E-Commerce: Does The Internet Taxman Cometh?

The technology "bubble" has burst, all but halting Wall Street's dot-com frenzy. Even as investors have watched their pocketbooks shrink, the Internet and e-commerce have continued to expand at a tremendous rate. Unfortunately, tax laws have not kept up with e-commerce's new and ever-expanding breadth.

The technology “bubble” has burst, all but halting Wall Street’s dot-com frenzy. The news in the tech sector has not been all bad, however. Even as investors have watched their pocketbooks shrink, the Internet and e-commerce have continued to expand at a tremendous rate. Now, any small business realistically can reach beyond its local market and operate on an interstate and even international basis. Unfortunately, tax laws have not kept up with e-commerce’s new and ever-expanding breadth. When applied to today’s technology-based businesses, traditional “brick and mortar” tax laws often create grave uncertainty. This article, while not eliminating the uncertainty, attempts to describe the current status of Internet taxation and indicate where it may be headed.


Sales/Use Tax. Most American activity regarding e-commerce taxation has focused on sales and use taxes. State and local taxing jurisdictions worry about lost tax revenues resulting from Internet purchases of goods from out-of-state vendors. Although most states require their residents to report and pay a use tax on those purchases, the use tax is almost universally ignored by consumers. As a result, the taxing jurisdictions want the Internet sellers to collect and remit the applicable tax.

In Quill v. North Dakota, 504 U.S. 298 (1992), the United States Supreme Court addressed a state’s attempt to impose a sales/use tax collection obligation on an out-of-state catalog retailer whose only contact with that state was through catalogs and solicitations sent through the mail. The Court found that the Constitution’s Commerce Clause prohibits a state’s requiring an out-of-state seller to collect a sales/use tax unless there is a “substantial nexus” between the seller and the taxing jurisdiction (including some physical presence of the seller in the state). The same standard would apply to Internet vendors. Although Congress could change the “substantial nexus” and physical presence standard, it has not yet done so, believing the tax collection obligation to be an undue burden on interstate commerce because of the variations in tax rates and the large number of taxing jurisdictions involved.

To date the sole foray of Congress into e-commerce taxation has been the passage of the Internet Tax Freedom Act, originally enacted in 1998 for a three-year period and recently extended through November 1, 2003. Many people erroneously believe the ITFA or “Internet tax moratorium” to be a complete prohibition against imposing or collecting taxes on Internet transactions. In fact, the ITFA only prohibits states and lower jurisdictions from imposing (1) taxes on Internet access (e.g., Internet connection services provided by companies such as AOL), unless the tax had already been enacted and was being collected when the Act was passed, and (2) multiple or discriminatory taxes on e- commerce. A company located in Georgia could easily sell products to a customer in Maryland through a Web site operated in Florida. If each of those states taxed the same transaction, the burden of the resulting multiple taxes would discourage the growing demand for goods and services purchased over the Internet. The Act therefore prohibits the states from taxing an e-commerce transaction that is also subject to taxation by another state unless there is in place a mechanism to avoid double taxation, e.g., a credit for taxes paid in another jurisdiction. Similarly, the Act prohibits states from discriminating against e-commerce transactions by imposing a tax on items sold over the Internet but not on similar items sold through more traditional means (such as catalog or telephone) or by taxing Internet sales at higher rates than are applicable to comparable sales made through more traditional means. The ITFA also considers discriminatory (and therefore prohibited) any tax if the ability to access the seller’s Web site on an out-of-state computer server is considered a factor in determining the seller’s tax collection obligation.

By prohibiting the consideration of access to a Web site maintained on an out-of-state server in the determination of nexus, the ITFA reinforces and affirms the physical presence and “substantial nexus” standard of Quill. So, when may a vendor be required to collect sales/use taxes on e-commerce transactions? Clearly, a seller that maintains a store or office or has employees in a state has the degree of nexus sufficient for that state to require the seller to collect its sales/use tax, even on sales made to state residents through mail-order catalogs or over the Internet. On the other hand, the necessary nexus would be lacking for a seller whose only contact with the state results from state residents placing orders through the seller’s out-of-state Web site. The answer is less clear if the Web site server is owned by the seller and located in the state seeking to impose the collection obligation.

Additional complications arise if the transaction takes the form of downloading digital information (e.g., software or music) rather than the sale of goods (e.g., a shrink-wrapped package of software or a compact disc) to be shipped to the purchaser. There is currently no consensus as to whether downloaded information should properly be characterized as tangible property (which would be subject to sales/use tax) or intangible property (which typically would not be subject to sales/use tax). In addition, because downloading is typically an anonymous transaction, there is currently no effective way to identify the purchaser’s location (i.e., the appropriate taxing jurisdiction) even if the downloaded material were characterized as tangible property.

Income Tax. From a domestic U.S. federal income tax perspective, the characterization or source of an Internet transaction is irrelevant because U.S. businesses, U.S. citizens and resident aliens are subject to tax on their worldwide income. However, from a state income tax perspective, the characterization and source of an Internet transaction can affect whether and to what extent a business has income subject to taxation in a particular state. Rules for allocating and apportioning income can differ depending on whether the property involved is tangible or intangible personal property. While a book sold at the local shopping mall would clearly be tangible personal property, the proper characterization of the text of that book downloaded from an Internet site is less clear; a computer download could be considered the sale of intangible property. As a result, in circumstances where income is subject to allocation rather than apportionment, the state to which e-commerce income should be allocated is sometimes unclear. Similarly, when income is subject to apportionment, the proper application of the apportionment formula may be problematic because of the unsettled character of the property involved and the inability to determine the location of anonymous Internet transactions for purposes of the formula’s sales or gross receipts factor.

The potential characterization of downloading as the sale of intangible property has another significant effect on e-commerce taxation. States are prohibited by the terms of Public Law 86-272 from asserting income tax jurisdiction over out-of-state sellers of tangible personal property whose only presence or activity in the state is through solicitations of orders to be accepted and filled out-of-state. Sellers whose activities include the sale of downloaded material would lose the protection of P.L. 86-272 if that material were considered to be intangible property. In addition, even if the downloaded items were considered tangible personal property, the existence of an owned computer Web server in the state could constitute an additional presence or activity in the state sufficient to void the protection of P.L. 86-272.


Income Tax. The absence of an international consensus on the characterization and source of transcontinental Internet transactions leads to the same types of issues regarding jurisdiction to tax and allocation and apportionment of income described above, but on a global scale. A single Internet transaction concerning a digital product could be characterized by different countries as producing sales proceeds, royalties or rentals, or even income from services, with each alternative being subject to different rules concerning income sourcing, taxing jurisdiction and rate of taxation.

The traditional rules to determine jurisdictional issues such as whether a trade or business is being operated in a country (or whether a permanent establishment exists in the case of a tax treaty) are not easily applied to Internet operations that can be controlled remotely from one country through a computer server located in another country. The result can be double taxation if, through different characterizations or sourcing conventions, both affected jurisdictions subject the same income to tax, but not all of the taxes paid in the foreign jurisdiction are allowed as a credit against the business’s home country tax liability.

Some attempts are being made to clarify these issues. For example, the United States has adopted tax regulations dealing with computer software that address some of the characterization issues. However, those regulations do not apply to other types of digital products, and they are not binding on other jurisdictions. In addition, the Organization for Economic Cooperation and Development (of which the U.S. is a member) has revised the commentary on its model tax convention (the basis of many bilateral income tax treaties) to clarify that a computer server can constitute a permanent establishment if it conducts “core” business activities such as accepting orders and payments. The OECD is also considering proposed guidance for the consistent characterization of many common Internet transactions. However, the questions continue to outnumber the answers.

Value Added Taxes (VAT). Members of the European Union have expressed concern that Internet sales by businesses outside the EU result in the loss of value added tax revenues (not unlike the concerns of the American states with respect to lost sales tax revenues) and place EU businesses at a competitive disadvantage since the EU businesses must collect the VAT on their sales. As a result, commencing in 2003 the EU will require that non-EU businesses making Internet sales to EU residents (other than business to business transactions) register in an EU state (selected by the business) and collect and remit the VAT applicable to sales where the purchaser resides. While the EU contends that the compliance burden will be minimal, the actual impact of the requirement remains to be seen. For example, it is not clear how the seller will be required to verify the purchaser’s residence to determine the applicable VAT rate in transactions that consist of downloading material (a problem not faced by EU businesses, which collect the VAT based on their own location rather than the purchaser’s). Equally unclear is whether the new EU requirement will affect sales tax collection obligations in the U.S. If American businesses can comply with a requirement to collect and remit VAT on Internet sales to Europe, it may be difficult for Congress not to allow states to require the collection of sales/use tax on Internet sales to their residents.


Ancient wisdom says there are only two certainties in life: death and taxes. However, many aspects of the taxation of Internet transactions are currently anything but certain. Given the enormous amount of tax revenues at stake, you can be sure that state, federal and foreign governments will continue their efforts to establish a workable system of e-commerce taxation. How those bodies ultimately will resolve the various issues remains open to debate. Rest assured, though, one day the Internet taxman will get his due.

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