Taxation and the Internet

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TAXATION AND THE INTERNET

The commercial Internet, by the 21st century, had already substantially transformed business transactions, both in the United States and worldwide. In the early 21st century, similar changes were expected in the realm of taxation. Despite the financial downturn of the early 2000s and the collapse of many dot.com start-ups, projections for rapid growth and burgeoning e-commerce profits suggest that the financial stakes involved could be exceptionally high. Thus, the nature of taxation in e-commerce was the source of no small amount of debate.

The very nature of e-commerce complicates the issues surrounding taxation. The lack of physical connection between the parties in online transactions renders collection of taxes difficult. Many items sold online, such as music, videos, and software, can be downloaded directly from the Web, making the tracking of their dissemination problematic. Furthermore, such items are considered intangibles, which historically have been exempt from U.S. sales taxes. States usually tax income where it is earned, but the Internet often obscures the identity and location of individuals or businesses engaged in taxable activities. The development of anonymous e-currencies could facilitate tax evasion. Finally, the Internet aids the mobility of firms and workers, who can easily transfer to low-tax destinations or tax havens. Many large-scale, chain retailers have created independent, online businesses with a physical presence in just one state to avoid collecting sales taxes elsewhere.

Consistent data about the financial ramifications of e-commerce taxation are difficult to find. A University of Tennessee study estimated that states and localities could lose $10 billion in sales tax revenue to untaxed e-commerce by 2003. However, Forrester Research reported that in 1999 these jurisdictions experienced only $525 million in lost sales tax revenue. A University of Chicago economist concluded that if sales taxes were applied to e-commerce transactions, online purchasing could decrease by 24 percent.

U.S. E-TAX POLICIES: LEGAL AND CONSTITUTIONAL DIMENSIONS

The Constitution's Commerce Clause grants Congress the power "to regulate commerce. . .among the several states." However, the formulation of state and local tax policy has traditionally been left to those jurisdictions. If the federal government preempts the states' ability to set their own tax policies, some argue it would violate the principles of federalism. Congress can regulate activities that "substantially affect" interstate commerce, but it cannot order states to enforce federal regulatory programs, since that infringes upon state sovereignty. A state's authority to regulate commerce within its borders is limited by the Due Process Clause of the 14th Amendment and the Commerce Clause. The latter gives states the jurisdiction to tax commercial sales only when sufficient contact between the buyer and seller exists within the state.

Generally, sales of intangible property are not taxed in the U.S. But technology now permits the conversion of many tangible goods, such as books and recordings, to digitized content that can be delivered entirely online. The taxable status of such content remains uncertain.

The Supreme Court established two important legal precedents for the e-taxation debate. In 1967, it ruled in National Bellas Hess v. Illinois that a state could only tax commercial transactions when the seller maintained a physical presence, or "nexus"—an office, a warehouse, of a sales agent—in that state. Requiring out-of-state vendors to cope with the complexity of various state and local sales tax systems constituted a barrier to interstate commerce. In 1992, the Court reinforced this decision in Quill Corp. v. North Dakota, which involved state sales taxation and out-of-state mail-order vendors. It reiterated the nexus requirement, but noted that Congress could pass laws requiring remote vendors to charge state sales taxes on all sales, if Congress provided national guidelines to simplify state sales tax collection.

This constitutional and legal framework affects e-commerce taxation in several ways. Since consumers can purchase goods and services online from evendors located anywhere in the U.S., questions of whether the federal or state government is the appropriate authority to generate tax regulations come to the forefront. The parallels between catalog sales and e-commerce transactions led officials to apply the Bellas Hess and Quill rulings to online sales taxation. However, the Internet's lack of geographical borders and the difficulty of defining what constitutes a "physical presence" or "substantial nexus" between e-buyer and e-vendor complicate this practice.

To gain time to generate comprehensive e-taxation policies and to allow unfettered growth of e-commerce, Congress passed the Internet Tax Freedom Act (ITFA) in 1998. ITFA placed a three-year moratorium on the creation of "discriminatory and multiple" e-commerce taxes by states and localities. It also banned federal sales taxes of Internet transactions, promoted tax-free international e-commerce, and established an Advisory Commission on Electronic Commerce to develop national guidelines for e-taxation. But the Advisory Commission failed to offer any official recommendations to Congress and the matter remained inconclusive.

The federal government levies excise taxes on Internet service transactions such as airline ticket sales and on telecommunications. Internet access is taxed in nine states and downloaded information and software in 29. Most states levy corporate income taxes on profits generated from providing Internet access and from the online sale of goods and services. States usually "source" income from e-commerce sales of tangible property to the customer's state of residence, and income from the sale of intangible digital content to the vendor's home state. The federal government taxes income earned through e-commerce in the same manner as income earned via traditional channels.

Numerous e-commerce taxation schemes have been proposed, many as legislative bills submitted to Congress. Possible solutions include:

permitting state and local e-sales taxes if states simplified and standardized their tax systems
banning all e-commerce taxation
instituting a national e-commerce sales tax
creating a centralized, third-party collection system for state sales taxes, to be used by all online vendors
establishing a national value-added tax (VAT) levied on all household consumption of goods and service, regardless of how they are sold.

ARGUMENTS FOR AND AGAINST E-COMMERCE TAXATION

Supporters of e-taxation argue that state and local governments, which rely on sales-tax revenues for one-third to one-half of their operating funds, will face serious income shortfalls if e-commerce remains untaxed. Sales-tax revenues pay for essential services such as schools, fire and police departments, public libraries, and health care. If budget needs can't be met, states will either shift the tax burden to other sources, such as telecommunications, energy, income, or property taxes, or simply cut services. And as online retailers drive traditional merchants out of business, property values and property taxes would decline, leading to greater revenue losses. Tax advocates also state that keeping e-commerce tax-free unfairly disadvantages traditional vendors who must pay sales taxes, while online retailers enjoy a competitive pricing edge.

In response to complaints that the thousands of separate U.S. tax jurisdictions create a taxation universe too complex for e-vendors to cope with, tax supporters counter that software could be developed that automatically identifies the applicable e-sales taxes for all taxable goods or services in each ZIP code. Tax proponents also claim that the Constitution guarantees states the right to collect tax revenues; thus legislation such as ITFA infringes on state sovereignty.

Finally, taxation proponents argue that tax-free e-commerce benefits the wealthy. Studies identify a growing gap in the percentage of higher-income versus lower-income households that utilize the Internet (the "digital divide"). Since lower-income groups have less access to the Internet, they cannot avoid sales taxes by purchasing online.

In comparison, e-tax opponents claim that taxing e-commerce would smother its expansion and impede online innovations. This argument formed the main impetus behind the ITFA. Opponents also point out that the U.S. contains roughly 7,000 state and local sales-tax rates in 45 states and Washington, D.C. In addition, taxable items are classified differently in different jurisdictions. It would cost far too much for e-retailers to calculate, collect, and remit sales taxes under such conditions. Opponents also question why e-vendors located in one jurisdiction should subsidize goods and services located in another.

Anti-tax arguments propose that Internet taxes imperil America's international competitiveness, since domestic e-businesses would relocate to evade them. And e-sales taxes would hamper overall U.S. economic growth, since e-commerce was one of the mainsprings of the 1990s boom. Finally, they point out that sales tax revenues lost to e-commerce have been so small as to have little effect on state revenues.

INTERNATIONAL E-COMMERCE AND TAXATION

Discussion of e-commerce taxation in the global arena primarily concerns industrialized nations, where most e-businesses are based and where the vast majority of online transactions occur.

As of 2001, downloads of digital goods made in the EU were subject to value-added tax (VAT) rates of the supplier's home country, while physical goods ordered online were assessed at VAT rates of the country in which they were consumed. Goods and services purchased from EU vendors by non-EU customers were generally zero-rated. Non-EU retailers selling digital goods and services to EU purchasers were not subject to VAT, giving countries such as the U.S. and Canada a pricing advantage in international e-commerce. New legislation was under consideration by the European Commission (EC) and the Organization for Economic Cooperation and Development (OECD) in the early 2000s. It was intended to ensure that online services and digital goods sold to individuals would be taxed where they are consumed. Non-EU vendors would register for VAT in one EU state and account for VAT on items and services delivered to EU residents at that country's rate.

International authorities are concerned about the potential tax revenue losses that may accompany un-taxed e-commerce. However, they have proceeded cautiously regarding international e-commerce taxes. As in the U.S., foreign governments and industries have been loath to retard the early expansion of e-commerce, and special taxes levied only on e-commerce have met widespread rejection.