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April 29, 2012 The Tax Lawyer

Taxing Internet Sales: Trying to Make a Two-Thousand-Year-Old Jurisdiction Test Work in the Dot-Com Economy

Vol. 64, No. 4 - Summer 2011

H. Beau Baez III


    Most people have purchased merchandise over the Internet believing that they were buying it tax-free—in practice true, but legally mistaken. Between 2008 and June 2011, Arkansas, Colorado, Illinois, New York, North Carolina, Oklahoma, Rhode Island, South Dakota, and Vermont passed legislation that will help them collect tax revenue on Internet sales that are currently not being taxed, while many other states are considering similar legislation. filed suit against New York and North Carolina, and if loses, it is expected that other states will quickly pass similar legislation. Some states are bypassing new legislation and instead are pursuing taxation of Internet transactions using their current statutory authority. Nascent Internet retailers may have needed protection from state taxation in the late 1990s, but they now represent a fully mature industry. The halcyon days of tax-free shopping on the Internet are coming to an end— the bell is beginning to toll.

    Remote sellers, as defined in this article, are retailers that sell their merchandise to customers using the Internet or catalogs and do not collect the sales tax other than in the states in which they have some sort of physical presence. This physical presence requirement is rooted in notions of territoriality and can be traced back two thousand years to the . In the 46 states that impose a sales tax, there is also a use tax, which is designed to capture untaxed Internet purchases that occur outside the state but are consumed or used in the state. When a remote seller does not collect the tax, in-state residents are required to keep track of their untaxed purchases and remit the appropriate amount of use tax to their state. But out of ignorance, negligence, or purposeful evasion, most taxpayers fail to submit their use tax to the state. Since the inception of the use tax in the 1930s, state governments have struggled to reduce the use tax gap—$10 billion for 2010—by requiring remote sellers to collect the tax at the time of purchase. Over half a century ago, one sales tax scholar observed that use taxes “can not [sic] conceivably be fully effective; the problems of interstate transactions remain as inherent limitations to state sales taxation”—that observation remains true today.

    But the attempt to recover lost revenue is secondary to the horizontal equity problem, which maintains that all similarly situated taxpayers should be treated the same. For every dollar that is not collected from an Internet sale, every other citizen in the state must shoulder a proportionately higher sales tax burden. Moreover, a rational tax system should not reward the tech savvy over the less sophisticated, poor, or rural members of society. The issue of whether Internet sales should be taxed is a policy question, with no state suggesting that the Internet is a tax-free zone.

    The most recent use tax collection battle between tax collectors and remote sellers involves what many are calling the “Amazon tax”—a reference to Internet retailer Though calling it the Amazon tax is memorable, it focuses too much attention on the activities of a single Internet retailer and provides the illusion that this most recent state tax enforcement action involves something other than the application of what is alternatively called agency nexus, affiliate nexus, attributional nexus, or representational nexus. This Article will use the term representational nexus because it is the most accurate. Regardless of the terminology, the underlying issue involves the extent to which a state may require remote sellers to collect the use tax on sales shipped from outside the state to customers within the state.

    Because Internet retailers generate more revenue when they receive higher traffic on their websites, they have become adept at using various methods to accomplish that end. One recent marketing trend—the one targeted by several new statutes—is “performance marketing” through the use of affiliates. Companies that promote this marketing method include, Dell, eBay, Google, and Yahoo. In Section V there is a discussion on whether these in-state affiliates create use tax nexus for Internet retailers, along with an examination of other recent legislative solutions to closing the use tax gap.

    Before delving into the recent nexus legislation and litigation, this Article will provide some context for the current debate. First, there is a discussion of performance marketing in Section II, followed by a brief sales and use tax history in Section III. The discussion on constitutional nexus standards in Section IV is lengthy but essential to understanding what follows. The nexus standards between the major state taxes—income tax, sales tax, use tax, and gross receipts tax—implicate both the Due Process Clause and the Commerce Clause, but the Supreme Court applies those provisions differently based on tax type. The most significant difference is that the use tax requires an out-of-state seller to have a physical presence in the state, while income tax nexus can be satisfied with economic presence in the state. The Article concludes by recommending the abandonment of the physical presence standard for a more modern approach in the dot-com economy.

Read the full article or download the complete issue.