The Slate Gist

Taxing the Internet

Virtually every type of commerce in the United States is subject to some form of taxation at the federal, state, or local level. The Internet industry (made up of Internet service providers and online service providers along with companies that do business over the Internet) is no exception. Yet the fast growth of electronic commerce, and the novel properties of the industry, pose special problems for tax authorities.

The federal government worries that the Internet could become a global haven for money launderers and tax evaders. States and localities worry that increasing use of the Internet will erode their tax bases as consumers and businesses shop and do business outside of their taxing jurisdictions. While they are anxious to develop more sources of revenue and expand their tax bases, they also realize that unilateral efforts to collect from the industry may simply drive the easily moved online operations over the state line. Not surprisingly, the Internet industry opposes any new taxes on its burgeoning commerce. Major online retailers and service providers, however, recognize that there is no case for exempting Internet sales and, perhaps, services from the same tax laws that apply to offline commerce. But they are especially concerned with developing uniform, consistent, and fair tax treatment by state and local authorities. Multiple taxation is seen as a particular threat.

Who has responsibility for taxing Internet commerce? As the Internet grows and changes, how is existing tax law being applied? What can and should be taxed–goods and services sold over the Internet? Online services themselves? And by what level(s) of government? These taxing questions are likely to keep accountants, lawyers, and international-trade consultants in BMWs for years.

Estimated revenues from the Internet are not huge–so far. But predictions of where they’re going are very big. According to industry research, subscription and advertising revenues from Internet and online services were as much as $2.2 billion in 1995 and may top $14 billion by the year 2000. Advertising revenues alone made up $131 million last year, but not surprisingly, this represented less than 0.5 percent of the ad money spent on other media.

Online sales of products over the Internet amounted to approximately $500 million, less than 0.4 percent of all mail-order sales. Forrester Research predicts this number will reach $6.6 billion by 2000, but that would still amount to only 5 percent of all predicted mail-order sales. But as more consumers become familiar with online commerce, they may very well begin to shop for products over the Internet precisely to avoid state and local sales taxes.

Taxing online sales of mailed products is one obvious revenue opportunity under existing tax law. The easy analogy here is to catalog sales (although these, too, have posed problems for state and local authorities). If you buy a pair of boots from L.L. Bean’s catalog, the company must charge you sales tax if you live in Maine (or any other state), where it maintains a place of business. By the same token, if you decide to use your computer to buy, say, a five-liter bottle of 1984 Napa Valley cabernet (for $629) from Virtual Vineyard, the same rule applies. Virtual Vineyard’s location (or “nexus” in tax-speak) is Palo Alto, so, unless you’re having the wine sent to a California address, there will be no sales tax.

But the situation is different in practice (if not principle) in the case of products delivered over the Internet. Establishing nexus can be a tricky issue, for example, when it’s a case of content–such as newspapers, magazines, books, videos, music, or computer software–being downloaded. The seller may have no idea of the buyer’s location, and hence whether sales tax is due (though new software packages being developed for online commerce may help remedy this). But the location of the seller may be even tougher to determine.

As noted above, a seller must collect sales tax from a buyer if the seller has a significant “physical presence” in the same jurisdiction where the buyer takes delivery. Suppose, for example, that the content in question is being sold by an online service such as America Online, the Microsoft Network, or any of a myriad of smaller services. Where does that service do business? Most online service providers operate Point-of-Presence (POP) locations that allow subscribers to log on to the Internet using a local phone number. These typically consist of a leased room with modems and routing equipment. Already, some states have argued that POPs constitute sufficient physical presence for taxing purposes. But the 1992 U.S. Supreme Court case Quill vs. North Dakota would seem to defeat such an argument. The Quill ruling protects sellers of tangible personal property from state taxation if their contacts within the state are limited to mail-order catalogs, telephone, or the Internet.

And what if the content is being sold by a separate vendor through an online service? Some states argue that taxable nexus can be established if a vendor operates over an online or Internet service with substantial physical presence within the state. This opens up a whole new basis for taxation opposed by the industry and unlikely to be upheld by the courts. After all, to return to our catalog analogy, if L.L. Bean uses UPS to deliver its boots, that doesn’t expose the sale to taxation in every state where UPS operates. And even if states can win the nexus argument in court, Internet providers are likely to flee to more tax-friendly jurisdictions, thus forcing (angry) subscribers to incur long-distance phone charges for online access.

In addition to sales taxes, 20 states also impose some form of tax on Internet and online services or activities. These include Pennsylvania, Connecticut, Massachusetts, Nebraska, Tennessee, Ohio, and Texas. Many cities are doing the same. Officials in Fort Collins, Colo., decided last year that Internet providers were subject to a city sales tax on telephone service and that subscribers would have to pay a 3 percent sales tax on top of their monthly access fee. The industry argues that it is not comparable to the (heavily taxed) telecommunications industry, and that such efforts result in double taxation–since service providers already pay taxes on phone-line usage–as well as for Internet vendors. Again, as in the case of wine sales, states have taxing jurisdiction over transactions only if the seller has sufficient physical presence in the state.

Tax authorities are further threatened by the growing use of electronic money. E-cash can be used to facilitate a host of illegal businesses, including drug transactions, thereby eliminating the need for suitcases full of $100 bills. It could also swell the underground economy, as people use it to pay for services, facilitating the avoidance of federal income tax.

Another dicey issue confronting Treasury Department enforcement officials is Internet gambling. Although federal law prohibits gambling by wire in the United States, and most authorities interpret that to mean that Internet gambling is illegal here, at least one online casino, Casino Royale, looks and feels like a virtual gambling emporium. (Sen. Jon Kyl, R-Ariz., has just introduced a bill to ban online gambling.)

Recognizing that the Internet effectively wipes out national borders, and fearing that the development of new technologies may be impeded by inconsistent tax policies, the federal government has been studying the issue of international tariffs on Internet transactions. At this point, no countries have imposed tariffs or other taxes on online commerce, but at least a dozen are considering them. This is a big area of concern for the administration, since the United States exports $40 billion in services annually, including software, entertainment and information products, and professional services.

The Clinton administration’s position is that the Internet should be a federal duty-free zone. In releasing a draft report on the subject, Deputy Treasury Secretary Lawrence Summers said, “We absolutely reject the idea that the Internet is some sort of golden goose whose feathers should be taxed. The key message of the report is no Internet taxes.” This does not mean, however, that the federal government supports abolition of any taxes on Internet commerce, only that it plans no new taxes at this time. The Treasury report itself stresses that, in principle, the tax code should treat Internet transactions exactly like other channels of commerce.

On March 13, Sen. Ron Wyden, D-Ore., and Rep. Christopher Cox, R-Calif., introduced the Internet Tax Freedom Act. The bill would impose an indefinite moratorium on state and local taxes on electronic commerce, though it would exempt certain taxes, including most sales taxes, that are already in place. The bill also calls on the administration to develop a comprehensive plan to address the issue, and to seek bilateral and multilateral trade agreements that make all Internet activity internationally free of taxes, tariffs, and trade barriers.

The administration is already working with the World Trade Organization and other international trade groups on uniform rules for taxation of electronic commerce. Meanwhile, there are tricky aspects to assessing taxes under current international tax treaties, including: 1) identifying the country or countries with authority to tax; 2) classifying the type of income arising from the transaction (e.g., royalties, sales of goods, or services); 3) tracing transactions handled with electronic money; and 4) identifying parties to transactions, and verifying records. In addition, some countries impose quotas on content such as books, movies, music, and software from abroad, but the origin of that content can be tough to trace in the thin air of cyberspace.