Brennan
Schwarz
Intern
July
1999
This paper was researched and written by
Brennan Schwarz, who served as an intern with the Senate Fiscal Agency
during the summer of 1999. Gary S. Olson, Director of the Senate Fiscal
Agency, provided assistance in production of this paper.
SUPREME COURT CASES ON TAXATION OF MAIL-ORDER PURCHASES
PROPOSED ALTERNATIVES FOR E-COMMERCE TAXATION
THE POTENTIAL IMPACT OF A TAX-FREE INTERNET ON THE STATE OF MICHIGAN
The rapid emergence of the Internet as a channel for mass communications has revolutionized how people work, learn, play, and shop. There are approximately 79.4 million Americans with access to the Internet either at home or at work.(1) The powerful capabilities of the Internet have cleared the way for the use of electronic commerce (e-commerce) as a means of conducting transactions that were formerly conducted in more traditional ways. The staggering amount of sales generated by e-commerce has caught the attention of policy-makers across the nation. While the current value of e-commerce transactions is small when taken as a percentage of the nation's economy, it is the potential rate of growth and future direction of e-commerce that have compelled leaders in government to consider the implication of allowing transactions that take place over the Internet to go untaxed.(2)
The rapid growth of e-commerce has refueled the debate over the right of states and localities to levy sales and use taxes on interstate commerce. Transactions that take place over the Internet do not pay heed to state lines. It is often the case that the Internet service provider, the purchaser, and the seller all are located in different states. The cross-border nature of e-commerce and the complexities associated with levying tax on interstate commerce mirror the states' difficulty in collecting taxes on the majority of goods bought through a mail-order catalog. There is, in general, a lack of understanding about the capabilities of e-commerce and the applicability, if any, of current state tax laws to this type of transaction. Add these ambiguities to the fact that the capabilities of the Internet are constantly evolving, and it becomes obvious that arriving at a consensus about taxation of the Internet will involve Herculean efforts at negotiation and compromise from policy-makers in government and in the business community. In order to come to an equitable solution to the problems and complexities that arise when considering taxation of e-commerce, the following issues must be addressed:
• What existing state sales and use tax laws, if any, are applicable to the Internet?
• Are the transmissions under consideration for taxation tangible or intangible services; what is the existing state tax law for purchases in the each of these forms?
• Is there a way to tax the Internet without imposing discriminatory or multiple taxes?
• What is the best way to quantify e-commerce
so as to allow the creation of equitable policy regarding the taxation
of transactions that take place over the Internet?
Mail-order companies have avoided the collection and remittance of sales and use taxes for decades. The mail-order industry's ability to avoid taxation on its sales for the past 30 years pivots upon the physical presence requirement of nexus. Many in state and local government have long argued that the competitive advantage held by the mail-order catalogs over Main Street competitors who must collect tax is an unfair one. L.L. Bean for example, had sales of $888 million in 1995 and must collect and remit sales taxes only to Maine, the state in which it is headquartered.(3) The same standards of nexus that apply to the tax treatment of mail-order sales can be applied to e-commerce sales. Obviously, it is in the mail-order industry's interest to defend the physical presence requirement of nexus. The Direct Marketing Association, the leading trade association for mail-order companies, has expressed strong support for a tax-free Internet.
The staggering amount of sales projected
by analysts studying the e-commerce industry points to an eventual erosion
of state and local tax revenues, leading many to view taxation of e-commerce
as inevitable. A study done by Boston Consulting Group and shop.org revealed
that the online retail market is increasing at an excess of 200% annually.(4)
Applying this 200% rate of growth to current estimates for e-commerce sales,
Table
1 shows that by the year 2000 revenue generated by e-commerce promises
to outpace the sales generated by mail-order catalogs. This potential growth
in e-commerce sales will force states to review their tax laws carefully
in order to ensure continued revenue growth.
The United States Supreme Court decision, in National Bellas Hess, Inc. v Illinois, 386 U.S. 753 (1967), established that a taxpayer or business whose only connection to a state or locality is through a common carrier or U.S. mail does not have what is referred to as "nexus".(5) In the most simple terms, nexus is defined as a "connection between things". When used in reference to state taxes, "taxable nexus", as described by the U.S. Supreme Court, is the "required level of contacts or connections between the taxing state and the taxpayer to subject the taxpayer to the state's jurisdiction".(6) The Court's ruling regarding "taxable nexus" as it applies to interstate commerce was based on its interpretation of the Due Process and Commerce Clauses of the United States Constitution. (Under due process requirements, a taxpayer must have sufficient contacts with a state that it would be reasonable for the taxpayer to defend a suit in that state. Since the Commerce Clause gives Congress the authority to regulate commerce among the states, a state must not place undue burdens on interstate commerce by taxing out-of-state mail-order sellers, for example--unless they have substantial nexus with the taxing state.)
Therefore, while the Michigan Use Tax Act levies a 6% use tax on tangible personal property used or consumed in the State, the State cannot constitutionally force corporations or businesses that engage in interstate commerce to collect and remit a sales or use tax if they do not have a physical presence in the State.
The decision in National Bellas Hess was partially reversed in Quill Corp. v North Dakota, 504 U.S. 298 (1992). The Quill decision essentially eliminated the Due Process Clause as a protection against a state's taxing jurisdiction for any seller who intentionally seeks to make sales into that state. The Court retained a physical presence test, however, and concluded that so long as the seller's activities are more than minimal there is fair warning that the state may decide to impose a tax on the seller.(7) This holding clears the way for congressional action on mail-order taxation, since Congress may authorize the states to take action that burdens interstate commerce.
As a result of standards of nexus, the payment of taxes on mail-order sales works on a kind of "honor-system", in which consumers are legally obligated to pay a use tax on mail-order purchases even though sellers are not required to collect and remit the tax on the consumers' behalf. Most states are not vigilant in making sure individuals pay the use tax owed on mail-order or Internet purchases, which means the tax generally goes unpaid and represents revenue forgone by the states.
While the State of Michigan has kept its
tax code relatively simple by maintaining a uniform statewide sales and
use tax rate of 6%, many states do not maintain a uniform sales tax rate,
allowing localities to levy tax rates separate from the sales tax rate
mandated in the state tax code. A complex web of over 30,000 taxing authorities
exists in the United States. Requiring mail-order catalogs to comply with
the various tax laws of every state and locality has the potential to be
a record-keeping nightmare and, in the opinion of the Court, delivered
by Justice Stewart for the Bellas Hess case, "The very purpose of
the Commerce Clause was to ensure a national economy free from such unjustifiable
local entanglements. Under the Constitution, this is a domain where Congress
alone has the power of regulation and control." The same issues raised
in the Bellas Hess and Quill cases regarding the taxation
of mail-order sales also apply to the taxation of e-commerce sales.
In order for Federal, state, and local governments to arrive at a decision concerning Internet taxation, a mutually agreed upon definition, clearly explaining exactly what kinds of transactions are appropriately classified as e-commerce, must be established. Currently, there is no such clear definition of e-commerce. In a paper written by the Minnesota Department of Revenue,(8) three definitions of e-commerce were provided:
Narrow: Retail sales to consumers that take place on open networks such as the Internet
Broad: All transactions that take place electronically including automatic teller machine transactions, electronic data interchange, and electronic funds transfer
Middle ground: Business that occurs on open networks such as the Internet.
The Minnesota paper uses the middle ground definition. The narrow definition excludes business-to-business commerce which is currently the most common type of e-commerce that takes place over the Internet. The use of the broad definition would beg the question of why the imposition of a tax on electronic data interchange and automatic teller machines transactions now? They are both services that have been around for decades with no taxation. Therefore, the middle ground definition is the most comprehensive, without creating a situation that could become unmanageable as policy-makers attempt to come to a conclusive decision about what should and should not be taxed.
President Clinton signed the Internet Tax Freedom Act (P.L. 105-277) into law on October 21, 1998. The Act, introduced by Representative Christopher Cox (R-CA) and Senator Ron Wyden (D-OR), was a preemptive strike against states' efforts to apply sales and use taxes to the Internet, and places a three-year moratorium on new Internet-related taxes.
Major provisions of the Internet Tax Freedom Act include the following:
• The three-year moratorium prohibits state and local governments from taxing Internet access providers from October 21, 1998, to October 21, 2001. There is a "grandfather" clause in the legislation that allows states that were taxing Internet access providers prior to October 1, 1998, to keep the tax in place if they could prove that their taxes had been "generally imposed and actually enforced".
• The moratorium bars states and local governments from imposing discriminatory or multiple taxes on electronic commerce. This provision ensures that buyers and sellers of electronic commerce are not subject to taxation in multiple states. It protects buyers and sellers of electronic commerce from the imposition of taxes due to the establishment of nexus in a particular state. Also, it ensures that goods or services that are sold exclusively over the Internet and have no offline equivalent will not be subject to taxation for the duration of the moratorium.
• The Act mandates the creation of a temporary Advisory Commission made up of leaders from business and Federal, state, and local government. The Commission has 19 appointed members; of the 19 members, three are specifically named in the statute authorizing the creation of the Commission: Ambassador Charlene Barshefsky, Commerce Secretary William Daley, and Treasury Secretary Robert Rubin. The remaining 16 were appointed by congressional leaders and consist of eight representatives from state and local government and eight business and consumer representatives. The role of the temporary Commission is to study the increasingly complex relationship between electronic commerce and state and local tax issues. The Commission has been asked to report back to Congress after 18 months of deliberation. The Commission also was asked to create model legislation that ensures that e-commerce will not be subject to multiple or discriminatory taxes, and will serve as a framework for Congress to use when deciding whether Internet taxation is needed. Ultimately, it is up to Congress to decide whether to accept the Advisory Commission's suggestions. The Congress is in no way obliged to accept any proposal put forth by the Commission.
Some states that were levying taxes on
Internet service providers or purchases made over the Internet, have repealed
the tax since the passage of the Internet Tax Freedom Act.
The tremendous growth projected in e-commerce and the cross-border nature of the industry have led business and government leaders to come together to discuss what form taxation of e-commerce should take once the moratorium declared by the Internet Tax Freedom Act has ended. It is widely recognized that a solution cannot be arrived at in any other way. Both business and government have too much at stake to remain disinterested. Most alternatives proposed have included simplification of the existing web of complex tax jurisdictions in the United States, as well as the development of some level of uniformity across state lines.
The National Governors' Association (NGA) recently issued a policy paper that called for a 21st century sales tax that would be "a joint industry/government development of a simplified sales tax system including greater consistency among states in definitions, forms and rules, and significantly easier compliance, reporting and audit requirements".(9) The proposal is meant to include all forms of sales: sales that are currently taxable, mail order, and Internet. As described in the policy paper, the main principles of the NGA's proposal include:
• One sales tax rate per state, with states having the option of not imposing the sales tax. In states where a sales tax is levied, each state should establish a single rate for remote sellers to collect. Also, states will have to establish a method of distributing to local governments their share of such taxes.
• The development of a system that provides definitions that will ensure that the taxation of goods and services is uniform across state lines. The development of clear definitions will give states the ability to identify and address instances in which discriminatory or multiple taxation currently exists.
• Joint industry/government development of significant simplifications in the administration of the sales tax in areas such as uniform registration, tax returns, remittance requirements, and filing procedures.
• Congressional re-establishment of fairness in state sales tax systems, through a requirement that remote sellers collect sales taxes for any state that simplifies its tax system in accordance with the forgoing principles. If a state chose not to simplify, the sales tax would remain subject to the requirement of nexus. The expanded duty to collect would require remote vendors to collect sales and use taxes in every state where they sold taxable products and services only if:
-- The vendor had national sales above some de minimis level in the past year; and
-- The vendor's sales to that state's consumers were above some lower de minimis level in the past year.
The NGA's proposal contains elements that
appear in nearly every proposal regarding taxation of e-commerce: the need
for uniformity across state lines, defining what goods and services are
taxable and what is nontaxable; and a solution that holds e-commerce and
the mail-order catalog industry to the same standards concerning issues
such as the establishment of nexus, and collection liability. In order
to arrive at an equitable solution, Congress must take action and create
legislation that establishes a fair, rational approach to state taxation
of interstate commerce. If Congress does not address the issue of nexus
concerning remote sellers and neglects to establish circumstances that
will enable states to collect taxes from remote sellers that have no physical
presence in their state, the majority of retail e-commerce will continue
to have constitutional protection against taxation under the Commerce Clause.
The rapid growth of e-commerce has led to a disparate assortment of laws as states attempt to create even-handed treatment of the Internet and the services it provides while protecting their tax base. A handful of states levy a tax on certain areas of e-commerce. In 1998, the year the Internet Tax Freedom Act was passed into law, 10 states had already taken steps in taxing e-commerce. Soon after the Act was passed, however, a number of states that had taxes on e-commerce in place repealed the taxes in favor of aligning their state law with the Federal moratorium on Internet taxes, and for the purpose of further reviewing the issue so as to make an effort at better understanding the issues surrounding e-commerce and the implications of taxing it. Among the states taxing e-commerce the justifications for taxation are varied, and often are simply a manipulation of telecommunications tax, or a tax on information services. For example, the State of Ohio imposes a tax on Internet service providers to businesses as an electronic information service, whereas subscribers from home are not required to pay a tax on their Internet access.(10)
Texas began applying a sales and use tax to data processing services and information services in 1987. At that time the existence of the Internet was virtually unknown in mainstream America.(11) Through an extension of the existing tax code to the Internet, Texas is currently one of the few states that does tax Internet service providers. Texas also taxes information downloaded from the Internet as tangible personal property if the server from which the user obtains Internet access is located in Texas. Pending legislation would repeal all sales and use taxes on data processing services and information services in Texas. Internet access is currently included in these taxable services.
Tennessee tax law requires Internet access
providers to collect and remit sales tax on flat monthly charges, hourly
charges, and installation charges as sales of telecommunication services(12)
if the service originates or is received in Tennessee and is billed or
charged to a Tennessee address. Calls made by dialing out-of-state long
distance at the subscriber's expense are not considered to originate or
be received in Tennessee.(13)
The State of Michigan levies 6% sales and use taxes, which generated an estimated 23.7% of all tax revenue in the State during fiscal year (FY) 1998-99. The sales tax will generate an estimated $5.9 billion during FY 1998-99.(14)
• The State of Michigan does not levy a sales or use tax on Internet service providers. Michigan's use tax technically does apply to goods bought over the Internet and shipped to an address in Michigan.(15)
• The State does not impose a tax on charges for information delivered electronically since it does not consider this to be a transfer of tangible personal property. Canned software, however, is taxable regardless of how it is delivered.(16)
• There is currently no pending legislation in the State of Michigan that addresses the issue of Internet taxation(17).
If Michigan chooses to begin taxing e-commerce, the base of any such tax will have to be determined. Some categories of e-commerce that could be considered for inclusion in the tax base are discussed below.
Currently, the majority of e-commerce falls in the category of business-to-business transactions. The Minnesota Revenue Department estimated that 80% of e-commerce purchases in Minnesota are business-to-business sales.
The following are examples of business-to-business transactions that are taxable in the State of Michigan: office equipment, machinery and supplies not used in industrial processing, canned software, computers and related hardware.
Examples of nontaxable business-to-business sales in Michigan include: goods purchased for resale; materials and machinery used in industrial processing; Internet access charges; e-mail; information downloaded from the Internet.
Using numbers from a study done by the Minnesota Department of Revenue, it is reasonable to estimate that in Michigan, approximately 20% of e-commerce is business-to-consumer transactions. The largest segment of business-to-consumer e-commerce is the transfer of intangible goods that are delivered directly to the consumer's computer over the network. These goods generally fall into five categories: entertainment, travel, newspapers/magazines, financial services, and e-mail; none of these is taxable under Michigan law. The following are examples of nontaxable sales in the State of Michigan: Internet entertainment (when viewed in an intangible form); pornography; movies; music; interactive games; periodicals (online or tangible form); tickets to events; e-mail; Internet access charges; Internet gambling; financial services (electronic banking, bill paying, stock brokerage); and travel tickets.
The following are examples of the most
commonly transacted business-to-consumer sales that are taxable in the
State of Michigan: books; clothing; music (tapes, compact discs); computers
and related hardware; flowers, jewelry and other gift items; canned software;
and household goods and supplies.
The following are examples of the displacement of traditional business and communication transactions as consumers begin to utilize e-commerce on a regular basis:
• Instead of corresponding through mail, fax or telephone, people are using e-mail. As a person becomes more and more familiar with e-mail as a method of communication, it is estimated that an individual will send an average of 25 e-mail messages a day. Also, it is estimated that since 1993, business-to-business first-class mail dropped by over a third because of e-mail.(18)
• Instead of browsing through books and magazines at a bookstore, people are visiting online booksellers who carry millions of book titles, in addition to videos, CDs, and DVDs, all of which are taxable in the State of Michigan if bought in a traditional store. For example, Amazon.com announced that its 1998 fourth quarter sales were approximately $250 million, more than three and one-half times its 1997 fourth quarter sales of $66 million.
• Instead of visiting a travel agent, more
and more people are purchasing tickets over the Internet. During the first
quarter of 1999, Travelocity.com had gross sales of more than $128 million,
a 156% increase over the same period last year, and registered 1.2 million
new members.(19)
Table 2 shows the potential revenue
that would be generated by the State of Michigan if policy-makers taxed
transactions made over the Internet and through mail order. Estimates of
mail-order sales and the potential tax revenues from those sales were included
in the table as a benchmark against which to illustrate how quickly e-commerce
is growing. It must be noted, however, that the data in Table 2
portray the maximum amount of tax revenue that e-commerce could
generate for the State: The numbers are slightly inflated because not all
e-commerce transactions are taxable under the Michigan Tax Code. E-commerce
is in its infancy, and its tremendous growth rate caught state governments
off guard. As a result, there is currently a lack of data concerning specifics,
such as a breakdown of the percentage of sales made through e-commerce
that are taxable and nontaxable. The data available simply allow for a
rough estimate as to how much revenue the state has forgone in the absence
of a tax on e-commerce.
| Table 2 | ||||
| COMPARISON
OF POTENTIAL MICHIGAN SALES AND USE TAX REVENUES
GENERATED BY E-COMMERCE AND MAIL-ORDER INDUSTRY FOR 1999 (millions of dollars) |
||||
|
1999 |
E-commerce Sales |
Potential Michigan State Tax Revenue from E-commerce |
Mail-Order Sales |
Potential Michigan State Tax Revenue from Mail Order |
| Business-to-Business | $5,132 | $308 | $ 773 | $46 |
| Business-to-Consumer | 1,283 | 77 | 1,208 | 73 |
| State of Michigan Total | $6,415 | $385 | $1,981 | $119 |
| Source: The Minnesota Department of Revenue, "Sales Tax and E-Commerce: Presentation to the Working Group on the Taxation of Telecommunication Services"; OECD, "The Economic and Social Impact of Electronic Commerce: Preliminary Findings and Research Agenda", Andrew Wyckoff, Alessandra Colecchia; U.S. Census Bureau; The Direct Marketing Association, "Economic Impact: U.S. Direct Marketing Today". | ||||
While the potential State revenue currently lost from the failure to tax e-commerce is quite low, the rapid growth projected for e-commerce sales could change these numbers quickly. Figure 1 provides a graphic summary of estimates of potential tax revenue for business-to- consumer e-commerce and business-to-consumer mail-order sales for the period 1997 through 2000 as a percentage of the existing sales and use tax collections. Continued rapid growth in e-commerce sales will quickly make the State tax treatment of these sales an important State fiscal issue.
Before policy-makers are able to reach a rational solution regarding the taxation of the Internet, it is necessary to develop a clearer quantitative picture of the current impact and the future direction of e-commerce than currently exists. There is no lack of information about the phenomenal growth in e-commerce over the last four years. Projections for the next four years indicate no deceleration in the growth of the industry. Currently, however, most of the information measuring e-commerce is produced by firms that make a living providing advice and data about the current state and future direction of e-commerce. These firms have an interest in creating the most optimistic picture possible regarding the e-commerce market, and can be expected to have an inherent bias toward suggesting that the e-commerce market is large and rapidly growing.(20) One thing that is common to all projections is that the growth rate associated with e-commerce is enormous and estimates today far outpace estimates that were made just two years ago.
This rapid growth and the potential erosion of the State tax base could make the State tax treatment of e-commerce sales the major State fiscal issue of the next millennium.
3. "A Federal 'Moratorium' on Internet Commerce Taxes Would Erode State and Local Revenues and Shift Burdens to Lower-Income Households", Michael Mazerov and Iris J. Lav, May 1, 1998, Center on Budget and Policy Priorities.
4. "Data Highlights: First Comprehensive Study of Online Retailing Practices"
5. U.S. Supreme Court, National Bellas Hess, Inc. v Illinois Department of Revenue, 386 U.S.753 (1967).
6. "State Taxation of Electronic Software Distribution", KPGM Peat Marwick LLP, May 1998.
7. U.S. Supreme Court, Quill Corp. v North Dakota, 504 U.S. 298 (1992).
8. "Sales Tax and E-Commerce: Presentation to the Working Group on the Taxation of Telecommunication Services," Oct. 1998, Minnesota Department of Revenue, Minnesota House Research.
9. "EC-12. Streamlining State Sales Tax Systems", National Governors' Association Policy Paper, Winter 1999, The National Governors' Association.
10. Vertex Inc., http://www.vertexinc.com.
11. "Report of the Texas Internet Tax Policy Working Group", Carole Keeton Rylander, http://www.window.sta te.tx.us/taxinfo/itpwg/tx99itpwg2.html.
12. Vertex Inc., http://www.vertexinc.com.
14. Budget Status Report Issue 1999-1: Economic, Revenue, and Year-End Balance Estimates FY 1998-99 and FY 1999-2000, Senate Fiscal Agency.
15. Vertex Inc., http://www.vertexinc.com.
18. "The Economic and Social Impact of Electronic Commerce: Preliminary Findings and Research", Michael Wyckoff, Alessandra Colechia, OCED.
19. "Travelocity.com Continues as Online Travel Industry Leader", Sabre news release, June 3, 1999, http://www.sabre.com.
20. "Measuring Electronic Commerce," OECD Committee for Information, Computer and Communications Policy, 1997, http://www.oecd.org/dsti/sti/it/ec/