State taxation of cyberspace.

The rapid growth of electronic commerce is fundamentally changing the way Americans conduct business and home activities. While electronic commerce received its initial impetus from commercial online services such as America Online and CompuServe, it has increasingly become identified with the Internet, which is accessible by an estimated 40 million people in the U.S. and Canada.

Currently, use of the Internet and other forms of electronic commerce far exceed the commercialization of such channels. Although most users expect to surf the Internet for free, the gap between use and commercialization is likely to narrow significantly over the next five years.

As a general rule, businesses capable of transferring their goods or services electronically will find the Internet a fast and cost-effective means of reaching consumers. While the distribution of large durable goods such as automobiles and refrigerators will not occur electronically, other major business and consumer items lend themselves to the digital age, including E-mail, movies, publications, music albums, customer service, financial transactions and computer software. In fact, it is estimated that by 1999, one-half of all software sold will be transferred electronically.

Multistate Taxation of the Internet

As the commercialization of the Internet expands, so too will the taxation of electronic commerce. Indeed, the taxation of electronic commerce is a current reality. It is not surprising that state income tax laws apply to income earned from electronic commerce transactions. However, it is less widely known that many states also impose sales taxes on electronic commerce transactions.

Most states already impose sales taxes on the transmission component of electronic commerce (i.e., on the telecommunications channels). A few states, including Texas, New York, Ohio and Pennsylvania, also impose sales taxes on the content of electronic commerce, including such items as downloaded software, legal databases, financial information and other services provided online.

Taxing jurisdictions with expansive sales tax bases did not consciously set out to tax the Internet; instead, these states impose sales taxes on certain categories of electronic commerce as a result of a hodgepodge of existing laws intended to tax other types of activities. In many cases, states are attempting to use tax systems designed for manufacturers and vendors of tangible personal property to tax a technologically advanced service industry. Accordingly, it is not surprising that these tax rules are often ill-suited to taxing electronic commerce.

The Complex Issues of Electronic

Commerce

Given the complex, intangible nature of electronic commerce, the growth of the Internet touches on some of the most controversial and cutting-edge issues in state taxation, including (1) the extent and manner in which services and certain items transferred electronically should be subject to sales and use taxes; (2) whether the states' sales factor-sourcing rules for corporate income and franchise tax purposes adequately address nontraditional services, such as those related to electronic commerce; and (3) what level of activity will be deemed to constitute sufficient nexus to impose a state tax, or tax collection obligation, on out-of-state vendors selling goods and services from remote locations.

* Should services be taxed as extensively as tangible personal property? If so, what rules should be applied to the taxation of such services, particularly electronic services?

Example: A computer software company, CSC, sells ABC Company the right to use its software in 500 different user locations in 10 different states. CSC electronically transfers a single version of its software to ABC's sole server site, from which the software is accessed by all of ABC's 500 employees. Is the sale of the software taxable only in the jurisdiction in which the server is located? What if that jurisdiction does not tax software that is transferred electronically? Would a use tax be due in some, or all, of the other nine states from which the software is accessed by ABC's employees?

* Should the sourcing rules for state corporate income and franchise tax purposes be revised? The sourcing rules for computing the sales or receipts factor of the apportionment formula were adopted by most states more than 40 years ago when the economy was comprised primarily of manufacturers and retailers of tangible personal property. Under these sourcing rules, sales of tangible property typically are sourced to the state (i.e., included in the numerator of the sales or receipts factor) where the consumer is located, while sales of services are sourced to the state where the vendor is located. Applying these contrasting tax rules results in a disproportionate tax burden in the service provider's home state.

* Nexus: If an activity is subject to a sales or income tax, there generally is no filing requirement unless sufficient "nexus" with the vendor is established. Nexus describes the degree of business activity that must be present before a taxing jurisdiction has the right to impose a tax, or an obligation to collect a tax, on an entity. Accordingly, should the states' nexus rules be extended to remote sellers who have no physical presence in the state, but have a significant consumer base or a presence through the activities of a third party operating on their behalf within the state?

Balancing Act

States will face conflicting pressures with regard to the taxation of electronic commerce. On one hand, states will be inclined to tax products delivered electronically that are subject to sales tax when sold at in-state retail outlets. Similarly, states will likely aggressively pursue remote sellers so as to create a level playing field with in-state vendors who are subject to income and sales and use taxes. Conversely, there will be demands on the states to proceed cautiously so as not to impose undue tax or compliance burdens on the fast-growing businesses commercializing the Internet.

Massachusetts provides a good example of these competing forces at work. Massachusetts currently taxes both the intrastate and interstate transmission components of electronic commerce, but has avoided taxing the content of electronic commerce and has appointed a special legislative commission to review the taxation of telecommunications and the Internet.

The Future of Cybertaxation

The state taxation of electronic commerce is in its infancy and there are many unresolved issues and statutory and regulatory ambiguities. The stark differences in approaches already being taken by the states are creating considerable confusion and a lack of uniformity in state tax rules and, in some cases, are creating traps for unwary electronic commerce vendors and users alike.

While the complexity, novelty and economic importance of electronic commerce may inhibit states from enacting new laws to tax the Internet, the vast expansion of electronic commerce will create strong countervailing pressures on the states to broaden their state tax laws to encompass electronic commerce. Vendors and users of the Internet need to keep current with such law changes to ensure they do not later find themselves liable for significant state taxes.

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