Escaping the Internet Sales Tax Cartel

The moratorium on Internet tax legislation ends this month, and it is likely the debate will intensify in the coming weeks. Parties whose goal seems to be preservation of existing business models or market position are leading the pro-tax campaign.

The Internet Tax Moratorium, enacted three years ago, did not prohibit Internet taxation. The legislation merely precluded the imposition of new, discriminatory taxes. State and local governments always have been entitled to collect sales and use taxes based upon Internet transactions in accordance with law existing at the time the moratorium was enacted.

State and local governments complain they have difficulty collecting taxes for transactions conducted over the Internet. The biggest issues facing the states are jurisdiction and taxpayer compliance.

State sales taxes depend upon jurisdiction for enforcement. States can enforce sales tax collection and impose payment responsibilities on sellers only to the extent such sellers have a nexus with the taxing authority. The Internet vendor in Minnesota is not subject to Florida sales tax enforcement because the vendor has no presence in that state.

This does not necessarily mean that Florida must forgo sales tax proceeds from transactions between the Minnesota vendor and the Florida resident. The Minnesota vendor is subject only to the jurisdiction of Minnesota and cannot be taxed by Florida. However, the Florida resident that purchases from the Minnesota vendor is subject to the jurisdiction of Florida and can be taxed.

Each state resident is responsible for payment of use taxes to the state taxing authority on applicable purchases, regardless of seller location. The system depends upon voluntary compliance and reporting from buyers that typically do not file use tax returns.

Recognizing these risks, Congress enacted a three-year moratorium on state and federal tax legislation regarding Internet transactions, and it created the Advisory Commission on Electronic Commerce (ACEC)

The ACEC was charged with making a formal recommendation to Congress on the question of Internet taxation. However, it failed to reach unanimous agreement.

The commission created two diametrically opposed proposals on Internet taxation. The first, supported by Virginia's Republican Gov. James Gilmore, advocated a ban on Internet taxation, as well as reform or elimination of many other state and local taxes. The second proposal, by Utah's Republican Gov. Mike Leavitt, who represents the National Governor's Association, would require e-commerce vendors to collect and remit sales taxes to the states and localities of every customer served.

Gilmore, who chairs the commission, was able to convince a majority of the 11 members to support extending the existing moratorium to 2006. The extension would preserve the status quo and the barriers states face in collecting local sales and use taxes.

The Great Debate

The Internet tax debate is somewhat puzzling on the surface. Consumers clearly do not want to pay sales taxes on Internet transactions. Just as clearly, Internet vendors do not want to calculate, collect and remit taxes due to any or all of the more than 7,500 tax jurisdictions throughout the United States.

Who wants Internet taxation? The most obvious advocates are state and local governments.

State authorities suggest that if the Internet is left untaxed, tax receipts will decline. This argument is misleading. Even if all Internet sales were left untaxed, the lost tax proceeds would be minimal. Aggregate retail sales in the United States last year were $3.2 trillion, with less than 1 percent of these conducted over the Internet.

Even mail order sales, which are four times greater than Internet sales, accounted for less than 4 percent of all retail transactions in 2000.

It is difficult to argue that state authorities are losing revenue when tax receipts are climbing despite increases in Internet sales. The National Conference of State Legislatures confirms that state sales tax receipts rose 5 percent to 6 percent during the last several years, despite an increase Internet sales.

Established New Economy players also are fueling the debate on Internet taxation. These large companies can handle the complexity of government tax regulations, especially if the end result is to keep a start-up off the field of competition.

Finally, some favor Internet taxation as a way to regulate against competition. This group includes the so-called "main street" retailers that perceive the Internet retailer as having a competitive pricing and market advantage, which threatens store traffic and local sales. This group has been among the most vocal and ardent supporters of Internet taxation on the basis of fairness.

Fair Play?

The fairness debate is whether Internet vendors have an unfair advantage over the main street retailer that is subject to state and local taxes. Some retailers want to restore tax fairness by imposing taxes on the Internet vendor.

A few flaws can be found in the fairness argument. First, Internet vendors are subject to tax by the state taxing authorities where they are located. The notion that the Internet vendor is not subject to taxation is simply incorrect. Internet vendors are not subject to taxation in every jurisdiction in which they sell product. Of course, neither are main street retailers required to collect taxes for sales they conduct in foreign jurisdictions.

Advocates for imposing tax collection responsibilities on e-commerce vendors for transactions in foreign jurisdictions compromise the goal of fairness by forcing these vendors to pay taxes in jurisdictions where they receive no benefit. Taxes are for services rendered by government. The e-commerce vendor located outside the state receives no such services and, therefore, should not be taxed.

The logic of the middleman in this debate is curious. The more attractive proposal would seem to be that since the Internet vendor pays no tax, the competitive playing field is best leveled by allowing main street retailers to run their businesses tax-free.

To the extent the Internet vendor has an advantage over the "brick and mortar" retailer, this advantage is not derived from escape of the sales tax. E-commerce vendors have an advantage because of the efficiencies of their business models. The vendors need for retail outlets, large inventories or a sales staff. Markets are not limited by geographic reach. These cost and marketing advantages loom large, regardless of the sales tax question. The best competitive response is to enter the market and compete, rather than throw up regulatory barriers to protect an eroding position.

The proposal promises to rationalize a uniform sales tax system applicable to all participating states. The tax on all online sales would be collected by a National Sales Tax Cartel. Participating states would cede local control and collection authority to a national bureaucracy of unelected officials. The arrangement subjects the residents of each participating state to taxation by all other participating states. The proposal does not require approval of a majority of the states, but would be imposed on all citizens of states electing to participate.

The plan derives from the National Governor's Association (NGA) proposal that failed to achieve majority endorsement of the ACEC last year. The NGA proposal flies in the face of Supreme Court precedent and the U.S. Constitution. Under the Commerce clause, only Congress has the authority to regulate commerce among the various states. States cannot by compact empower any cartel to collect taxes they cannot collect themselves. Advocates of the plan propose to deal with this problem by amending the U.S. Constitution.

The NGA proposal stands in stark contrast to the New Economy Tax Fairness Act (Net Fair) and the Internet Tax Nondiscrimination Act. These bills, supported by Senators Judd Greg (R-N.H.), George Allen (R-Va.) and Conrad Burns (R-Mont.), preclude states from collecting sales taxes from businesses without a nexus to the taxing authority. Under these bills, states can impose whatever tax they choose, but the impact is limited to those with a nexus to the state -- the beneficiaries of state spending. This is the same arrangement applicable to catalog sales and serves as a sensible solution.

Attention on both proposals has increased recently because of the end of the current moratorium. Clearly, Congress could let the moratorium expire without addressing the issue. Another alternative is to embrace the recommendation of the ACEC in extending the moratorium an additional five years. Finally, the NGA and Burns proposals stand as starkly different policy choices.

Regardless of congressional action, it appears that tax competition among the several states may provide an important counterbalance in avoiding new taxes on the Internet. Oregon's Democratic Gov. John Kitzhaber recently signed an Internet tax ban. Other states, recognizing the economic benefit of an Internet free of new and discriminatory taxes, may opt in favor of consumers and entrepreneurs by declining participation in any Internet Tax Cartel.

Richard Scott Draughon is the president and chief executive counsel of Draughon Professional Association, a Jacksonville, Fla.-based technology law firm. He is also the founder and author of MyTechnologyLawyer.com, an online interactive resource for managing the legal affairs of the technology enterprise. He can be reached at (904) 358-3777 or dralaw@draughonpa.com.

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