Introduction

Although originally the exclusive domain of governmental agencies and educational institutions, the Internet is now pervasive in businesses and homes across the globe. Industry analysts predict that the number of worldwide users of the Internet will exceed 130 million by the end of 1999, and will exceed 315 million by the end of 2002. Perhaps more telling, the United States Commerce Department recently determined that the number of Internet users is doubling every 100 days .

With such staggering growth, it should be no surprise that businesses have seized upon the opportunity to turn the Internet into a "commerce superhighway", in which electronic commerce, or e-commerce, is conducted with little or no external restriction. By the end of 1998, approximately 10 million households within the United States alone had made one or more online purchases. Analysts predict that by the end of 2002

this number will reach 36.5 million. The revenue numbers are similarly staggering. According to the United States Commerce Department, as much as $7.8 billion in retail sales will be made via e-commerce in 1999. Industry analysts estimate that, in 2003, e-commerce will generate $108 billion in retail sales.

With so much money at stake, it was inevitable that state and local governments on the one hand, and the e-commerce industry on the other, would begin to stake out opposing positions regarding the application of sales and use taxes to e-commerce. State and local governments acknowledge that the current morass of state and local taxes potentially applicable to e-commerce transactions is complex and cumbersome, but they steadfastly argue the necessity of maintaining appropriate tax revenue levels. Meanwhile, the e-commerce industry has sought out greater clarity and uniformity regarding the sales and use taxation of e-commerce so that the administrative behemoth of state and local tax compliance does not stifle the growth of the "commerce superhighway".

In this context, Congress enacted the Internet Tax Freedom Act ("ITFA") in October 1998, establishing a three-year moratorium on certain forms of e-commerce sales and use taxation. In enacting this moratorium, Congress intended to halt the spread of e-commerce taxation while providing all interested parties with an opportunity to determine the most appropriate and equitable sales and use tax treatment of e-commerce. It appears, however, that the ITFA provides only limited additional protection to e-commerce buyers and sellers beyond that currently available under traditional doctrines of state and local sales and use taxation. Moreover, the ITFA leaves unaddressed many critical issues.

The Statute

Congress passed the ITFA on October 21, 1998 to allow the Internet generally, and e-commerce in particular, to expand without the potential application of new state and local taxes, and to explore through an advisory commission the development of a more uniform and administratively accessible system of state and local taxation. The ITFA seeks to relieve the tension between the desire to provide an unrestricted environment for the burgeoning new marketplace that is e-commerce and the need to preserve the coffers of state and local governments from which they provide the public with essential services. As discussed below, it appears that the ITFA ultimately may prove to be inadequate in achieving its goals.

In general, the ITFA imposes a three-year moratorium, which expires on October 21, 2001, on (i) new taxes on Internet access, (ii) multiple taxes on e-commerce, and (iii)discriminatory taxes on e-commerce. In addition, the ITFA created the Advisory Commission on Electronic Commerce (the "Commission") to conduct a study of federal, state and local, and international taxation of Internet transactions. Each of these components of the ITFA is discussed below.

Taxes on Internet Access

The ITFA provides that, during the term of the moratorium, no state or local taxing entity may impose a tax on Internet access unless the tax was "generally imposed and actually enforced" prior to October 1, 1998. For this purpose, a tax is considered to have been generally imposed and actually enforced if, before October 1, 1998, the tax was authorized by statute and either (i) a provider of Internet access services had a reasonable opportunity to know by virtue of a rule or other public notification made by the state or local taxing authority that the tax had been interpreted to apply to Internet access services, or (ii) the state or local taxing authority generally collected the tax on charges for Internet access. For purposes of the ITFA, "Internet access service" is "a service that enables users to access content, information, electronic mail, or other services offered over the Internet and may also include access to proprietary content, information, and other services as part of a package of services offered to users."

This component of the ITFA addresses the inherent double taxation that may arise when a sales or use tax is imposed on Internet access services. Specifically, the charge for an Internet access service is typically comprised largely of the cost of the telecommunications service used to connect the subscriber to the Internet. Because most states tax the sale of telecommunications services, a tax on Internet access service causes the cost of telecommunications services to be collected twice, once from the Internet service provider and once from the subscriber to the Internet access service. While several states previously had, and continue to, impose sales and use taxes on Internet access services, most states, perhaps in recognition of the unfairness of the double taxation, either prior to or following the enactment of the ITFA have exempted Internet access services from their sales and use taxes. Consequently, the ITFA does not provide most Internet service providers or subscribers with any meaningful exemption from the application of sales and use taxes.

Additionally, and perhaps more significantly, the ITFA definition of Internet access service does not address how the moratorium applies with respect to Internet access services sold together, or "bundled", with traditional telecommunications services, such as local and long distance telephone service and cable television service. As stated above, most states tax these traditional telecommunications services. Moreover, most states impose their sales and use taxes on the total charge when taxable services and nontaxable services are sold together, unless the charges for the nontaxable services are separately stated. Accordingly, unless the Internet access provider separately states the charges for the bundled Internet access service, states may be tempted to impose their taxes on the entire cost for the services, regardless of the ITFA and regardless of the exemption from tax for Internet access services enacted in most states.

Multiple Taxes

The ITFA imposes a three-year moratorium on the imposition by the states of multiple taxes on e-commerce. In general, a "multiple tax" is any tax that is imposed by one state on the same or essentially the same e-commerce that is also subject to a tax imposed by another state (whether or not at the same rate or on the same basis), without a credit for taxes paid in the other jurisdiction.

While the intent here is clear, i.e., to prevent multiple taxation by states of the same e-commerce, the language "essentially the same e-commerce" is vague and may leave the door open for multiple taxation by two or more states. In addition, it is unclear how this provision should be applied where one state places the legal incidence of taxation with respect to a sale of property on the buyer (for example, California's Sales Tax) and another state places the legal incidence of taxation for the same sale on the seller (for example, Illinois's Retail Occupation Tax). Finally, it is unclear how this provision applies to bundled sales of property or services, where, for example, a service previously taxed in one state is subsequently bundled with a taxable service in another state.

Discriminatory Taxes

The ITFA also imposes a three-year moratorium on discriminatory taxes on e-commerce. For this purpose, the ITFA defines a "discriminatory tax" to include three types of taxes: (i) taxes applicable only to e-commerce transactions; (ii) taxes based solely on the ability of a state's residents to access a server; and (iii) taxes based on classification of an Internet service provider as the agent of a remote seller. While the ITFA attempts to cast a broad net of prohibition with this definition, in fact, state and local governments arguably were already prohibited from imposing the first and second type of tax by virtue of the United States Constitution. With respect to the third type of discriminatory tax, the ITFA appears to provide some meaningful protection to Internet service providers and e-commerce sellers from the application by state and local governments of the doctrine of attributional nexus (discussed below), but it may not go far enough to forestall all attempts to apply such doctrine.

Taxes Applicable Only To E-commerce Transactions

The first component of the "discriminatory tax" definition includes taxes considered "discriminatory" under traditional constitutional principles. In particular, the definition of "discriminatory tax" includes: any tax imposed by a state or local government on e-commerce that: (A) is not generally imposed on transactions involving similar property, goods, services, or information accomplished through other means; (B)is not generally imposed at the same rate on transactions involving similar property, goods, services, or information accomplished through other means unless the rate for e-commerce is lower; (C) imposes an obligation to collect or pay the tax on a different person or entity than in the case of transactions involving similar property, goods, services, or information accomplished through other means; or (D) establishes a classification of Internet access service providers or online service providers for purposes of establishing a higher tax rate to be imposed on such providers than the tax rate generally applied to providers of similar information services delivered through other means.

Essentially, this portion of the ITFA provides that a state or local taxing authority may not treat e-commerce differently than other, traditional forms of commerce, such as in-store purchases and mail-order purchases. Yet, pursuant to the Commerce and the Equal Protection Clauses of the United States Constitution, a state or locality could never single out a certain class of taxpayers, activities, or property for detrimental tax treatment where there is no rational basis for the disparate treatment under the law. For example, a state could never have constitutionally imposed a sales tax on the purchase of a sweater via e-commerce, but not imposed a sales tax on the purchase of the same sweater at a store located within the state, unless there were some rational basis for such a taxing scheme. Thus, to the extent that a state imposes a tax limited to transactions conducted through e-commerce, traditional Constitutional doctrine appears to provide an adequate remedy, rendering the ITFA, in this regard, superfluous.

Ability to Access a Server not Sufficient for Nexus

In addition, the ITFA provides that, except with respect to a tax on Internet access that was generally imposed and actually enforced (as described above) prior to October 1, 1998, the definition of "discriminatory taxes" includes any tax where "the sole ability to access a site on a remote [i.e., non-physically present] seller's out-of-state computer server is considered a factor in determining a remote seller's tax collection obligation." Essentially, a state may not require a remote seller to collect the state's sales or use tax solely because the state's residents may access the seller's web site via the seller's out-of-state server. Although this provision could be interpreted to apply either when the server is out-of-state as to the taxing state, or when the server is out-of-state as to the seller, in order to give this provision meaning, it presumably must be applied from the perspective of the seller. That is, the provision apparently prevents a state from asserting that the presence of the remote seller's server in the state constitutes physical presence within the state.

Internet Access Provider May Not Be an Agent for a Remote Seller

Finally, the ITFA defines "discriminatory tax" to include any tax where a provider of Internet access services or online services is deemed to be the agent of a remote (i.e., non-physically present) seller for determining the tax collection obligations solely as a result of (A) the display of the remote seller's information or content on the out-of-state computer server of a provider of Internet access services or online services, or (B) the processing of orders through the out-of-state computer server of a provider of Internet access services or online services. Although this provision is also poorly worded, it appears that it prevents a state from asserting that an Internet service provider is an agent of a remote seller simply because the Internet service provider provides a link to the seller's web site or because the Internet service provider's out-of-state server is used to process the orders of the seller. Accordingly, during the moratorium, a state may not assert that a remote seller has a physical presence in the state by virtue of the presence of a computer server in the state operated by an Internet service provider alleged to be the agent of the seller.

Here, the ITFA essentially seeks to prevent states from applying the doctrine of "attributional nexus". In particular, the United States Constitution generally requires that a business must have a substantial relationship (i.e., nexus) with a state before that state can oblige the business to collect its sales or use tax. For this purpose, the Supreme Court has determined that a substantial nexus exists only when the business maintains a "physical presence" in the taxing state.

Under the doctrine of attributional nexus, a state may attempt to attribute the in-state presence of an Internet service provider to a remote seller in order to require the seller to collect sales or use taxes with respect to sales made by it in the state, even where the seller, by itself, does not have nexus with the state. States have sought to apply the doctrine of attributional nexus under one of three theories: the agency theory, the alter-ego theory, or the unitary theory. Pursuant to the agency theory, a state will assert nexus over a remote seller based upon the in-state presence of an agent of the seller. Pursuant to the alter-ego theory of attributional nexus, a state will assert nexus over an out-of-state seller where a business with in-state physical presence is sufficiently similar to the out-of-state seller such that the two businesses should be treated, essentially, as one business. Finally, under the unitary theory, a state will assert nexus over an out-of-state seller simply because of its relationships with in-state businesses, regardless of the substance of those relationships.

Significantly, the ITFA only prohibits states from seeking to apply the agency theory of attributional nexus. That is, the ITFA provides that an Internet service provider may not be deemed by a state to be an agent of an out-of-state seller simply because the Internet service provider provides a link to the seller's web site, or because the Internet service provider's out-of-state server is used to process the orders of the seller. Accordingly, the ITFA leaves open the possibility that states may assert the alter-ego or unitary theory of attributional nexus with regard to the relationship between an out-of-state seller and an Internet service provider in order to require the seller to collect sales and use taxes with respect to sales made in such state. Generally, however, states have been unsuccessful in asserting these two theories, and Congress may have addressed the agency theory of attributional nexus as the only potentially viable theory available to the states to assert nexus over a remote seller.

The Commission

The ITFA established the Commission to study e-commerce taxation. The Commission must report its findings to Congress within 18 months of the enactment of the Act (i.e., by April 2000), and make any recommendations, including legislative recommendations, as required to address the findings of the Commission. The ITFA provides that the Commission shall be comprised of 19 members, including three representatives of the federal government (the Secretary of Commerce, the Secretary of the Treasury, and the United States Trade Representative), eight representatives from state and local governments (including one representative from a state that does not impose a sales or use tax and one representative from a state that does not impose an income tax), and eight representatives from the e-commerce industry, telecommunications carriers, local retail businesses, and consumer groups.

State and Local Governments Sue to Enforce Representation Rights

Several months following the formation of the Commission, Congress appointed nine e-commerce industry representatives to the Commission and only seven state and local representatives. After several unsuccessful attempts by state and local governments to negotiate with members of Congress to bring the composition of the Commission into conformity with the explicit provisions of the ITFA, the United States Conference of Mayors and the National Association of Counties, among others, sued the Commission and all of the persons previously appointed in order to have the Commission declared invalid due to its illegal composition, and to prevent the Commission from meeting until such time as the Commission was constituted in conformity with the explicit terms of the ITFA.

The suit was successful in forcing Congress, prior to a hearing on the complaint, to remove one of the e-commerce industry representatives from the Commission and to replace that person with a local government representative. Moreover, the suit was successful in impressing upon the members of the Commission, Congress, and the e-commerce industry that state and local governments are very serious about protecting their interests with respect to e-commerce. In this regard, the complaint had asserted that the pre-suit composition of the Commission would have "deprive[d] [the states and local governments] of a vital source of revenue if the business sector representatives that constitute an unlawful majority of the Commission work together to ensure that state and local taxation of Internet sales and/or businesses cannot be enforced."

Composition of Commission

The current composition of the Commission is: Grover Norquist, President of Americans for Tax Reform; Richard Parsons, President of Time Warner, Inc.; David Pottruck, President and CEO of Charles Schwab and Co.; John Sidgmore, MCI Worldcom Vice Chairman; Stan Sokul, Consultant for Association for Interactive Media; Robert Pittman, President and COO of America Online; Michael Armstrong, Chairman and CEO of AT&T Corp.; Ted Waitt, CEO of Gateway, Inc.; Delna Jones, County Commissioner, Washington County, Oregon; Dean Andal, California Board of Equalization; Paul Clinton Harris, Jr., Virginia Delegate; Governor James Gilmore of Virginia; Governor Michael Leavitt of Utah; Governor Gary Locke of Washington; Mayor Ron Kirk of Dallas; Gene LeBrun, president of the National Conference of Commissioners on Uniform State Law; William Daley, Secretary of Commerce; Lawrence H. Summers, Secretary of Treasury; and Charlene Barshefsky, U.S. Trade Representative.

The Commission held its first meeting June 21 and 22, 1999 in Virginia. The Commission's work consisted primarily of administrative actions, including the adoption of rules of conduct, and the contentious selection of the executive director of the Commission, Heather Rosenker. Certain members of the Commission were concerned about a potential conflict of interest on the part of Ms. Rosenker, who is married to the vice president of public affairs for the Electronic Industries Alliance.

At its first meeting, the Commission also heard reports from representatives of state and local governments and the e-commerce industry, as well as from independent parties regarding the impact of e-commerce on state tax revenues. At least two independent reports concluded that state and local governments are not currently losing revenue as a result of e-commerce because most e-commerce sales are otherwise exempt from sales and use taxation either as sales for resale or as sales of intangible property or services. Others emphasized, however, that if the predicted increases in the levels of e-commerce come to fruition, state and local governments are certain to lose a significant amount of sales and use tax revenue if the current taxing scheme remains in place.

Finally, the members of the Commission offered opening statements regarding their perspectives on e-commerce taxation and their goals for the Commission's work. Most members stressed that e-commerce taxation should be "neutral" and "simple". Neutrality requires that, in order to avoid giving e-commerce an unfair competitive advantage, sales made via e-commerce should not be taxed differently than sales made via traditional forms of commerce, such as in-store purchases and mail-order purchases. The call for simplicity reflects the fact that many e-commerce sellers are small and mid-sized companies that do not have the administrative capacity to comply with the tax laws of the approximately 30,000 state and local taxing jurisdictions.

The members of the Commission offered no insight, however, into what the substantive provisions of a "neutral" and "simple" tax scheme for e-commerce would look like. Such insight cannot be far off though, as the Commission is required to submit to Congress its suggestions for e-commerce taxation by April 2000. The Commission is scheduled to meet in New York in September 1999, in San Francisco in December 1999, and in Dallas in March 2000.

Other Significant Issues Regarding State Taxation Of E-commerce Not Addressed By The ITFA

Internet Subsidiaries

For many e-commerce sellers, the above nexus issues are mooted because many virtual sellers are, in fact, virtual companies with few employees, no inventory, and no affiliated or related entities. Such a business generally will have physical presence only in the state in which it operates and will be required to collect sales tax only on sales made to customers in that state. Moreover, even if the business must have an out-of-state server, as discussed above, the business may select a state that does not consider the presence of such server sufficient to give rise to physical presence in the state.

In an effort to simplify business structures and, more importantly, to compete in the virtual world, however, many traditional "bricks-and-mortar" companies are establishing so-called "Internet subsidiaries" to conduct their Internet businesses. The concept is that the Internet subsidiary may be able to compete more effectively with strictly e-commerce sellers by avoiding a general obligation to collect sales tax in states in which its parent has tax nexus. To this end, Internet subsidiaries generally establish physical presence in only one state.

The problem many Internet subsidiaries are facing is the potential application by the tates of the doctrine of attributional nexus. Specifically, to the extent that the parent has a physical presence, through stores or otherwise, in a state or states, such states may seek to attribute the nexus of the parent to the Internet subsidiary. For example, states may assert that the parent is the agent for the Internet subsidiary if there are advertising, service, or distribution agreements between the parent and the subsidiary. If a state were successful in such an assertion, then the Internet subsidiary would be required to collect sales taxes in the states in which the parent is present.

The ITFA provides no guidance regarding the application of attributional nexus theories to Internet subsidiaries. While in many cases, creative structuring and attention can avoid the application of attributional nexus to the relationship, it is likely that the states will be very aggressive on this issue. Specifically, as evidenced by the suit over the composition of the Commission, the states are very concerned about the potential loss of sales and use tax revenue from e-commerce sales. Thus, to the extent that businesses that are physically present in a state attempt to avoid the obligation to collect sales and use taxes through the use of Internet subsidiaries, it very well could be the state's worst revenue-loss nightmare.

The Definition of Property

The ITFA also fails to address the characterization of certain items sold over the Internet as services or property. Specifically, most states tax solely the sale of tangible personal property and certain services (such as telecommunications services). While many sales made via e-commerce, such as the sales of clothing or computers, are clearly sales of tangible personal property, sales of software, music, and other downloadable information may be considered sales of tangible personal property, intangible property, or even services. Moreover, the determination as to whether such items are property or services is likely to be different in each state and locality. Assessing the character of such items on an ongoing basis promises to be administratively burdensome for e-commerce sellers and buyers. Accordingly, the establishment of a uniform system of characterization of items sold via e-commerce fits directly within the Commission members' stated goals of simplicity and neutrality.

Issues of Location

Finally, the ITFA does not address one of the most significant issues faced by the e-commerce industry - the anonymity associated with the Internet. Specifically, there currently is no technology available that identifies the location of a user based solely on the user's e-mail address. Accordingly, even if an e-commerce seller knows that a sale of tangible personal property may be properly subject to sales tax, the seller may not know which state's taxation scheme is applicable. Indeed, even in instances where the buyer provides a mailing address for the goods sold, there is no certainty that the address is actually correct, as it is possible to offer a false address. Moreover, in instances where software, music, or information is downloaded from the seller, it is virtually impossible to determine the location of the buyer. Accordingly, the most well-intentioned e-commerce seller literally may not be able to collect sales or use tax with regard to certain e-commerce transactions.

Current proposals to address this issue include encrypting e-mail addresses with a code that reflects the location of the user, and establishing a "throw-back" rule for e-commerce pursuant to which if an e-commerce seller is unable to determine the situs of a buyer, the seller must nevertheless collect the sales or use tax and must remit it to the seller's state of residence.

Conclusion

The ITFA moratorium on new taxes on Internet access service, multiple taxes on e-commerce, and discriminatory taxes on e-commerce expires in a little more than two years. Under the current taxing regime, it is administratively prohibitive for many e-commerce sellers to collect sales and use taxes in the multiple taxing jurisdictions, and, moreover, it is too expensive for such sellers to determine if they are constitutionally required to collect such sales and use taxes. When enacted, the ITFA offered the promise of a more clear, uniform, and neutral system of e-commerce taxation. Upon further analysis, however, while the ITFA purports to restrain state taxation of Internet activity, it does surprisingly little to achieve that goal. Thus, the Commission appears to offer the only potential salvation from the most significant tax dilemma to face our country in decades.

Richard Giuliani
[email protected]

Michael Nathanson

Kimberly Wethly
[email protected]