Part 2 of 2
Taxation of E-Commerce
Nexus – The Foundation of State and Local Taxation
The Commerce Clause Limitation
The Commerce clause of the U.S. Constitution prevents states and their political subdivisions from imposing taxes that unduly burden interstate commerce. The key issue is whether the company that is being taxed has sufficient connection (nexus) with the taxing authority.
Example: A company that operates in Nevada and does not sell products in California or to Californian residents cannot be taxed by California. Conversely, both California and San Francisco have the right to tax a company physically located in San Francisco, such as a hotel, even when its guests reside in another state.
The issue arises when a business is not physically located in California, but sells to Californian residents. Under what circumstances may California levy a tax on sales to Californian residents?
Supreme Court Case: Quill v North Dakota
In Quill v North Dakota, 504 U.S. 298, 1992, the US Supreme Court held that a remote seller could be required to collect sales taxes only if the seller had the requisite nexus with the buyer’s state. Quill corporation sold office furniture products through a catalogue. Although it was not physically present in North Dakota and did not have sales agents in the state, the North Dakota Supreme Court held that by selling its product to North Dakotan customers, Quill established an economic presence in North Dakota, thus creating nexus for sales tax purposes.
The Supreme Court held otherwise, ruling that a state could impose a requirement that a company collect and remit sales taxes only where the company had substantial connections (a physical presence) with the state. Under the commerce clause, a mail-order company without a physical location, employees or sales agents in North Dakota could not be compelled to collect sales tax on its sales to North Dakotan customers.
Article I, section 8, cl. 3 of the constitution expressly authorizes Congress to regulate Commerce with foreign nations, and among the several states. The Supreme Court reaffirmed the safe harbor for vendors whose only connection with customers in the taxing state is by common carrier or the mail. Such vendors are free from state-imposed duties to collect sales and use taxes. The Court noted that Congress could change the current law and require mail-order companies to collect and remit sales taxes.
Collection of Sales Taxes
It is the Commerce clause’s concept of nexus that prohibits most e-commerce purchase and sales transactions from being taxed by the states or their localities. In general, the duty to collect a sales or use tax depends on where the seller is located and whether the buyer is a consumer or a business. Three general rules apply:
1. Retail sales by venders to in-state consumers are subject to sales tax on the purchase, but it is the vendor’s obligation to collect and remit the tax to the taxing authority.
2. Out-of-state vendors making consumer sales are not required to collect and remit sales taxes, unless the vendor has sufficient nexus under the commerce clause with the purchaser’s state to require collection.
3. If the out-of-state vendor cannot be required to collect the tax, then the consumer is legally obligated to pay a self-assessed tax directly to the taxing agencies on the purchase. This is usually referred to as a “use” tax, instead of a sales tax, since the consumer is paying a tax for the use of the property. As a practical matter, this has been virtually impossible to enforce, hence the emphasis on requiring out-of-state vendors to collect and remit the tax.
E-Commerce and the Absence of Nexus
Anonymous and Instantaneous Transactions
The absence of nexus is even more pronounced in the e-commerce context. Not only do internet companies not have physical presence in the taxing jurisdiction, often they can be located outside the jurisdiction of the U.S. altogether. Even, in theory, if a transaction can be taxed, in reality, e-commerce transactions occur instantaneously and often without identity of the seller’s or buyer’s location. Because the sales tax is destination-based, unless a state or locality can pinpoint the physical location of the seller and buyer, it is impossible to determine jurisdiction for sales tax purposes.
Example of the Challenge
Example: California wants to apply a sales tax to the sale of software to its residents. For California to levy the tax, it must determine that the purchaser is a Californian resident and that the seller has sufficient nexus with California to be required to collect and remit the sales tax. Without ascertaining the location of the seller or buyer, California cannot determine whether the purchaser was a Californian resident and whether the seller had sufficient physical presence in California.
Note: If the goods or property purchased are tangible (books, CDs or clothing), then the traditional notions applicable to mail-order taxation could be applied since it could be ascertained where the goods were shipped from and where they were delivered.
Will E-commerce Really Erode the Tax Base
for States and Localities?
States are Overstating the Effect of E-Commerce on Tax Revenues
Although state and local tax officials express grave concern that e-commerce will decimate the ability of states and localities to levy taxes on these transactions, this response might be overblown. Currently, the commerce clause prevents states and localities from taxing remote sellers, unless they have sufficient nexus with the state. This means that mail order and telephone solicitation commerce by most remote sellers is not subject to tax.
Unless the Supreme Court drastically alters its reading of the constitution’s Commerce clause, or Congress legislates a change allowing taxation of remote sellers, e-commerce merely extends the trend to avoid taxes by engaging in remote selling without a physical presence.
Current Exemptions to Sales Tax
Most services, food and medicines are not currently subject to sales taxes anyway. In California, services such as legal, accounting, and medical services are not subject to sales taxes. Neither are food or medicine. Therefore, e-commerce involving these transactions will not cause an erosion of the tax base.
The Actual Tax Impact of E-Commerce
Although e-commerce is rapidly growing, as of 1998, it represents much less than 1% of total consumer spending . Remember that business-to-business sales are subject to use tax payments made by in-state businesses (usually at a reduced “reseller’s” rate), and approximately 80% of current e-commerce is business-to-business.
To the extent e-commerce is merely a substitute for other remote seller transactions, e-commerce does not affect the tax base since remote sales involving mail order or telephone solicitation are exempt from sales tax under the commerce clause.
There is evidence that even if all e-commerce was subject to sales taxes, the revenue generated to the states and localities would represent about one-tenth of one percent of all sales and use taxes currently being collected. Also, sales and use taxes continue to grow, despite e-commerce.
The Future for E-commerce Taxation
The Problem: 7,500 Taxing Jurisdictions
Problems Achieving a Uniform Tax Rate
The Commission on Electronic Commerce, created by TFA legislation, has not been able to make any headway in the taxation debate. However, several members have voiced support for internet taxes, provided the tax is simple to calculate. This could mean a uniform tax rate agreed to by all states, or technological advances that would allow businesses to calculate the sales tax without a large investment in time and resources.
Unfortunately, the current state and local tax systems, which number close to 7,500 throughout the U.S., are notoriously parochial when it comes to defending their jurisdiction. In Texas alone, there are more than 1,300 separate sales tax jurisdictions! These numbers could significantly increase if states and local jurisdictions were allowed to tax e-commerce.
Small businesses would be buried in costly paperwork attempting to comply with all these often-conflicting tax clauses. That is precisely why the commerce clause in the Constitution prohibits taxes which are an undue burden on interstate commerce.
Apportioning Internet Taxes Among the States
To gain agreement among this diverse group will be difficult at best. Also, what is the fairest apportion of internet taxes among the competing jurisdictions? Does California which accounts for 15% of the country’s business receive 15% of the internet tax revenue, or would California argue for a larger share? How would it calculate the proper percentage? To successfully tax e-commerce will require a degree of cooperation and unity never before experienced between the states and localities, much less among the countries throughout the world.
Suggested Approaches to E-Commerce Taxation
Use of a Electronic Trace to Identify Parties and Transactions
If government controls the e-cash so that an electronic trace could be placed on purchase and sales transactions, then the identity of the seller, buyer and goods could be determined and the traditional sales tax rules could be applied. Also, if governments required e-commerce to be channeled through “toll-booths” which levied a tax on the purchase and sale transaction, then government could collect taxes.
Purchasers and Self-Assessment of Use Taxes:
The answer to e-commerce taxation in particular and remote selling in general is to require a state or locality’s resident to self-assess the tax that should have been collected by the remote seller. There is no prohibition against the use tax; the problem lies in enforcement. Therefore, although e-commerce prevents states from forcing remote sellers to collect and remit sales tax, the ultimate tax liability is not affected since in-state consumers have the legal tax liability to self-assess and pay the tax anyway.
Congress could pass legislation requiring common carriers, such as Federal Express or the post office, to report purchases by residents, similar to the IRS information reporting Form1099. Since common carriers know the vendor, purchaser and goods being delivered, they could transmit the information to the appropriate state taxing authority. Then the state’s residents would be required to self-assess and pay the tax.
This approach would permit states to enforce the use tax without placing an undue burden on those out-of-state venders transacting business via e-commerce, mail order and telephone solicitation. The added burden of transmitting information to the purchaser and taxing authority could be subsidized by the states. Intangible sales over the internet, however, would not be captured under this system.
Government’s Use of Criminal Laws to Force Compliance
Outside such technical innovations, governments might have to rely on purchaser’s self-assessment backed by criminal enforcement to ensure the payment of taxes on e-commerce transactions. This approach, of course, could backfire, as an angry population that believes e-commerce transactions should not be taxed in the first place, has revenge on the politicians who enacted such measures.
Computer Hacking – A Hidden Problem with E-Commerce Taxation
Remember, too, the internet is home to many brilliant but diabolical hackers who would relish the challenge of crippling government’s attempts to tax e-commerce transactions. While it is doubtful that the fear of hackers would dissuade governments from taxing e-commerce, it should be noted that an unprecedented threat does exist from those who understand the workings of this new technology. Even if an attack did not occur directly against government computers and equipment, sophisticated hackers and others could devise programs to thwart attempts at taxing the internet under privacy grounds. In short, governments should not underestimate the hackers’ response to e-commerce taxation.
Given both the outdated and overly complex mechanisms employed by thousands of jurisdictions to tax traditional transactions, it is clear that a fundamental restructuring of our current sales tax laws is needed to simplify tax collection, to decrease the burden of compliance on business, and to deal with the increasingly integrated economy of e-commerce. Then again, it is far from certain that voters will permit politicians to tax e-commerce or that the supposed loss in sales tax revenues is really significant, given the numerous exemptions from sales taxes that already exist.
Even if politicians decide that an e-commerce tax is needed to provide parity with brick and mortar retailers, will the thousands of taxing jurisdictions give up their “fiefdoms” for a unified, national solution? Perhaps the biggest practical hurdle to taxation is whether e-commerce transactions, flying around the internet at the speed of light, are susceptible to taxation when both the location of seller and purchaser are unknown and the medium of payment is often untraceable. The ultimate question is whether governments can keep pace with technology as newer, faster and numerous forms of commerce evolve.
**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**