State taxation of cyberspace.

• Author: Frieden, Karl A.

The rapid growth of electronic commerce is fundamentally changing the way Americans conduct business and home activities. While electronic commerce received its initial impetus from commercial online services such as America Online and CompuServe, it has increasingly become identified with the Internet, which is accessible by an estimated 40 million people in the U.S. and Canada.

Currently, use of the Internet and other forms of electronic commerce far exceed the commercialization of such channels. Although most users expect to surf the Internet for free, the gap between use and commercialization is likely to narrow significantly over the next five years.

As a general rule, businesses capable of transferring their goods or services electronically will find the Internet a fast and cost-effective means of reaching consumers. While the distribution of large durable goods such as automobiles and refrigerators will not occur electronically, other major business and consumer items lend themselves to the digital age, including E-mail, movies, publications, music albums, customer service, financial transactions and computer software. In fact, it is estimated that by 1999, one-half of all software sold will be transferred electronically.

Multistate Taxation of the Internet

As the commercialization of the Internet expands, so too will the taxation of electronic commerce. Indeed, the taxation of electronic commerce is a current reality. It is not surprising that state income tax laws apply to income earned from electronic commerce transactions. However, it is less widely known that many states also impose sales taxes on electronic commerce transactions.

Most states already impose sales taxes on the transmission component of electronic commerce (i.e., on the telecommunications channels). A few states, including Texas, New York, Ohio and Pennsylvania, also impose sales taxes on the content of electronic commerce, including such items as downloaded software, legal databases, financial information and other services provided online.

Taxing jurisdictions with expansive sales tax bases did not consciously set out to tax the Internet; instead, these states impose sales taxes on certain categories of electronic commerce as a result of a hodgepodge of existing laws intended to tax other types of activities. In many cases, states are attempting to use tax systems designed for manufacturers and vendors of tangible personal property to tax a technologically...