The final frontier.

EXCLUSIVE SUMMARY

* THE INTERNET TAX FREEDOM ACT (ITFA) ENACTED IN 1998, puts a three-year moratorium on the imposition of new taxes on Internet access and electronic commerce. It also creates a 19-member commission to recommend how--and if--remote commerce, including Web sales, should be taxed.

* ONE PROPOSAL UNDER CONSIDERATION WOULD declare the Internet a permanent tax-free zone. State governments, which depend heavily on sales-tax revenue, see such a proposal as a threat to their sovereignty. Others are concerned such a change would give Internet sellers an advantage over conventional merchants.

* ANOTHER SOLUTION IS TO EXTEND CURRENT sales tax concepts to Internet transactions. Taxes would be levied based on the destination of a sale--usually the state where the buyer is located. To make this easier, the National Tax Association has reached an agreement that would result in each state charging a single tax rate on all transactions.

* A THIRD POSSIBLE OUTCOME IS TO FORMULATE a new method of taxation that recognizes the unique nature of remote commerce. One such proposal is a seller-based tax system, that grants the seller's state the sole right to tax a transaction. While this is consistent with European methods, it differs dramatically from the way transactions are currently taxed.

* IT IS UNLIKELY THE ITFA COMMISSION WILL REACH a decision within the required 18-month timetable. It does seem likely, however, that the days of untaxed Internet commerce are numbered.

How should electronic commerce be taxed?

Who--if anyone--gets to tax transactions that take place in cyberspace? The question becomes more pressing as Amazon.com, ebay.com, etrade.com and similar Web sites become a more popular way to buy everything from books and used guitars to stocks and bonds. When President Clinton signed the Internet Tax Freedom Act (ITFA) into law in October 1998, the act's three-year moratorium on Internet taxation was hailed as a victory for consumers and electronic commerce. Passage of the act, however, does not mark the death of Internet taxation. Rather, it is only the beginning of a long debate to determine how to tax electronic commerce, a debate that could last well into the new millennium. Businesses--and the CPAs who work for or advise them--should understand clearly what the ITFA does and does not do, so they can begin to gauge the impact Internet taxation could have on their operations.

THE SEARCH FOR A SOLUTION

The ITFA has declared a hiatus on the imposition of new taxes on Internet access and commerce while a special commission examines the issue. Its work could--within the next several years--lead to a federal law granting states the right to tax Internet commerce.

The ITFA has two major provisions.

* Tax moratorium. The act imposes a three-year moratorium on taxes on Internet access (unless the tax was generally imposed and actually enforced prior to October 1, 1998) and multiple or discriminatory taxes on electronic commerce.

* Electronic commerce advisory commission. The act creates a 19-member advisory commission on electronic commerce (see the exhibit on page 35). Members include the secretaries of Commerce and Treasury, the U.S. trade representative and representatives from state and local governments and the electronic commerce industry.

ITFA Commission Members

Dean Andal, chairman, California Board of Equalization 

Michael Armstrong, chairman and CEO, AT&T

Charlene Barshefsky, U.S. Trade Representative

Larry Carter, president, Cisco

William Daley, Commerce Secretary

James Gilmore, governor of Virginia 

Paul Harris, delegate, Virginia

Delna Jones, county commissioner, Washington County, Oregon 

Ron Kirk, mayor, Dallas

Mike Leavitt, governor of Utah

Gary Locke, governor of Wisconsin 

Grover Norquist, president, Americans for Tax Reform 

Robert Pittman, president and CEO, America Online 

Richard Parsons, president, Time Warner, Inc.

David Pottruch, president and CEO, Charles Schwab and Co.

Robert Rubin, Treasury Secretary

John Sidgmore, vice chairman, MCI-WorldCom

Stan Sokul, consultant, Association for Interactive Media

Ted Waite, chairman and CEO, Gateway

The commission's task is to conduct a thorough study of federal, state, local and international taxation, as well as tariff treatment of transactions using the Internet and Internet access and other comparable sales activities. The commission is slated to deliver its findings--including legislative recommendations--to Congress within 18 months of ITFA's enactment. Any recommendations are to be tax and technology neutral--providing no relative advantage or disadvantage to Internet access or commerce--and apply to all forms of remote commerce.

The commission's work is expected to form the basis for federal legislation governing taxation of all remote commerce. Remote commerce includes not only the Internet but also mail-order, phone and television sales and other methods of shopping at home.

As it formulates its recommendations, the commission faces the daunting task of balancing political, economic and even constitutional requirements. Although reconciling the elements is complex, the commission is expected to recommend one of three courses of action:

* Declare the Internet a permanent tax-free zone.

* Tax all remote commerce according to current principles of sales taxation.

* Formulate a new method for levying sales taxes.

TO FREE OR NOT TO FREE

State and local governments fear Congress will, following completion of the commission's study, pass a law forbidding or limiting state and local taxation of Internet transactions. The Clinton administration advocated a tax-free Internet in its 1997 Framework for Global Electronic Commerce. Senator Bob Smith (R-N.H.) already has introduced a bill that would make the moratorium on Internet taxation permanent.

Although the U.S. Constitution's commerce clause grants the federal government the right to regulate interstate commerce, state governments are concerned that making the Internet tax-free threatens their sovereignty. Utah Governor Mike Leavitt, head of the National Governors' Association and a commission member, labeled Internet taxation "the most significant issue related to the ongoing shape of state governments that we have faced in decades."

One objection to a federal mandate prohibiting Internet taxation is that it would shift power from state and local governments to the federal government. Because this shift would directly affect states' prerogative to levy taxes on transactions within their borders, no major change is likely to take place without a fight.

Another consideration is the advantage such a tax break would give Internet sellers over conventional merchants. With Internet sales expected to grow from $8 billion in 1998 to over $327 billion annually within the next five years, this threat is significant. Legislation exempting Internet transactions from tax would give online merchants a permanent price advantage equal to state sales tax rates.

The migration of commerce to a tax-free Internet could also cause a crisis in the funding of local government services. By one count, sales, use and excise taxes make up 50% of state and local revenue. These taxes fund schools, roads, police and other local services. If sales migrate from taxable local stores to nontaxable Internet merchants, local governments will be forced to find new revenue sources to replace their shrinking sales tax base.

The threat to states of an eroding tax base and the resulting difficulty in funding state and local services leads back to the issue of state sovereignty, underscoring the reason why states are hesitant to support federal limits on Internet taxation. During the ITFA debate, Senator Dale Bumpers (D-Ark.) likened the potential loss of revenue from uncollected remote sales taxes to an unfunded federal mandate. Because of the serious economic consequences of a tax-free Internet, state and local governments will lobby hard to ensure that the commission's recommendations preserve or strengthen their ability to tax remote commerce.

KEEP THE STATUS QUO?

The commission also could propose to extend current sales tax concepts to Internet transactions. Under the present system, taxes are usually levied based on the destination of a sale. Generally, only the state in which the buyer is located has the right to levy sales tax on that transaction.

Such a solution is not as simple as it might seem. The U.S. Supreme Court, through its decision in the 1992 Quill case, prohibits a state from imposing a use-tax collection responsibility on out-of-state mail-order or telephone sellers if the sellers have no physical presence in the state. Although buyers have a statutory obligation to remit use taxes when the seller has not charged them, the vast majority of remote purchasers ignore this obligation, and enforcement on nonbusiness buyers is impractical. This results in the loss of billions of dollars of state tax revenue every year. Internet sellers would fit this category, since they also sell largely without physical presence.

While Congress has the power to override the Supreme Court decision, in order to be meaningful any Internet tax legislation would have to grant states this long-awaited ability to tax remote sellers. Senator Bumpers has already anticipated this need by introducing a bill that would mandate sales tax collection by remote sellers.

The ITFA also took this into consideration by requiring the commission to consider fairness among all types of commerce when formulating its recommendations. If legislation resulting from the commission's work authorizes the taxation of Internet transactions, it is also likely to include language requiring sellers to collect sales tax regardless of the seller's location or physical presence. The law will apply to all remote sellers, allowing states to require mail-order and telephone sellers and the like to collect and remit sales tax on all transactions.

The National Tax Association (NTA), an industry and government tax group, has been working for some time on solutions to this issue through its communications and electronic commerce tax project. The project is seeking an equitable method for taxing electronic commerce. In the summer of 1998, the group agreed unanimously on a proposal that would result in each state charging a single tax rate on all transactions. This would remove from industry the burden of determining tax rates and methods for multiple jurisdictions in each state. In exchange, industry would be expected to take seriously its duty to collect and remit sales tax on remote transactions.

If the ITFA commission adopts this proposal, the resulting changes would address the fairness issue, since remote and conventional commerce will be taxed equally. The changes would also address the sovereignty issue, since state and local government representatives have agreed to the NTA plan. Most important, the revenue base of local governments will be protected.

The problems with applying this solution strike at the heart of Internet taxation. The tracking required to determine where a sale is ultimately taxable is complicated. When a customer in one state purchases an item from an out-of-state on-line catalog, charges the sale to a bank in a third state, and has it shipped to yet another state, where did the purchase actually take place? In which state or states is the purchase taxable?

In such a situation, the NTA proposes that taxes be levied on the destination of the purchased goods. In other circumstances, such as on-line software purchases, where the destination cannot be determined, a complicated formula would allocate taxes to states in the same proportion as identifiable sales. While this approach seems workable for purchases in which the buyer and seller are in the United States, it is not problem free.

The NTA proposal is directly at odds with the system supported by America's European trading partners, who have committed to a system that imposes taxes based on the seller's location. If the ITFA commission is to truly bring U.S. Internet tax policy in line with international policy, it will need to resolve the conflict between the destination-based tax the NTA currently favors and the seller-based tax advocated in Europe.

Privacy protection is a second problem. NTA proposals would require the seller to obtain information about the buyer's location--information tax officials could examine. This intrusion is illegal in some states and might even be unconstitutional. Such a requirement also would not meet the fairness standard, since such information is not collected from traditional retail customers.

Privacy issues raised by the NTA proposal open up the possibility that consumers in high tax states could use privacy claims to reduce or avoid taxes. Under current privacy laws, consumers must be notified that address information will be used for tax collection purposes, and sellers would have to give consumers the option of withholding the information. If a consumer asked that his or her address be withheld for tax reporting purposes due to privacy claims, the seller would either collect no tax or charge a default rate. In either case, consumers would quickly learn to use privacy laws to ensure the lowest possible tax rate on their purchases.

A SELLER-BASED TAX SYSTEM

The formulation of a new method of taxation is a third possible outcome--one that recognizes the unique nature of remote commerce. An article in State Tax Notes (October 5, 1998) proposed one such method--a seller-based tax system. Under this proposal, federal legislation would grant the seller's state the sole right to levy state and local transaction taxes. The tax would be levied at the rate mandated by the seller's state.

The seller-state method would address a number of the objections discussed earlier. Through consistency with European tax methods, it would avoid potential double taxation in international trade. It would also preserve state sovereignty and funding resources, since every state would have the right to determine whether and at what rate transactions would be taxed. The method addresses fairness--remote sellers and Main Street businesses would be taxed equally. Privacy would be protected, since no information about the buyer is necessary in order to tax. Uncertainty about nexus (sufficient presence in a jurisdiction to be subject to tax) would also be removed, since there is little difficulty identifying where a seller's place of business is located.

While the seller-based concept makes sense in many respects, support for such a dramatic change in sales-tax concepts is unlikely. Governments and industry are accustomed to a destination-based tax, and there is a great deal of support for this method. The agreement the NTA has already reached to extend the destination-based system to electronic commerce further decreases the chances of success. The majority of states base their income tax apportionment systems on the destination-based tax. Changing this system could require rethinking the basic, fundamental concepts on which state taxation is based.

Fairness to consumers and merchants also becomes an issue with this system, since buyers would pay different rates of tax on purchases, depending on the location of the business. This could lead consumers in high-tax states to make as many purchases as possible from out-of-state sellers. It also might lead sellers to relocate to low-tax states to gain a competitive advantage over sellers in high-tax states. In the end, this could simply shuffle elements of the current situation, with consumers buying from certain merchants and stores choosing their locations for the tax advantages.

Finally, such a dramatic turn in tax policy flies in the face of years of settled state tax statutes and case law. Even common-law concepts related to the taxation of transactions would be affected. State governments and industry would face a monumental burden to set precedent and develop interpretations of the law.

GET INVOLVED

CPAs in companies that will be affected by the ITFA and the legislative outcome of the commission's work can help their employers by taking these actions:

* Combat misinformation about the ITFA in your company. People who have not read the act often have the mistaken impression that it permanently exempts all Internet transactions from tax. By reminding management of current state laws governing sales and use taxation and keeping them informed about the legislation that could result from the commission's work, CPAs can decrease the likelihood management will make business decisions based on a misunderstanding of the ITFA.

* Keep potential legislation in mind when planning for the future and when designing new financial systems. Future legislation could require many companies that don't currently charge sales tax on transactions to begin doing so. Planning now for that possibility can save financial managers considerable headaches.

* Closely monitor developments in the Internet taxation debate. The Web sites listed in the box on page 33 post periodic updates on Internet-tax related issues.

* Get involved in the debate. Contact the NTA, members of Congress and members of the commission listed in the exhibit to provide your input on how the Internet tax could affect your company. Industry involvement is vital to developing the best solution.

TAXING THE FINAL FRONTIER

The ITFA does not solve the Internet taxation issue. It simply provides a "time out" to allow for a full debate of the complex issue of taxation in the electronic age. As the commission continues its work, several points are clear:

* The issue is exceedingly complex. A meaningful recommendation will require careful study of complex technical and economic arguments.

* Lobbying will be intense. With so much at stake, and so many divergent groups likely to be affected, key interest groups are sure to make their voices heard.

* A solution will require federal action. With roughly 30,000 jurisdictions levying taxes in this country, it is impossible to implement a coordinated plan to tax remote commerce without the involvement of Congress.

* State and local governments will have to sacrifice sovereignty. States are facing the fact that decisions on this issue will be made at the federal level. They must work with the commission to ensure an outcome that protects their interests.

* The solution will affect all remote sellers. Mail-order and other remote sellers who do not charge sales tax must realize that their de facto tax exemption is ending. If an Internet tax is passed into law, they will be responsible for charging and remitting sales tax.

* A decision within the 18-month ITFA deadline is highly unlikely. Delays in beginning the commission's work (its first meeting will be held in late June) and the requirement of a supermajority to reach a recommendation will slow the process.

Like the last days of the old West, the days of the untaxed, open frontier of Internet commerce are numbered. With the dramatic growth expected in electronic commerce in the next five years, passage of tax legislation governing Internet access and transactions is inevitable. The only question left is where the fencelines will be set.

Web Updates on Internet Taxation

* The Internet Tax Freedom Law Homepage (Rep. Christopher COX, R-Conn.) www.house.gov/cox/nettax/

* The Congressional Internet Caucus www.netcaucus.org

* National Tax Association Communications and Electronic Commerce Tax Project www.nhdd.com/nta/ntaintro.htm

* The Internet Tax Fairness Coalition www.stopnettax.org

ANDREW C. LEE, CPA, is a senior tax consultant with Ernst & Young's telecommunications practice in Denver. His e-mail address is [e-mail].