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State & Local Tax Bulletin (July 2000)

Federal and California Internet Tax
Freedom Acts–What Do They Mean?

By Jeffrey M. Vesely, a tax partner and Richard E. Nielsen, of counsel in the San Francisco office of Pillsbury Winthrop Shaw Pittman LLP. If you have or can obtain the Acrobat Reader, or have an Acrobat-enabled web browser, you may wish to download or view our July 2000 State & Local Tax Bulletin (a 127K pdf file), containing a printed version of this article and also available via ftp at ftp.pmstax.com/state/bull0007.pdf.

This bulletin concerning California state and local tax matters is part of the Pillsbury Winthrop Shaw Pittman LLP Tax Page, a World Wide Web demonstration project, no portion of which is intended and cannot be construed as legal or tax advice. Comments are welcome on the design or content of this material.

A large segment of the public seriously misunderstands exactly what occurred on October 21, 1998 when Congress passed and the President signed into law the Internet Tax Freedom Act of 1998 (the "Federal Act"). Most people mistakenly believe that due to the Federal Act transactions completed over the internet are not subject to tax. The Federal Act did nothing of the kind. Effective October 1, 1998, the Federal Act bars states and their political subdivisions from imposing (1) taxes on internet access, unless such tax was generally imposed and actually enforced prior to the effective date and (2) multiple or discriminatory taxes on electronic commerce. The moratorium runs for three years and bars new taxes but not the applicability of existing taxes and their underlying principles to transactions conducted over the internet. The Federal Act specifies that it is not to be construed so as to expand the duty of any taxpayer to collect taxes beyond that which existed before the passage of the Federal Act.

The Federal Act specifies that its provisions are not to be construed to impair or supersede current state or local statutory provisions pertaining to taxation that are otherwise permissible. Further, the Federal Act specifies that it does not affect liability for taxes accrued and enforced before the effective date of its enactment. Accordingly, existing state taxes are not impacted by the Federal Act, contrary to the beliefs of much of the public.

The California Tax Freedom Act ("California Act") became effective January 1, 1999. The California Act places a three-year ban on new local taxes on internet or online services. It prevents the State and local governments from levying taxes and fees on companies offering interactive computer services and access to the internet until federal laws and regulations on internet taxation are developed. The California Act prohibits the imposition or collection of tax on internet access, online services, or the use of the internet access or online services.

In response to complaints by local retailers, California legislation is currently pending to "clarify" sales and use tax nexus law concerning dot.com subsidiaries of companies with California nexus. Assembly Bill No. 2412 ("AB 2412") would provide that if a remote seller holds a substantial ownership interest in a retailer maintaining sales locations in California and sells the same or similar products under the same or similar name as the retailer located within the State, the remote seller is required to collect use tax from the purchaser. Also, if the stores or employees of the instate retailer are used to promote the remote seller, the remote seller would be required to collect use tax from the purchaser. AB 2412 provides that the retailer maintaining sales locations in the State under these circumstances would be presumed to be an agent of the remote seller; therefore, the remote seller would be required to collect use tax.

Another piece of legislation is pending which would prevent any new taxes on access to the internet, and on any "bit" or "byte" taxes. Assembly Bill No. 1784 would also extend for three additional years the current moratorium under the California Act discussed above which is set to expire in January 2002.

The foregoing is but a brief discussion of the confusing nature of the existing moratoria at the federal and California state levels. The moratoria do not prevent taxation of internet transactions under existing law and do not overturn traditional use tax collection principles if substantial nexus is found to exist. The moratoria ban new taxes but not the application of existing jurisprudence to transactions conducted over the internet. Similar to the controversy concerning mail order operations, if the internet seller has sufficient physical presence (e.g., employees, property, offices) in a state, it will be required to collect use tax if the transaction is otherwise taxable. The moratoria do not affect these principles.

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