Taxation of Internet Commerce

By Ken Griffin, Paula D. Ladd, and Roy Whitehead, Jr.

According to Jupiter Communications, a new-media research company that specializes in emerging consumer online and interactive technologies, Internet commerce will grow from the current $30 billion to $80 billion by the year 2000. The tax revenue that could be extracted by the Federal, state, and local governments from this stream of commerce is enormous. In fact, growing Internet commerce may divert tax revenues from traditional sales and service taxes. An observer only has to look to retailing giant Wal-Mart and its goal of having thousands of items available for sale over the Internet within the next five years to realize that Internet commerce will continue to grow into the foreseeable future. Those who advocate taxation of Internet commerce rely on the proposition that because the Internet provider is present in the state on the seamless World Wide Web, there is sufficient nexus between the provider of goods and services and the state to justify taxation. They contend taxation of Internet commerce falls within the state's traditional police power to protect and provide for the needs of its citizens. Conversely, those who oppose state and local taxation generally contend the Internet is a classic example of interstate and foreign commerce that is within the sole jurisdiction of the Federal government under the Commerce Clause of the Constitution. They argue that to subject Internet actors in foreign and interstate commerce to thousands of conflicting state and local tax jurisdictions is the undue burden that was specifically intended to be prohibited under the Commerce Clause. As in other instances, what will be required to resolve this Federal and state conflict is a careful measuring and balancing of the interests of all concerned. The important position of the third branch of government, the courts, in resolving this question is just developing and is presently unsettled because of an absence of precedence.

No New Internet Taxes

The Clinton administration recently fired the first shot in this battle when it issued its no new taxes on the Internet stance in a paper entitled the Framework for Global Electronic Commerce. The paper is available on the White House Internet site. This report advocates the Internet be declared a tax free environment whenever it is used to deliver products and services. Additionally, Congress entered the battle when H.R. 1054 was introduced by Representative Christopher Cox, R-California in the House and S. Bill 442 was introduced by Senator Ron Wyden, D-Oregon, in the Senate. These bills would provide for a national moratorium on any new state and local taxation of the Internet, interactive services, and commerce conducted over those media. These bills are collectively called the "Internet Tax Freedom Act." The rationale for this act is as follows:

* The Internet is a global network that crosses state and international borders, and is inherently a matter of interstate and foreign commerce within the sole jurisdiction of the United States Congress under the Commerce Clause of the United States Constitution.

* Within the United States, the Internet crosses state lines and operates independently of state boundaries. Internet addresses are designed to be geographically indifferent. Internet transmissions are insensitive to physical distance and can have multiple geographic addresses.

* Internet transmissions use packet-switching technology that makes it impossible to determine with any degree of certainty the precise geographic route or endpoints of specific Internet transmissions and infeasible to separate intrastate from interstate transmissions and domestic from foreign transmissions.

* Taxes imposed on Internet activity by state and local governments would be inconsistent and impossible to fairly apportion between the states. This inconsistency would subject not only consumers, businesses, and other users engaged in interstate and foreign commerce to multiple, confusing, and burdensome taxation but would also restrict the continued growth of the Internet itself. This raises the question of the continued viability of this constantly developing medium.

* Because the Internet was developed after tax laws and regulations were established, their application to the Internet is unintended. Unpredictable policy would threaten every Internet user, access provider, vendor, and interactive computer service provider.

* The Internet provides services, products, and ideas that can be especially beneficial to senior citizens, the disabled, citizens in rural areas, and small businesses. Educational institutions and charitable organizations can also benefit from a variety of uses.

* It is possible for consumers, businesses, and others engaging in interstate and foreign commerce over the Internet or interactive computer services to be subjected to more than 30,000 separate taxing jurisdictions in the United States alone.

* The consistent and coherent national policy concerning taxation of Internet activity that best avoids burdening this evolving form of interstate and foreign commerce can best be accomplished by the Congress exercising its authority under Article I, Section 8, Clause 3 of the United States Constitution, the Commerce Clause, that says, "The Congress shall have the power to.... regulate commerce
with foreign nations and among the
several states..."

This tax freedom act only proposes a moratorium on Internet taxation. It provides that within two years of its passage, the President will recommend to Congress a policy on taxation of sales and other transactions affected on the Internet or through interactive computer services. Of course, the President's policy recommendation might be to maintain the status quo.

Opposition to the
Internet Freedom Act

The National League of Cities. At a meeting of the National Press Club on July 7, 1997, the president of the National League of Cities, Mark Schwartz, fired his own shot when he said that hard- pressed cities "absolutely" should have the ability to tax Internet and electronic transactions. He stated that one-third of the cities reported their fiscal conditions are worse off than a year ago because their general fund expenditures exceeded revenues. Schwartz agreed the United States does need a competitive tax policy approach if the Federal government and businesses are to thrive in the electronic age. However, this approach should, in his opinion, encompass the ability of state and local governments to generate revenue from the Internet.

The Federation of Tax Administrators (FTA) has also adopted a resolution opposing the Internet Tax Freedom Act as it is currently written. The FTA believes the proposal could be interpreted as allowing for a much broader moratorium than is intended by Senator Wyden and Representative Cox. The FTA states the act has the potential to substantially disrupt state and local sales and property taxes currently applied to electronic transactions. However, Representative Cox says the act is intended to stop new taxes that target the Internet in a discriminatory way. An example would be the European Union's proposal for a "bit tax," a new excise that would take the form of a very small tax on each bit or byte (character) of information transferred over the Internet. Even so, most concerns being expressed by state and local officials are that the act leaves open to interpretation, and possibly litigation, current applications of existing taxes not specifically addressed in the act. Services already taxed, like telephone services, can be expected to raise
an equal protection argument if
Internet commerce is specially exempted from taxation.

The Resolutions Committee of the Multistate Tax Commission (MTC) has taken the unusual step of adopting opposing stances on the Internet Tax Freedom Act. One version forwarded to the MTC opposes the adoption of the act as currently written. This version also says the MTC should work on developing a uniform approach to state taxation of electronic commerce with the National Conference of Commissioners on Uniform State Laws, should that organization undertake a project on the subject.

An alternative recommendation to the MTC by the Resolutions Committee supports the Internet Tax Freedom Act. The chief executive of the most populous state, California Governor Pete Wilson, and the California State Board of Equalization and Franchise Tax Board have also endorsed the legislation. They urge Congress to pass the act and President Clinton to sign the bill. The MTC
will meet to decide which resolution
to adopt.

The New York Approach

Governor Pataki of New York apparently agrees with the Internet Tax Freedom Act's no-tax approach, because on January 10, 1997, he announced that Internet service providers will be free of New York sales tax [The announcement may be viewed at http://www.state.ny.us]. The Department of Taxation and Finance then announced by memorandum that it would consider Internet charges as unremunerated services and thus not subject to state and local tax or the state telecommunications excise tax [TSB-M-97(1) C and S].

The decision not to consider Internet applications as a telecommunications service has significant implications for the future taxation of Internet commerce in New York and nationwide. Proponents of state and local taxation of Internet commerce have contended that Internet services are of the same nature and employ the same principles and apparatus for transmission of information as telephone and telegraph services that are taxable because they are doing business in the state. The position of the Department of Taxation may result from an understanding that there is a relevant difference between telephone and Internet service. The probable relevant difference is that telephone services provide transmission services between known specific locations. The sender knows where and to whom the transmission is addressed. Internet services, on the other hand, allow transmission to nonspecific locations and for unknown users to retrieve the content from nonspecific sites throughout the World Wide Web. The memorandum also stated an important policy position when it said, "nexus within the state is not created merely by having a non-New York company's advertising appear on a New York server or through a New York Internet service provider."

The Position of the Courts

Advocates of some state and local taxation of Internet commerce may be encouraged by at least three court decisions that hold Internet providers are doing business and present in the state for the purposes of jurisdiction when a substantial number of citizens of the state "hit" on the foreign Internet sites in response to a solicitation. In State of Minnesota v. Granite Gate Resorts [opinion found at http://www.ag.state.mn.us/consumer/news/onlinescams/ggorder.html], a gambling service advertised online betting services over the Internet and offered the opportunity to be placed on a mailing list. Hundreds of interested residents of Minnesota "hit" on the site. The Minnesota court found significant "contacts" with Minnesota because the gambling operation made a 365-days-a-year marketing campaign directed at any Minnesota resident who had a computer. In Maritz v. Cybergold [947 F.Supp 1328], the court found sufficient minimum contacts with Missouri because Missouri citizens "hit" on Cybergold's site to get on a mailing list. In CompuServ Inc. v. Patterson [89 F.3d 1257], the 6th Circuit Court of Appeals found that a subscriber in Texas had created substantial "contacts" with CompuServ in Ohio because he had uploaded two shareware applications to the CompuServ Ohio site.
The finding of "doing business" in
the state is important because it
triggers jurisdiction over the out-of-state Internet provider under the state's
long-arm statue.

At least two New York Federal court cases appear to agree with the reasoning of the New York Department of Taxation and Finance. In the analogous jurisdiction case of Bensusan Restaurant Corp. v. King [937 F. Supp. 161], the Federal district court refused to find jurisdiction over King, who was infringing on the trademark of a New York restaurant by posting ads, information, and how to order tickets over the telephone from a Missouri web site. The court said the mere fact a person can get information over the Internet is not the equivalent of physical presence in the state to sell products or services. Mr. King, by creating a web site, did not purposefully establish business contacts (nexus) in New York, said the court. The Federal district court in Hearst Corp. v. Goldberger [1997 WL 97097] agreed, stating that "a finding of personal jurisdiction in New York based on an Internet web site would mean there would be nationwide (indeed worldwide) personal jurisdiction over anyone who established a web site." The court found such result inconsistent with "law and public policy." Interestingly, the court specifically rejected the Maritz case rationale that "hits" on the Internet site can be considered "contacts" for the purpose of doing business in a state. Fraudulent or criminal activity, as opposed to advertisements, may change the result. In a New York state court case involving jurisdiction over fraudulent Internet solicitation, People v. Lipsitz, the trial judge ruled that jurisdiction existed in New York because both the sender and the New York recipient of e-mail have an "address" in New York. The court said that because the fraud occurred at a New York address the state has a sufficient nexus to take jurisdiction.

The Future of Internet Taxation

Because the various jurisdictions are still attempting to resolve the tax and jurisdiction questions raised by Internet commerce, a definitive answer concerning future taxation is not possible. What is possible, however, is to review the positions of the current actors and the court decisions for clues about which relevant factors will be weighed in, balancing the interests of Internet providers; traditional businesspersons; and Federal, state, and local governments. First, the New York approach advocated by the Department of Finance and Taxation and the Federal courts appears reasonable. The mere appearance of an Internet site on a computer screen should not constitute a sufficient presence or "nexus" with the state or local government to justify taxation. The fact a New York resident has "hit" on an Internet site does not mean the taxing entity has provided any police power benefits to the foreign entity or that a taxable event has occurred. However, where the resident of the state or local government has actually entered into a contract over the Internet for the sale or provision of goods or services, sufficient nexus may be found. It is well settled that states may fairly tax income or profits made in its jurisdiction.

The New York position that the state's traditional telecommunications tax does not apply to the Internet appears reasonable. The relevant difference is that telecommunications transmissions are directed to a known person or a specific location. Internet services, on the other hand, are directed to nonspecific locations and can be retrieved by nonspecific sites throughout the world. Internet services, unlike telecommunications, would be subject to thousands of conflicting tax jurisdictions around the world. Figuring out the tax and whom to pay would be impossible.

Given the perceived need for additional tax revenue at the state and local level and the concerns of small businesspersons that Internet tax breaks will disadvantage them, the likelihood that Internet transactions will escape all taxation is remote. As Internet commerce continues to grow at a phenomenal rate, the revenue that could be generated from this form of business may well be considered vital to state and local governments, particularly if Internet commerce impacts local forms of commerce and causes a loss of sales and service tax revenues. Most commentators are in agreement that a uniform national policy on Internet commerce is necessary to prevent undue burdens on Internet users. As a result, Congress probably will choose to exercise its regulatory authority under the Commerce Clause. Given state and local government's need for revenue, and the locally sited small business outcry if the Internet is completely exempt from local taxation, it is unlikely that Congress will prohibit all Internet taxation. It is likely, however, that Congress will balance the interests of all concerned by only allowing state and local taxation in nexus situations very similar to the New York approach. Finally, new developing technologies may well allow for improved tracking of Internet transmissions, thus providing a way to identify and fairly tax Internet commerce with a nexus to state and local governments. *

Ken Griffin, DBA, is a professor of information systems, Paula D. Ladd, EdD, an assistant professor of information systems, and Roy Whitehead, Jr., JD, LLM, an associate professor of business law, all at the University of Central Arkansas.

In Brief

Does Anyone Get a Piece of the Action?

It has been estimated that Internet commerce will grow from the current $30 billion to $80 billion by the year 2000. The question is whether this commerce should be subject to state or local taxation or be the sole jurisdiction of the Federal government under the Commerce Clause of the Constitution.

The White House has issued a report that advocates the Internet be declared a tax-free environment whenever it is used to deliver products and services. Bills have been introduced in Congress that would provide a national moratorium on any new state and local taxation of the Internet, interactive services, and commerce conducted over these media.

Various organizations representing state and local governments generally oppose these views, and recent court cases support taxation in certain situations. In New York, Internet charges will not be subject to state and local tax or the state telecommunication's excise tax.