Determining taxability in the ever-evolving world of e-commerce.

• Author: Newton-Clarke, Rebecca

In a world of rapidly evolving technology, e-commerce transactions have become the norm. While the term e-commerce initially referred to Internet-based sales of physical items, recent years have given rise to a new breed of purely electronic transactions including cloud computing, digital downloads, streaming entertainment, and information services, which have further complicated the already-complex sales and use tax landscape.

Taxation of purely electronic transactions is often confusing, if not downright uncertain, as most state tax legislation is based on the idea of a physical sale or use occurring in a particular state. With technology advancing so rapidly, state tax laws, which depend on lengthy legislative processes, lag behind. The result is that states' approaches vary widely, with some taxing agencies attempting to stretch statutes to encompass transactions that were inconceivable when the laws were originally adopted.

While federal rulings and laws provide some foundational guidance, the real understanding for tax practitioners comes from comprehensive state-by-state analysis of e-commerce taxation. Here, we take a high-level look at understanding nexus and determining the taxability of purely electronic transactions.

UNDERSTANDING NEXUS

Nexus, which arises from a retailers sufficient physical presence in a state, determines whether an online retailer is required to collect sales tax from out-of-state customers. The U.S. Supreme Court has established that a seller must have a physical presence in a state for the state to obligate the seller to collect sales and use tax for that state. The seller can have this presence because of its own property or activities in the state or because of the property or activities of a third party that establishes or maintains the out-of-state seller's market in the state.

The first question for e-commerce transactions, as in all transactions involving out-of-state sellers, is whether the seller's contacts with or activities in the state are sufficient to establish nexus there. The Internet Tax Freedom Act effectively precludes a state from claiming sales and use tax nexus if the "sole ability to access a site on a remote seller's out-of-state computer server is considered a factor in determining the remote seller's tax collection obligation." The location of third-party servers in the taxing state--as when the seller contracts with a third party to house remotely accessed software or other cloud...