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Jurisdiction: Building Confidence in a Borderless Medium

July 26-27, 1999
Montreal, Canada

Taxation of Electronic Commerce - Issues of Public Policy and Legal Jurisdiction

Peter v.Z. Cobb, Esq.
Fried, Frank, Harris, Shriver & Jacobson
One New York Plaza
New York, New York 10004
1-212-859-8177 Telephone
1-212-859-8588 Facsimile


  1. Fundamental policy concerns
  2. 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.

    1. The governmental view
      1. Tax Policy Concerns. As a matter of pure tax policy, the state has a legitimate interest in administering a tax system that
        1. is fair to those who are subject to it,
        2. minimizes any distortion of economic decision making within the economy,
        3. does not require undue effort by either the tax collector or the taxpayer to interpret and administer, and
        4. 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 squawking.

      2. 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.
      3. 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 compensation.
      4. 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 the consumer.
        • 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.

    2. The Taxpayer View
    3. 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:

      1. 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 fairly 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.
      2. 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.
      3. 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.

  3. Legal Constraints on the power of a United States taxing jurisdiction to compel compliance with payment, collection and reporting.
  4. 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.

    1. Limitations on state and local regimes
      1. Federal Constitution — the due process clause. It 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:
        1. they rely principally on the concept of fairness,
        2. there must be a "minimum connection" between the person and the state,
        3. no physical presence in the jurisdiction is necessary, and
        4. the "purposeful direction of activity toward the state" is sufficient.
      2. 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.
        1. Under current law, a state or local tax will satisfy dormant commerce clause scrutiny if it meets four requirements:
          1. The activity being taxed must have substantial nexus with the taxing states.
          2. 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).
          3. The tax must not discriminate against interstate commerce.
          4. There must be a fair relationship between the tax and the services provided by the state.
        2. The proper interpretation of the "substantial nexus requirement is the subject of some controversy at this time.
          1. 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.
          2. 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.
          3. 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.
        3. 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.
      3. Federal Constitution — other relevant provisions
        1. 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.
          1. 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 particular circumstances.
          2. State courts, interpreting their own equal protection provisions, have generally followed the US Supreme Courtís lead in most areas.
          3. 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.
        2. 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.
          1. It is fairly settled that the reference to imports and exports in this clause refers only to foreign commerce and not to interstate commerce.
          2. 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.

      4. 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.
      5. State constitutional and statutory law. Although these are important, they are beyond the scope of this outline.

  5. Electronic Commerce — special problems
    1. Consumption Taxes — (Sales & Use; VAT)
      1. 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.
        1. 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.
        2. 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.
          1. 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.
          2. 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.
          3. 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.

      2. 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 ultimate consumer.
        1. 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.
        2. 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 administrative nightmare.
        3. There are a variety of practical, political and constitutional limitations on the ability of a taxing regime to cast its net too broadly.
          1. 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.
          2. 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.
          3. 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 competitors.

    2. Income Taxes
      1. 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.
      2. 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 of income.
        1. 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 rules.
        2. 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.
      3. 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.
      4. Compliance. The internet and related technologies clearly could have a very substantial impact on compliance efforts.
        1. There has been particular attention paid to the various threats to current compliance methods posed by the new technologies. These include the following:
          1. Electronic payment systems may make it harder to trace the movement of cash or to identify the true identity of parties to a transaction.
          2. Offshore banking, securities trading and gambling, all fertile ground for tax evasion by resident tax payers, may be greatly facilitated by internet access.
          3. 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.
        2. There may also be opportunities for enhancing compliance efforts through the use of the technology of electronic commerce.
          1. 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 way.
          2. 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.
          3. 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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