State Sales & Use Tax on Internet Transactions.

• Author: Owen, Sandi

1. INTRODUCTION

   With the explosive growth of electronic commerce, the way people do business is dramatically changing. More and more transactions are being conducted electronically, and the geographic boundaries that once played such a significant role in commerce are rapidly disappearing. With this growth and globalization of electronic commerce, state and local taxing authorities have become concerned that the information superhighway bypasses state and local taxation. Since sales and use taxes on transactions are major sources of revenue for state and local governments, erosion of this tax base has serious repercussions for their ability to support local infrastructures. Industry interests, however, express concern that taxation of Internet transactions, both from a financial and administrative perspective, would discourage innovation and investment in the information superhighway and impede its growth.

   This Note argues that the existing structure for taxation of physical commerce does not fit the developing reality of an electronic commerce-based economy. The traditional means of taxing the sale of goods and services is based on concepts of physical assets, geographic locations, and face-to-face encounters. Commerce on the Internet is based on technology where there is no locality, no physical presence, and no geographic boundaries. Since Internet transactions do not fit into the traditional physical commerce tax structure, new standards for defining when and how a taxing jurisdiction may tax an Internet transaction must be developed.

   Internet transactions have virtually eliminated the geographic boundaries between states and localities that formerly provided the framework for sales and use taxation. As a result, a national tax policy must be developed either through uniform state laws or federal legislation. Any federal legislation or uniform state laws developed to regulate interstate electronic commerce must balance the needs and concerns of state and local taxing authorities with the needs of businesses and consumers. This balance must occur within the framework of basic tax principles of fairness and equality and minimization of administrative and compliance burdens.

   Although the taxation of electronic commerce raises issues in several tax areas, including international taxes, federal income taxes, and state and local property taxes, the focus of this Note is on state and local sales and use taxes. The Internet transactions that are discussed are the sale of goods and services over the Internet, with either physical or on-line delivery to the purchaser from the vendor. This Note does not discuss sales and use tax issues relating to other Internet transactions, such as the sale of Internet access services, Web space, or Web page advertising.

   Part II of this Note provides an overview of the traditional sales and use tax structure and discusses why modern electronic commerce does not fit into this traditional structure. Part III discusses some of the challenges of taxation of electronic commerce and the concerns of state and local taxing authorities versus those of businesses and consumers. Part IV provides a review of what guidance is currently available and the constitutional considerations in the taxation of Internet transactions. Part V proposes a national approach, through federal legislation or uniform state laws, to the sales taxation of Internet transactions and offers recommendations, such as a shift of focus from the seller's to the buyer's location, for addressing the taxing challenges of doing business in cyberspace.

2. OVERVIEW

   1. Traditional Sales and Use Tax Structure

      The typical sales tax structure of a state involves a retail sales tax imposed on tangible personal property purchased in the state.(1) A state may also impose a use tax on its residents for tangible personal property acquired in another state but used in their resident state.(2) Sales and use taxes are typically imposed on purchases by the final consumer, and transactions between businesses are exempt.(3) The sales tax has been referred to as a "tax on the freedom of purchase[,]" whereas the use tax is a "tax on the enjoyment of that which was purchased."(4)

      Three factors determine whether sales or use tax liability in a particular state exists for a transaction: (1) the type of good being sold, (2) situs, or the location where the transaction takes place, and (3) nexus.(5) Traditionally, sales tax has been imposed on tangible goods, not on intangible goods or most services, and is assessed and collected at the location where the good is transferred from the seller to the buyer (the situs).(6) The concept of nexus concerns whether the taxing jurisdiction has sufficient connection to have the authority to impose taxes on the transaction and collection responsibility on the vendor.(7) Each of these factors will be explored within the context of the Internet, as opposed to traditional physical, retail transactions.

   2. Shift to Electronic Commerce

      Electronic commerce is defined as "`the ability to perform transactions involving the exchange of goods or services between two or more parties using electronic tools and techniques.'"(8) Examples of electronic commerce include on-line catalogs for ordering goods, computer software that can be downloaded, and on-line information, such as LEXIS or West-Law electronic databases.(9) Some of the primary growth areas for consumer purchases over the Internet are airline tickets, computer hardware and software, and books, music, and entertainment.(10)

      In 1997, approximately "100 million people logged onto the Internet, up from 40 million the year before."(11) A recent Forrester Research, Inc. study projects that "electronic commerce will reach about $350 billion by 2002, from an estimated $22 billion this year."(12) Approximately "80% of business on the Net today is conducted between companies," with the remaining 20 percent involving direct sales to consumers.(13) The Forrester study estimates that "[n]early one-third of online households made a Net purchase [in the first six months of 1998], up 50% from [1997]," and that "[t]hose who didn't buy online used the Net to help make a purchase decision."(14)

      The shift from physical commerce to electronic commerce has brought about changes in the way businesses market, package, and distribute their products. Traditionally, the purchase of goods by consumers involved either the consumer going to the merchant's local retail store and buying the good or a representative of the company coming to the consumer's home. These geographical constraints were first weakened by the advent of catalog shopping beginning one hundred years ago, which allowed consumers to order goods by mail from other locations.(15) Direct marketing technologies, such as the use of toll-free numbers, computers, and faxes, have further reduced companies' needs for sales personnel or retail stores within states to sell to consumers there. With Internet Web pages increasingly replacing catalogs mailed to people's homes, the physical connection between mail-order sellers and consumers is becoming even weaker.(16) Today, with personal computers and modems, consumers have instantaneous, twenty-four-hour access to a full range of goods and services from all over the world without having to leave their home or office.

      The type of goods that consumers purchase is also shifting from tangible to intangible goods and services. Increasingly, it is the packaging, and not the content, of the good that classifies it as tangible. For example, in purchasing a book you physically acquire a tangible item--the book's cover, binding, and pages. However, what you are really purchasing are the contents of the book--the story contained in the words on those pages. As technology improves, there will be greater opportunities for purchasing goods such as books, software, music, and videos electronically by downloading over the Internet, which will allow the purchaser to acquire the content while avoiding the packaging altogether.

      To illustrate the evolution of consumer purchases from traditional physical commerce to electronic commerce, assume that you wish to purchase a newspaper. Ten years ago, either you would go to a newsstand or store to purchase the paper or a "paperboy" would come to your home to deliver the paper and collect what you owed. Today, you could order the newspaper directly from the company over the phone or the Internet and have it delivered to your home by a common carrier, such as the postal service. Moreover, you could receive the newspaper in electronic form, either over the Internet or through electronic databases such as LEXIS or WestLaw. The newspaper is displayed on your computer screen rather than on paper, thus eliminating the "packaging" altogether, along with the expense and delay of shipping. As this example shows, the development of electronic commerce has brought about a broader range of choices at potentially lower costs to consumers.

   3. Lack of Fit Between Old Sales Tax System and New Electronic Commerce

      The three factors traditionally used in determining whether sales tax liability exists for a retail transaction present numerous problems in an electronic commerce environment. First, regarding the content or substance of the transaction, most taxing schemes impose a retail sales tax on tangible goods, yet more and more retail transactions involve intangible goods and services. Some intangible goods, like music, which are normally transferred through a tangible medium, such as a compact disc, can now be delivered through an electronic medium and avoid classification as a tangible good. As long as sales taxes are only imposed on tangible goods, this shift in the type of goods being purchased results in...