Virtual taxation: electronic commerce poses problems for state tax collections.

This article is adapted from Fiscal Notes, March 1996, published by the Texas Comptroller of Public Accounts, and is reprinted with permission.

Traditionally, the states have levied sales taxes on the sale of tangible goods - shoes or furniture, for example - and the tax base has been easy to define and maintain. Now, with changing business practices and the burgeoning use of electronic commerce, the definition of business and where it takes place - the foundation of sales or business taxation for the states - is growing more fuzzy.

If consumers buy a pair of hiking boots at the local sporting goods store, in most cases they pay a tax. If they buy the same boots through a catalog by phoning an out-of-state company, or after downloading a catalog from the Internet onto a computer, they might not be charged a tax.

As a result of a U.S. Supreme Court ruling, there is no doubt that a vendor having nexus, or presence, only through the mail or through delivery by common carrier is not required to collect the use tax levied by the state of destination. Many questions remain about the collection of sales and use taxes on goods and services sold over the Internet.

In many states, including Texas, sales and use tax means a transaction tax on goods and some services. On the Internet, for example, the transaction is not that simple. Where did the sale take place? Where are the profits earned? Is the item purchased a taxable item?

States are struggling to collect needed receipts from the sales and use tax, which in Texas' case brings in more than half of the state's total tax revenue. With rapid growth in interstate sales through the Internet, mail order, and television, the collection of sales and use taxes will become increasingly inequitable and unenforceable in the absence of corrective legislation, according to the National Conference of State Legislatures (NCSL). Also, local retailers and out-of-state retailers with a physical presence in taxing states face "a serious competitive disadvantage," NCSL says.

On-line Commerce

In the past several years, thousands of businesses wishing to sell goods or services electronically have set up marketing addresses on the World Wide Web portion of the Internet, the worldwide system of computer networks.

Estimates of sales over the Internet vary widely. Forrester Research Inc. of Cambridge, Massachusetts, offers a frequently quoted estimate of $240 million of on-line consumer spending in 1994, based on a national survey of merchants, on-line service providers, and consumers. The Federal Trade Commission (FTC) estimates that sales transactions worth nearly $3 billion took place through the global information network in 1995 and that sales will reach "tens to hundreds of billions of dollars" in the next decade. Panelists at the 1995 annual meeting of the Multistate Tax Commission anticipated that sales on the Internet will range from $2.4 billion to $7 billion by 2000.

More than 2.5 million people - approximately 14 percent of World Wide Web users - have bought products or services over the Internet, according to an October 1995 survey by CommerceNet and Nielsen Media Research. A study from the Information Sciences Institute at the University of Southern California estimates that more than 10,000 companies offered information and services for sale over the Internet at the end of 1994, and the number of companies is expected to reach 1 million by the turn of the century.

Security concerns have been a major barrier to commerce on the Internet. Individuals who buy goods and services by credit card on the Internet fear that their financial information will not be transmitted securely through what many perceive as an unregulated netherworld of information flow. Most likely, the security problem will be solved with some form of "cybercash." (See the accompanying sidebar.)

Consumers who wish to purchase goods and services on-line are currently faced with several unattractive options, according to the associate director of credit practices with the FTC. They can risk sending their credit card information off into cyberspace, or they can sign off, contact the merchant by phone or mail and use traditional payment methods such as cash or checks or credit cards. All consumers do on-line with any degree of confidence is window shop. If the global information infrastructure is to achieve its potential as a mechanism for commerce, payment systems must be developed to provide consumers with security.

Virtual vs. Physical

The sale of goods and services over the Internet falls into four basic categories: direct selling of products, selling advertising space, charging service fees for information, and charging fees for on-line links.

One of the fastest growing yet most elusive sources of potential tax revenue is the "virtual mall." Retailers establish Internet "storefronts" that allow users to browse through catalogs ranging from jewelry to food to software.

In the case of physical retail malls, Texas requires merchants to collect the tax even if they are based out of state. With products purchased at virtual malls and new methods of selling, however, states face new administrative challenges in collecting the tax. Is the "virtual merchant" or the purchaser required to collect/pay the tax?

In Texas, both physical and virtual mall merchants are required to collect the tax if they have a "physical presence" in the state. The definition of physical presence is the crux of the controversy.

Mail Sale

The largest and most established form of at-home sales - when the buyer and seller do not meet - is mail order, a $60 billion to $80 billion industry that has roughly doubled since 1987 and shows no signs of slowing.

Tax collection on mail order sales, called one of the core inequities in state taxation, was addressed most recently in the 1992 U.S. Supreme Court decision in Quill Corp. v. State of North Dakota. The court ruled that a company having no substantial nexus in the state and conducting its business through the mail is protected from collecting the tax.

Out-of-state mail order sales are estimated to cost the states between $3 billion and $4 billion per year in lost tax revenues. In 1994, Texas' state and local governments lost $235 million because of out-of-state mail order purchases, according to the U.S. Advisory Commission on Intergovernmental Relations. [ILLUTRATION FOR EXHIBIT 1 OMITTED.]

Mail-order companies argue that the absence of a national tax rate hinders the collection of taxes on mail-order sales. Neither the states nor local governments have been willing to accept tax rates lower than those collected by in-state vendors. (For a discussion on sales and use taxes on mail-order purchases, see the article on page 46 of this issue.)

The seller is not obligated to collect the tax, and the existing system is difficult to enforce. The 1992 Supreme Court ruling does allow states to require companies to provide information concerning their operations if a state believes that the company may have nexus within the state.

Some industry observers believe the explosion of on-line retailing will cause the demise of mail-order catalogs because online retailing is less expensive for sellers, more engaging for buyers, and more conducive to impulse buying. Others disagree, saying paper catalogs still meet needs that electronic media cannot.

Shoppers' Networks

The decade-old home shopping industry began with the concept of penetrating the final, most effective retail location: the living room couch. The two primary home shopping television networks, Home Shopping Network (HSN) and QVC, sell about $2 billion in goods annually.

While shopping through TV is popular with individuals accustomed to it - HSN reports that half of its 5 million "active" households make repeat purchases - viewers must wait until they see something they like, rather than being able to browse as they would in a store or catalog. Now, general merchandise stores are planning their own shopping channels with interactive electronic arrangements that would allow the at home customer to make direct purchases.

HSN and QVC, unlike their mail-order and on-line counterparts, collect a tax on merchandise sold in Texas. Although it has no physical presence in Texas, HSN has decided to collect a tax because, in the company's words, it is "not willing to assume the potential liability that could be assessed if Texas were to assert that sufficient presence in Texas existed."

Taxing Issue

Whether an out-of-state seller is responsible for collecting the tax on electronic sales of goods and services is a legal issue still in the early stages of discussion. In November 1995, a conference of tax policy experts and business delegates sponsored by the Multistate Tax Commission (MTC) considered whether government can afford to resolve this issue without the cooperation of business and whether business can afford to ignore the application of state taxes to on-line services.

States vary in their approaches to applying the sales tax. For example, while most states tax computer hardware the same way, they may tax software and maintenance contracts differently, creating additional record-keeping requirements for retailers.

The NCSL urges federal legislation that would require the collection of sales and use taxes by interstate sellers who solicit business in a taxing state and that would allow states to establish a single statewide tax rate for use by out-of-state retailers.

According to the chief executive officer of a company that designs software that will automatically compute sales tax, once the states realize how much money will be involved in on-line shopping transactions, they may go after taxes with a vengeance.

Current concepts of nexus are outmoded and must be rethought to be applied to electronic commerce, according to the director of the MTC's national nexus program. One example is anonymity in on-line transactions. While security is necessary for the growth of electronic commerce, it muddies the taxability of the transaction.

States are just beginning to wrestle with the implications of electronic retailing. While tax administrators do not want to impede commerce or collect taxes the states do not deserve, they fear that if the tangible tax base evaporates, then the burden on other taxpayers and the stresses on state fiscal systems will increase.

RELATED ARTICLE: CYBERCASH ON THE BARREL HEAD

The promise of electronic commerce depends on a reliable, secure system of money. Today's cashless payment comes in many forms, known as cybercash, digital cash, e-cash and "smart cards."

Generally, there are two types of cybercash: identified and anonymous. Identified cybercash can reveal the person who withdrew money from the bank. Anonymous cybercash works like paper cash: once withdrawn from an account, it leaves no transaction trail. Both forms of cybercash can be transacted either on-line or off-line. On-line means the parties to the transaction interact with a bank; off-line means no bank or financial institution is involved.

A good example of identified, on-line cybercash is the smart card, embedded with a microchip that enables the owner to "load" it with cybercash. When the holder makes a purchase, the smart card is processed through an electronic reader, and funds are transferred from one account to another electronically. Similar to a credit card, identified cybercash enables the bank to track the money as it moves through the economy.

An anonymous, off-line method of electronic payment is the cash card, a simplified smart card. Financial institutions sell cash cards with a stored value, say $40. Each time the card is used, that amount is deducted from the $40. When the card is "empty," the owner may reload it with more money or throw it away.

A computer checkbook best exemplifies identified, off-line cybercash. This type of checkbook enables the user to make payments, similar to writing paper checks, through electronic mail. The "e-check" can contain all the information that paper checks contain, plus a digital signature - a security code proving that the check was authorized by the account holder.

Security is the greatest obstacle to the acceptance of cybercash as a purchasing medium. A 1994 Harris poll revealed that only 28 percent of the public said they were comfortable divulging their credit card numbers to make purchases over the telephone - a familiar technology.

Cybercash software designers contend that encryption - scrambling information so it can be read only by people with the proper decoding keys - protects merchant and consumer financial information. One drawback to encryption, however, is getting the necessary software into the hands of a large number of consumers.

Cybercash is more flexible than traditional money, and its administration may wind up costing financial institutions less than paper checks and records. The infrastructure is in place for cybercash to provide more information security in a transaction than credit cards do now. As confidence in this security grows, cybercash will gain more acceptance.

On the downside, however, uncontrolled growth of cybercash systems could produce many different systems that may not be able to communicate with one another and may prove difficult to regulate. Cybercash may be less secure than currency and checks, and it may be available only to those who can afford a home computer.

Many in the financial services and computer industries call the advent of cybercash a revolution. Soon after 2000, purchases may never be made the same way again.

JOHN SHARP is the Texas Comptroller of Public Accounts.