Jurisdiction: Building Confidence in a Borderless Medium
July 26-27, 1999
Taxation of Electronic Commerce - Issues of Public Policy and Legal
Peter v.Z. Cobb, Esq.
Fried, Frank, Harris, Shriver & Jacobson
One New York Plaza
New York, New York 10004
- Fundamental policy concerns
In order to understand the issues that are of particular importance to
the taxation of electronic commerce, one has to start by examining the
purposes and problems of our tax systems more generally. No tax system has
ever been popular or perceived as fair by all of those subject to its
burdens. But each constituency Ė the state itself; the taxpayers who will
both bear the economic burden of the tax and receive the benefits of the
concomitant government spending; and the businesses that will be operating
within the taxing stateís economic sphere Ė have legitimate expectations as
to how their particular tax regime will operate.
- The governmental view
- Tax Policy Concerns. As a matter of pure tax
policy, the state has a legitimate interest in administering a tax
- is fair to those who are subject to it,
- minimizes any distortion of economic decision making within the
- does not require undue effort by either the tax collector or the
taxpayer to interpret and administer, and
- raises a sufficient amount of revenue to carry out the legitimate
functions of government.
Generally, all four of these goals are best met through a tax
system that has as broad a base as possible and that has effective,
but societally acceptable, methods of enforcement. A well-run tax
system has been likened to the feather industry: you want to get as
many feathers as you can off each goose with the least amount of
- Tax expenditures. Not infrequently, (and to the
dismay of tax policy purists) government will make use of the tax system
to pursue policy goals unrelated to taxation. For example, the use of
enterprise zones or investment tax credits to foster economic
development or the exemption from VAT or from sales and use tax of goods
and services that are viewed as basic needs. Such positive uses of a
tax system to foster non-tax policy ends are frequently referred to as
"tax expenditures". Tax expenditures can be a source of great
complexity in any tax system, as the state attempts to draw them
narrowly and limit their use to their true policy objectives and
taxpayers seek to interpret their scope and purpose as broadly as
possible. Inevitably, tax expenditures create discontinuities within
the tax system that can exploited by well-advised taxpayers and abused
by an overzealous fisc.
- Tax Penalties. Taxation can also be used by the
state as a regulatory tool for controlling or discouraging activity of
which it disapproves. Thus the ancient adage that "the power to
tax is the power to destroy". Not only can the state impose a
special tax burden on activities or goods that it disfavors like
tobacco, alcohol or cars that consume too much gasoline but it can
deny generally available tax benefits thus distorting the normative
rules of a tax system to discourage or penalize disfavored activity.
Examples include recent US federal income tax legislation that limits
the deductibility of lobbying expenses and excessive executive
- Reporting and collection. Finally, the state
has a strong interest in requiring businesses to assist it in
determining and collecting the taxes borne by others.
- In many states, the imposition of the sales tax on vendors
in-state or out can be thought of in as simply making the vendor a
collection agent for the use tax that is to be borne economically by
- In most income tax systems, information reporting by financial
institutions and wage reporting and withholding by employers is the
central support of the audit and enforcement process.
- The Taxpayer View
At the most simplistic level, the primary interest of each taxpayer is
obviously to pay the least amount of tax it can. However, there are
subtler taxpayer interests as well, including the following:
- Proportionality. The total amount of taxes paid
to the state should have some reasonable relationship to the services that
the state provides to the taxpayer.
- For resident taxpayers individual and business it is a
straightforward exercise in civics to describe those services, although
in practice there will be wildly different views of their value.
- For non-residents subject to the tax regime the search for the
quid pro quo can be subtler. For example, in one leading case
upholding the right of a state to impose sales and use tax obligations
on an out-of-state mail order vendor, the court found as significant
that the state had expended signficant resources to create and nurture
an economic climate supporting a demand for the vendorís products, had
provided a legal infrastructure that protected and secured the vendorís
financial interests and had disposed of as waste many tons of the
vendorís catalogs and promotional materials.
- Neutrality. The tax regime should not favor one
business over another where both are in natural competition. Thus, a
major source of the pressure on state taxing authorities to extend the
reach of their sales and use tax regime to out-of-state retailers comes
from in-state retailers who feel legitimately disadvantaged by having to
collect the tax when their competitor across the state line does not.
- Minimization of administrative burden. Where the
tax rules are unnecessarily complex, or if the taxpayer operates a
business in a large number of different jurisdictions each with its own
particular rules, the task of complying with all of the different systems
may be unreasonably burdensome.
- Legal Constraints on the power of a United States taxing
jurisdiction to compel compliance with payment, collection and
Under US law, the power of the various taxing authorities federal,
state and local is subject to limitation from several sources:
federal and state constitutions as well as federal and state statutes.
- Limitations on state and local regimes
- Federal Constitution the due process clause.
has long been recognized that the due process clause of the
14th amendment to the US Constitution is a source of some
limitation on the power of a state to impose the obligations of its tax
regime on persons located outside its borders. Modern case law has
read this limitation in a manner quite favorable to the States. The
scope of the due process clause as a source of the power to tax may be
broader than in the "long arm" context e.g., the power of a
court to exert its power over an out-of-state person. The principal
features of current due process limits on the taxing power are:
- they rely principally on the concept of fairness,
- there must be a "minimum connection" between the person
and the state,
- no physical presence in the jurisdiction is necessary, and
- the "purposeful direction of activity toward the state"
- Federal Constitution the commerce clause.
The so-called "dormant commerce clause" is currently the most
significant limitation on state and local taxing authority. This is a
judicial doctrine derived from the provisions in the Constitution that
gives power to the federal government to regulate interstate and foreign
commerce. Courts have found that in the absence of specific exercise
of that power by Congress, there are still constraints on the power of
the states to enact legislation that undermines the commercial
uniformity that is the implicit purpose of the commerce clause. State
and local taxation that has the potential for imposing multiple and
inconsistent tax burdens on persons engaged in interstate or foreign
commerce has been frequently challenged successfully on that ground.
- Under current law, a state or local tax will satisfy
dormant commerce clause scrutiny if it meets four requirements:
- The activity being taxed must have substantial
nexus with the taxing states.
- The tax must be fairly apportioned (i.e., the measurement
of the tax must be such that if other states were to impose the same
tax, the activity would not be subject to multiple taxation).
- The tax must not discriminate against interstate commerce.
- There must be a fair relationship between the tax and the
services provided by the state.
- The proper interpretation of the "substantial nexus
requirement is the subject of some controversy at this time.
- The Supreme Court has ruled that at least in the context
of the imposition of sales tax requirements on out-of-state mail
order business, some physical presence is a prerequisite for
requiring the vendor to collect the tax.
- New York Stateís highest court, also in a sales tax
context, was purporting to follow Quill in finding that the
physical presence required by the "substantial nexus" test
need not itself be "substantial". Rather, the presence
must only be "demonstrably more the a "slightest
presence" and can be satisfied by the "presence in the
taxing state of the vendorís property or the conduct of economic
activities in the taxing state performed by the vendorís personnel
or on its behalf.
- On the other hand, in a case dealing with income tax
and not consumption tax, the South Carolina Supreme Court has ruled
that, at least in the context of an income tax, the substantial
nexus requirement does not require a tangible, physical presence and
that the use of the taxpayerís intangible property within the state
pursuant to a license agreement was sufficient.
- Congress has the power to override any dormant commerce
clause limitations on state and local taxation by legislation.
Subject only to other more absolute constitutional limitations such as
the due process clause, Congress can either tighten or loosen the
limits found in the case law.
- Federal Constitution other relevant
- Equal Protection. There is a very substantial jurisprudence
under the Equal Protection clause of the 14th Amendment to
the US Constitution and its counterparts under most State
constitutions with regard to the limits on the ability of a State to
impose discriminatory taxes.
- Unless some other constitutionally significant interest is
present, the US Supreme Court has generally granted the States great
latitude to craft tax classifications imposing a "rational
basis" test that it generally has found to be met in the
- State courts, interpreting their own equal protection
provisions, have generally followed the US Supreme Courtís lead in
- The Supreme Court has frequently insisted on stricter scrutiny
of state tax statutes where there is discrimination against
non-residents. However, the Court has been quite permissive when
the discrimination goes the other way and it is the resident
taxpayer who is disadvantaged.
- The Import-Export Clause. The States are specifically
prohibited from levying "Imposts or Duties on Imports or
Exports" (with a narrow exception for "Inspection Laws"
without the consent of Congress. Even with such consent, the net
revenue from such a tax belongs to the federal treasury.
- It is fairly settled that the reference to imports and exports
in this clause refers only to foreign commerce and not to interstate
- Recent cases have focused on the definition of "imposts
and duties" rather on trying to determine whether a particular
tax is a tax on imports or exports. As a result, the focus is on
whether the particular levy discriminates against imports or
exports. Under this approach, a tax that is neutral will withstand
Import/Export clause scrutiny.
- Federal Legislation. As noted above, Congress
clearly has the authority to regulate the state and local taxation of
interstate commerce. It has rarely exercised that power, although the
Internet Tax Freedom Act, discussed below, is a recent example.
- State constitutional and statutory law. Although
these are important, they are beyond the scope of this outline.
- Electronic Commerce special problems
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- Consumption Taxes (Sales & Use; VAT)
- Definitional issues: As a practical matter, every
consumption tax regime makes distinctions between goods and services
that are fully subject to tax and those that are exempt or subject to a
reduced rate of tax (frequently zero). Such distinctions may also
determine, in the case of cross-border transactions, whether the tax is
to be assessed on the basis of the destination of the transaction or its
origin. The operative rules must therefore draw clear distinctions
between such categories that permit the law to be administered
efficiently. These distinctions, drafted in a pre-electronic era,
have in many cased become blurred by the business methods available
through electronic commerce.
- The need for clarity. The first order problem that this
definitional murkiness raises is simply the need for clarification
if the tax status of a particular item is difficult to determine under
existing rules, then the rule needs to be clarified to
give certainty to the system.
- The need to rethink. The second order problem is more
fundamental. There may be a need to rethink the basis for the
underlying distinction that is being brought in question.
- For example, a tax regime may historically have drawn a
distinction between two categories of goods (e.g., tangible and
intangible) taxing the first and not the second. One could imagine
that in the past such a distinction might not have created problems
of neutrality, fairness or revenue erosion, if in fact the two types
of good rarely competed with each other in the market place and the
consumption of the taxable category was fairly uniformly distributed
throughout the economy.
- But if electronic commerce can break down the real world
distinction between the two categories, as it so has in the case of
the sale of music, software and information generally, then the
rationale for the original distinction may have disappeared and the
rule has to be rethought entirely.
- From a tax policy point of view, rethinking the rule is likely
to lead to a broadening of the tax base rather than a narrowing of
it Ė in a perfect world of course, if the goal is to preserve, not
expand the tax revenue generated, the broader base should carry with
it a lower rate of tax.
- Jurisdictional issues: Consumption tax regimes
tend to rely on the vendor of the taxable item to collect the tax, even
though the economic burden, at least in theory, is on the purchaser or
- The internet substantially facilitates the sale of goods
and services into a jurisdiction from outside, putting the revenue of
the taxing state at risk as well as the competitive position of
competing vendors operating within that state.
- On the other hand, because of the ease with which the
internet vendor can sell on a world wide basis, the possibility of
being drawn into hundreds of different taxing regimes can be an
- There are a variety of practical, political and
constitutional limitations on the ability of a taxing regime to cast
its net too broadly.
- Due Process. An internet vendor who purposefully directs its
activities toward residents in the taxing state cannot expect to
rely on the due process clause to protect it from taxation. It
seems unlikely that due process will emerge as a significant part of
the jurisprudence of internet taxation. Conceivably, a due process
defense may be available to the vendor who is caught by the
occasional incidental and unintended sale into a jurisdiction.
- Commerce Clause. In the absence of Congressional action,
current case law appears to require some genuine presence in the
state as a prerequisite for sales/use tax jurisdiction over an
out-of-state vendor. Geoffrey indicates that the presence of
intangible property in the state may be sufficient, but that case
may not be applicable to the consumption tax context. There has
been speculation that the presence within the State of electronic
equipment utilized in the course of the electronic transaction may
be sufficient to meet the physical presence test of Quill.
- Other Provisions. It does not appear that either the Equal
Protection clause or the Import-Export clause will provide a
significant brake on a Stateís ability to tax e-commerce unless the
tax is discriminatory in the sense that out-of-state or foreign
e-vendors are more heavily taxed than their in-state
- Income Taxes
- Taxable Presence. Generally, active business
income is subject to income tax in a jurisdiction if the entity
conducting that business is either resident in that jurisdiction, in
which case it is taxable on its worldwide income, or is a non-resident
with sufficient activity within that jurisdiction to make the income
derived from that activity subject to tax. The tools of electronic
commerce may make it much easier for a foreign business to derive
substantial income from sources within a jurisdiction without engaging
in the types of activity within the jurisdiction that would constitute a
taxable presence. There is a significant concern that this will result
in internet business establishing themselves in tax haven jurisdictions
with a consequent erosion of worldwide tax revenues.
- Source Rules. As a general rule, a non-resident
business will not be subject to US taxation on income that does not have
its source in the United States. There are elaborate rules and
regulations that govern the determination of the source of various types
- Income from certain types of electronic commerce, e.g.,
the sale of digitized information, does not fall easily within these
rules, or can be managed in such a way as to manipulate the
- Generally, the rules of international taxation give
source-based taxation primacy over residency based taxation that is,
if a taxpayer resident in country A is subject to tax in country B on
income with country B as its source, A will generally grant the
taxpayer a credit against country A tax for the tax paid to B. Some
have argued that the difficulty of creating clear source rule for
income from electronic commerce will create pressure to make residence
more important. In its extreme form, this would give rise to a rule
that the source of all electronic commerce income is deemed to be the
country of residence of the taxpayer.
- Income characterization. Under the complex
rules of international business taxation, it can matter greatly how a
particular item of income is characterized. Thus, for example, a
payment by a business in country A to another business in country B will
give rise to very different tax consequences to each of them depending
on whether it is considered a royalty or payment for the purchase of
goods. Again, transactions involving the transfer of interests in
digitized information, may prove hopelessly difficult to categorize in
any systematic and useful way.
- Compliance. The internet and related
technologies clearly could have a very substantial impact on compliance
- There has been particular attention paid to the various
threats to current compliance methods posed by the new technologies.
These include the following:
- Electronic payment systems may make it harder to
trace the movement of cash or to identify the true identity of parties to a
- Offshore banking, securities trading and
gambling, all fertile ground for tax evasion by resident tax payers, may be
greatly facilitated by internet access.
- If reliable forms of unaccounted electronic
cash are developed that can accommodate high value transactions, they could
facilitate the development of underground economies that erode the current
tax base for both direct and indirect tax systems.
- There may also be opportunities for enhancing compliance
efforts through the use of the technology of electronic commerce.
- Much has been made of the fact that new forms of
electronic payment may facilitate the widespread use of so-called
micro transactions, where a person can be charged relatively small
amounts for use of a data-base, for example. If the software can be
developed to keep track of such amounts with incurring the
transactions costs that current credit and debit card facilities
require, it may also be possible to use that technology to collect
certain taxes with greater accuracy and lower transaction costs. For
example, a state could, with the cooperation of the financial
institutions administering such a electronic cash system, collect use
tax directly from its residents with respect to purchases made in that
- The use by governments of the internet to track
transactions and collect taxes will be a source of great concern for
those who worry about privacy. But whatever rules are developed to
protect privacy interest in the context of the vast amount of personal
information that an active web user may transmit to the
world can certainly be made to apply to governments as well as others.
The IRS, certainly, has an admirable record of protecting the privacy
of the information that it gathers on all taxpayers.
- The key to constructing a system that protects the
legitimate taxing function of the state without placing an undue
burden on the various legitimate participants in e-commerce will be
cooperation among governments and between business and government to
make the most effective and least intrusive use of modern technology
to deal with the impact of that technology on our tax systems.
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