The next debate: taxation of digital goods and services.

• Author: McGahan, Sarah

This is a digital world. People read books on digital readers. They listen to music on phones and tablets, some downloaded and some streaming. They turn off the lights and lock the doors in their homes remotely while standing in the office. They download apps to help with everything--cooking, running, driving, and entertaining. Digital goods and services are becoming more and more integrated into people's lives.

Consider the following facts about sales of digital goods and digital services:

* In 2008, 10 million ebooks were sold in the United States; in 2012, 457 million ebooks were sold. (1)

* A 2013 music industry report showed that digital album sales made up 43% of all album sales in the first six months of 2013. In addition, there were over 50 billion audio and video streams in the first six months of 2013. (2)

* Apple Inc. recently announced that customers spent over $10 billion in the App Store in 2013. Customers downloaded almost 3 billion apps in the month of December alone. (3)

* Netflix generated more than $2.7 billion in revenue from its domestic streaming segment in 2013. This represented a 26% increase in revenue generated from the same segment in 2012. (4)

With states looking for ways to increase revenue, a natural source may be the burgeoning area of digital goods and services. It is reasonable to ask, therefore, how states apply their sales and use tax provisions to these digital goods and services. Often the answer is not clear. This column begins by considering how states define digital goods and services.

Defining Digital Goods and Services

What are digital goods exactly? States generally tax the sale of tangible personal property and enumerated services. Into which of these buckets do digital products fall? Are they tangible personal property? Are they services? Does it make a difference if the digital good is downloaded to a purchaser's device or streamed over the internet?

Not surprisingly, after reviewing various states' definitions, it is apparent there is no agreement on defining digital products and services. The states take different approaches. These approaches include taxing digital goods and services under a state's definition of tangible personal property, taxing items as the equivalent of tangible personal property, using the Streamlined Sales and Use Tax Agreement's (SSUTAs) definitions of specified digital products and codes, and taxing items as services.

Tangible personal property: Many states have statutes that define tangible personal property broadly to include "anything perceptible to the senses." Some states have been using this definition to tax digital goods. For example, a Louisiana statute defines tangible personal property as including anything "perceptible to the senses." The state uses that broad language to tax digital goods. (5)

A Louisiana regulation further expands the definition of tangible personal property to include "canned' computer software, electronic files, and 'on demand' audio and video downloads." (6) Streaming music or video appears to fall under the definition of tangible personal property because streaming music or video is perceptible to the senses. However, unlike regularly downloaded digital content where the purchaser owns the rights to the content that is either stored on the purchaser's devices or in the cloud, streaming audio and video content is only heard or viewed by the purchaser for a limited time. This would be more akin to a lease, which is a temporary use of tangible personal property. However, in this case, the property may reside on a server in another state and is simply heard or viewed over the internet.

Tangible personal property equivalents: Other states tax digital goods if the tangible personal property equivalent is taxable. Texas, for example, defines the term "taxable item" to include tangible personal property and taxable services. The definition goes on to state that the sale or use of a taxable item in electronic form instead of on physical media does not alter the item's tax status. (7) This broad definition allows the state to subject certain digital goods and services to sales tax without having to clearly define what constitutes a digital good and service.

SSUTA definitions: The Streamlined Sales Tax Project (SSTP) has tried to create uniform definitions of digital products across the states. The SSTP was organized in March 2000 with the charge to simplify and modernize sales and use tax laws in the United States. Over 40 states contributed to the drafting of the SSUTA. Under the SSUTA, member states must adopt specific definitions; other states may adopt these definitions voluntarily. Currently, there are 23 full member states.

Included in the SSUTA are definitions for "specified digital products" such as "digital audio-visual work," "digital audio works," and "digital books." (8) Items such as digital cards, music, movies, pictures, and ringtones are specifically identified as meeting the...