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Internet Tax Freedom Act.

As part of the 1998 budget package, Congress passed the Internet Tax Freedom Act (ITFA), effective Oct. 1, 1998 and ending Oct. 20, 2001. The ITFA exempts Internet service providers (ISPs) from state and local sales (and similar) taxes. The most important part of the ITFA, however, may be the commission set up to study taxation of electronic commerce. This commission could ultimately recommend that Congress grant states the power to tax remote sellers, both Web-based vendors and traditional mail-order companies. Should Congress grant such powers, these companies would lose a major competitive advantage that currently enables them to make tax-free sales. (For additional discussion of the ITFA, see the Tax Clinic, p. 26, this issue.)

ITFA Exemption for Internet Access Services

The ITFA exempts Internet access from state and local taxes. For this purpose, a tax includes any kind of charge other than a fee imposed due to a specific benefit or service. The exemption is only temporary, however, and contains many exceptions. The exemption applies to taxes that were not imposed and enforced prior to Oct. 1, 1998; ISPs cannot be subjected to any new taxes, but taxes already in force may still be imposed.

Taxes on Internet Access

As of Oct. 1, 1998, the income or franchise tax of each state was generally enforced on all taxpayers. Accordingly, ISPs will continue to be subject to these taxes in all states that impose them.

As of that date, a limited number of states and localities imposed and actually enforced taxes other than income taxes on Internet access. The most common tax imposed is the gross receipts tax (sales tax) levied by states. The ITFA provides rules for determining which states' non-income taxes may continue.

There are two tests to determine if a tax was imposed and actually enforced on Internet access. Under both tests the tax must be authorized by statute. This is an easy requirement; most statutes, especially those related to sales and use tax, are fairly broad. Assuming a tax is authorized by statute, under the first test, taxes will be considered imposed and enforced if an ISP had reasonable opportunity to know that such taxes would be imposed. This occurs when there is a rule or other public proclamation specifically stating that Internet access would be subject to tax. Few states meet this criteria; few have made specific rulings on such taxes.

Under the second test, a tax is considered imposed and enforced if the state or local government generally collected such taxes on Internet access. Whether a tax was generally collected is a difficult question to answer; states and localities often have unpublished internal guidelines on what is and what is not subject to tax. However, states and localities may have a difficult time proving that taxes are generally collected if they did not previously make a public announcement of their rules.

The ITFA does not contain a list of states or localities that meet these tests. In the original House version of the ITFA (H.R. 4105), there was a listing of states that imposed sales and use tax on Internet access; these states included Connecticut, Iowa, New Mexico, North Dakota, Ohio, South Dakota, Tennessee and Wisconsin. However, this list was dropped from the final version of the bill.

It is unclear whether this list represents those states that can continue to impose tax on Internet access. Equally unclear is whether additional states or localities should be added to this list. ISPs must consult the tax rules in states in which they are potentially subject to tax and contact state tax authorities to determine collection policies.

Internet Access Not Exempt from Tax

While not imposing direct censorship on Internet content, Congress is using the ITFA to encourage ISPs to exercise self-censorship. The ITFA provides an exception to its provisions, generally applicable to companies that knowingly engage in the business of providing access to materials harmful to minors, unless they restrict minors from accessing those materials. ISPs do not qualify for the ITFA's tax exemption, to the extent they are engaged in the business of providing unrestricted access to materials harmful to minors.

In addition, the ITFA provides that an ISP is not exempt from tax unless it offers customers software that filters harmful content to customers. This provision applies to new contracts entered into six months from Oct. 21, 1998.

Advisory Commission on Electronic Commerce

The ITFA also established the Advisory Commission on Electronic Commerce (the Commission). The Commission will consist of 19 members, with three Federal, eight state and local, and eight industry representatives. It will meet for 18 months from Oct. 21, 1998, then submit its recommendations to Congress.

The Commission's mandate will range far beyond electronic commerce issues; it will study state and local taxation of Internet access, remote commerce involving other countries, sales and use taxes in the U.S., consumption taxes (such as VATs) in other countries, possible model state sales and use tax legislation, and the advantages and disadvantages of authorizing state and local governments to require remote sellers to collect and remit sales and use taxes.

The Commission's main function will be to examine and make recommendations on the taxation of remote sellers, electronic or otherwise. Since the Supreme Court decision in Quill v. North Dakota (1992), Congress has had the power to legislate sales and use tax on remote sales. Despite heavy lobbying by the states, Congress has not enacted any such legislation. The creation of the Commission, which will include a large number of state representatives, gives states a forum in which to press their case for authority to tax remote sales, both electronic and traditional.

Prohibition on Discriminatory Taxes

The ITFA prohibits discriminatory taxes on electronic commerce. Discriminatory taxes include taxes imposed on electronic commerce not generally imposed on transactions accomplished by other means. For example, a state could not impose a tax on access to an online newspaper if the sale of a newspaper from a street corner is tax-free.

In addition, discriminatory taxes include taxes imposed at a different rate on electronic commerce than on the same transactions accomplished by other means. For example, a state could not impose a 7% sales tax on sales of flowers via the Internet if it imposes a 5% tax on sales from a local florist.

Taxation of Remote Sellers

The ITFA includes provisions on states' ability to require a remote seller to collect sales and use tax. Generally, a state cannot require an out-of-state vendor to collect sales and use tax unless that vendor has nexus in the state. Usually, nexus exists only if the vendor has physical presence in a state. However, a vendor can have nexus in a state if it has agents in that state.

One provision relates to the effect of access to a Website on a vendor's liability to collect sales tax. According to the ITFA, states may not require a vendor to collect a tax if "the sole ability to access a site on a remote seller's out-of-state computer server is considered a factor in determining a remote seller's tax collection obligation."

Example: USWebCo is a California vendor of apparel. Clothing is sold from a California-based Web server owned by USWebCo. The Website is accessible (and orders may be placed) from all 50 states. However, the fact that the Website may be accessed in a state cannot be used to determine if USWebCo has nexus in any state outside California.

A similar rule applies when a Website is housed on an ISP's Web server. Importantly, the provision specifically relates to a remote seller's "out-of-state computer server." This language clearly intends to open the door to a nexus claim when a server is located in a state. The ITFA does not preclude a finding of nexus when a Website is hosted on a Web server located in a state. The ITFA prohibits a finding of nexus only when an out-of-state computer server is used. By writing the ITFA this way, Congress may be sending a message to states that it does not object to such nexus claims.

It seems likely some states will pursue a nexus claim when a Web server is used in a state. For instance, if a California company uses a Michigan ISP to host its Website, Michigan may claim the California company has nexus for sales and use tax in Michigan.

The ITFA prevents states from imposing an obligation to collect or pay tax on a different person than is obligated for non-Internet transactions involving similar goods and services.

Example: USWebCo, a California vendor, operates an Internet mall from a server based in Michigan. Assume that USWebCo has nexus in Michigan for sales and use tax, and Michigan can compel the company to collect sales and use tax on its own sales to Michigan customers. Assume that USWebCo's clients do not have nexus for sales and use tax in Michigan. Because the clients do not have nexus in Michigan, that state cannot force them to collect tax on sales in Michigan. Under the ITFA, Michigan cannot compel USWebCo to collect tax on behalf of its mall clients.


The ITFA has no real effect on companies engaged in electronic commerce, other than a few ISPs. On the other hand, the newly established Commission can have a major impact both on Web-based vendors and on traditional mail-order companies. For the future, it is the Commission that companies should watch.

Editor's note: Mr. Maida and Mr. Brown are members of the AICPA Tax Division's Tax Technology Committee. David E. Hardesty, CPA, is with Markle Stuckey Hardesty & Bott, CPAs, Larkspur, CA, and is the author of the book Electronic Commerce: Taxation and Planning (Warren, Gorham & Lamont), available in early 1999.

If you would like additional information about this article, contact Mr. Maida at (609) 882-6874 or ncmcpa@prodigy, net or Mr. Brown at (703) 848-2502 or Mr. Hardesty can be reached at

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Author:Hardesty, David E.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Jan 1, 1999
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