The Internet Tax Freedom Act and sales tax.

Electronic commerce allows parties to exchange goods and services using electronic tools. There are many forms of electronic commerce; each presents different sales tax issues for industry and state and local governments:

* Internet access. Internet service providers provide Internet access, e-mail service, browser programs and custom Websites.

* Retailing. Businesses advertise through Websites and cybermalls delivering products via common carriers, such as the U.S. Postal Service, UPS, Federal Express, etc.

* Digitized products. Businesses advertise their products and then deliver them through the Internet. Examples of products that can be sold and delivered in this manner include computer software, movies, music products, books, newspapers and magazines.

* Information databases. For a fee, users can subscribe to information databases accessed through the Internet.

* Gambling. Individuals may now gamble over the Internet. It is legal as long as the companies are set up in locations where gambling is legal.

* Stock trading. Investors may now trade stocks and manage their investments over the Internet. This provides a low-cost alternative to traditional brokers.

* Banking. Most banks are currently offering on-line banking.

Consumers appear to be moving away from the traditional forms of buying goods and services to the convenience of on-line shopping. This trend has state and local governments concerned about the potential loss of tax revenue. For example, many consumers are now buying computers and books over the Internet rather than buying the identical items at a retail store. Every time a consumer purchases an item over the Internet, there is a good chance the retailer is not required to collect the state's sales tax, thereby transferring the liability to a use tax imposed on the consumer. Because use taxes have historically not had a high compliance rate, states will no doubt lose sales tax revenue.

Businesses also have concerns about the taxation of electronic commerce. These concerns relate to tax system equality and the potential for multiple taxation on a single transaction. Businesses want states to impose sales tax on electronic commerce in the same manner as it is imposed on the more traditional types of commerce (e.g., mail order sales, generally not subject to sales tax). In addition, many businesses are concerned that more than one state may claim the right to tax, thus making the taxpayer subject to double taxation.

Historically, sales tax systems have changed in response to changed forms of commerce. For example, as the U.S. economy gradually changed from a manufacturing-based economy to a service-based economy, states changed their laws to include certain services in their sales and use tax base. However, current sales tax laws have not been updated for electronic commerce.

The Internet creates a variety of sales/use tax issues. For example, where is the Internet retailer deemed to have physical presence? For a state to legally impose a tax on an out-of-state retailer, states are required to prove the out-of-state retailer has sufficient physical presence in their jurisdictions (e.g., who gets to tax a transaction if an Internet retailer is located in one state, the buyer in another state and a computer server in yet a third state?). If the retailer and the buyer are in the same state and the server is in another state, do both states have the right to impose a tax on the same transaction? A second issue relates to whether electronically transferred products (e.g., computer software, music and movies) are considered taxable tangible personal property, services or intangible property.

The Internet Tax Freedom Act 

President Clinton signed the Internet Tax Freedom Act (ITFA) into law on Oct. 21, 1998. The ITFA was intended to protect Internet users from multiple and discriminatory taxation. It provides for a moratorium on certain taxes, thus allowing states to study the issues and determine a consistent method of taxing electronic commerce and avoiding multiple taxation on a single transaction.

Internet Access Moratorium

The ITFA provides a moratorium, for the period beginning Oct. 1, 1998 and ending Oct. 21, 2001, on state and local governments from imposing tax on Internet access. Section 1104 of the ITFA defines "Internet access" as a service that enables users to access content, information, electronic mail or other services 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 (e.g., a fee paid to America Online or CompuServe for the ability to access the Internet). This term does not include telecommunication services.

The moratorium does not apply to states that imposed and actually enforced taxes on Internet access prior to Oct. 1, 1998. Therefore, the ITFA grandfathered state laws that were in effect and legally enforceable prior to that date.

States eligible for the grandfather clause can choose not to tax Internet access. The following states were eligible for the grandfather clause--Connecticut, Iowa, New Mexico, North Dakota, Ohio, South Carolina, South Dakota, Tennessee, Texas and Wisconsin. Several states have altered their statutes since the ITFA was signed into law (e.g., South Carolina chose not to tax Internet access).

Multiple Tax Moratorium

The ITFA provides for a moratorium, beginning Oct. 1, 1998 and ending Oct. 21, 2001, that prevents assessment of multiple taxes on electronic commerce. Section 1104(6) defines multiple taxes as a tax imposed by multiple jurisdictions on the same transaction. Taxes are considered multiple taxes whether or not the tax is assessed at the same or different rates by multiple jurisdictions. The grandfather clause discussed above does not apply to the multiple tax moratorium.

Discriminatory Tax Moratorium

The ITFA provides a moratorium, beginning Oct. 1, 1998 and ending Oct. 21, 2001, that prevents assessment of discriminatory taxes on electronic commerce. Section 1104(2) defines a discriminatory tax as a tax on electronic commerce that is otherwise not legally enforced if the tax on transactions involving similar property, services, goods or other information is accomplished through other means. Therefore, a discriminatory tax is a tax imposed on an Internet transaction, but not on a similar non-Internet transaction.

Example: A clothing retailer (K) has locations in Minnesota and Wisconsin. In addition, it has mail-order sales to consumers in Minnesota,Wisconsin and North Dakota. K must collect sales tax on mail-order sales delivered or shipped to Minnesota and Wisconsin because it has substantial physical presence in those states. However, North Dakota is not allowed to impose tax on mail-order sales terminating in that state because K does not have substantial physical presence.

The ITFA prevents North Dakota from requiring K to collect sales tax on the sale of clothing ordered over the Internet, because it cannot impose the tax on K's mail-order sales. The ITFA, however, would not prevent Minnesota and Wisconsin from imposing a tax on K's Internet sales.

The ITFA also protects from taxation the sale of goods or services that are Internet-unique and not sold off-line. Examples of such items would be electronic mail, Internet bulletin boards and Internet search-engine services.

The definition of discriminatory tax also prevents state and local governments from asserting that Internet contacts create substantial physical presence. The ITFA prevents a state or local government from asserting nexus solely due to the ability to access a site on a remote seller's computer server. Therefore, if an Iowa retailer maintains its Website on a server in Illinois, Illinois is prohibited from requiring the retailer to collect Illinois sales tax (assuming the Iowa retailer has no other presence in Illinois). The grandfather clause does not apply to the discriminatory tax moritorium.

Advisory Commission on Electronic Commerce

The ITFA established a 19-person committee called the Advisory Commission on Electronic Commerce. The committee is required to make legislative recommendations to Congress no later than April 21, 2000, on whether electronic commerce should be taxed and, if so, how it should be taxed without creating multiple and discriminating taxes.

Federal Taxes

The ITFA prevents the Federal government from taxing electronic commerce and Internet access through special excise taxes or sales taxes.

Summary

The ITFA will enable the Internet to continue to grow without the threat of multiple and discriminatory sales taxes. The goal is to design a system that allows the states to impose a fair and consistent tax on electronic commerce, which can be put in place after the moratoriums cease on Oct. 21, 2001.

Recommendations include an extension of the moratorium or the development of an Internet national sales tax system. Another recommendation could include a discussion of what specific contacts create substantial physical presence in a state. This will not only affect retailers who sell over the Internet, but also retailers who sell by mail order. The mail-order industry should be concerned with the Commission's recommendations. If the Commission recommends Internet retailers to collect sales taxes, it would seem practical that mail-order retailers would be required to collect sales taxes. Thus, the Commission's recommendations could significantly alter the definition of nexus.

The only certainty is that retailers selling over the Internet are not required to collect sales taxes in states where they do not have a physical presence until Oct. 21, 2001. After that date, the rules could significantly change.

FROM LANCE LESLIE, CPA, DAVENPORT, IA