Awaiting the Internet Tax Man

Business and government leaders hope to strike a deal to impose sales tax on E-commerce in exchange for a simpler system.
Ian SpringsteelSeptember 1, 1999

Life in the virtual world of E-commerce may soon encounter a cold reality – the introduction of state and local taxation. Currently, businesses selling remotely- whether online or by phone and mail – aren’t required to collect state or local sales taxes unless they have a physical presence in a buyer’s state. But a blue-ribbon federal commission seeded with top CEOs, three governors, and key interest groups is set to debate whether to recommend that federal lawmakers overturn that “nexus” standard – the physical-presence requirement – which will require businesses to collect sales taxes from all consumer sales.

The group, officially known as The National Advisory Commission on Electronic Commerce, was created by last year’s Internet Tax Freedom Act and charged with recommending to Congress what, if any, future taxes should be allowed on Internet access or sales. Instituting such taxes, however, would mean overturning the U.S. Supreme Court’s 1992 Quill v. North Dakota decision -which established the current nexus requirement – and undoing the tax-free advantage enjoyed by most online and catalog sellers. Moreover, it would place sales tax collection burden squarely on E-commerce sellers.

To balance that increased collection duty, several business representatives are pressing for a major simplification of sales tax rates and compliance. “As one of the largest direct sellers of computers on the Web, we’re in a unique position of collecting sales tax in all the states that have one, because of our Gateway Country centers, and other business practices,” says John Heubusch, vice president of government affairs at North Sioux City, South Dakota­based, $7.7 billion Gateway Inc., which has a seat on the commission. “Many of our competitors, through various accounting and legal maneuvers, don’t collect sales taxes. We’d just like to see an even playing field, so that all businesses are neutral on this issue.”

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Many Internet retailers, however, are far from neutral. They point to studies, such as one done by Austan Goolsbee, an associate professor of economics at the University of Chicago, that suggest that applying sales taxes to online purchases would reduce the number of buyers by 24 percent and the amount of online spending by up to 30 percent. If such figures were to hold true in a post-Quill reality, E-commerce retailers could see dramatic slowdowns in revenue growth. In addition, such companies would be required to install complex sales tax collection and remittance software.

As a result, the recommendation to overturn Quill “will be the most divisive issue the panel will deal with,” says William McArthur, a partner at PricewaterhouseCoopers LLP, and former executive director of the Committee on State Taxation. “Everyone has a different price tag for Quill. Some businesses would gladly give up Quill if they [gained] significant simplification. Others are going to fight this every step of the way.”

Perception vs. Reality

The 19-member commission, which met for the first time in late June, is slated to submit its recommendations to Congress no later than April 2000. But the ideas it’s debating are far from new.

“This is old wine in a new bottle,” insists Richard Prem, a partner for multistate tax at Deloitte & Touche LLP in San Francisco. “States have been fighting for 30 years to get mail order and telemarketers to collect sales taxes,” he explains, adding that the Quill decision was actually based on a mail-order situation. All that has changed, he says, is the emphasis. “E-commerce has shone a bright spotlight on this issue and brought high-level attention to the problem.”

The staggering growth in E-commerce, after all, is hard to ignore. Consumer sales over the Internet, in fact, were about $10 billion last year, according to Forrester Research, and are expected to reach $100 billion by 2003. And business-to-business commerce is expected to be $1.3 trillion at that time.

To states and localities hungry for revenues, the booming E-commerce sector represents a lost opportunity. In reality, however, taxes currently lost only to Internet sales are minuscule. Washington State, whose governor, Gary Locke, serves on the commission, lost just $8 million to $35 million of sales taxes to Internet retailers in 1998, a tiny percent of the state’s $6 billion in annual state and local sales tax collections, according to Washington Department of Revenue estimates. Nationwide, the amount lost to online sales was about $170 million in 1998, says Thomas Neubig, national director, policy/economics, at Ernst & Young LLP, which recently published a study on the issue.

To states and localities hungry for revenues, the booming E-commerce sector represents a lost opportunity. In reality, however, taxes currently lost only to Internet sales are minuscule. Washington State, whose governor, Gary Locke, serves on the commission, lost just $8 million to $35 million of sales taxes to Internet retailers in 1998, a tiny percent of the state’s $6 billion in annual state and local sales tax collections, according to Washington Department of Revenue estimates. Nationwide, the amount lost to online sales was about $170 million in 1998, says Thomas Neubig, national director, policy/economics, at Ernst & Young LLP, which recently published a study on the issue.

“So far, the impact of the Internet on lost sales taxes is very small, just one-tenth of one percent of total sales-tax collections,” says Neubig. That’s partly because 80 percent of the $100 billion or so of online sales last year were business-to-business. Some of these transactions were not taxed, because of resale and manufacturing exemptions. In other cases, the taxes were captured through voluntary business compliance with use-tax payments. “Our experience, and that of the states, is that businesses are highly compliant with use-tax payments. They are audited too often, and the penalties are too high, not to do so,” says Neubig.

Still, states are hoping to use the headline value of E-commerce and the threat of special taxes on Internet access and sales (see sidebar, page 116) as a lever to finally overturn Quill, which mainly benefits catalog- based mail- and phone-order firms. But some government representatives worry that the effort may backfire. Says Dean Andal, chairman of the California State Board of Equalization: “If the argument that the growth of the Internet is going to diminish state sales tax revenues to a substantial degree were true, you would think it would show up in California. But the opposite has been true. Before we chase out existing systems that allow the Internet to grow, we should be certain to prove the harm.”

A Divided Front

Among companies involved in E-commerce, there’s even less of a united front. Many would argue that imposing taxes on the Internet could stifle growth and create an administrative nightmare. But just how such taxes would affect an Internet company depends on its structure and its customers., for example, currently collects sales tax only from customers in Washington and Nevada, where it has major operations. Broad collection duties would require the company to file hundreds, if not thousands, more sales tax returns a year. There is also the possibility that paying sales taxes could deter a significant portion of online shoppers, as the Goolsbee research suggests. “People shop on the Internet for convenience, price, and selection, and they will continue to do so,” says Bill Curry, vice president of public relations. And although he declines to comment on the “what-if” scenario of Internet taxation, Curry admits the company is “watching this game very closely.”

Another company that is watching the tax debate with interest is $19.9 billion Dell Computer Corp., which does much of its business over the Web from its Texas-based operations. But, suggests spokesperson Cathie Hargett, collecting sales taxes from all customers wouldn’t be much of a strain. “We sell 90 percent of our product to businesses, and in those sales, we collect the use taxes for the states in which the buyer is located voluntarily,” she says. These agreements with the states don’t extend to consumer sales, she says, “but we notify all our buyers of their responsibility to pay use tax, where required by law.”

Other Internet firms are happy to stay on the sidelines. For example, Ebay Inc., the fast- growing online auction service, doesn’t collect any sales taxes from the millions of dollars of auctions it hosts each day. Explains CFO Gary Bengier, “We’re a venue, not an agent, and we never take title or facilitate any payment, nor do we ship the merchandise. The buyers and sellers in our community may generate tax obligations, but we don’t get involved.”

The major telecom companies, such as AT&T, and major cable and Web-service providers, such as America Online Inc., of course, couldn’t be more involved. But the main reason their CEOs have a seat at the negotiating table is to lobby for the removal of telecom and Internet access taxes at the federal, state, and local levels. These firms are pushing for a permanent abolition of such taxes, and will likely use their support for overturning Quill to get government officials on the commission to recommend tax relief for their industries.

“My company fills out 39,000 tax forms a year; that’s one every three and a half minutes,” said AT&T CEO Michael Armstrong at the commission’s first meeting. “We’ve got to use this opportunity for simplicity.” Armstrong also attacked the 3 percent federal telecommunications tax, which was initially implemented 100 years ago to help pay for the Spanish-American War. “Last time I checked, we’d settled that issue,” quipped Armstrong, “but we continue with the taxation.”

Compromising Positions

How much simplicity states are willing to provide is another question. “States realize the need to simplify,” says Douglas Lindholm, executive director of the Committee on State Taxation, a Washington, D.C.-based corporate lobbying and education group. “But they also realize that every move toward standardization is a move away from sovereignty in determining their taxes. That’s tough for them, because that is their raison d’etre.”

Nevertheless, the commission members will examine numerous simplification measures. One possibility is a single rate per state, which would allow corporations to collect and remit sales taxes at one rate in every state, regardless of local taxes. Another possibility is tax-base simplification – essentially a national standardization of what items and services can be taxed. Panel members will also debate the merits of a centralized sales tax collection system, and the benefits of the standardization and electronic filing of all state and local sales tax returns. However, there is no federal mandate to adopt certain methods. Instead, each state would have to voluntarily debate and adopt any changes the commission may suggest.

Despite the complexities, many observers believe the commission may provide Congress with a good starting point from which to pick up the issue next year. “Debate on these issues has been stuck for a long time,” says PWC’s McArthur. “But the debate has never been at this level before among governors, CEOs, the secretary of the Treasury, and other leaders. This commission has the ability to reach compromises of their individual interests. After all, mediation works only when decision makers are at the table.”

———————————————– ——————————— Cybertaxes: The Current State of Affairs

The Internet Tax Freedom Act (ITFA), which was passed by Congress last October, instituted a three-year moratorium on all new taxes on Internet access, data transmissions, and related services. But that hasn’t stopped several states from adding to their coffers.

“Because the ITFA grandfathered existing laws of states, a number of states are still collecting taxes on access and some online sales,” says Richard Prem, a partner with Deloitte & Touche LLP who compiled a roster of state cybertax positions as part of a recently published guidebook, Taxation of Cyberspace. The only existing taxes the ITFA does not allow, explains Prem, are discriminatory taxes, which target the Internet but not other technologies; and multiple taxes, an example of which is a state-imposed tax on Internet service as both a telecommunications service and a taxable good.

Leading the pack of cybertax-hungry states is Connecticut, which asserts that the state’s sales tax should apply to Internet access charges. So far, the state has defended its position in its own Supreme Court, winning a case against America Online Inc. for more than $3 million in uncollected sales taxes on leased modems. The Revenue Department asserted that the modems constituted nexus for purposes of sales- and use-tax collection. AOL is appealing the ruling to the U.S. Supreme Court.

Other tough states include Illinois, which had subjected access fees to the state’s telecommunications tax prior to the ITFA. Tennessee, heavily reliant on sales taxes for revenue, takes a stand similar to Connecticut’s. And Washington State asserts that Internet service providers with a server in the state have nexus for collecting sales tax on their fees.

But not every state is so aggressive. Texas, for example, recently reversed its stand that servers in the state create nexus for any kind of E-commerce sale. In August, Massachusetts repealed its sales and use tax on Internet service provider fees. And Iowa recently gave up its telecommunications tax on such access fees.

In short, businesses still need to watch their step. “The ITFA proclaimed a time-out on new Internet-specific taxes,” says Prem, “but not on all taxes related to the Internet.”