Part 1 of 2
TAXATION OF E-COMMERCE
Introduction
The Challenge of E-commerce
Electronic Commerce (“e-commerce”) involves using the internet for the sale, lease, license, offer or delivery of property, goods, services or information (collectively “purchase and sale transactions”). Because e-commerce involves numerous computers communicating at the speed of light, purchase and sale transactions are both instantaneous and anonymous.
Distinguishing E-Commerce from Traditional Remote Venders
E-commerce differs from mail order and telephone solicitation, the two most traditional forms of business using remote sellers (sellers in another state or country), because these involve the delivery of goods by common carrier (UPS, FedEx) to and from a specific physical location. In short, there is still a physical delivery of property from an identifiable seller to an identifiable buyer.
E-commerce presents an unprecedented challenge to federal and state tax authorities. States and local jurisdictions have wrestled with the issue of collecting taxes from out-of-state mail order sellers and telephone solicitors for decades; e-commerce enables almost any business – large or small — to sell to customers in different states and countries.
Taxes are Territorial Based
Taxation is based on jurisdiction. From the time of the Boston Tea Party Rebellion, when tea was taxed by customs officials as it physically landed on American shores, to sophisticated concepts in international taxation, a government’s authority to tax has always been premised on territory and jurisdiction. For instance, the U.S. government taxes its residents on their world-wide income because they are connected with the U.S. through citizenship and residency. The U.S. also taxes foreign individuals and businesses receiving income from U.S. sources.
But the U.S. cannot tax a French resident and citizen who earns income outside of the U.S., because the U.S. has no jurisdiction over the person or the source of income.
E-Commerce Defies Traditional Tax Jurisdictions
Using the internet, a company can, in theory, move its e-commerce business to a tax-haven country (a country which levies no income or sales taxes) and conduct e-commerce outside the jurisdiction of any country that would otherwise tax the transaction.
Also, because of the speed in which transactions occur and the frequent absence of a traditional paper trail, it will be very difficult, if not impossible, to apply traditional notions of tax jurisdiction. This is especially true with intangible property transmitted by computer such as software, digital music or electronic books and services.
While governments which depend on an income tax might have difficulty taxing e-commerce, states and local jurisdictions that rely on sales and property taxes to fund their operations could be in deeper trouble. As discussed below, the commerce clause of the U.S. constitution requires a sufficient “nexus” (physical connection) with the state or local jurisdiction to burden the company with a tax obligation. Obviously an out-of-state company that merely engages in a purchase and sale transaction with an in-state customer is not sufficient nexus.
Little Support for Taxation
Lack of Political Motivation
The Supreme Court has stated ruled Congress has the right to change the Constitution’s Commerce clause to permit states to collect sales taxes from remote sellers. Aside from pressure from state and local tax authorities and traditional brick-and-mortar businesses which complain they are at a competitive disadvantage because they must collect sales taxes, there is little enthusiasm for internet taxation.
According to a Gallup Poll, 73% of active internet users oppose an internet sales tax, compared to 14% in favor. Thirty-six percent of respondents who use the internet indicated that they would be less likely to vote for a politician who supported taxing internet transactions.
Why E-commerce is Unique
Distinguishing Features of E-Commerce
E-commerce has some or all of the following features, which make it difficult to tax under traditional concepts:
- Computer-to-computer transactions rarely leave a paper trail.
- Because computers are communicating with each other, the purchase and sale transactions are anonymous, particularly when new forms of exchange, such as electronic cash are used.
- With anonymous transactions, there is a lack of information regarding the locations of seller and purchaser; sales tax laws are dependent on this information.
- E-commerce makes possible the electronic delivery of property and goods (books, CDs and movies in electronic form), and services (brokerage or accounting services) so there is no physical delivery by a common carrier. Also, the form of the goods is converted from tangible (a physical CD) to intangible (a downloaded computer program of the music) which does not exist as an object. Many sales-tax regimes exempt intangibles from taxation.
- E-commerce makes possible the bundling of taxable and non-taxable items, such as taxable goods with tax-exempt services, such as a software package with email technical support.
Lack of a Paper Trail
Unless a tangible product is delivered by common carrier, it is impossible for a taxing jurisdiction to determine that an e-commerce transaction occurred. For instance, if a consumer downloaded a computer game from a computer located in a foreign country for $19.95, paying by credit card, how would a taxing jurisdiction discover that such a transaction occurred?
How would it determine the physical location of the seller? What if the purchaser had an internet service provider (ISP) in a foreign country as well?
Transmuting Property From Tangible to Intangible
Consider the following issues: Would the receipt of a computer game in electronic form convert the game into a non-taxable intangible item, whereas the purchase of the same game at a local computer store would be taxable because it is a tangible product?
Also, if a newspaper has an exemption from sales tax (as most do), will a newspaper that is downloaded in electronic form receive the same exemption? If not, would the tax levied on the electronic version of the newspaper be a discriminatory tax in violation of the commerce clause (discussed below)?
Electronic Money and Secrecy
E-cash Issues
Electronic money (“e-cash”), is a type of debit card (similar to a telephone calling card) where the card itself keeps track of the remaining balance, rather than a third party bank. This could emerge as the preferred medium of exchange for e-commerce. E-cash will have the same anonymity as cash does in the current “underground” economy. Use of e-cash will further frustrate states and local jurisdictions on taxing e-commerce.
Even without E-cash, E-commerce Lends Itself to Concealment
Consider the following example:
Suppose your uncle living in Nevada (a state with no sales tax) downloads a computer game then sends it to you as an e-mail attachment. The next time you see your uncle, you reimburse him. How will your state or local jurisdiction monitor this transaction?
In short, e-commerce has the potential to stymie tax collections because of the speed and lack of information on buyers and sellers and also because purchase and sale transactions could enjoy the same secrecy as cash deals have in the underground economy.
Current Law – A Moratorium on Internet Taxes
Moratorium on Internet Taxes
Because of the issues complicated surrounding e-commerce taxation, Congress passed the Internet Taxation Freedom Act (“ITFA”) in 1988. This act which imposes a 3-year moratorium on federal and state taxation of internet transactions. The moratorium began October 21, 1998 and remains in effect until October 21, 2001. ITFA’s purpose is to halt the rush by states to tax transactions occurring on the internet until Congress has had opportunity to study the issue.
Congressional Concerns
Congress realized that the internet needed growth time to become a viable medium for commerce, without being subjected to various taxing regimes imposed by the states. Congress noted that the internet is inherently susceptible to multiple and discriminatory taxation in ways that traditional commerce is not. Congress was concerned that because internet transactions involve a number of computers, routing transactions throughout the country and even throughout the world, potentially dozens of jurisdictions could attempt to tax a single transaction. Thus, ITFA would protect internet businesses from being taxed in complicated and unexpected ways by remote jurisdictions.
Definitions
Internet Access
ITFA applies to taxes on internet access that were not generally imposed or actually enforced prior to October 21, 1998. The ban prevents to states or political subdivisions from imposing new taxes on internet access. Internet access means, in general, any computer, telephone communication facility, equipment or operating software which comprises the internet (the interconnected world-wide network using Transmission Control Protocol/Internet Protocol known as TCP/IP). Telecommunications without TCP/IP, however, are excluded from this definition, so taxation of telephone services has not been suspended.
Example: ITFA bars a tax on monthly ISP services provided by AOL, CompuServe or a company like Earthlink, but the taxes on telephone services used to connect to an ISP are not prohibited.
Electronic Commerce
The key provision of ITFA applies to e-commerce which is defined as:
“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.”
ITFA bars states or political subdivisions from imposing any “multiple or discriminatory” taxes on transactions involving e-commerce, including income and franchise taxes, property, sales and use taxes, as well as a seller’s obligation to collect and remit such taxes.
Discriminatory Taxes
Discrimination is Broadly Defined
A discriminatory tax traditionally involved a tax that favored local commerce over interstate commerce, but the definition under ITFA has been broadened to include the coverage of the tax, its application or a differential tax rate. In other words, if an e-commerce transaction is subject to a tax that is any different from a tax imposed on similar property, goods or services through other means, then the tax is discriminatory.
Example: If the purchase of a book through the internet is subject to a tax that is different than in a bookstore, the tax is discriminatory. The same would be true if the taxing authority charged a higher rate of tax for e-commerce purchases of books.
However, it is permissible to charge a lower rate on an e-commerce transaction. It other works, a taxing jurisdiction may discriminate in favor of e-commerce.
Out-of-State Vendors
Out-of-state vendors engaged in e-commerce do not have an obligation to collect sales taxes if traditional remote sellers, such as mail-order and telephone solicitation vendors, do not collect sales taxes. Sales tax cannot be levied on a transaction just because the purchaser uses e-commerce to access the seller’s computer to acquire property, goods or service. Also, states cannot use an “agency nexus” theory to claim that a purchaser’s ISP is an in-state agent for the seller.
Example: If a purchaser in California uses his computer to connect with a bookseller’s computer located in Nevada (a non-sales tax state), neither California nor and political subdivision may levy a sales tax, even if the purchaser used a California ISP to connect to the internet.
Example: If a Nevada-based seller hosts his website on a California computer and a Californian resident purchases a book, California cannot claim there is an agency nexus to tax the transaction.
In addition, if a remote seller in one state, uses a computer in another state for internet access or online services, there is no agency relationship between the remote seller and the company providing the access or online services.
Example: Where a New Hampshire company, with no physical presence in California, hosts its website with a California ISP, California cannot impose a sales tax on purchase and sale transactions just because a California ISP was involved.
If books, magazines, newspapers or forms of tangible information are not subject to sales tax, then downloads of that same information cannot be taxed. Also, a tax obligation cannot be imposed on a different entity such as a credit card company, if the vendor selling the product, service or property would be the entity responsible to collect sales tax under conventional commerce.
Multiple Taxes
Multiple taxes on the same transaction or service, either in the same taxing jurisdiction or two or more taxing jurisdictions, are prohibited. This could occur if a state-taxed internet access services as telecommunications and then taxed located telephone services as well. Unless a credit is given to eliminate any double-taxation, such a tax would violate the prohibition against multiple taxation.
There is an exception to the multiple taxation prohibition if the tax is imposed by a state and a local subdivision, such as California’s sales tax and San Francisco County’s add-on sales tax for its Bay Area Rapid Transit.
Exceptions to ITFA transactions
Obscene Materials
Vendors who knowingly conduct e-commerce involving obscene materials that are otherwise harmful to minors cannot rely on ITFA as a defense against taxation. However, the vendor can use ITFA as a defense if he uses credit card verification or procedures to insure he is dealing with persons over age 17. The ITFA protections apply to internet information and search services such as Yahoo, Lycos or Alta Vista or ISPs that host such websites as well as telecommunication companies that transmit information over the internet.
Bundled Software
Bundled software that includes protected e-commerce or internet applications are protected under ITFA, but only in proportion to the e-commerce or internet applications.
**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.**