurdle--The Senate Notwithstanding the House’s unanimous approval of the Internet Tax Freedom Act, there is still significant work to be done to move the bill through the Senate. In fact, a handful of hard- charging Senators – led by Sens. Bob Graham (D-FL) and Dale Bumpers (D-AK) – are preparing to do all they can to stop the bill from becoming law.
Even though Sen. Wyden’s companion legislation (S. 442) has already been approved by the Commerce Committee, a secondary committee of jurisdiction, the Finance Committee, asserts jurisdiction over the legislation. As a result, on July 16 yet another hearing is held on the issue, so that the Finance Committee can take testimony from Rep. Cox, Sen. Wyden, Treasury official Joseph Guttentag, and other interested parties. Connecticut Senator Joe Lieberman (D) also announces at the hearing that his state’s Governor, John Rowland (R), is volunteering to fully comply with any Internet tax moratorium. Less than two weeks later, on July 28, the Finance Committee makes changes to S. 442 so that it resembles the House-passed bill, and approves the bill on a 19-1 vote.
After adjourning for the month of August, the full Senate returns in September ready to consider the legislation. Senate debate is extremely contentious and lasts more than two weeks, as Sen. Graham and a handful of other opponents use every procedural tool at their disposal in an attempt to block consideration of the measure. On two separate occasions – September 29 and October 7 – the Senate is forced to invoke cloture in order to prevent Sen. Graham from filibustering the legislation.
During debate on the bill, several pro-tax amendments are defeated. First, the Senate defeats, on a 66-29 vote, an amendment offered by Sen. Bumpers that would overturn the Quill case and compel Internet merchants and other out-of-state businesses to collect taxes on all their interstate sales. The Senate also defeats, on a 83-15 vote, an amendment offered by Sen. Graham that would have required a supermajority vote for a future Congress to extend the Internet tax moratorium past October 2001.
Finally, after two full weeks of vigorous debate, the active stewardship of Sens. Wyden and McCain pays its dividend: on October 8 – in one of the final recorded votes of the entire 105th Congress – the Senate approves the Internet Tax Freedom Act by a 96-2 vote.
October 1998: The Bill Becomes Law To ensure the law’s quickest possible enactment, House and Senate leaders decide to include the Senate-passed version of the Internet Tax Freedom Act in the Omnibus - - 61 - -
Appropriations bill, a must-pass measure needed to keep the government running during the 1999 fiscal year. The Internet Tax Freedom Act is included as Titles XI and XII of the omnibus appropriations bill, which is approved by the House and the Senate on October 20 and signed into law by President Clinton on October 21. With the President’s signature, the Internet tax moratorium officially takes effect. Under the terms of the law, it will remain in effect from October 1, 1998 until October 21, 2001.
In looking back at the achievements of the 105th Congress, many observers rank the Internet Tax Freedom Act as one of the most substantive accomplishments. The new law is described as “historic” by ABC News and as one of Congress’ most significant achievements by Congressional Quarterly. The law is also called the “most important tech issue” of the 1997-98 session by the Tech Law Journal, and the “most cherished political goal” of high-tech companies worldwide by the London Financial Times.