State & Local Tax Bulletin (November 2001)
E-Commerce: United States Sales
Use Tax Consideratons
R. Gercken, a tax partner in the
San Francisco office of Pillsbury Winthrop
Shaw Pittman LLP.
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Mr. Gercken presented this paper at the International
Bar Association conference at Cancun, Mexico on
October 31, 2001.
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- A gross-basis sales tax is imposed by most states.
- The tax is typically imposed on:
- Retail sales of tangible personal property (unless
specifically exempted) and
- Services (if specifically enumerated).
- Sales of intangible property are generally not
subject to the tax.
- In practice, it is sometimes difficult to tell
whether certain products (e.g., customized
computer software) should be treated as tangible
or intangible property.
- Sales tax issues relating to e-commerce activities
are conceptually very similar to the jurisdictional
and product classification issues that out-of-state
catalog retailers and computer software vendors
have been addressing for years.
- Accelerating e-commerce activities have put more
pressure on the system and have led to efforts to
simplify and rationalize the existing rules:
- Internet Tax Freedom Act ("ITFA") and
- Streamlined Sales Tax Project ("SSTP").
Sales and Use Taxes
Sales Tax General Concepts
Use Tax General Concepts
- Sales tax is a gross-basis tax imposed on the retail
sale of most tangible personal property and some
- Sales of tangible personal property are generally
taxable unless specifically exempted;
- Services are generally nontaxable unless
- "Mixed" sales (i.e., sales that have tangible
personal property and service components) are
generally taxed based on the portion that
corresponds to tangible personal property.
- The seller is generally required to collect the tax
and remit it to the state in which the sale occurs.
- A sale is typically considered to occur in the state
in which the buyer is located.
- A state may generally not impose a sales tax on sales
made outside its borders.
- The U.S. Constitution limits the ability of a state
to impose collection responsibility on
out-of-state sellers for cross-border sales to
- Use tax is a "complementary" tax imposed on the
use, storage or consumption of tangible personal
property or services within a state where the
property was purchased in another state.
- The use tax base and rate is generally the same as
the sales tax base and rate.
- The use tax is generally intended to plug the gap
left by a state's jurisdictional inability to levy a sales
tax on sales transactions occurring outside its
- The state may require a seller to collect and remit
use tax if the seller has sufficient taxable nexus in
the state otherwise, the in-state buyer is required
to self-report and remit the appropriate use tax.
- In practice, it is almost unheard of for retail
buyers to self-report and pay use tax.
- Sales tax and use tax is levied by approximately
7,500 separate state and local governments.
- Tax rates range from 0.875% to 11% (depending
on jurisdiction and type of product).
- Sales and use tax revenue typically represents from
25% to 33% of state and local revenue.
- State and local governments collected $237
billion in sales and use tax revenue in 1999.
- There is widespread fear among state legislators and
tax administrators that unless out-of-state sellers
can be required to report sales and remit taxes, the
expansion of e-commerce will significantly increase
the volume of remote-selling, thereby eroding the
local sales and use tax base.
Basic Sales and Use Tax Issues for E-tailers
- A seller's obligation to collect and remit sales and
use tax is a fiduciary obligation (i.e., the seller acts
as an agent for the state in collecting the tax).
- The administrative burden imposed on sellers in
the collection and remittance process can be very
- Sales and use tax return filing requirements
(including calculation of proper overall effective
rate applicable to all political subdivisions within
the state to which sales are made),
- Collection and maintenance of supporting
documentation (e.g., transaction records, buyer
exemption certificates and direct-pay permits),
- Electronic funds transfer requirements for
- Electronic Data Interchange (bilateral
software-based documentation and compliance
tool for large-volume transactions) and
- Sales tax software packages (e.g., Taxware,
- Jurisdictional: Does the seller have a "taxable
nexus" in the destination state?
- If not, the state cannot require the seller to collect
sales or use tax.
- Definitional: Is the product tangible personal
property or taxable services?
- If not, no sales or use tax will be payable.
Tax Nexus Issues
U.S. Federal Safe Harbor Jurisdictional Limitation
- A seller must have a "taxable nexus" in a state before
the state can require the seller to collect and remit
sales and use tax.
- Although each state will apply its own nexus
standards, the answer will generally depend on an
application of an inherently imprecise
facts-and-circumstances analysis that asks whether
the seller has "sufficient" contacts with a state to be
subject to its jurisdiction.
- Out-of-state sellers with minimal presence in many
states will often have difficulty effectively managing
nexus issues due to differing and inherently fuzzy
standards applied by different taxing jurisdictions.
- Two fundamental Constitutional limitations on the
ability of states to subject out-of-state sellers to sales
and use tax collection responsibility:
- Due Process limitation: requires that seller have
"minimum contacts" with destination state (not
necessarily including physical presence) for nexus
- Will not provide much practical assistance to
out-of-state sellers since activities such as
advertising in the state or sending catalogs into the
state will usually be sufficient to establish
- Commerce Clause limitation: requires that seller
have "substantial presence" in destination state
(including physical presence) for nexus to exist.
- In the context of mail-order retailers, the U.S.
Supreme Court has held that out-of-state mail order
retailers with no physical presence in the state do
not have taxable nexus where their only connection
with customers in the state is by U.S. mail and
common carrier. See National Bellas Hess, Inc., 386
U.S. 753 (1967); Quill Corp., 504 U.S. 298 (1992).
- This is a somewhat more useful safe harbor, subject
to two important limitations:
- "Physical presence" standard is not necessarily
clear-cut generally, and can be especially
uncertain for e-tailers accessing state markets
using in-state communications and computer
- Unlike Due Process limitations, Congress can
legislatively waive or limit the protection afforded
to out-of-state sellers.
- As a practical matter, National Bellas Hess and Quill
will probably not be very helpful much beyond the
limited mail-order setting in which they arose.
- Physical presence:
- Nexus is usually found where an out-of-state
seller has employees or agents physically present
in the state (although sporadic or temporary
presence may, under some circumstances, not be
- Agency nexus:
- Nexus will often be found if the out-of-state seller
engages in-state third party contractors to
perform certain activities (e.g., sales solicitation
or warranty repairs).
- Affiliate nexus:
- Nexus can sometimes be found due to the
in-state activities of an affiliate of the out-of -state
seller especially if the affiliate's activities
facilitate (even in a very minor way) the activities
of the out-of-state seller.
- Economic nexus:
- Some states have attempted to assert nexus solely
by reason of commercial exploitation of the
in-state market by the out-of-state seller (e.g.,
through advertising or licensing of intangibles
by in-state licensees).
- Some states have begun to apply these general rules
in certain specific e-commerce contexts. Examples
- Virginia: An out-of-state vendor was found not
to have a taxable nexus in Virginia where its only
connection to the state was the use of in-state
computer servers to host web sites for use by
in-state customers. See Ruling of Commissioner,
Virginia Department of Taxation, P.D. 00-53
(April 14, 2000).
- Kansas: A vendor with both a store in Kansas
and a web server in California was required to
collect use tax on web sales from California into
Kansas because the Kansas store had a computer
terminal that some of its customers used to access
the California web site. See Kan.Op.Ltr.No.
O-2000-042 (December 5, 2000).
- Tennessee: AOL was found not to have a taxable
nexus in Tennessee despite the fact that AOL
utilized both tangible and intangible property in
the state (e.g., telephone lines, computer software,
local telephone numbers). See American Online,
Inc. v. Johnson, No. 97-3786-III (Tennessee
- Arkansas: Recently amended state statute
provides that an out-of-state Internet, mail order
and similar vendor is responsible for collecting
use tax if it has an in-state affiliate that sells the
same products, uses the same business name or
utilizes its facilities or employees to advertise or
promote sales by the out-of-state vendor. See
Ark.Code § 26-53-124(a).
Tangible vs. Intangible Property Computer Software
- Longstanding area of dispute: Is software "tangible"
(taxable) or "intangible" (nontaxable) property?
- Software is not easily classifiable as either "tangible"
or "intangible" since the real value is inherent in
the information contained in the software, rather
than the physical medium.
- Many states approach this problem by classifying
software as either "canned" or "custom."
- "Canned" or "prewritten" software can usually
be purchased off the shelf, and is generally treated
for sales tax purposes as a sale of tangible
- "Custom" software is created to serve a particular
customer's needs, and is generally treated for sales
tax purposes as nontaxable (either because it is a
sale of intangible property or the sale of a
- Note that the amount of customization needed to
convert "canned" to "custom" software can vary
widely from state to state.
- Certain states also have a "modified canned"
software classification most (but not all) of
these states would treat the sale of "modified
canned" software as the taxable sale of tangible
- Some states will not tax software (whether
"canned," "modified canned" or "custom") that
is downloaded by the buyer in electronic format.
- Some states have imposed sales or transaction taxes
on services provided by Internet service providers
- Tennessee: Internet access services provided by
ISPs (even those with no connection to the state
other than having customers located there)
constitute telecommunications services and are
subject to sales tax. See TCA § 67-6-102(30).
- Illinois: Internet access services that include
1-800 service and that separately assess customers
with a per minute charge for use of 1-800
numbers are subject to telecommunications
excise tax. See IU Dept.of Rev., ST97-0277 GIL
(May 21, 1997); Chicago Muni.Code § 3-70-030.
- Connecticut: Taxable sale includes services
related to creation, development, web-hosting or
development of a web site. See Conn.Stat.Ann.
- Some states have exempted Internet access charges
from both sales tax and telecommunications excise
- New York: Internet access charges considered an
unenumerated service that is not subject to sales
tax or telecommunication excise tax. See NY
Dept.of Tax & Fin. TSB-M-97(1)(C), (1.1)(S)
- California: Sales tax chargeable only on sales of
tangible personal property. See Cal.Rev.&
Tax.Code § 6051; Cal.Reg. 1684(a).
- Florida: Internet access service, e-mail, electronic
bulletin board service not included in taxable sale
of communications service. See Fla.Stat.Ann.
§ 202.11(3), (12), (13).
- Other Internet-related services have tended to be
treated as not taxable:
- Fulfillment services (NY Tax Law Code
§§ 1101(b)(8)(V)(A), 1101(b)(18), NY Dept.of
Tax & Fin. TSB-A-99(49)S (Nov. 17, 1999)).
- Web-site creation (NY Tax Law §§ 1101(b)(6),
(14); Okla.Admin.Code § 710; 65-19-156(b);
D.C. Code Ann. § 47-2001(n)(2)(G)).
- Web-hosting services (Fla.Stat.Ann. § 212.05,
Fla.Dept.of Rev. TAA 98A-083 (Nov. 16, 1998)).
- Advertising services (NY Tax Law Code § 12(c),
NY Dept.of Tax & Fin. TSB-A 95(33)S (Aug. 14,
1995); Conn.Legal Rul. 2001-2 (Jan. 17, 2001);
Okla.Admin.Code § 710.65-19-156(b)(4);
Fla.Dept.Rev. T.AA 98A-083 (Nov. 16, 1998)).
- Other services incidental to Internet access (e.g.,
software tools and e-mail, billing and customer
care services that involve data processing, remote
access, and information storage services)
(TSB-M-97(1)(C), (1)(S); TSB-A98 (57)S
(Aug. 6, 1998)).
- Overall, there is a trend towards legislating
exemptions for Internet access.
Internet Tax Freedom Act ("ITFA")
Prohibition of "Multiple and Discriminatory Taxes"
- Passed by U.S. Congress in 1998 (Public Law
- Three basic provisions:
- Prohibition against "multiple and
discriminatory" taxes on electronic commerce.
- Moratorium on new sales taxation of Internet
- Established the Advisory Commission on
Electronic Commerce ("ACEC") to recommend
proposals for the taxation of e-commerce.
- Contrary to common perception, ITFA does not
provide a general tax exemption for all goods and
services sold online.
- ITFA scheduled to sunset on October 21, 2001.
- Current prospects for extension are uncertain.
- No "multiple" taxes: an online transaction cannot
be taxed more than once (i.e., in both the seller's
and buyer's jurisdiction).
- Given the lack of clear rules on the sales and use
tax consequences of e-commerce transactions,
it could be quite difficult for a state to even be
able to determine whether another state would
seek to tax the same transaction.
- No "discriminatory" taxes: the tax burden on an
online transaction cannot be heavier than on a
similar offline transaction.
- States may not impose taxes (including sales and
use taxes) on "Internet access."
- Exception: taxes "generally imposed and actually
enforced" prior to October 1, 1998.
- "Internet access" is defined to include a fairly wide
range of e-commerce activities:
- Basic access to the Internet (i.e., ISPs) and
- Access to both proprietary and non-proprietary
"content, information, electronic mail, or other
ACEC Majority Proposals
- The ACEC issued its report in April 2000.
- Required 2/3 consensus was only reached on three
relatively non-controversial or insignificant issues:
- Measures should be taken at both the federal and
state level to close the "digital divide" between
those with access to the Internet and those
without such access.
- Congress should explore the privacy issues
associated with the collection and administration
of taxes on e-commerce activities.
- Congress should support the implementation of
a standstill on tariffs.
ACEC Minority Proposals
- A "majority" report (mostly representing the views
of the ACEC's members from industry, rather than
the members representing state and local
government) called for the following:
- A five-year extension of the tax moratorium,
- The passage of a uniform sales and use tax act
that would simplify the application and
administration of the sales and use tax for remote
- The passage of legislation to clarify that the
following would not, in and of themselves, cause
a remote seller to be considered to have taxable
nexus in the buyer's state:
- use of an ISP that is physically located in the state,
- placement of information on a server located in the
- use of telecommunications services provided by a
telecommunications provider that has a physical
presence in the state,
- ownership of intangible property that is used in or
is present in the state,
- the presence of the seller's customers in the state,
- the seller's affiliation with another taxpayer that has
a physical presence in the state,
- the performance of repair or warranty services in
- the fact that the seller has a contractual relationship
with another party located within the state to allow
products purchased over the Web from the remote
seller to be returned to the other party's physical
location within the state and
- the advertisement within the state of the seller's
business location, telephone number and Web site
- A minority of commission members (mostly
representing state and local government) believed
that the majority proposals would, if enacted,
unjustly benefit e-commerce activities at the
expense of local "brick-and-mortar" business.
- In order to level the playing field with "old
economy" retailers, the minority has recommended
- No federally mandated tax nexus standards (i.e.,
nexus would continue to be determined in
non-uniform fashion under the law of each state)
- The voluntary adoption by the state of a
simplified sales and use tax system that would
impose collection responsibility on remote
Streamlined Sales Tax Project ("SSTP")
- There is a general perception by state and local
governments that the expansion of e-commerce
will significantly erode the local sales tax base.
- A recent GAO estimate puts this loss at $20B in
- Recognizing that e-commerce is not going away,
state and local governments have come to realize
that they need to make it easier for remote sellers
to comply with local sales and use tax rules.
- Approximately 40 states have now joined together
in the SSTP in an effort to simplify, modernize and
harmonize sales and use tax administration.
- The SSTP has produced a model act (the "Uniform
Sales and Use Tax Administration Act") which has
been passed or is currently under consideration in
a number of states.
- The primary goals of the project are to
- Expand the traditional tax nexus rules to
encompass remote sellers and
- Encourage remote sellers to comply with their
mandatory collection responsibility by
simplifying and streamlining the rules to make
- Key features of the SSTP:
- Uniform definitions within tax bases (even
though states would still decide what was taxable
and what was exempt),
- Simplified exemption administration for use and
- Rate rationalization (i.e., a single rate per state
so that remote sellers do not have to calculate
differing sales tax rates for each local jurisdiction
within a state),
- Uniform sourcing rules,
- Streamlined administration, including central
registration and uniform returns, and
- Uniform audit procedures.
- Remote sellers would not be forced to participate
in the SSTP.
- Voluntary participation might be attractive to many
remote sellers for several reasons:
- The remote seller would receive audit immunity
for prior periods.
- This may be quite significant even for remote
retailers who don't think they have much audit
exposure given the expansive view that individual
states have taken on the basic tax nexus issue.
- The simplified and streamlined system should
substantially ease the remote seller's
administrative burden associated with proper
- The states will generally bear the cost for the
- Participation in SSTP will not constitute tax
nexus for purposes of any other tax (e.g., state
corporate income or franchise tax).
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