James Eads Jr. tells a story that illustrates the monumental task of sorting out the problems of state and local tax issues with e-commerce.
A few years ago, when Congress took up the issue of how to handle e-taxes, a businessman from Tennessee testified before a congressional committee on how ambiguities in the law ruined him.
“It was in the early days of the Internet,” explains Eads, a tax expert in Ernst & Young LLP’s Atlanta office. “The man set up a Web site, went to the state of Tennessee and asked if what he was selling would be taxable. They said no.”
Three years later, the state changed its mind. Officials took the position that Internet access in Tennessee was a telecommunications service and therefore, all commerce conducted via the Internet in Tennessee was taxable. The man was assessed three years of back sales tax based on his sales.
“Of course, it was impossible to go back and track down each customer and ask them to pay sales tax,” Eads says. “So the man was forced to go bankrupt.”
There are nearly 7,500 different state and local government municipalities nationwide that require businesses to collect and remit some sort of sales tax. Most states have laws on the books that require consumers to report out-of-state purchases to the proper tax authorities and remit sales tax on their own.
So it’s no wonder that e-commerce has government taxing agents and business owners shaking their heads over who could owe what to whom and where to draw the lines.
This abundance of question marks led a befuddled Congress in 1998 to enact the Internet Tax Freedom Act, which placed a three-year moratorium on new taxes for Internet-access fees and prohibited multiple and discriminatory taxes on e-commerce. In layman’s terms, the law put the brakes on starry-eyed state and local officials who were licking their chops and hoping to send out tax bills to every business in its jurisdiction that was engaged in e-commerce.
The government also appointed an advisory committee to investigate the impact of e-taxes and present Congress with options for resolving the debate.
In the meantime, the issue has raised a fundamental tax policy question: Does the current state and local sales tax collection system still work in an increasingly national consumer market dominated by e-commerce?
Finding an answer has become a top priority, especially since analysts predict U.S. business on the Internet to reach $1.3 trillion by 2003. Under current regulations, little, if any of that, will be taxed.
“There’s a huge policy debate going on at all levels about how to sort it out,” says Eads, who is also a member of the Steering Committee for the National Tax Association Communications and Electronic Commerce Tax Project, the organization charged with studying e-tax issues and issuing Congress its recommendations later this month.
“There are some people who say we should leave the Internet alone and let it mature into a significant economic entity and not kill it with taxes. Another side argues the Internet is making millionaires and billionaires and thus, commerce on the Internet needs to be taxed. And then you’ve got mainstream merchants, who say they have to collect sales tax, so everybody should.”
Every side has a compelling argument, says Eads, but devising a solution won’t be easy, especially when you consider that the issue of collecting what amounts to remote sales tax isn’t new. The Supreme Court ruled on it twice before — in 1967 and 1992. Both cases addressed catalog sales retailers, and the court consistently held that requiring catalog companies to collect sales and use taxes in states where it does not have a physical presence (employees or property) violates the U.S. Constitution’s Commerce Clause.
“The court affirmed that in order to collect sales taxes, the company must have substantial connections with the state,” Eads says. “Otherwise, it would present a huge burden on a business.”
Compounding the issue this time around is that while much of the activity over the Net — services and nonretail goods — isn’t taxable at all, new products such as downloadable digital software could be. And determining where these products are located isn’t an easy process, leading to further questions of which tax entities will be responsible for assessing sales tax, should Congress lift the tax ban.
And what of those brick-and-mortar companies that migrate the bulk of their business to the Net? How will they be taxed?
Even more confounding is the fact that the Supreme Court has set a precedent with catalog companies. Any tax structure change would have a significant effect on every company that does any remote selling, Web-based or not. Because of that, the courts have been reluctant to tinker with decisions that help lay foundations for how business is conducted within a specific industry.
Finally, toss in one more potential disaster: What happens when one tax authority suddenly decides that it has a law on the books that allows it to start taxing an Internet business within its jurisdiction without breaching the current moratorium? Explains Eads, “The actions of a single jurisdiction exercising its authority to tax cannot be viewed in isolation. That single jurisdiction’s action becomes a part of a web of taxation that can cumulatively harm interstate business.”
The end result is a confusing situation that will take years to unravel. And as with any government-related issue, the e-tax question won’t be answered quickly and it won’t be defined in one sweeping law. But, Eads says, the lines have been clearly drawn.
“If you’re an online seller, the main argument against it (taxes) is simple: Why should I suddenly have to be subjected to 7,000 tax jurisdictions?” he says. “We (E&Y) did a study that showed that if a start-up company suddenly was subjected to taxable jurisdictions, it could face costs of collecting and reporting that money as high as 87 percent of the money collected.
“That begs the question: Is that a legitimate burden for a business to undertake?”
How to reach: Ernst & Young, (216) 861-5000
Dustin Klein ([email protected]) is editor of SBN.
