Internet Tax Analysts Encounter Legislative, Regulatory Minefield

To tax or not to tax online sales; that is the question for lawmakers who must weigh benefits, drawbacks.

The passionate debate about whether to collect sales tax on purchases made over the Internet has politicians, economists and industry searching for the right course of action to continue unprecedented economic growth while supporting the flow of revenue to states or to countries. Experts on both sides of the issue have strong convictions, leaving the legislators with some very hard choices to make during the next several years.

The choice between collecting or foregoing sales tax on items bought over the World Wide Web appears at first to be black and white: Either treat these transactions as all other purchases and require sellers to collect taxes, or consider the Internet a tax-free zone. However, as members of the congressionally appointed Advisory Commission on Electronic Commerce soon found out, today’s intricate sales tax system completely changes the complexion of the matter. Auditing procedures and ensuring privacy come into play. State sovereignty becomes an issue. Any conclusion on these matters is likely to agitate someone, yet the light-speed growth of e-commerce makes it a decision that will carry serious consequences.

As a result of the Internet Tax Freedom Act passed by Congress in 1998, the current e-commerce sales tax policy includes a three-year moratorium on imposing Internet access taxes, bit taxes and multiple or discriminatory taxes on e-commerce. As part of that Act, Congress called for the formation of the Advisory Commission on Electronic Commerce (ACEC) and tasked it with investigating the issue and making recommendations about the direction that should be taken. The ACEC consisted of 19 representatives from federal and state governments as well as several telecommunications companies. Theodore Waitt, president and chief executive officer of Gateway Incorporated, was the single commission member representing retailers.

Arriving at a consensus with such a widely diverse group of individuals posed multiple challenges. However, several commissioners were able to agree on certain key concepts. The entire commission concurred that e-commerce holds vast potential and that it is in the national interest to create an environment that fosters continued growth. But the Internet also creates mobile consumers who can choose to shop at stores located in their own neighborhoods or across the country.

At the end of their fourth and final meeting earlier this year, commissioners agreed to present Congress with guidance on some issues, but they were unable to agree on a position on all items proposed. Most panel members expressed disappointment that a super majority of the commission could not reach an agreement on more recommendations. However, all concurred that the discourse that spanned 10 months of meetings confirmed how complicated e-commerce taxation is and enlightened everyone involved about the various issues and the numerous nuances of each.

In its report to Congress, the ACEC expressed the opinion that the 3 percent federal excise tax on telecommunications services should be repealed. This tax was instituted during the Spanish American War and has remained on the books and continued to be collected since that time. In addition, the commission suggested permanently prohibiting states or localities from taxing Internet access subscription charges and extending the Internet taxation moratorium on multiple and discriminatory taxation for five years. A majority of the commissioners also agreed that states’ sales and use tax systems must be simplified in preparation for a conclusive debate on taxing e-commerce.

Under the current system, buyers must pay sales taxes on purchases if the retailer has a store in their state. This is referred to as a nexus. If the company does not have a retail outlet in the buyers’ states, purchasers are only required to pay what is known as a use tax if their home states levy sales taxes. This use tax already applies to mail-order purchases; however, collection is not enforced and payment is generally ignored. Some commissioners wanted to specify that nexus would not be established simply by consumers opening World Wide Web pages in their homes. The Internet environment requires a new definition of nexus, commissioners say.

However, commissioners representing states that do not charge sales tax are concerned that income tax, one of their primary sources of income, could be affected by changes in the definition of a nexus. At the same time, states that do not collect income tax are concerned that a decrease in sales tax income would negatively affect their ability to meet budgets.

Today’s sales tax system is not airtight. Five states do not levy sale taxes: Alaska, Delaware, Montana, New Hampshire and Oregon. States adjacent to them are accustomed to a leaky sales tax system, according to ACEC Commissioner Stanley S. Sokul, independent consultant, Association of Interactive Media, Washington, D.C. Lax enforcement of a use tax is another leak in the sales tax system that states have chosen to overlook, he adds.

However, the Internet could put a huge hole in these already compromised systems and threatens to be an unacceptable drain on local coffers. State and local officials are concerned that, given the choice, consumers will elect to visit an online store to avoid paying sales tax. This could severely and negatively impact funds available for schools, roads and law enforcement.

According to Gene N. Lebrun, ACEC commissioner and president of the National Conference of Commissioners on Uniform State Laws, the average percentage of total state revenue derived from sales and use taxes is in excess of 40 percent, and in some states it exceeds 60 percent. If a significant portion of citizens in a particular state make retail purchases over the Internet or by means of other remote transactions where the vendor has no obligation to collect the sales tax, they are evading a policy of that state to tax retail sales transactions, he says. The effect is to give out-of-state vendors a competitive advantage while depriving the state and local governments of sales tax dollars. That money would have to be made up from other sources, he contends.

Today, despite the fact that many states and localities are enjoying a surplus in revenue due in part to the increase in technology-based companies, some governors are concerned that a decrease in traditional purchasing would offset any gains. “This is a narrow view,” Sokul says. “The Internet has been a strong economic driver, so you have to take into consideration that the Internet is contributing to the economy. If people couldn’t buy tax-free on the Internet, then the economy of it would be smaller, and the result would be that the economy of the state would be smaller. It’s better for the state and local governments to keep things the way they are so they can grow. We need more data on this before we could prove this, but that’s the general sense.”

The issue of remote sales is not new, Sokul explains. Debate about this topic began when mail order became a new way to purchase products. Similar fears surfaced then. States and localities were concerned that they would lose an unacceptable amount of sales tax revenue through this new form of shopping. The issue was settled by a 1992 U.S. Supreme Court decision that says a state cannot compel a remote seller to collect sales tax unless the seller has a nexus in that state. The ruling also expresses the notion that it would be too burdensome for a single state to impose its rules on other states or jurisdictions, he adds.

Current economic figures indicate that the amount of individual consumer sales online is small—only 10 to 15 percent of all business conducted over the Internet. In addition, of all shopping done by consumers, only about 1 percent of it takes place online. “With the Internet, in terms of individual consumers, the fears are not justified yet. People still like to go to the mall. But the business-to-business benefit is huge. Internet sales won’t continue to grow exponentially. It will grow, but it won’t overtake traditional shopping. The idea or fear that the Internet will overtake traditional shopping is the tail wagging the dog,” Sokul observes.

Business-to-business e-commerce is sales tax exempt; only the final product is taxable and the consumer pays this tax. Currently, businesses must be registered with the states of companies from which they buy as consumers.

Early on in ACEC discussions, participants agreed that sales tax systems are complicated across the board. “At our first meeting, the dominant factor was fairness. Is having e-commerce continuing tax free going to be harmful? The other thing that happened … is that it’s flipped around, and it’s more that the local tax systems are a problem. ‘We know we have to reform our tax systems’ is what the commissioners said. We can’t bring e-commerce down into this sewer. The first order of business is simplifying the system. The real culprit is the Depression-era sales tax system that continues. It was very easy at the beginning—efficient. Each system grew up separately and [became] more complicated,” Sokul explains.

According to figures offered by Governor Michael Leavitt of Utah, there are currently 7,000 tax rates that sellers would have to monitor and implement. Because retailers are responsible for collecting the appropriate taxes and are also subject to audits from the respective municipalities, this number is unruly.

Sokul believes requiring Internet companies to put a tax infrastructure in place could prevent some entrepreneurs from opening a business. “It is a collection question and whether you want to impose 50 state and 50 IRS [Internal Revenue Service] offices on any guy who puts up a Web site. … So when a guy puts up an e-commerce business, should the welcome wagon include a load of all these regulations and tax rules?” he asks.

In addition to the state of the current sales tax system, several other key issues have been identified.

Some government officials believe that exempting Internet purchases from sales tax is a dangerous precedent to set. When shoppers purchase items at a store, they are required to pay sales tax, and the company must have the infrastructure in place to remit the monies to the state or locality. If online companies are not required to collect this tax, they have an advantage both in overhead costs and in offering the tax-free product option, Leavitt points out.

“The question is do we create a permanent special privilege. If we chose not to have a level playing field, it is clear what would happen. We’re all clear on the rules, and then everyone would buy through the Web. At that point, governments would have two choices: raise the income tax or raise the property tax. Neither is viable. … It is simply not in the interest of this country to grant special privileges and say you don’t have to support schools, roads, law enforcement,” Leavitt asserts.

The governor compares the concept of the Internet as a tax-free zone to a store with multiple cash registers. In one checkout line, customers would be required to pay sales tax, while at the others no tax would be charged. “I don’t think the line for that [taxed] cash register would be very long,” he says.

Sokul agrees that designating the Internet as a tax-free zone is not a totally feasible solution. If customers could purchase items on the Web without paying taxes, retailers could set up computers with Internet connections within their stores. Consumers would then take advantage of buying an item online and simply pick up their order at the location, he explains.

Leavitt predicts that an immediate future with the continued moratorium on online commerce taxes will not result in concern from retailers. However, as e-commerce grows and the holiday season approaches, large retailers will rapidly get involved in the discussion. “Large players, like JCPenney or Sears, will then begin to say, ‘We have an obligation to collect this in every state now.’ And they’re going to storm Capitol Hill with one phrase on their lips: ‘level playing field for everyone,’” Leavitt maintains.

Two closely tied issues involve digital products and privacy protection. Under the current system, consumers can download digital items such as music or software directly from the Web and are not required to pay taxes. However, in most states, when the same item is bought from a retail store, the applicable sales tax must be paid. When downloading software, the customer provides a minimum of information, usually just credit card information. However, if companies are required to collect sales tax on digital items, they would also need other details such as names and addresses.

One concern is that this personal information could then be used for purposes other than verifying that the purchase was made and that the correct amount of sales tax was collected. In its report to Congress, the commission noted that any tax-administering system for e-commerce should be developed in a manner that minimizes disclosure of consumers’ personal information and should contain sufficient security to protect that information.

“If I go into Wal-Mart, I don’t have to tell them who I am. So if I’m shopping online, I shouldn’t have to do that either. It’s an invasion of privacy,” Sokul explains. Grover G. Norquist, president of Americans for Tax Reform, Washington, D.C., and ACEC commissioner agrees with Sokul. “It is not a question of should you tax digital merchandise, it is a privacy issue. If the authorities have to know everything in order to tax you, that brings them into your PC,” Norquist warns.

Although current discussions about sales tax on e-commerce primarily focus on the United States, the global nature of the Web environment also makes this issue an international one. If states are required to collect sales tax for other states, a policy would also have to be in place concerning purchases made from other countries, Sokul says. And once again, since businesses that collect sales taxes are subject to an auditing process, the question becomes whether other countries would be allowed to send auditors into U.S. companies. Additionally, if other countries choose to allow the Internet to be a tax-free zone, U.S. firms could be at a disadvantage.

Sokul believes that other countries will be looking to the United States for leadership on this matter, so the laws that are put into place have a broader reach than just what occurs in individual states.