INDUSTRY ANALYSIS
Local Taxation of Online Sales: Only a Matter of Time?

The majority of U.S. states are moving to end the tax-free ride for most online shoppers, a development that is facing opposition from some members of the public, businesses and a number of federal lawmakers.

At present, 43 states have joined a states-led coalition called the Streamlined Sales Tax Project (SSTP), which is taking steps to collect sales tax on all Internet purchases, and are working to clarify their tax codes to make collection easier.

States have been complaining for years that they have been missing out on valuable tax dollars generated through Internet sales , arguing that they lose as much as US$16 billion annually in tax revenues.

Diverse Laws

The online sales tax program is still voluntary, so not all merchants collect taxes; however, some established businesses like Eddie Bauer and Wal-Mart already collect sales taxes for online purchases.

Online retailers have avoided collecting sales taxes due in part to the diverse sales tax laws at the local and state levels. This web of local and state laws and regulations often has different definitions for the same item.

Currently, an online seller, similar to the case of a mail-order retailer, has to collect sales tax on a transaction only if it has a physical presence in the state where the buyer resides. Some large retailers avoid charging sales tax by establishing separate legal subsidiaries to handle Internet business; however, this has raised the ire of thousands of brick-and-mortar retailers whose customers must still pay tax.

The SSTP program would enable states to collect sales tax from out-of-state merchants who have no stores, warehouses or other physical facilities in the state where the sale occurs.

Because the proposed program streamlines collection procedures, it will likely reduce the burden on online retailers, eliminating their argument that it is impractical to collect sales taxes for online transactions. Specifically, the proponents of the SSTP program say that the new software that is to be used as part of the program will make collecting the money almost automatic, and the collection systems could be in place as early as Oct. 1.

Incentive Offered

Due to the fact that the SSTP program is voluntary, the states involved are assuming that businesses, as responsible social entities, will collect and pay the local sales taxes. As an incentive to businesses that enroll in the program, the SSTP would designate such companies as "audit proof."

Despite the voluntary nature of the SSTP, many companies, especially larger ones that also have offline activities, will likely enroll in the program due to recent court decisions that have pushed the limits of when an online operation is required to collect sales tax.

For example, in a recent decision, a California appellate court upheld a determination by the State Board of Equalization that the bookstore chain Borders represented its online entity "for the purpose of selling" goods in the state and that, due to this finding, the online entity was required to collect and remit a use tax from its California customers.

In this case, the court determined that the activities of Borders' offline entities, the bookstores, were closely tied to the purpose of selling the online entity's goods in the state, since customers who purchased items online could refund or exchange these goods at the actual stores within a specified period of time.

The court agreed with the board's reasoning that the online entity was engaged in business in California because the physical bookstores were acting as agents or representatives for it through their acceptance of returned merchandise bought online.

The second issue that the court considered was whether Borders' online entity had a sufficient physical presence in the state to justify the imposition of the tax collection burden. The Commerce Clause of the U.S. Constitution states that there must be a sufficient connection or nexus between a state and a retailer in order for the state to impose a use tax on the seller's goods.

Online Taxation Likely To Expand

A crucial factor in determining whether such nexus exists is whether the activities performed in the state on behalf of the taxpayer are significantly associated with the taxpayer's ability to establish and maintain a market in the state for the sales.

The court found that Borders' online entity's return policy was part of its strategy to build a market in California, thus creating a sufficient nexus to determine that the online entity had a representative with a physical presence in the state and that the representative's activities were significantly associated with the online entity's ability to establish and maintain a market in the state for the sale of its goods.

Taken together, the court found that the online site was obligated to collect and remit a use tax from the state's customers.

The Borders case is just a recent example of the progression towards ever expanding online taxation of e-commerce transactions. This being the case, it is quite possible that the SSTP program will eventually become a mandatory national program with some federal oversight.