Taxing the Nontaxable: Are State and Local Governments Allowed to Tax Internet Streaming Service Providers?

• Author: Wallace, Michael

TABLE OF CONTENTS I. INTRODUCTION 180 A. INTERNET STREAMING SERVICE PROVIDERS ARE FACED WITH A 181 CONFUSING WEB OF CONFLICTING CONSUMER TAXATION LAWS II. THE CONFUSION AND COMPLEXITY FACING INTERNET STREAMING 182 SERVICE PROVIDERS III. STATE AND LOCAL GOVERNMENTS CANNOT REQUIRE INTERNET 184 STREAMING SERVICE PROVIDERS TO COLLECT AND REMIT SALES AND USE TAXES A. THE PERMANENT INTERNET TAX FREEDOM ACT 185 1. APPLICABILITY OF THE PERMANENT INTERNET TAX 186 FREEDOM ACT 2. THE PURPOSE OF THE PERMANENT INTERNET TAX 189 FREEDOM ACT B. THE COMMERCE CLAUSE 190 1. THE TAXATION OF ISSPS BY STATE AND LOCAL 191 GOVERNMENTS' FAILS TO SATISFY THE SUBSTANTIAL NEXUS TEST REQUIRED BY THE COMMERCE CLAUSE 2. COUNTER ARGUMENTS RAISED BY PROPONENTS OF 195 TAXING ISSPS VIOLATE THE COMMERCE CLAUSE C. THE DUE PROCESS CLAUSE 196 IV. CONCLUSION 198 I. INTRODUCTION

For Netflix, Hulu, and other Internet streaming service providers ("ISSPs"), the years 2015 through 2017 have been filled with confusion and frustration. ISSPs are required to collect and remit varying tax amounts from customers based on state and local governments' sales and use tax codes. (1) Yet, imposing such taxes violates the Permanent Internet Tax Freedom Act, burdens interstate commerce in violation of the Commerce Clause by requiring the ISSP to sort through hundreds of tax codes, and possibly violates the Due Process Clause of the Fourteenth Amendment by enforcing statutes and regulations on companies that are not under the state or local government's jurisdiction.

The application of existing state and local governments' sales and use tax codes imposes a substantial burden on ISSPs. According to the Federal Communications Commission ("FCC"), "the current patchwork of state and local laws and regulations relating to taxation of digital goods and services . . . may hinder new investment and business models," (2) thus hindering interstate commerce. For example, a double or triple taxation issue could arise if a resident of Washington, D.C. streams a video through an ISSP based in California during a layover at Dallas Fort Worth International Airport, and each jurisdiction claimed a right to tax the streamed video. (3) Adding to the complexity and confusion, "some [state and local governments] tax [online sales] as part of the sales tax imposed on tangible personal property; others tax them as a separate category of services." (4) Furthermore, each taxing jurisdiction differs on the content and products that are subject to be tax. (5)

Various sources of law, however, suggest that it is impermissible to require ISSPs to collect and remit sales and use taxes. (6) The United States Congress enacted the Internet Tax Freedom Act in 1998, which prohibited the introduction of new taxes on Internet access. (7) In 2016, Congress passed the Trade Facilitation and Trade Enforcement Act, which extended the Internet Tax Freedom Act's applicability to 2020. (8) Importantly, ISSPs fall within the category of "Internet access" as defined by the Internet Tax Freedom Act. (9) Further, a state or local government violates the Commerce Clause by requiring an ISSP to collect and remit sales and use taxes, unless the ISSP has a "substantial nexus" with the taxing jurisdiction. (10) Finally, the exercise of jurisdiction over ISSPs by state and local governments may also violate the Due Process Clause. (11)

1. Internet Streaming Service Providers Are Faced with A Confusing Web of Conflicting Consumer Taxation Laws

   ISSPs are in a state of confusion regarding its tax obligations for online streaming services. State and local governments have passed and implemented legislation and regulations that require ISSPs to collect and remit sales and use taxes. (12) However, Congress intended to prevent the taxation of Internet access when it permanently extended the Internet Tax Freedom Act in 2016. (13) In addition, the Commerce Clause and the Due Process Clause limit the actions of state and local governments. (14) In 1992, the United States Supreme Court held that a "substantial nexus" is required for states to force out-of-state sellers to collect and remit taxes from customers, formulating a test for imposing sales and use taxes on out-of-state companies. (15) In order for a state or local government to tax an ISSP, the Due Process Clause requires the company to be "physically present" in the jurisdiction or "purposefully direct[] its activities" at residents of the jurisdiction. (16) Yet, state and local jurisdictions continue to pass legislation that subject ISSPs to various and differing sales and use taxes. (17) ISSPs are therefore uncertain as to whether they are required to collect and remit sales and use taxes. With all of this confusion, what should ISSPs do? The answer to this question rests on how the courts interpret the interplay of the Permanent Internet Tax Freedom Act, the "substantial nexus" requirement of the Commerce Clause, and the Due Process Clause. (18) This Note argues that state and local governments are not permitted to require ISSPs to collect and remit sales and use taxes because doing so would violate the Permanent Internet Tax Freedom Act, the Commerce Clause, and possibly the Due Process Clause.

   This Note looks at past and present legislation, case law, congressional intent, and agency and commission recommendations to conclude that state and local governments are not permitted to require ISSPs to collect and remit sales and use taxes. In doing so, this Note explores how courts should address the issue of multiple and differing methods of taxation, and the overall burden on interstate commerce that arises by the taxation of ISSPs by state and local governments. Part II provides a brief background on the developments affecting the taxation of ISSPs. Part III outlines a three-part argument as to why courts should prohibit state and local governments from requiring ISSPs to collect and remit sales and use taxes. The contentions are (1) the Permanent Internet Tax Freedom Act prohibits ISSP taxation, (2) such taxation violates the Commerce Clause by placing an undue burden on interstate commerce, and (3) the imposition of such tax laws on ISSPs may violate the Due Process Clause.

   2. THE CONFUSION AND COMPLEXITY FACING INTERNET STREAMING SERVICE PROVIDERS

      With the advent of Internet video streaming in the late 2000's, cities and states have tried to recuperate some of their lost tax revenue by taxing ISSPs. (19) For example, Netflix was founded in 1997, but it was not until 2007 that Netflix started providing online streaming service in the United States. (20) Hulu, another ISSP, launched its streaming services in 2008. (21) Because of these technologies, the traditional tax bases, including cable video services and in-store video rentals, are diminishing, thereby increasing the pressure on state and local governments to expand their tax reach. (22)

      Therefore, cities and states are rapidly, and increasingly, passing new statutes and regulations levying various taxes on ISSPs. (23) Some cities and states tax ISSPs under their general sales tax. Searcy, Arkansas, for example, applies a sales tax rate of 9.5% on Internet video streaming. (24) In Pennsylvania, on the other hand, ISSPs are required to charge customers "a 6[%]sales tax on digital downloads." (25) The "digital tax" went into effect August 1, 2016, and required sellers to "collect [sales] tax on digitally or electronically delivered or streamed video," therefore adding an additional six percent to their monthly fee. (26)

      Another method of taxing ISSPs is through use and excise taxes. (27) Washington State passed an act in 2009 amending its existing excise taxation policy to include the taxation of digital products. (28) This amendment permitted the taxation of digital goods to "protect the sales and use tax base [of the state] ." (29) The city of Chicago implemented an amusement tax on ISSPs in September 2015. (30) The Chicago Department of Finance specified that "the [city's] amusement tax applies to charges for the privilege to witness, view, or participate in an amusement either in person or electronically delivered" (31) Therefore, citizens of Chicago now pay a nine percent amusement tax on top of the membership fee Netflix, Hulu, and other ISSPs charge. (32) Chicago requires the ISSPs to collect and remit the tax if the customer's residential street address or primary business address is in Chicago" (33) Chicago consumers have challenged the city's amusement tax on ISSPs by claiming that the application of the amusement tax on Internet streaming services violates the Permanent Internet Tax Freedom Act and the Commerce Clause. (34)

      Other cities and states tax ISSPs under service taxes. In California, ISSPs may be subject to the service tax rate applied to cable providers in up to 46 cities in the near future. (35) One of those cities, Pasadena, decided that an existing "9.[%] tax on 'video services' [will apply] to subscribers of streaming video providers." (36) On the other side of the country, the state of Florida currently taxes ISSPs under "Florida's communications services tax." (37)

      In sharp contrast, some states do not tax ISSPs at all. The state of Idaho, for example, clarified that "streaming services are not subject to tax." (38) Similarly, Alabama briefly considered enacting a streaming tax, but abandoned the measure after pressure from its citizens. (39) As a result, ISSPs are faced with the burden of interpreting, applying, collecting, and remitting taxes according to multiple state and local governments' sales and use tax codes.

   3. STATE AND LOCAL GOVERNMENTS CANNOT REQUIRE INTERNET STREAMING SERVICE PROVIDERS TO COLLECT AND REMIT SALES AND USE TAXES

      The Permanent Internet Tax Freedom Act, the Commerce Clause, and possibly the Due Process Clause prohibit state and local governments from requiring ISSPs to collect and remit sales and use taxes. The Permanent Internet Tax Freedom Act...