E-Commerce Delivers a Renewed Call for Sales Tax Uniformity

Since Quill Corp. v. North Dakota, 504 US 298 (1992), state tax collectors have lobbied for Congressional legislation allowing them to expand the use tax nexus to require more remote businesses to collect these taxes. With the growth in popularity of the Internet (not only as an information highway but also as a convenient way to shop), taxation of purchases made over the Internet has become a focal point of this charge. Passage of the Internet Tax Freedom Act in 1998 drew added attention to Internet activities. While this law did not prohibit states from imposing their sales or use taxes on Internet sales, many think it did. Those pressuring for legislation to allow the states to require collection from businesses selling into their market via the Internet have focused attention on their perception of lost revenues. Others have called for abandonment of sales taxes as a revenue source altogether, suggesting that enforcement is impractical in the modern economy.

Much recent attention has focused on the competition between “main street business” and e-commerce. While this terminology tends to focus the controversy on the issue of fairness, the most vocal retailers are multistate chain stores, whose efficient purchasing, distribution and marketing systems forced out the true “main street” businesses years ago. Time will ultimately prove whether it is a cost-effective retailing medium. In the meantime, it has focused attention on the problems of use tax collection.

Today’s sales and use tax laws are largely home-grown in each state. The economic and political climate of the states imposing the tax, coupled with the varying state constitutional restrictions, has lead to a system with only minimal uniformity. To date, as differences continue to grow, the states have ignored most appeals for uniformity and simplification of sales and use taxes.

While sales and use taxes are far from popular with the general public, they are so intermingled with the purchase of the goods on which they are assessed that most simply consider them part of an item’s cost. Consequently, the perception of “pain” associated with other taxes, annually assessed as a single figure, is missing with sales and use taxes. Accordingly, taxpayer outrage (when compared to revenue collections from these taxes) is relatively low, making them a politically favored revenue source. As total sales and use tax collections now account for about 25% percent of state and local tax revenue, it is unlikely that these taxes are going away. Attempts to encourage or enforce voluntary compliance on the citizens of the imposing states have been largely unsuccessful as well. Without “collection at the source,” it is clear that use tax compliance will remain problematic. However, because the Supreme Court in Quill linked the physical presence test to the Commerce Clause, Congress has the authority to address this issue. The question is whether Congress will address the uniformity problem in the process.

Even though limited, 45 states now rely heavily on sales and use taxes as a revenue source. Thirty-five of these states allow at least some political subdivisions to also impose sales and use taxes. In all, over 30,000 taxing jurisdictions do (or could) impose sales and use taxes. Unlike local retailers, whose physical locations are fixed and generally within a single taxing jurisdiction, remote sellers (whether by Internet or more traditional sales practices) may have to deal with the laws of these jurisdictions at some time. Even identifying the taxing jurisdiction of the delivery address has been problematic, as one zip code frequently overlaps several political subdivisions. Several years ago, Missouri attempted to alleviate this problem by imposing an average flat-rate use tax on remote sales. This attempt was ruled unconstitutional, because residents of localities with an overall tax rate below average bore heavier taxes on interstate purchases than on local transactions.

At least in theory, using the nine-digit zip code, today’s technology would allow construction of a database that would provide an accurate tax jurisdiction and rate for every street address in the country. Today, many remote sellers rely on simplified versions of such a database, generally using a five-digit zip code with supplemental flags to refine the jurisdiction when necessary. To the mass mail-order and e-commerce houses, the annual tens of thousands of dollars required to maintain such a database might not represent a significant cost. However, these represent only a small percentage of the businesses the advocates of an expanded tax base seek to tax.

Much of the e-commerce controversy has centered on the purchase of digital products deliverable over the Internet. Downloading digital music from Websites to avoid paying tax is one of the most frequently identified problems. For now, this is clearly more smoke than fire; few people with a 56K-V90 modem will spend the required 30 or more hours downloading and recording a 70-minute digital music CD, just to save about a dollar in tax. The same is largely true for home-use computer software that could be transmitted electronically. However, this is not the case with sales to the business community. With high-speed modems and communication lines found in many businesses today, coupled with high-quality business software, this is a realistically attractive way to deliver some products. While this type of e-commerce may be the focus of the day, it is not the real problem for either business or the tax collectors.

In today’s economy, few consumer goods manufacturers can provide satisfactory customer service without offering repair parts, supplies or accessories for sale directly to the end user, either through mail order or the Internet. The same is true for suppliers of various materials and equipment used or consumed in the business community. The variation in exemptions from state to state is overwhelming. A simple example is manufacturing machinery. About two-thirds of the states provide exemptions for new manufacturing equipment. However, this exemption is not uniform, because the definition of manufacturing equipment is inconsistent. The tax collecting business must also contend with the special rules, rates and single-item tax caps that various states provide. Machinery installed in a new production plant might be exempt, but replacement machinery taxable. Repair parts costing less than some percentage of the machine of which they become a part might be taxable. A seller may have no way of knowing if a claimed exemption is legitimate, and yet many states require the seller to assume this responsibility.

Small businesses selling valuable and innovative specialized products over a wide geographic market, may be forced to deal with many tax issues they are not equipped to understand. To say the states can be less than forthright about providing explanations to business is also an understatement. Examples of ambiguities and confusion exist in the statutes and regulations of every state imposing a use tax. The percentage of split court decisions on sales tax issues verifies the difficulty in understanding these provisions.

Collection costs are also significant business expenses. Added to the thousands of dollars used to purchase and maintain a database of tax rates is the administrative time, as well as taxes, penalties and interest imposed on businesses for failure to understand the confusion. Even with diligent efforts to pay and collect taxes properly due, many audit assessments are in the hundreds of thousands of dollars. The relative cost of compliance generally varies inversely with the size of a business. Few businesses can do more than estimate the cost of compliance. However, estimates range from 3–4% of tax collected from mass-market remote retailers, to costs equaling or exceeding the tax for some small businesses with scattered geographic markets.

If the requirement for collection of use tax were limited to major corporations dealing with thousands of repetitive and similar transactions, this might be a reasonable cost of doing business. However, under the current standard, the sales force or agents traveling into a state need not be employees to establish nexus for use tax collection. A manufacturer’s representative or commission sales agent soliciting in a state will also satisfy the physical presence requirement. Most small niche-market manufacturers use some form of commission agent to market their products. Accordingly, most have use tax collection nexus nearly everywhere they have customers. With today’s information technology, these businesses are being discovered and forced to attempt to comply with collection requirements. Of course, this requires an understanding of the applicable ambiguities and confusion of the market states, a task for which small business management is generally not well equipped.

One of the majority proposals of the Advisory Commission on Electronic Commerce was for Congress to encourage state and local governments to adopt a uniform sales and use tax act. To be effective, however, Congress would have to require adoption of a uniform code and rate in each state as a condition of imposing the collection requirement. At least some members of Congress appear to have recognized this problem; legislation invoking these requirements on Internet sales has been introduced in multiple versions. Because Congress has the authority to expand this nexus reach, it also has authority to reduce the states’ reach. If Congress were to extend the proposed condition on collection to cover remote sellers with nexus under the current standards, nearly everyone would win. The result would reduce the cost of operations for many businesses, ensure better tax compliance and eliminate “unfair competition” based strictly on the method used to submit a sales order.

From Richard H. Griffen, CPA, Elkhart, IN