January 2001
The Tax Angle of E-commerce
By Chaim Kofinas
The first year New Jersey had a state sales tax (fiscal 1967), the rate was 3% and the state collected more than $208 million, representing over 25% of the state’s revenue for the year. The current rate, 6%, was reduced from 7% in 1992. The revenue collected in recent years has ranged $4–5 billion, representing, on average, one-third of the total state revenue. For fiscal 1999, just over $5 billion was collected from the sales tax levy, representing 31.2% of tax collections.
For 1998, the last year for which national information has been compiled, the Federation of Tax Administrators surveyed the tax collection statistics for all 50 states and found that, on average, sales taxes represented 32.9% of all taxes collected. Tennessee and Florida had the highest proportion of sales tax revenue, at just over 57%; Texas came in third at 50.6%. Protecting this tax base and revenue source is a high priority in the state legislatures, and Congress has also joined the fray.
State tax administrators view the Internet as a very real threat to their tax base. Forrester Research, Inc., predicts that the value of e-commerce transactions will reach $3.2 trillion as early as 2002. At an average sales tax rate of 5%, this represents $160 billion in potential revenue at stake.
Pre-Internet Rules
Before a state can require a seller to register itself to collect and remit sales tax, the selling company must have some connection with that state, a minimum required connection known as a nexus. The nexus rule was developed by a series of Supreme Court rulings starting with Miller Bros. (1954), National Bellas Hess (1967), and, most recently, Quill (1992).
These established, through constitutional principle, that out-of-state direct mail order sellers cannot be compelled to collect sales tax. Because the power to regulate interstate commerce is reserved for the federal government, a state cannot, absent any compact to the contrary, directly tax a sale made by an out-of-state vendor. For example, a New York vendor making a sale to a New Jersey customer is not required to collect either New York or New Jersey sales tax.
Once a vendor intends to transact business in a particular state, the due process and commerce clauses of the U.S. Constitution come into play. The due process clause requires a “minimum connection” before the state is allowed to tax. Purposefully directed efforts, such as flyers, advertisements, and catalogs being mailed into a state can meet this test without physical presence. The commerce clause, however, requires the vendor to have a “substantial presence” in the state. The courts in the aforementioned cases defined substantial as physical presence in the state by either people or goods. Therefore, in applying this rule a seller attains nexus in any state in which the vendor’s salespersons call on prospective customers or in which the seller warehouses its inventory.
In e-commerce, sellers are usually at remote locations from their buyers and merchandise is shipped using common carriers or overnight delivery services. These ever-increasing types of sales escape the sales tax. To replace this lost revenue, states now want to tax the Internet itself. But, with the Internet fueling the longest-running economic boom in U.S. history, Washington does not want to kill the goose that laid the golden egg.
As a result, Congress passed the Internet Tax Freedom Act (ITFA; P.L. 105-277), which was signed into law on October 21, 1998. It imposed a three-year moratorium on the state and local taxation of Internet access and multiple or discriminatory taxes on e- commerce. ITFA provides that “no state or political subdivision may impose, for the period beginning October 1, 1998, and ending October 21, 2001:
Internet access charges are currently subject to sales tax in Connecticut, North Dakota, Ohio, South Dakota, Tennessee, Texas (effective October 1, 1999, Texas allows a monthly exemption of up to $25), and Wisconsin. The definition of Internet access under the act specifically excludes telecommunications services. “Discriminatory” is defined as “not generally imposed and legally collectible by the state or political subdivision on transactions involving similar property, goods, services, or information accomplished through other means.”
The act established an Advisory Commission on Electronic Commerce (ACEC), composed of representatives from federal, state, and local governments and computer and telecommunications industries, to help Congress address Internet taxation issues. The results of its study were to be submitted to Congress within 18 months of the bill’s enactment on October 21, 1998. However, ACEC was slow in getting organized and slower in setting its first meeting, possibly because the National Tax Association (NTA) was itself in the midst of a similar study. Unfortunately, the NTA’s Communications and Electronic Commerce Tax Project could not reach a consensus, leaving ACEC with a huge project and little time to complete it.
Although ACEC worked diligently, it too was hampered by dissention and could not muster the two-thirds majority required for recommendations to be submitted to Congress. Proposals that received a simple majority were included in a report submitted in April and H.R. 4267, an amendment to the ITFA, was subsequently introduced (see News & Views, June 2000). This bill, titled the Internet Tax Reform and Reduction Act of 2000, would
“1) prohibit all state and local taxation of Internet access, including
that grandfathered under the ITFA;
2) extend for five years the existing moratorium on multiple and discriminatory
state and local taxes on electronic commerce;
3) impose a five-year moratorium on state and local taxes on sales of digitized
products and their counterparts;
4) specify factors that would not empower a state to impose tax collection
obligations on a seller not physically present in the state or require a
seller to meet business activity and income tax obligations of the state;
and
5) encourage the states and localities to develop a uniform sales and use
tax act, simplifying the existing system, in cooperation with the National
Conference of Commissioners on Uniform State Laws.”
Congress continues to debate the issue. Although some lawmakers favor the proposed five-year extension of the moratorium, state tax administrators have been lobbying to lift it. Some tax administrators even advocate the imposition of a new tax directed specifically at Internet companies. At present, the only certainty is that the debate among the more than 3,800 separate taxing jurisdictions will continue for the foreseeable future. However, impetus for consensus comes from a decline in sales tax revenue during what now appears to be a slowing economy or, even worse, a potential economic downturn. Pressed for revenue to provide needed services, the states will be forced to simplify the current system or face the specter of a quickly eroding tax base.
In Quill, the Supreme Court followed its 25-year-old precedent of National Bellas Hess and exempted Quill from collecting or remitting the North Dakota sales tax. Just as National Bellas Hess spurred the boom in catalog sales 25 years ago, the 1992 Quill ruling set in place the fundamentals for the e-commerce explosion. Before the five-year extension (if enacted) of the moratorium expires, the eroding tax base of the state and local taxing jurisdictions will prompt them to make changes, regardless of the overall economic outlook. A slowdown will only add immediacy to the situation. Instead of working on the outside, the states may ask Congress to revisit the area and protect their tax base, whereas the business community will lobby for retaining the status quo. Either way, this problem will not go away unless Congress takes a definitive stand, and it will most certainly be on the front burner until it is resolved.
State and Local Editor:
Stewart Buxbaum, CPA
S. Buxbaum & Company, P.C.
Interstate Editor:
Nicholas Nesi, CPA
BDO Seidman LLP
Contributing Editors:
Henry Goldwasser, CPA
M.R. Weiser & Co. LLP
Steven M. Kaplan, CPA
Kahn, Hoffman, Nonenmacher &
Hochman, LLP
John J. Fielding, CPA
PricewaterhouseCoopers LLP
Warren Weinstock, CPA
Marks Paneth Shron, LLP
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