by Todd Stanford Snyder¹

I. Moratorium

The Internet Tax Freedom Act of 1998 (ITFA)³ placed a three-year moratorium on the imposition of "taxes on Internet access" services as well as any "multiple or discriminatory taxes on electronic commerce"⁴ by state or local governments.⁵ Accordingly, during the moratorium period, states: (1) could not impose a tax on charges to access the Internet, and (2) states could not collect tax on Internet purchases at a rate different than purchases made through other mediums (such as traditional "brick and mortar" stores). States that had a tax on access charges already in place and enforced it as of October 1, 1998 maintained their ability to impose such a tax through a grandfather clause.⁶ It is a misconception that the ITFA directly addresses existing state sales taxes; rather it remains permissible to apply an equal sales tax on all sales (where there is nexus) without regard to the medium of purchase. On November 1, 2003 the moratorium expired and it should not be re-enacted.

The legislative intent behind the ITFA was to ensure that not more than one jurisdiction taxed the same electronic commerce ("e-commerce") transaction, to protect Internet accessibility during its infancy through prohibiting new burdensome access taxes, and to prevent discriminatory tax treatment (taxing Internet commerce differently than commerce through traditional venues). In the 107th Congress, the Internet Nondiscrimination Act of 2001 was enacted to extend the ITFA moratorium an additional two years.⁷ Several proposals have been considered in the 108th Congress that would either extend the moratorium through November 8, 2008 or render it permanent.⁸ The Bush administration has voiced support for continuing the moratorium.⁹

The prime reason the moratorium expired was disagreement over the definition of "Internet access." In the House of Representatives, H.R. 49 amended the definition to include any telecommunications service used to provide Internet access. Some, siding with state governments, feared that underlying telecommunications services (traditional telephone lines and cable) would suddenly be exempt from state and local tax, costing cash-strapped states billions annually. This concern was more pronounced in the Senate, as S. 150, which similarly broadened the definition of "Internet access," did not pass. Senators who were former state governors were particularly instrumental in blocking S. 150.¹⁰

H.R. 49, S. 52 and S. 150 would render the moratorium permanent, while other introduced bills would have simply extended the moratorium.¹¹ H.R. 49 continues the grandfather clause (allowing some states to continue taxing Internet access as they had prior to enactment of the ITFA), while S. 150 would only extend the grandfather protection three more years. H.R. 49 passed the House by voice vote on September 17, though the Senate did not pass either corollary bill, S. 52 and S. 150, in time to extend the moratorium.

Expiration of the moratorium has only muddied the already confusing waters surrounding Internet taxation issues. Now states are free to tax Internet access charges, though at the time of this writing no state has so imposed such a tax. Christine LaPaille, spokeswoman for the National Governors Association, said that "governors are not planning on taking advantage of the lapse in the moratorium."¹² This may be due to expressed Congressional interest in revisiting the issue this spring. On February 10, 2004, Senate Majority Leader Bill Frist indicated that S. 150 would soon be brought to the floor.^12a Consequently, states are left uncertain how to act. A spokesman for Senator George Allen (R-Virginia) likened the Senate's actions (or inaction) with regard to the moratorium to the Peanuts' character, Lucy, yanking the football right before Charlie Brown tries to kick it.¹³

The prime initial intent of the Internet access tax moratorium has been met. During the early years of dramatically rising Internet usage, the access fees were not subject to burdensome taxes. Most consumers are predictably against taxing such charges, but today the moratorium - if reinstated - operates as an unfunded mandate for the states by the federal government. Although the Internet provides valuable and new communications capabilities, it is not a sacrosanct tool. The federal government can elect not to tax Internet access, but it should permanently refrain from tying the states' hands now that the dominant purpose is largely extinguished. Were Congress to reinstate the moratorium with an expanded definition of Internet access, it would represent an example of incrementalism serving special telecommunications lobbying concerns.

II. Out-of-State Sellers

State governments depend on sales and use taxes for more than one-third (35.8%) of their total revenue.¹⁴ The traditional method of collecting sales and use taxes¹⁵ has been via brick and mortar retailers who collect the tax from the purchaser, and then remit the money to a state agency on a periodic basis. This method has broken down in the out-of-state seller context (whether mail order or Internet sales) because a seller with no substantial nexus to the state is under no enforceable obligation to collect sales tax.¹⁶ Given the exponential rise in e-commerce, states justifiably worry about lost tax revenues. A recent study estimates that lost "state tax revenue from Internet purchases will total $55 billion over the next ten years."¹⁷

The Due Process¹⁸ and Commerce¹⁹ Clauses of the United States Constitution limit a state from imposing tax liability or collection responsibilities on a business concern unless there is a substantial nexus or in-state contact established with the state. There is currently no statutory authority and scant case law on the subject of nexus and the Internet, but the Supreme Court has given considerable guidance in the analogous area of taxation of mail order sales. The two major Supreme Court decisions in this area are National Bellas Hess, Inc. v. Department of Revenue of the State of Illinois²⁰ and Quill Corp. v. North Dakota.²¹

In the formative 1967 Bellas Hess decision, the Supreme Court considered whether a retailer's communications with consumers via mail or common carriers were sufficient to establish jurisdiction for the purpose of tax. Incorporated in Delaware and maintaining its principal place of business in Missouri, Bellas Hess semi-annually mailed catalogues to residents of Illinois and processed purchase orders it received through the mail.²² Bellas Hess did acknowledge its obligation to collect a use tax in Alabama, Kansas, and Mississippi, as it had retail outlets in those states.²³ In determining that Illinois could not require collection of the tax, the Court utilized a physical presence standard for nexus for both the Due Process and Commerce Clauses.²⁴ Looking to analogous precedent,²⁵ the Court found that it "has never held that a State may impose the duty of use tax collection and payment upon a seller whose only connection with customers in the State is by common carrier or the United States mail."²⁶

Decades later, the Supreme Court again addressed mail order sales in Quill v. North Dakota.²⁷ In Quill, a case factually similar to Bellas Hess, the Court eliminated the clear-cut physical presence test for nexus under the due process clause that Bellas Hess employed, instead requiring only that the seller's efforts be "'purposefully directed' toward [the] residents of [the taxing state]."²⁸ Accordingly, the Due Process Clause was therefore no longer an impediment to requiring tax collection by the out-of-state seller.

The Quill Court then proceeded to the Commerce Clause inquiry and articulated its distinction from the Due Process Clause. The Court stated: "The two standards are animated by different constitutional concerns and policies."²⁹ It is possible for a tax to be consistent with due process and yet unduly burden interstate commerce."³⁰ In Quill, the Court found the state's tax, which imposed a collection duty on every vendor who advertised in the state three times in a single year, to be an undue burden on interstate commerce.³¹ While here the retailer may have had "minimum contacts" under the Due Process Clause, it still lacked the requisite "substantial nexus" with North Dakota under the Commerce Clause. Consequently, the state could not require the tax.

The removal of the Due Process Clause as a roadblock opened a door for Congress, under its commerce powers, to legislatively empower the states to require the collection of these taxes. The Supreme Court in Quill specifically invited Congress to act in this area: "[T]he underlying issue is not only one that Congress may be better qualified to resolve, but also one that Congress has the ultimate power to resolve."³² To date, Congress has not enacted legislation in this area. On September 25, 2003, however, Representatives Delahunt (D-Massachusetts) and Istook (R-Oklahoma) introduced legislation that would level the playing field between Internet and brick-and-mortar retailers by allowing states to tax Internet and other out-of-states sales regardless of the seller's location.³³

The current tax treatment of e-commerce violates tax policy by shaping economic decisions. In other words, consistently imposing a tax on brick-and-mortar purchases while doing so only infrequently on Internet and mail-order purchases creates a competitive advantage for the Internet. Some consumers are motivated to buy items, such as books and collectible wine, over the Internet specifically to escape sales tax. The federal government has no business influencing the venue from which consumers make their purchases.

III. Streamlined Sales Tax Project

One frequent objection to requiring out-of-state sellers to collect state sales tax is the multitude (more than 7,500)³⁴ of different sales tax rates based on jurisdiction and the type of good being sold.³⁵ Acknowledging administrative complexity, a widespread effort at the state level is now underway to address this concern. The Streamlined Sales Tax Project (SSTP) is comprised of 40 states and the District of Columbia.³⁶ The coalition states approved the Streamlined Sales and Use Tax Agreement (the agreement) on November 12, 2002. The agreement is model legislation that would limit states to one sales tax rate per state, plus one per local jurisdiction, with the possibility of an additional, different rate for food and drugs. Additionally, the agreement would mandate that states and their local governments use common tax definitions and eliminate the widely-imposed requirement that businesses file tax returns with local governments.

Successful implementation of the SSTP will rely largely on technology. It envisions providing retailers the opportunity to employ one of three technology models to ease and modernize sales tax administration. Model 1 consists of a certified service provider, paid for by the states, which performs all of the retailer's sales tax functions. Model 2 is a certified automated system that provides only the tax calculation function. The third option would be for the retailer (typically large nationwide retailers) to develop their own system and have it certified by the SSTP.

On the legislative front, the Streamlined Sales and Use Tax Act, H.R. 3184 (House) and S. 1736 (Senate), was recently introduced in Congress supporting SSTP's simplification efforts.³⁷ Generally, these companion bills express the sense of Congress that the SSTP agreement provides sufficient simplification and uniformity to warrant federal authorization to participating states to collect and remit the sales and use taxes of such states and of local taxing jurisdictions of such states. If enacted, this act would give a federal blessing to the SSTP's state-level efforts and national objectives.

The SSTP is a beneficial and pragmatic grassroots effort. Ultimately, the success of the SSTP will require joint cooperation from states, retailers, and Congress. So far, many states seem willing and invested in the effort.³⁸ Retailers must announce their intention and register to collect sales tax on Internet sales. Among others, Wal-Mart Stores, Inc. and Target Corp. have voluntarily begun collecting sales and use taxes on online purchases, including purchases made by customers in states where the retailer does not have a physical presence. In addition, Congress has introduced supportive legislation.

IV. Conclusion

Congress must soon act decisively to clear an important issue clouded by confusion and uncertainty. One barrier may be the pervasive corollary issues to the ITFA moratorium that simultaneously demand attention. More than a decade ago, the Supreme Court deftly invited Congress to clarify remote sales and related issues. With new bills such as H.R. 3184 and S. 1736, Congress seems poised to finally provide much-needed clarification, as well as tacitly allowing states access to greater revenue through the imposition of sales and use taxes on Internet purchases. With regard to the Internet access tax moratorium, Congress neglected to provide needed clarity when given ample opportunity. Worse, with the moratorium expired, Congress is now failing states by leaving them unsure of their future tax authority. Greater visibility of Internet transaction issues, the SSTP effort, and Congressional action may soon resolve and clarify these widely misunderstood issues.

Footnotes

¹ Todd Snyder recently joined Husch & Eppenberger's Tax and Estate Planning Group in its St. Louis office. Prior to that, he served as a Presidential Management Fellow with the IRS in Washington, D.C. Snyder holds degrees from Miami University (1999) and Washington University School of Law (2002).

² This article only reflects the views of the author and in no way represents the positions of the Internal Revenue Service.

³ The Internet Tax Freedom Act, Pub. L. No. 105-277, 112 Stat. 2681-719, §§ 1100, et seq., comprises Titles XI and XII of Division C of the Omnibus Consolidated and Emergency Supplemental Appropriations Act of 1999.

⁴ In pertinent part, the act defines "discriminatory tax" as imposing "an obligation to collect or pay the tax on a different person or entity than in the case of transactions involving similar property, goods, services, or information accomplished through other means. Pub. L. No. 105-277, 112 Stat. 2681-719, § 1104(2)(a)(iii).

⁵ Pub. L. No. 105-277, 112 Stat. 2681-719, § 1101(a). The moratorium was originally set to expire on October 21, 2001.

⁶ Id. at §1101(a)(1). Ten states and the District of Columbia qualify for this exemption. As of April 2003, only seven of these states impose a sales and/or use tax on Internet access.

⁷ Pub. L. No. 107-75, 115 Stat. 703.

⁸ Internet Tax Nondiscrimination Act, H.R. 49, 108th Cong. (1st Sess. 2003), S. 150, 108th Cong. (1st Sess. 2003), S. 52 108th Cong. (1st Sess. 2003), would each render it permanent. Internet Growth and Freedom Act of 2003, 108th Cong. (1st Sess. 2003), H.R. 1481 would extend the moratorium another five years. In addition, four Senators are expected to introduce a competing bill to S.150 which, among other differences, would provide for a two-year extension of the Internet moratorium. 2004 TNT 28-5, "Senators Call for Two-Year Extension of Internet Moratorium," February 11, 2004.

⁹ Letter from Treasury Secretary John W. Snow and Commerce Secretary Donald L. Evans to House Judiciary Committee Chairman F. James Sensenbrenner, Washington (May 14, 2003) (on file with author).

¹⁰ Lamar Alexander, former governor of Tennessee, was credited with tabling S. 150 in December, 2003.

¹¹ See footnote 8.

¹² Molly Peterson, States Seen as Unlikely to Rush to Enact Internet Taxes, Nat'l J. Congress Daily, December 5, 2003.

^12a 2004 TNT 28-1, "Frist Moves to End Highway Bill Debate, Lines Up Items for Senate Agenda," February 11, 2004.

¹³ Emily Pierce, Internet Access Tax Ban Dead, Roll Call, December 8, 2003 at p. 1.

¹⁴ U.S. Bureau of the Census, "National Totals of State Tax Revenue, By Type of Tax," available at www.census.gov/govs/qtax, visited March 1, 2004. Currently 45 states and the District of Columbia impose a sales tax. Only Delaware, New Hampshire, Oregon, Montana, and Alaska do not collect sales tax.

¹⁵ In most states, a use tax complements the local sales tax and is designed to impose a tax on goods purchased intended for use in the state.

¹⁶ Several states impose a duty on the in-state buyer to report the purchase from an out-of-state seller and remit the use tax. Predictably, compliance with these requirements is very low.

¹⁷ Study by the Center for Business and Economic Research at the University of Tennessee, commissioned by the Institute for State Studies, referenced in Matthew Vandum, State and Local Finance: NGA: Looming Sales Tax Losses Make Simplification a Must, The Bond Buyer, Oct. 3, 2001, at 4.

¹⁸ U.S. Const. amend XIV, §1.

¹⁹ U.S. Const. art. I, § 8, cl.3.

²⁰ 386 U.S. 753 (1967).

²¹ 504 U.S. 298 (1992).

²² Bellas Hess, 386 U.S. at 754.

²³ Id. at 758.

²⁴ Id. Generally, the Due Process Clause relates to the fairness of the tax burden and whether a business has minimum contacts with the taxing jurisdiction. The Commerce Clause is concerned with the effect of the tax on interstate commerce.

²⁵ The Court also took note of legislative history, finding confusion and administrative nightmares in requiring out-of-state compliance with various state taxation schemes. See Report of the Special Subcommittee on State Taxation of Interstate Commerce of the House Committee on the Judiciary, H.R. 565, 89th Cong. (1st Sess. 1965). Bellas Hess at 760.

²⁶ 386 U.S. 753 at 758.

²⁷ 504 U.S. 298 (1992). See also Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977) for incorporation of nuances to the bright-line, physical presence requirement of Bellas Hess.

²⁸ Quill at 308.

²⁹ Id. at 312.

³⁰ Id. at 314. See also Tyler Pipe Industries, Inc. v. Washington State Dept. of Revenue, 483 U.S. 232 (1987).

³¹ Quill at 313.

³² Id. at 318. The Court also noted that it is not unlikely that the mail-order industry's dramatic growth over the last quarter century is due in part to the bright-line exemption from state taxation created in Bellas Hess; Id. at 316.

³³ Streamlined Sales and Use Tax Act, H.R. 3184, 108th Cong. (1st Sess. 2003). A Senate corollary to this House of Representatives bill is expected shortly. See Kerrita McClaughlyn, "Senate Internet Sales Tax Bill to be Unveiled this Week, Lobbyist Says," 2003 Tax Notes Today 189-7 September 30, 2003.

³⁴ Christopher J. Shafer, Federal Legislation Regarding Taxation of Internet Sales Transactions, 16 Berkeley Tech. L.J. 415 (2001).

³⁵ Paul Misener, "Amazon.com Testifies at Hearing on Extension of Moratorium on Internet Taxation," 2003 Tax Notes Today 137-72, July 17, 2003.

³⁶ Another related organization is the Multistate Tax Commission, www.mtc.gov, which is comprised of state governments and whose stated goals include improving the fairness, efficiency and effectiveness of state tax systems and preserving state tax sovereignty.

³⁷ Streamlined Sales and Use Tax Act, H.R. 3184, 108th Cong. (1st Sess. 2003), was introduced September 25, 2003. Section 2 of this bill states: "The Congress consents to the November 12, 2002, Streamlined Sales and Use Tax Agreement." This bill was referred to the House Subcommittee on Commercial and Administrative Law on October 22, 2003.

³⁸ Twenty states have enacted legislation conforming to the model legislation under the agreement.