The Tax Man Cometh

They fought over Social Security, tax cuts and defense. But Al Gore and George W. Bush agreed on one thing: Both pledged to extend the current three-year moratorium on new Net taxes. Score one for e-commerce, right? Not exactly. While the moratorium lets Washington lawmakers appear both pro-Internet and antitax, it doesn't bar existing taxes -- just new ones. In fact, states and municipalities are already allowed to apply existing sales taxes to Net purchases. And with half a billion dollars in lost revenues at stake, they're working feverishly to figure out how to levy -- and collect -- those fees.

The urgency is understandable. Every dollar spent online is a dollar not spent on Main Street -- and that many fewer pennies going into city and state tax coffers. Online consumers sales totaled $12.8 billion last year. In that same period, Forrester Research estimates, states and municipalities lost $524 million in potential tax revenues. A recent study by the University of Tennessee predicted that those annual losses would total $10.8 billion by 2003. "We have grave concerns about the magnitude of that money," says Ray Scheppach, executive director of the National Governors' Association.

The lack of online taxes also puts non-wired retailers at a disadvantage. Says Andy Ross, owner of Cody's Books in Berkeley, Calif.: "I can compete against the Internet. I can compete against chain stores. But I can't compete against a tax system that discriminates against me." That system also discriminates against the millions of Americans with no Net access, making the Internet a duty-free shop for the digital elite.

The story of the Net's rise as a tax haven began before most Americans had heard of e-anything. In a 1992 Supreme Court case, Quill Corp. vs. North Dakota, the justices ruled that a vendor doesn't have to collect taxes on remote sales unless it has a "physical nexus" -- meaning employees or tangible property, such as a store -- in the state where the purchases are made. The ruling made most mail-order purchases tax-free, because few mail-order companies have such physical assets. Quill applies to Internet sales as well: If an online store has an office in your state, you owe tax on anything you buy from it. Amazon, for example, should tax customers who live in Washington, where the company is headquartered.

But, as with catalogs, most online sales go untaxed. For one thing, like their mail-order counterparts, few Internet retailers own tangible property beyond their headquarters. Collection is another problem. Whey they do owe taxes on online purchases, and the vendor doesn't collect then, consumers are supposed to pay them at the same time as they make their annual state or local income tax payments. Few buyers are even aware of this requirement, much less meet it.

To help resolve the mess, Congress two years ago passed the Internet Tax Freedom Act, which created a three-year ban on new Internet taxes. That ban ends October 2001. Last May, the House voted to extend the moratorium an additional five years, but the Senate has yet to take up the matter. Note that word "new": The moratorium did not invalidate existing tax laws. It was simply intended to give everybody involved time to ponder the problem.

At the same time it created the original moratorium, Congress created the Advisory Commission on Electronic Commerce, a blue-ribbon panel consisting largely of high-tech CEOs and other Internet-industry notables. But last April, the 19-member panel dissolved in stalemate. Members agreed on some tangential issues (such as scuttling a century-old 3 percent telecommunications tax, originally passed to fund the Spanish-American War), but couldn't achieve the necessary two-thirds consensus on the central question: Can states require e-vendors to collect sales taxes?

Online businesses argue that if they were forced to play tax collector, sales would suffer, and the e-commerce boom would fizzle. Tech-dominated antitax groups such as the Internet Tax Fairness Coalition -- members include America Online, Cisco Systems and Microsoft -- insist that Internet taxation is just too complex. To quote the coalition Web site: "There is no cheap and easy technological solution."

It may be hard to believe that the geniuses of the new economy -- the same folks who create multibillion-dollar stock valuations on no revenues -- are daunted by a little thing like tax collection. But they may have a point. Collecting taxes on each Net purchase would mean identifying the relevant state and local jurisdictions for the customer, then calculation the associated sales taxes. Vendors would then have to remit payments and submit paperwork to each of the country's thousands of taxing authorities.

The taxing authorities themselves are attempting to help. The National Governors' Association, its municipal allies and a handful of brick-and-mortar businesses have formed the Streamlines Sales Tax Project, an effort to create a uniform national system for collecting sales taxes. So far, more than 30 states are taking part, drafting a new, one-size-fits-all tax policy that state legislatures can easily enact. The SSTP is also helping private companies develop software to simplify collection. The goal is a "zero burden" system in which states kick back a portion of the tax revenues to vendors to compensate them for the cost of compliance.

States are trying to make more immediate changes. The California state Senate, for instance, recently approved a bill that attempted to clarify the definition of "physical nexus." Gov. Gray Davis vetoed the bill, but backers vow they'll reintroduce it in 2001. If it becomes law, online vendors like Barnesandnoble.com that are part-owned by companies with a California nexus will have to collect taxes.

Meanwhile, North Carolina added a new item to its 1999 tax forms. The paperwork now clearly explains that taxes are due on Internet purchases that weren't already taxed by vendors. The addition helped North Carolina garner roughly $3 million in use taxes, up from roughly $225,000. Says Charles Collins, an administrator for the North Carolina Department of Revenue: "We want to make things simple while making it clear that all commerce applies to all taxpayers."

E-taliers and consumers, consider yourselves warned.