Tax Policy Issues
E-Commerce Location Planning
Tax Compliance Software
Exhibit 1. Useful Web Sites for State and Local Taxation of Electronic Commerce
Exhibit 2. Taxation of Internet Sale by Vertex
Exhibit 3. Internet Tax System Flow Chart by Taxware
As anyone not hidden under a rock knows, thousands of businesses are selling goods and services through electronic commerce, including the Web and private electronic networks. Selling through electronic commerce is a rapidly growing channel for sales to both retail consumers and businesses.
Since about one-quarter of all state and local revenue comes from sales, use, and gross receipts taxes, the state and local governments are eager to avoid losing any tax revenue to electronic commerce. Traditional brick and mortar stores on Main street, however, now face heightened competition from electronic commerce sellers who are not collecting sales tax.
A major problem is that most existing state and local tax law is based on transactions with physical products and services. The state and local governments and taxpayers are struggling to apply prior law to electronic commerce systems that cross traditional geographic and industry boundaries at a rapid rate.
Currently, there are over 36,000 state and local taxing jurisdictions in the U.S., ranging from states to local improvement districts. Approximately 7,000 of these jurisdictions impose sales and use taxes. Each state and local jurisdiction has variations in the way these concepts are applied.
Sales Tax.A sales tax is generally levied on the sale or transfer of tangible personal property (TPP) or certain enumerated services. Tangible personal property is physical property that is not permanently affixed to real property. For example, TPP sold through electronic commerce includes clothing, electronic devices, and books. Jurisdictions that levy sales tax generally tax all sales of TPP unless the statute provides for exemptions.
Enumerated services are sales of services that the jurisdiction's statutes specifically define to be subject to sales tax. For example, most states do not tax information services, but the Texas sales tax statute, and those of a few other states, specifically include information services. If a service is not enumerated in the statute, it is exempt from sales tax. Some services, such as telecommunications, are subject to additional sales taxes not in the general sales tax statutes.
Electronic commerce involves many products that are not readily classified under the existing sales tax statutes. For example, music sold on a compact disc is TPP, but that same music downloaded from a Web site and stored on a hard drive is usually not considered TPP. What about software downloaded from the Web site where the seller allows customers to order a back-up copy on a compact disc? How should the seller allocate the sales price between the intangible download and the tangible disc?
Consider a more complex case where a customer buys a bundled product consisting of software downloaded through the Internet, a disc sent by common carrier, information services delivered by either the Internet or telephone, and on-site training. Potentially, that one sale could include TPP, enumerated services, and exempt services; when the disc is sent to one state and the information services are sent to several others with radically different sales and use tax laws, the complexity and chances of multiple taxation are enormous.
The existing laws cover relatively simple situations, such as an automobile repair bill that includes both taxable parts and nontaxable services. Electronic commerce often involves much more complex bundles of goods and services, delivered to numerous jurisdictions. Customers may be offered several options in how they receive the goods and services.
Nexus. A sufficient connection, or nexus, is required between the parties to a transaction for the state or local taxing jurisdiction to have the legal authority to tax the transaction. Generally, nexus for sales tax purposes is determined by the physical presence of the seller. Determining nexus for some types of transactions, however, is extraordinarily difficult, and has been the subject of thousands of administrative rulings and judicial opinions. Transactions could have nexus in a particular state for income tax purposes, but not sales tax purposes. Determining nexus for electronic commerce transactions can be difficult when the transaction involves communication among servers located in different states.
Use Tax. A use tax is a tax on the receipt, possession, consumption, storage, or use of property. All jurisdictions that have sales taxes have enacted use taxes to cover transactions where no sales tax is collected. For example, if a sale of consumer goods is subject to a 5% sales tax when the sale takes place within the state, the state will enact a 5% use tax on sales of that same type of merchandise by an out-of-state seller to an in-state customer. Most consumers and many businesses are not aware of their legal responsibility to pay use tax on purchases from out-of-state sellers. Although many state and local governments choose not to collect use tax from individuals, they regularly audit and assess businesses for failure to remit use taxes.
For many years, the state and local governments have sought to require large vendors using direct mail for telemarketing to collect use tax when they sell to customers. In Quill Corp. v. North Dakota, 504 U.S. 298 (1992), the Supreme Court held that a state cannot compel a seller to collect sales or use tax unless that seller has a physical presence in that state. Quill was a victory for direct-mail merchants, but the state and local governments have not given up. For example, New York wishes a catalog seller based in Maine would collect use tax on sales to New York consumers. The merchant based in Maine with no physical presence in New York relies on Quill to avoid collecting use tax on sales to New York customers. Although the out-of-state seller may have no legal obligation to collect use tax, the states argue that the out-of-state sellers gain an unfair competitive advantage over in-state sellers.
The rapid growth of electronic commerce has exacerbated the state and local governments' long-standing feud with out-of-state sellers. The governments fear the quantity and range of goods and services sold via electronic commerce will provide even more possibilities to evade use taxes. Although various studies show that the states have not yet lost much of their tax base to electronic commerce, they are fearful of what may happen in the future.
Exemptions. Numerous transactions are exempt from sales and use tax due to legal exemptions enacted by legislatures. Transactions may be exempt because a state has declared a sales tax holiday for a limited time. Products, such as food and medicine, may be exempt for social policy reasons. Customers, such as out-of-state consumers, federal government agencies, and charitable organizations, may be exempt from some sales and use taxes.
Wholesalers do not collect sales tax when the purchaser submits a valid resale exemption certificate stating the sales tax will be collected when the product is sold to final consumers. States may also provide exemptions for manufacturing equipment, research and development investments, businesses in low-income enterprise zones, and a host of other specified purposes. In some situations, the media of delivery, such as Internet versus a disc, can change the sale from nontaxable to taxable.
Sellers with nexus in a state that charge sales tax have an obligation to collect sales tax on all sales within that state unless they can produce adequate documentation or other proof to show that the sale is exempt. For some exempt products, the seller's own internal records can be adequate proof of exemption. For other exempt transactions, such as sales to exempt organizations or resellers, the seller is obligated in some states to obtain a signed exemption certificate from the buyer and maintain exemption certificate files for the state or local tax auditors.
A traditional retail store manager in one physical location may need to know only about the exemption certificate rules that apply to sales in that particular state and local jurisdiction. Interstate sellers using electronic commerce of direct mail, however, potentially need to know about the exemption certificate rules in any of the 7,000 jurisdictions that have a sales tax.
State and local taxation of electronic commerce is a hot topic in tax policy. State and local governments wish to prevent any erosion in their tax bases so that they can finance government expenditures without tax rate increases. Many businesses wish to expand their electronic commerce sales and purchases without increasing tax compliance problems. To follow the latest in the electronic commerce tax debates, check out some of the tax policy Web sites listed in Exhibit 1.Each jurisdiction has its own tax rates, and many of them use different rules to determine what is taxable or exempt. Many states collect and administer sales and use tax on behalf of the local jurisdictions. Alabama, California, Colorado, Louisiana, and some other states, however, authorize some cities, counties, and other local jurisdictions to administer their own sales and use taxes. Businesses find it difficult to keep up with the thousands of changes in tax rates, tax bases, and tax forms that occur throughout the U.S. every year. Exhibit 2 shows how each state picks its own mix of Internet sales to tax or exempt.
In 1997, the National Tax Association began its Communications and Electronic Commerce Tax Project ("Project"). The goal of the Project was to bring together a wide range of representatives to identify issues involved in applying state and local taxes to electronic commerce and to make recommendations to state and local tax officials. The Project Steering Committee consisted of 39 members: 16 from business, 16 from government, and seven from various associations and universities. The Project issued a final report on 9/7/99 that described various issues, but was unable to reach a consensus on recommendations. The inability of the Project to reach consensus suggests that future proposals to simplify electronic commerce tax policy will face significant opposition.
During the early stages of the Project's work, there was substantial consensus among the government and business representatives regarding the need for radical simplification in the application and administration of the states' varying sales and use tax laws. In July 1998, the project representatives, including all but one of the local government representatives, voted to support a requirement of a single sales and use tax rate for each state for all commerce. The government representatives, however, then made it clear that in exchange for radical simplification (including the single rate per state rule), they expected the business community to support a congressional override of Quill (and thus governments could require vendors with no physical presence in the state to collect that state's use tax on sales to that state's residents). The business representatives responded by noting that they would consider supporting an override of Quill only in the context of radical sales and use tax simplification plus clear, strong safe harbors from business activity taxes (income, franchise, etc.) for businesses with only minimal presence in a state. At that point, productive discussions of tax simplification broke down.
In 1998, the U.S. Congress passed the Internet Tax Freedom Act, Public Law 105-277, Division C, Title XI ("Act"). The Act provides a three-year moratorium on state and local governments from enacting any new taxes specifically on Internet access. States that imposed Internet taxes prior to 10/1/98 are allowed to continue collecting these taxes; however, some of those states have decided to eliminate or phase out taxes on Internet access. The three-year moratorium also bars state and local governments from imposing multiple and discriminatory taxes on electronic commerce.
Many electronic commerce transactions remain subject to sales and use taxes. For example, an electronic commerce merchant with nexus in the states that imposed Internet taxes before 10/1/98 would still be obligated to collect sales tax in those states. The Act also declared the sense of the Congress that there should be no federal transaction taxes on Internet access or electronic commerce.
The Internet Tax Freedom Act established a 19-member Advisory Commission on Electronic Commerce (ACEC) to make recommendations on electronic commerce tax issues. The ACEC members consist of representatives from business and local, state, and federal governments. The ACEC is required to report its findings to Congress in April 2000. The discussions during the initial ACEC meetings suggest that, similar to the NTA Project, it may be unable to reach a consensus on major policy recommendations.
Numerous other proposals on the taxation of electronic commerce and direct-mail marketers will be discussed during the next election campaign cycle. In July 1999, Senator Ernest Hollings introduced S. 1433 to impose a 5% national retail excise tax on all Internet and direct mail sales. Although tax practitioners can hope for simplification and consistency among the jurisdictions, the most likely outcome is a continuation for the existing complex sales and use tax system.
Because sales and use taxes depend on the location where products are sold and used, understanding the siting of electronic commerce activities is crucial. There are 15 possible locations where activities may take place in a complex electronic commerce transaction:1. Buyer.
2. Buyer's Internet service provider.
3. Electronic commerce mall Web site.
4. Seller's Internet service provider.
5. Sales authorization center.
6. Credit authorization.
7. Shipping warehouse.
8. Common carrier to deliver product.
9. Buyer's temporary storage warehouse.
10.Buyer's accounts payable.
11.Buyer's operating facility.
12.Seller's technical support.
14.Resale to final consumer.
15.Delivery to final consumer.
Although many electronic commerce transactions involve fewer than 15 locations, it is not uncommon for the transaction to involve four or more locations. Since the Internet makes it possible to move information very quickly between locations, these activities can be performed in remote locations. Each different location potentially has different sales and use tax laws and rates.
Many electronic commerce merchants seek ways to reduce their sales and use tax collection responsibilities to the lowest possible level. Some electronic commerce merchants locate their sales centers in states, such as Oregon, New Hampshire, or Montana, that do not have any sales and use tax. Many states shown in Exhibit 2 do not tax downloaded software or information services.
Oregon is a particularly popular tax haven for software. Some large companies arrange to purchase software for delivery in Oregon, load the software on to servers located in Oregon, and then transmit copies to servers in other states. Oregon collects no sales or use tax. Users in some states, such as California, are exempt when they download software from the Oregon server. Users in other states, such as Texas, are subject to use tax when they download the software.
Other tax havens are located outside the U.S. One possibility is to locate the sales point to a server on an outer-space satellite.
States are very aggressive about finding ways to determine whether a business has nexus. If any division of a corporation has physical presence in the state, governments argue that all divisions of that corporation have nexus with that state and all its cities. For example, suppose a corporation locates its electronic commerce sales center in Oregon, but has one employee performing installations in one California city. In this example, the corporation has nexus with California for all sales. If the transaction is structured as the lease of tangible personal property or real property, the merchant has nexus with every state where that property is located. Leasing a single telecommunications switch in a state might be sufficient to establish nexus with all jurisdictions within that state. To determine if an out-of-state business has nexus, state revenue officers may scour the Web site or sales literature of the business to find any references to manufacturer's representatives or installers located in that state.
The formation of separate legal entities is another strategy to avoid nexus. For example, a manufacturer of electronic components could have plants in several states, but arrange all retail sales to be made by a separate subsidiary corporation located in a tax-haven state. Businesses attempting this strategy must be extraordinarily careful to avoid locating any employees or property outside the tax-haven state. Strategies of the tax planner may be undone by marketers unaware of the tax consequences. Some states assert an affiliate nexus theory that finds nexus for a corporation if any of its affiliated entities have nexus.
The location of the Web-hosting service is easily overlooked. Many businesses lease space for their Web sites on a Web-hosting service whose server is located in some other state. The physical location of the Web host could be determined by scouring the publicly accessible records of domain name registration services, such as Network Solutions, Inc.
Determining tax due. Determining the sales or use tax on a particular transaction is often difficult. Tax analysts need to consider these questions:
1. What is being transferred?
2. What payment or other consideration is coming from the purchaser?
3. What is the payment schedule?
4. Which jurisdiction's laws govern the contract?
5. Is the contract a lease or purchase?
6. Where does title transfer?
7. On what day does title transfer?
8. Who moves the goods?
9. What is the intended use of the product?
10.Will some or all of the product be resold?
11.On what day does use begin?
12.Where does use take place?
13.Which sales, use, excise, gross receipts, or business occupation tax laws are relevant?
14.Do any exemptions apply?
15.Is a proper exemption certificate provided by the purchaser?
16.If two jurisdictions tax the same transaction, is a credit provided by the second jurisdiction for taxes paid to the first jurisdiction?
17.If taxable, who is responsible for collecting tax?
18.What is the taxable amount (tax base)?
19.What are the applicable state and local tax rates?
20.When is the tax return due?
All the types of goods and services being sold by electronic commerce should be reviewed by a competent analyst. Many states issue letter rulings, regulations, or other administrative pronouncements that determine the taxability of various goods and services.
Location of sale. Knowing the exact location of sale or use is essential to the proper determination of sales and use tax. Some electronic commerce sellers do not require the buyer to reveal his or her physical location. For example, customers downloading music or software may be required to provide only a valid credit card number on the seller's Web site. The credit card billing address which the seller sometimes gets validated, might not be the location where the product is delivered. Some electronic commerce merchants are experimenting with "virtual cash," similar to telephone calling cards or debit cards whereby the merchant is paid by the issuer of virtual cash without ever needing to know the customer's name.
Taxing jurisdiction. The boundaries of many local taxing jurisdictions are not the same as city or county boundaries. In many urban areas, the sales tax rate includes components for the state, city, and another local taxing authority. For example, local transit authorities and crime control districts may include only limited parts of a city. Standard five digit postal zip codes are not adequate to determine local taxing jurisdictions. Over 3,000 jurisdiction boundaries change each year as cities and local authorities expand. Some of the software publishers listed in the bottom section of Exhibit 1 have tables that identify local taxing jurisdictions by nine-digit zip codes or special geocodes; none of these systems are perfect, however, due to the intricacies of jurisdictional boundaries.
Enterprise zones are even more complex. States authorize the creation of enterprise zones to encourage business development in economically disadvantaged areas. The boundaries of an enterprise zone rarely coincide with other local boundaries. Numerous special tax incentives provide relief from state and local taxes for businesses that move to or expand in an enterprise zone. For example, a research and development business that locates a new facility in an enterprise zone might be exempt from use tax on equipment.
The task of sales and use tax compliance for 7,000 jurisdictions may seem overwhelming. Since hundreds of state and local tax rates change every year, the rate tables must be updated frequently. Fortunately, tax compliance software vendors have developed many different applications to assist businesses. Six of these software vendors are listed in the bottom of Exhibit 1.For businesses whose transactions are concentrated in a few geographic areas, it may be possible to rely on the tax rate tables published by the state revenue department's Web sites or printed tax bulletins. Electronic commerce businesses need comprehensive nationwide tables that are frequently updated.
Sophisticated sales and use tax compliance applications are available from Vertex and Taxware (see Exhibit 1). These applications are loaded with very large databases of taxability determinations and tax rates by customer, product type, and location. The electronic commerce merchant's server transmits the customer's billing address, delivery address, and product type to these applications that determine amount and jurisdiction of sales tax on each transaction. At the end of each month, these applications generate the tax returns that must be filed with each jurisdiction.
The Taxware Internet Tax Flowchart shown in Exhibit 3 illustrates one way that electronic commerce merchants can comply with sales tax laws. These merchants can join electronic malls where the mall operator provides sales tax compliance, credit verification, and delivery management services for a fee. The merchant can promote its products through either the mall's Web site or through the merchant's own Web site. When sales are made, they are routed through the electronic mall software for determining the correct sales tax to bill the customer. The merchant pays the mall operator fees determined by month, per transaction, or per dollar of revenue.
Many state and local governments are using the Web to assist taxpayers with tax compliance. Nearly all states and some large cities provide their forms and instructions on free Web sites. Some go even further and allow monthly or quarterly sales and use tax return filing through a secure Web site.
Government tax auditors have substantial power to assess taxpayers without adequate records. For example, the auditors know that many businesses do not maintain adequate records of their sales down to the local taxing jurisdiction level. When a business is unable to produce complete records that show exactly where every sale took place, the auditor may make a rough estimate of the unpaid local taxes and slap the business with a large assessment.For example, some electronic commerce sellers keep track of the current billing address of their customers, but do not maintain complete files of the delivery address for all past sales. If a business does not have adequate records of the sales or use location, the auditor may apply a throwback rule that sweeps all unidentified sales back to the place where the sales agents were located.
Exemption certificates. Sellers must also maintain files of exemption certificates to show the auditor. Some states have specific forms and compliance rules for exemption certification, while other states are much less restrictive. Obtaining and storing exemption certificates can be a significant problem for electronic commerce merchants. If they do not accept any exemption certificates, they may lose sales from customers who chose to buy from other vendors who do accept the exemption certificates.
If the merchant is too casual in accepting the customer's assertion of exemption, the state auditor may deny the exemption and assess sales tax, penalty, and interest during an audit. Some states are beginning to allow electronic exemption certificates, thus allowing sellers to eliminate maintaining paper exemption certificate files.
Limitations period. All taxing jurisdictions have a limitations period for the assessment and refund of sales and use taxes. This period is generally three to five years after the return is filed and the tax is paid. Once an audit or refund claim begins, the taxpayer and government may agree to extend the limitations period. If the taxpayer does not agree to an extension, the auditor could decide to issue an arbitrary estimated assessment immediately or to deny the refund arbitrarily.
When the extensions are in place, the auditor and taxpayer may be working with records for transactions that occurred more than three years ago. Some sales and use tax audit appeals drag on for more than ten years after the transactions took place.
If a taxpayer never filed a tax return for a particular time period or jurisdiction, the limitations period never begins to run, and the taxpayer is potentially liable for tax on transactions back to the beginning of the business.
Sales and use taxes are not the only taxes that must be considered in electronic commerce. All states except Nevada tax the profits or gross receipts of some businesses. Rules for business activity taxes (corporate income, franchise, gross receipts, or business and occupation taxes). For example, in California, the corporate franchise tax is administered by the Franchise Tax Board, and the sales and use tax is administered by the State Board of Equalization.
Income tax. State business activity tax liabilities depend on formulas that may consider the sales, payroll, or property a taxpayer has in the state. Computing the sales, payroll, and property factors for an electronic commerce business is particularly difficult since the activities could occur on servers in many different locations. For example, electronic sales activities may take place on different servers located in several different states, and it might be difficult to determine how to compute the relative share of activities in each state.
Property tax. For some businesses, property taxes can be a problem. Each state and local taxing jurisdiction has its own rules for real, personal, and intangible property. Some of the equipment and intellectual property used in electronic commerce is particularly difficult to value. Government tax assessors may attempt to shift the valuation of an electronic commerce business from intangible to tangible personal and real property. The taxpayer's valuation experts may argue that most of an electronic commerce business is in its intangible intellectual property and not subject to property tax.
Payroll tax. Also, payroll taxes and information returns can be a problem. Companies may employ application programmers located in other states to do work on their Web site, and the payroll administrator might inadvertently fail to file all required state and local payroll tax returns. Some cities, such as Philadelphia and New York, aggressively seek income taxes from any consultant performing services within their boundaries. Both federal and state governments attempt to reclassify independent contractors as employees.
Federal and international issues. Although this article is limited to state and local taxation, there are also many federal and international tax issues to consider. Some electronic commerce providers will be responsible for remitting sales and use tax to domestic states and value-added tax (VAT) to foreign countries.
Unclaimed property compliance is overlooked by many businesses. All states have laws that require unclaimed payments, deposits, and other valuable items to be turned over to the state after some specified period, such as three to five years. For example, suppose an electronic information service creates depository accounts for customers such that the customer deposits cash into an account, and the merchant reduces the available balance as the customer downloads information. If the account is inactive for more than three years, the unclaimed balances must be turned over to the appropriate state agency.
States publish lists of individuals and entities with unclaimed property. Failing to remit this unclaimed property to the state can result in large penalties and interest.
The taxation of electronic commerce is a rapidly evolving topic. Administrative systems must constantly respond to new ways of doing business. Complying with existing state and local tax law based on physical boundaries is particularly challenging for electronic commerce merchants whose activities can take place on different servers scattered across many taxing jurisdictions. Although many tax policy advocates long for simplification, tax practitioners must implement tax compliance systems for the complex laws that exist today.