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Friday, June 1, 2007

Internet Taxation

One of the most misunderstood tax topics involves application of taxes to anything involving the Internet. Some people believe that no taxes should be applied to the Internet. They may mean that access fees should not be taxed to the payor and/or they may mean that anything you purchase via the Internet should not be taxed. Thus, if you purchase clothes at your local store, it is ok to charge sales tax. If you order clothes from a catolog, it is ok to be charged sales tax. But, if you get the same clothes from a vendor who set up a webpage to handle the sale, it should not be taxed. Such positions are hard to understand. (If you are looking for more information on these positions, you can find several through a Google search.)

While some of the people proposing no tax on anything related to the Internet may just want to see all or most taxes disappear, the statements likely also stem from lack of understanding of use taxes. A 5/23/07 article on ("Net taxes could arrive this fall" by McCullagh) explains that states are working together to convince Congress that it should allow the states to collect sales and use tax from vendors who are not physically located in their state. The article notes that this would allow states to "collect billions of dollars in new revenue by next year." This does make it seem like a money grab by states with no rationale for doing so.
(Note - I'm not picking on CNet, there are many articles that say the same thing.)

But, what Congress is proposing is allowing the states a more effective approach to collect a tax that has existed in most states since the 1920's. The way sales and use tax works today, within requirements laid out in the U.S. Constitution, is as follows:
  • States are allowed to create and impose taxes that are within their state and U.S. constitutions.
  • Most states include a sales tax in their array of taxes. This is a tax imposed on the buyer of taxable items (most tangible personal property and some services; the rules vary from state to state). However, the seller collects and remits the sales tax.
  • In 1992, the U.S. Supreme Court ruled in Quill Corp. v. North Dakota (504 U.S. 298) that a vendor must have a physical presence in a state before a state could require the vendor to collect sales tax from customers in the state. The constitutional premise is the Commerce Clause. This clause, at Article I, Section 8, provides: "The Congress shall have power ... to regulate commerce with foreign nations, and among the several States, and with the Indian tribes." The U.S. Supreme Court found that states and cities had varying sales tax rules such that what was taxable and the rate was different in every taxing jurisdiction. Thus, they concluded that if a vendor, for example, located only in Illinois, but with customers in all states, had to learn and keep track of and comply with up thousands of different sets of rules, the vendor would find that such rules did impede interstate commerce. In reality, the costs of complying with sales tax in more than one state is very costly and time-intensive. Very large companies with a physical location in many states purchase expensive software and hire many people to help them comply. Such costs for a smaller business would be enough to potentially put them out of business (or at least keep them from making sales to customers in other states). However, the Court did note that since Congress controls the commerce clause, Congress could pass legislation allowing states to collect the sales tax from remote (non-present) vendors.
  • When a taxpayer buys something subject to its state's sales tax rules, but is not charged sales tax because the vendor is not required (per Quill) to collect the tax, THE CUSTOMER OWES USE TAX! The use tax is equivalent to the sales tax. So, today, if you buy books from and live in a state where does not have a physical presence, you are not charged sales tax. BUT, you need to keep track of this purchase so you are sure to self-assess and pay the use tax you owe. Many people think this is laughable because they have never heard of the tax and it sounds like a lot of records to keep track of - and, really, is the state really going to come after them?!

So - what is the solution to get the sales and use tax collected on all taxable purchases? Asking customers to self-assess the use tax will result in low compliance and asking vendors to voluntarily collect it is unlikely due to the cost.

So, in 2000, several states got together to solve the problem in light of what the Court said was the problem in Quill. That is, the rules are not uniform from one state to the state and that causes complexity. Thus, the solution is to create a model sales and use tax law, have states adopt it (replacing their current sales and use tax law) and then ask Congress to pass a law saying that states that have adopted the uniform law can require non-present vendors to collect sales tax. (Information on the model act can be found at:

This is what Senator Enzi has proposed with S. 34 (5/22/07). It is not the first time such a bill has been introduced. S. 34 explains the requirements that must exist in the state sales tax law to be considered simple (and it is a long list!).

Benefits of S. 34:

  • Responds to positive state actions to simplify sales tax compliance for vendors by having the rules and definitions similar form state to state and providing simplified collection methods. Not all states have been involved with the uniform law activities and not all states have enacted it. California has not adopted the uniform law (and probably won't anytime soon - more on that in another entry).
  • Enables states to more effectively collect a tax that is already on their books rather than looking for needed revenues through tax rate increases.
  • Simplifies use tax compliance for individuals because the vendors would be collecting the tax eliminating the need for them to keep records and self-assess the tax.
  • The uniform law (SSUTA) provides for technological solutions for vendors and compensation for their collection efforts.

Weaknesses of S. 34 and the SSUTA:

  • It will not eliminate use tax issues for all consumers. First, not all states have adopted the SSUTA so won't benefit from S. 34. Also, S. 34 will only enable sales and use tax to be collected when the vendor is in the U.S. If you buy something from a vendor in Germany, you still need to self-assess and pay the use tax on the item.
  • The SSUTA is not as simple as many vendors would like. One originally called for simplification was to have one rate per state. That is not required in the SSUTA. This means that vendors must keep track of, for example, what the rate is in Denver, Boulder and all cities in Colorado as they will differ. Also, while definitions are uniform, a state can exempt items in a cateogry (in effect a tax rate of zero) so vendors must also keep track of what is taxable and what is not.
  • The SSUTA governing structure gives each adopting state a single vote. This is not very attractive to large states such as California and New York and may prevent them from joining. (But, perhaps an argument can be made by California given the size, that it as a state has a uniform system (although rates can vary from county to county, but the tax base does not) and is large enough that any U.S. vendor should be required to collect use tax on sales to CA customers.)
  • The SSUTA will lead to winners and losers within most states in that it requires sales to be "sourced" at destination. This is not the way all states (including CA) apply sales tax today. In California, if a business has one location, it charges sales tax based on the rate for that city. Thus, if I sit at my computer in San Jose and buy a book online from a Los Angeles store, the city of Los Angeles gets the city tax (origin approach). Under the SSUTA, the destination is the required sourcing. So under it, the LA store would need to know where I live and charge me the sales tax rate for San Jose. This change would lead to winners and losers in terms of city and county revenue. If a city today tends to have a lot of vendors selling outside of the city, it benefits (it gets the tax). If a city tends to have a lot of customers (who buy from elsewhere), it would become a winner under SSUTA because its customers would now be generating sales tax for the city. The city that has customers outside of the city, will be a loser. The dollars where could be substantial for some cities and this would make it difficult to enact the SSUTA in California. The required use of the destination rule also made the SSUTA problematic for some vendors in other states. For example, in some states, a florist only had to collect tax based on the rate in their city (origin approach). However, under the destination approach, it must collect sales tax based on the rate of the city where the customer resides, thus requiring more recordkeeping.

Now - back to the original statement - do bills like S. 34 allow states to easily collect NEW revenue? No. First, it would only apply to the states (over 20 of them) that have enacted the SSUTA. Second, it would enable states to collect a tax already on their books, rather than create a new tax. Of course, with use tax compliance being so low and the reality that it will be easier to collect the tax from vendors rather than consumers, it will lead to greater collection by the states, but a use tax is not a new tax.

There are lots of subtopics here:

  • Is the sales tax still the best form of a consumption tax given the Internet and digital transactions (for example, where is the customer who downloads a book while sitting at an airport somewhere?).
  • What other tax issues are raised by the Internet and e-commerce and how can they be resolved in order to move tax systems into the 21st century?
  • What about the Internet Tax Freedom Act where the federal government prohibits state and local governments from collecting tax on Internet access fees? The current moratorium expires in November and Congress is looking at whether to renew it again.
  • How does all of this fit in with other needed reforms in California, other states and at the federal level?

more later...

Thanks for reading. I look forward to your comments.

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