July 07, 1999 | Legal Times

Internet Tax: An Uncharted Sea

5 min

The rise of e-commerce poses intriguing legal questions, of which Internet taxation is one of the hottest. As with all e-commerce issues, some of the old laws apply easily, some need tweaking, and other transactions don't fit any current model.

Let's say you set up an e-commerce business. You are located in Washington, D.C.; the server that processes the transactions is located in Pennsylvania; the fulfillment house that you use to complete the orders is in Kansas; and you are shipping into all 50 states. Whose tax laws will apply to the transaction? Will one state's law supersede the others? What type of products will be subject to tax? Which forms of tax will you have to worry about?

As companies get into e-commerce, they are changing their business methods. While in the past they have done business out of one central or regional location, they now have to deal with national or international sales and will probably establish fulfillment distribution facilities in a number of places.

The location of even one server may be enough contact to have an impact on tax liabilities. Although the mere presence of a fulfillment house in Kansas will probably not make you liable for sales or use tax there, if you own a server and property or inventory at the fulfillment house, the result would likely be different. If your server is in a jurisdiction where you fill orders, you might become subject to sales tax liability in that state. There may also be inventory or personal property tax issues there.

What about sales tax where your customers reside? Merely shipping into a state, with no other contacts, would probably not obligate you to collect sales tax for those states. However, attending trade shows and sending salesmen there might well subject you to that obligation. It would be prudent for an e-commerce business that sells in various jurisdictions to analyze state laws to see how aggressively the states interpret their statutes and what have been held to be the minimum contacts for tax liability.

Another new factor in e-commerce is that manufacturers are now selling directly to retail customers. In the early days of online business, manufacturers shied away from selling online for fear of alienating distributors and retailers. Their sites were merely online brochures with directions on how to contact a local distributor. Today, more and more manufacturers sell directly on the Web. To placate their distributors, they often provide some form of fee sharing, service sharing, and/or referral basis.

Will these arrangements subject manufacturers to the collection of sales tax and have other tax ramifications in the locations where their distributors and retailers are located? Do these relationships provide the necessary contacts for the state to impose tax liability? These are open questions.

There is also the issue of what goods are subject to tax. Services and intangibles are generally not subject to sales tax, while tangible personal property is. It was long ago decided that even though the main value of a recording is in the intellectual property, not the few cents' worth of plastic or tape, the whole product is subject to sales tax. For computer software, the sale of off-the-shelf software subjects the whole package to sales tax, while custom-designed software is generally not subject to a sales tax as it is considered a service.

What about online electronic distribution of intellectual property? If one downloads music, a book, a movie, or software and there is no physical component in the transaction, all that is being licensed, leased, or sold is intangible intellectual property. Is it subject to sales tax?

In an effort to prevent the states from overtaxing the Internet and stifling e-commerce, Congress passed the Internet Tax Freedom Act in October 1998.

The legislation was designed to "establish a national policy against state and local interference with interstate commerce on the Internet or interactive computer services."

While many applaud the act, many scholars have criticized it for poor draftsmanship, large loopholes, and broad ambiguities. Even the advisory committee that was authorized to issue a report under the act was immediately embroiled in controversy. State and local governments felt that business interests were too heavily represented. As a result of a lawsuit, some members resigned in order to establish a more balanced panel. The suit was dropped, and now the commission can begin its work.

The act bars three categories of taxes: (1) taxes on Internet access, except those that were enacted and enforced prior to October 1998; (2) multiple taxes on electronic commerce; and (3) discriminatory taxes on electronic commerce. This moratorium is to last for three years, with the advisory commission study due in 18 months.

Some of the problems arise from the definitions. For example, the forbidden class of taxes on Internet access can easily be read to include taxes on monthly fees of ISPs like America Online. However, Internet access charges often include telecommunications services, which are not exempt. The problem is likely to come up more frequently as providers bundle their products, providing telecommunications as well as Internet services. What can be taxed and what cannot remains open to question.

The multiple tax definition clauses are also somewhat confusing. Multiple tax is defined as "any tax that is imposed by one state on the same or essentially the same electronic commerce that is also subject to another tax imposed by another state without a credit for taxes paid in other jurisdictions." It would appear that Congress' intention was to prevent one electronic transaction from being subject to tax by more than one state.

However, the language opens up a Pandora's box of interpretations. It would also seem that two states could tax the same transaction if it is not imposed on the same basis.

If nothing else, the act puts states on notice that there is a federal policy against Internet taxation that will in any manner hamper the Web's development. The statute will probably cause states to think twice before imposing special Internet taxes.