Multistate taxation
of software and Internet companies

State taxation is one of the toughest tax areas facing software and Internet companies. It is a complex area because companies selling or providing services in different states face different rules in each state. The rules in the various states are often not sufficiently developed to deal with software and Internet companies. Many states are attempting to tax software companies using rules written for auto companies, and to tax Internet companies using rules written for telephone companies.

This is a chapter from the book, "Taxation of Software and Internet Companies", by David Hardesty. This book will be available soon for $39.99. Anyone interest in purchasing the book can call the author at (415) 925-1120 ext 104, or e-mail to cpa@mshb.com

David Hardesty, CPA, MBA (Tax)
Copyright, David Hardesty, 1997. All rights reserved.

Return to " Taxation of Software and Internet Companies"

Multistate income tax

State jurisdiction to tax - nexus

Due process clause
Commerce clause
Substantial nexus
Public Law 86-272
Fair apportionment
Discrimination test
Fairly related to services provided

Allocation and apportionment

Software company sales

Software shipped to buyer
Software delivered electronically
Sales of tangible property to states where a company is not taxable
Sales of intangible property to states where a company is not taxable

Internet companies

Types of Internet companies
Internet marketing companies
Internet services companies
Taxation of Internet services

Multistate sales and use tax

Sales tax
Use tax
State jurisdiction to tax - nexus
Sales and use tax on software sales

Sales of software considered to be tangible
Sales of software considered to be intangible
Electronically delivered software

Internet companies

Internet marketing companies
Online service providers
Online content providers
Personal services providers

Strategy for sales tax and use compliance

Current legislative proposals

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This chapter covers multistate income, sales and use tax issues facing software and Internet companies. A software or Internet company selling products and services outside its own state faces possible income taxation in all fifty states (to say nothing of dozens of foreign countries). Each of the fifty states has a different set of tax rules for the company to deal with. This, however, is nothing compared to the sales and use tax problems facing companies. There are over 30,000 cities, states and counties eager to tax a company selling to their residents. Each of these municipalities has its list of sales and use taxes, gross receipts taxes, excise taxes and fees of every description. Each of these jurisdictions uses a different set of rules.

A company is not required to file tax returns in every jurisdiction in which it makes sales. Besides being administratively impossible, states are constitutionally barred from taxing out-of-state companies whose presence in a state is not substantial.

To comply with multistate income, sales and use tax, the first thing to find out is in which states a company is taxable. Most companies will be taxable in only a few states. The next time you get a catalogue from a mail-order company, take a look at the bottom of the order form. The order form will direct you to calculate sales tax in at most a handful of states. This is because the mail-order company, even if it is very large, is only taxable in certain states. You may also notice that in certain states the sales tax rates will be different depending on which city the buyer lives in. This is because once a company is taxable in a state, it is also taxable in each of its cities, based on the different tax rates in each city.

The rules for determining liability for tax in a state are different for income tax as compared to sales and use tax. The rules for income tax are fairly well developed. Once again, with income tax, a company has only 50 potential state tax systems to deal with. The rules for sales and use tax are much more complex. With 30,000 cash strapped jurisdictions, each with its own set of rules, a company faces a formidable challenge. Attempts are being made to coordinate sales and use tax, but, so far, there is little agreement.

Multistate income tax

When a company makes sales in several states, the company will be taxable in each state in which it has "nexus". A company’s net taxable income is divided between the states in which it has nexus, and each state taxes its proportionate share. Taxable income is usually divided among states using allocation and apportionment rules. The allocation and apportionment rules apportion business income based on the percentage of income originating in each state. The percentage is based upon the sales, payroll and property in each state. Nonbusiness income is allocated based on the source of the income.

State jurisdiction to tax - nexus

A company doing business in several states is generally required to file income tax returns and pay tax in any state in which it has enough presence to give that state a jurisdiction to tax. Such a presence within a state is often referred to as nexus. A sales office with corporate employees in a state results in nexus. A sales person periodically visiting a state to solicit orders may or may not result in nexus.

The nexus requirement is applicable to all states. It comes from the due process and commerce clauses of the U.S. Constitution. The Constitution prevents a state from enforcing its taxes against a company that is a resident of another state, unless the company's activities meet certain threshold requirements that create nexus.

Due process clause

The due process clause provides that a state may not tax a company unless there is a sufficient nexus between the state and the company its seeks to tax. (1) Before a state can impose a tax there must be a minimal connection between the company's activities and the state. Also, the income attributed to the state must bear some relation to the intrastate values of the enterprise.(2)

It is not hard for a state to meet the requirements of the due process clause. For instance, the requirements might be met by a company that continuously sends catalogues to residents of a state.

Commerce clause

More stringent requirements are imposed by the commerce clause. In 1977 the U.S. Supreme Court decided Complete Auto Transit, Inc. v. Brady(3) which created a four part test that must be passed before a tax can be imposed on interstate commerce. A tax may not be imposed unless it is:

  1. Applied to an activity with a substantial nexus with the taxing state;
  2. Fairly apportioned;
  3. Not discriminatory against interstate commerce; and
  4. Fairly related to the services provided by the state.

Substantial nexus

"Substantial nexus" exists if a taxpayer is present within a state.(4) This is the test over which most of the arguments take place. It is a facts and circumstances test. Companies that maintain offices or employees in a state will be subject to that state’s income tax on revenues earned in that state. Companies that regularly send employees or agents into a state to service customers will likely be taxable in that state. Companies that own property in a state will likely be subject to that state’s income tax. All of these companies are likely to have nexus for taxation. Companies with only minimal contacts do not have nexus.

Public Law 86-272

Congress has provided a limited safe harbor which protects companies with minimal contacts in states in which they are not resident. Companies selling tangible personal property (including shrink-wrapped software) in interstate commerce are protected by Public Law 86-272 (5) from income taxation in states where their contacts are minimal. Public Law 86-272, enacted by Congress in 1959, provides that a state may not impose an income tax on the income of an out-of-state (foreign) corporation earned in interstate commerce if the corporation's only business activities within the State consist of the solicitation of orders for sales of tangible personal property. The corporation is immune from tax under Public Law 86-272 only if the orders are approved or rejected outside the state, and purchases are delivered from outside the state.

Public Law 86-272 does not apply to companies selling services, intangible products, or real estate. It applies only when the activities of a corporation are wholly interstate. Any intrastate activities remove the protection of Public Law 86-272. Public Law 86-272 does not apply to corporations of foreign countries. Engaging in activities beyond solicitation removes the immunity of Public Law 86-272.

A software company that transmits its software electronically to a buyer may lose the protection of Public Law 86-272. Some states may hold that software transmitted electronically is an intangible asset. In this case Public Law 86-272 does not apply.

A taxpayer that does not qualify for this law's safe harbor can still use judicial rulings to protect it from nexus in a state.

Fair apportionment

As long as a state uses a formula that results in a rough approximation of the income derived from the state in interstate commerce, this test will be met.(6) The "three factor formula" used by most states does provide such a rough approximation, so this test is usually met.

Discrimination test

This test provides taxpayers some protection against taxation of the same income by multiple states. However, the protection is not complete. Courts have ruled in many cases in favor of states, even when the same income was clearly taxed twice. The U.S. Supreme Court, in one case, upheld a state tax even though the taxpayer demonstrated that the conflicting apportionment methods of the two states resulted in the taxation of over 100 percent of its income. (7)

Fairly related to services provided

The requirement that the tax be "fairly related to the services provided" (8) is usually easy for a state tax law to meet. Companies doing business in a state benefit from police and fire protection, a trained work force, and the advantage of a civilized society. (9)

Allocation and apportionment

Most states follow a scheme of allocation and apportionment to figure out how much of a multistate business' income is taxable in each state. Business income is "apportioned" to multiple states by formula. All other income is "allocated", usually to only one state. Most states follow the rules described in the Uniform Division of Income for Tax Purposes Act (UDITPA). These rules apply to both corporate and noncorporate taxpayers in most states. The UDITPA rules attempt to provide conformity in the multistate tax rules of the various states; eliminate instances of multiple taxation of the same income; and insure that all income is assigned to a jurisdiction that has a right to tax.(10) In most instances these rules work well.

Apportionment of business income is usually done using a "three factor formula". This is a formula which takes into account sales, payroll and property in each state in which the company is taxable.

Example - Corporation A has nexus in states X and Y. 40% of sales, 10% of payroll and 10% of property are in state Y. The average of these three percentages is 20%. A's taxable income in state Y will be 20% of its total net income.(11)

Allocation is used for non-business income. Income from intangibles is usually taxed in the state in which the company has its commercial domicile. Non-business income from property, such as rents, is usually taxed in the state in which the property is located.

Software company sales

The biggest issue for software companies is the source of sales for purposes of multistate apportionment of income. Where a company has little payroll or property outside its home state, the source of software sales will be the factor that determines its tax in those states in which it has nexus. Software is unique in that it can either be shipped in a box to a buyer, or it can be delivered electronically. The method of delivery can change the source of the sale for purposes of multistate taxation.

Software shipped to buyer

The software company may ship a shrink-wrapped package containing software to the buyer. In most cases this will be considered a sale of tangible personal property and will be sourced in the state to which the product is shipped. However, if the software company is not taxable in the state to which the product is shipped, the sale will be thrown back to the state it was shipped from, as discussed below.

Software delivered electronically

Software can be delivered electronically. If software is sold over the Internet, the software can be downloaded anywhere in the world without the company even knowing the location of the buyer.

State tax laws are not sufficiently developed for us to generalize on how states will treat electronically delivered software. Some states may consider software to be tangible property regardless of how it is delivered. Others may take an opposite view. For states that consider electronically delivered software to be tangible property, the sales will be sourced where the product is delivered, or where the customer is located.

It is possible that many states will consider sales of electronically delivered software to be sales of intangibles or sales of services. For these states, the vast majority will source the sales where the vendor is located. In these states the source of income will depend on where the income producing activity is performed.(12)

For instance, in California sales of services and intangibles are sourced in the state in which the income-producing activity takes place. California follows an all or nothing rule where income producing activity takes place in more than one state. This rule provides that the income will be sourced in the state where the majority of the activity takes place. (13)

Other states source sales of intangibles proportionately based on the amount of income. Texas and Connecticut follow proportional sourcing rules.(14)

Sales of tangible property to states where a company is not taxable

A great many software sales will be to states where a company is not taxable because it lacks nexus. Sales of tangible personal property to states where a company is not taxable are subject to the "throwback" rule. This rule provides that sales to states in which the company is not taxable are sourced in the state from which the property is shipped. This rule attempts to insure that all sales are sourced to a state in which the seller is taxable. (15)

Sales of intangible property to states where a company is not taxable

Sales of intangible property are not subject to the throwback rule, which applies only to tangible property.(16) This being the case, a sale of intangible property assigned to a state in which the company is not taxable is not subject to tax. However, in states, such as California, where intangible property is sourced in the state of the income producing activity, a sale of intangibles would usually be sourced in that state. Companies which deliver software electronically will need to review the statutes of their state of commercial domicile to determine if 1) electronic delivery of software is the sale of an intangible and 2) the state sources the sale based on income producing activity.

For states that source sales of intangibles based on the location of the income producing activity, companies have an incentive to locate in states where they are not taxable. For instance, a software company based in Nevada, which transmits all of its software electronically will not be taxable in states that consider such a sale to be sale of an intangible, taxable only in the state in which the income producing activity takes place. Since Nevada has no income tax, the company's sale should be free of tax.

Determining the relevant income producing activity is a source of difficulty. Assume a company develops software in California. After the software is ready for distribution the company transfers the software to a server in Nevada. Customers will download the software from this server and payments will go directly into a bank account maintained in Nevada. The California company contracts with a third party to operate the server. What income producing activity will California look at? Will it look at the sales activities taking place in Nevada? Will it look at the past activity which took place in California?

The problems associated with the income producing activity rules for sourcing sales may prompt states to take a different approach. A number of states have begun to source some types of sales in the jurisdiction where the service is consumed. (17)

Internet companies

Internet companies have special problems in multistate taxation. The foremost of these is the lack of rules. Internet companies engage in many activities which were not contemplated when today's tax rules were written. Before looking at multistate income taxation of Internet companies we must first look at what Internet companies are.

Types of Internet companies

Internet marketing companies

Internet marketing companies are traditional retailers selling products over the Internet. The activities of these retailers are similar to those of mail-order companies. The differences between Internet marketing companies and mail-order companies are 1) transactions can be consummated on a Web site without the customer sending in a form or talking to an employee of the company; 2) the company reaches a worldwide market, instead of a targeted market that is reached by traditional advertising resources; and 3) in the case of products that can be downloaded, such as software and publications, the retailer may not know the location of the buyer.

Internet services companies

Online services should be analyzed as basic services, content services and personal services. Basic services include Internet access and e-mail services. Content services include access over the Internet to specific information. Personal services include traditional personal services, such as financial services, tax preparation, and other personal or business services delivered over the Internet.

Basic services

Internet service provider (ISP)

An Internet service provider is a company that provides a basic connection to the Internet. A user is provided access to the Internet through a local provider for a fee.

Online service provider (OSP)

Online service providers give users access to proprietary content, using their own networks. Some also provide access to the Internet. For the remainder of this discussion we will refer to OSPs and ISPs collectively as ISPs.

E-mail service provider

E-mail service providers give users access to worldwide e-mail. This service is most often bundled with services provided by an ISP. However, a user may buy e-mail only.

Internet content provider

Companies in this category provide content for a fee using the Internet. This type of company differs from an Internet marketing company in that they do not sell tangible products. The types of online content include:

  1. Books that can be downloaded
  2. Adult oriented photographs
  3. Music that can be listened too online
  4. Product information, such as auto comparisons
  5. Live video

Services delivered over the Internet

Internet advertising site

This is a company that maintains a Web site for the sole purpose of attracting advertisers. This is similar to advertiser supported newspapers that are given away on newsstands. This type of company provides free content in order to build traffic. Advertisers pay for banner ads on the site. Internet search engines are an example of this type of company. Other examples are Net magazines and newspapers.

Personal services using the Internet

Personal services using the Internet is an area in its infancy, but one which will grow. Currently, users can pay a fee to have their tax returns prepared. Information is input over the Internet, processed by computer, and tax returns are either printed and mailed to the customer or electronically sent to the IRS. Other areas which are available are legal services, computer consulting services, and marketing services.

This is an area that combines computer processing with live services. The difference between this type of service and traditional personal services is that the location of the service provider is not an issue. The only issue is the expertise of the service provider.

Taxation of Internet services

Most states source revenues from services in the state where the income producing activity is performed. ISP services should follow this basic model. However, ISPs with customers across the country may start to see states moving to source revenues in the state the customer is located in. This does not make the ISP taxable in each state in which it has customers, however. The ISP still has to have nexus.

Internet companies furnishing content should be taxable as service companies. However, some states may provide special rules for newspapers and publications. Internet publications may be subject to any such rules.

In most states, companies offering business and personal services over the Internet are likely to have sales sourced in the state in which the income producing activity takes place. However, as discussed above, industries such as financial services may face sourcing in customer states based on new rules addressing particular industries.

Multistate sales and use tax

Where a company sells in a state, that state may require the company to collect a sales or use tax, assuming nexus is established. Whether a company is liable for a tax depends on whether the company has nexus in the state. It also depends on the tangible or intangible nature of the product or service sold.

Nexus for sales and use tax is different from nexus for income tax. A company may have nexus for one and not the other.

Sales tax

Sales tax is a tax based on the gross sales price of property. It is collected by the seller of the property. The consumer of the property may be an individual buying the product from a local retailer, or a business buying a product which is "consumed" in the process of making other products.

There are a handful of exemptions from sales tax. The most common exemption is the purchase of an item for resale. The exemption that we are concerned with here is the exemption for a sale to an out-of-state buyer.

When a company sells to an out-of-state buyer, the sale is usually exempt from sales tax in the seller's state of residence. For instance, a retailer preparing a California sales and use tax return would find that "sales in interstate or foreign commerce" are exempt from sales tax. (18) The instructions to the California form indicate that exempt sales are "those involving shipments or deliveries from California to points outside this State which are exempt from tax as interstate or foreign commerce. In order to be exempt, property must be shipped to a point outside this State, pursuant to the contract of sale, and delivered by the retailer to such point by means of (1) facilities operated by the retailer, (2) delivery by the retailer to a carrier for shipment to a consignee at such a point, or (3) delivery by the retailer to a customs broker or forwarding agent for shipment outside this State." California's rules are fairly typical of the way out-of-state sales are treated.

A retailer making an out-of-state sale is usually not liable for sales tax in the retailer’s home state. Neither is the retailer liable for sales tax in the state where the customer is located, unless the retailer has nexus in that state. It is possible, then, for out-of-state sales to be completely free of sales tax.

Use tax

A sale that is not subject to sales tax in the states of either the buyer or seller is a serious problem. States have attempted to remedy this problem with a use tax. A use tax is exactly the same as the sales tax, except that it is charged to the buyer of property by the state in which the property is used. For example, a mail-order computer company may not be required to collect a sales tax. The buyer, however, is required to compute a use tax and pay it to the state in which the computer is used. Use tax, for all practical purposes, is the same as sales tax, and is meant to pick up sales which are not subject to sales tax.

The use tax is imposed on purchasers, not sellers. Out-of-state sellers with nexus in a state may be required to collect the use tax, but that does not change the fact that it is imposed on the purchasers. If the out-of-state seller does not collect the use tax, the state can come after the purchaser for the tax.

The difficulty with the use tax is that there is almost universal noncompliance. Most buyers do not know that they should pay a use tax. There are a few exceptions, however. For example, automobiles and boats purchased out-of-state must be registered. Use tax is payable at the time of registration.

Because of the difficulties involved in getting purchasers to remit use tax, states have attempted to get out-of-state sellers to collect the tax. The Supreme Court has consistently held against states unless the seller has nexus in the state.

States continue to seek ways to collect the use tax. In 1988, a group of states began developing lists of purchasers from mail-order companies. Each state shared information with other states based on their audits of mail-order companies headquartered in their state. Several years later, certain states began sending out forms to these purchasers. The forms requested the purchasers to verify reported purchases and pay use tax to the state.

Obviously, such efforts are only a drop in a very large bucket. Substantial mail-order business takes place without sales or use tax being charged, and with no chance of the consumer voluntarily paying the tax, or even knowing the tax is due. The states will have no chance of capturing even a small portion of this tax.

State jurisdiction to tax - nexus

A retailer is not required to collect sales and use tax if that retailer does not have nexus in a state. For the purposes of sales and use tax, nexus means physical presence. The U.S. Supreme Court has ruled that a state cannot require a company to collect use tax if it has no physical presence (place of business, employees, or property) within the state. A mail-order company that only mails catalogs and advertising to a state, is not liable to collect use tax on sales to residents of that state. (19)

A company must have physical presence in a state before it is subject to the collection of sales and use tax. For instance, a company may have physical presence if any of the following are true:

  1. The company has retail facilities, a warehouse or office space in the state. This is the case even if the activities being carried on in these facilities are unrelated to sales.
  2. The company's employees enter the state for the purpose of taking orders from customers in the state.
  3. The company regularly delivers orders to a state using its own vehicles.
  4. The company's employees regularly perform services in a state.
  5. Inventory is stored in a state.

The physical presence of a related company in a state may not create nexus. For instance, the physical presence in California of an out-of-state mail order vendor's parent corporation did not establish nexus, because the vendor and its parent were operated separately and did not solicit business or act as each other's agents for any purpose. (20)

It should be noted that the rules for establishing nexus are different for sales and use tax as compared to income tax. It is possible to have nexus for one and not the other. In addition, the protections against sales and use tax nexus come from judicial rulings. For income taxes, out-of-state sellers are protected by judicial rulings and by Public Law 86-272 (however, 86-272 only applies to tangible personal property).

Because so much sales tax is being lost on out-of-state sales. States are becoming ever more creative in the theories they use to subject an out-of-state seller to tax. State tax collectors are arguing that nexus exists where there is only slight physical presence. They are arguing attributional nexus, intangible property presence, and economic presence. There is so much uncertainty about the rules that a large number of top financial and tax executives list nexus uncertainty as their primary state tax concern.(21)

Sales and use tax on software sales

A sale of software may be considered a sale of tangible or intangible property. As tangible property (shrink-wrapped or canned software) it is usually subject to sales and use tax, assuming the seller has nexus. Software that is intangible property (usually only custom software) may or may not be taxable depending on the rules of the state in which it is sold. Software delivered in a box may be treated differently from software delivered electronically, depending on the state in which the sale takes place.

Sales of software considered to be tangible

The sale of tangible personal property is usually subject to sales and use tax. A sale of shrink-wrapped, or canned, software is usually considered a sale of tangible personal property. Almost all states subject sales of canned software to sales and use tax.(22) A seller of software needs to consult the sales tax rules of the state in which the sale is made, assuming the seller has nexus in that state. In the absence of specific state rules, a company can look to the general rules regarding the tangible and intangible nature of software.

Sales of software considered to be intangible

Custom software is usually not considered tangible property. In most cases it is considered services. In states that subject services to sales tax, custom software may be taxable. At least nine states tax all forms of software, including custom software.(23) Once again, the seller needs to consult the rules in each state in which it has nexus.

Electronically delivered software

Shrink-wrapped or canned software delivered electronically may be considered the sale of tangible or intangible property depending on the state in which it is sold. States have different rules regarding the liability to collect sales and use tax on canned software which is transferred electronically. In Texas the sale of canned software is taxable as tangible personal property contained on "electronic media."(24) Pennsylvania taxes the sale of a license to use canned software as a sale of a computer service.(25) Illinois taxes the electronic transmission of software. Illinois has specific language in its sales and use tax rules that say the sale of "canned software" is subject to sales tax regardless of how the software is transferred.(26)

Some states do not tax electronically transferred software, even though they may tax the same software sold in a box. California, Maryland, Massachusetts, Missouri, South Carolina, and Utah are all states that exempt from sales tax canned software that is transmitted electronically.(27) California, for example, will not tax canned software if it is "transferred electronically from the seller's place of business, to or through the purchaser's computer, and the purchaser does not obtain possession of any tangible personal property, such as storage media, in the transaction." (28)

Internet companies

As discussed above, Internet companies include Internet marketers and companies providing online services. Online services include basic services, content services and personal services. Basic services include Internet access service and e-mail service. Content services include access over the Internet to specific information. Personal services include traditional personal services, such as financial services, tax preparation, and other personal or business services delivered over the Internet.

Internet marketing companies

Internet marketing companies are similar to mail-order companies. A traditional mail-order includes an order for goods plus payment, with the goods shipped by common carrier. The order and payment can occur at the same time if the order is placed over the phone. Internet orders are not much different. The order and payment take place at the same time on a Web site. One difference is that intangible goods can be delivered immediately using the Internet. This is not possible using traditional mail-order.

At this time it appears Internet marketing companies will be treated the same as mail-order companies for sales tax purposes. However, Internet marketing companies offer states new opportunities to create nexus. One argument that is being put forward is a type of agency argument. The theory is that if an ISP operating an online mall has nexus in a state, any of the companies selling their products in that mall will have nexus in a state. So far this argument has not gone anywhere.

Online service providers

Providers of basic online access services (ISPs) and e-mail services operate in an uncertain sales tax environment. These companies are clearly providing services. The problem is that the services being provided are not contemplated by the sales and use tax laws of most states. States are unclear as to the category under which these services should be taxed. Equally unclear is the location of the transaction.

Some states assess sales tax on ISP and e-mail services. Tennessee taxes ISP services, South Carolina taxes database access and e-mail services, and Massachusetts taxes ISP and e-mail services. Other states exempt computer processing services that act on the form, content, code, or protocol of information, but are not directly involved in the transmission of the information. These exemptions may include ISP and e-mail services. These states include Indiana, Illinois, and Kansas.(29) This is not a comprehensive list, merely an indication that each state is going to go its own way absent some form of national consensus or legislation.

Sales of services are generally sourced where the consumer is located. This is true for computer services as well as many other types of services. A few states tax the sale where the provider is located, but this is the exception. Other states apportion the sales where the consumer uses the product in more than one state. (30)

An ISP may not know where a service is being consumed. This creates great difficulty in determining where it is liable for sales tax. The ISP may know where the service is being billed. But the billing address may not be the address where the service is being used. This is certainly the case with a corporate account where there is one billing address but many users.

Obviously there are more questions than answers with regard to the sales and use tax liability of ISPs.

Online content providers

Online content providers have a difficult problem in determining exactly what it is they are selling. Take an online magazine, for instance. States may consider this company to be selling any of the following: a magazine, computer services, database services, advertising, "enhanced" telecommunications services, etc. Each state is going to apply its own set of rules to these companies.

Online content providers that are not ISPs may find it impossible to identify the locations of buyers. In many cases the provider has only a credit card and e-mail address. To date there have been no serious answers to determining how such a provider will determine the location of its customers for sales tax purposes.

Personal services providers

The taxation of Internet based personal services should be similar to the taxation of those services provided in person or via the telephone. There are differences, however. The primary differences stem from the anonymous nature of the Internet and from the worldwide reach of the Internet.

A computer programmer can conceivably write a program, transmit it to the client, collect a fee, and never know the name or location of the client. This presents a problem for states that tax such services. These states may decide that the only way to tax such a transaction is to tax it based on the location of the programmer. However, most states are not there yet.

Those providing such services as the creation of Web pages can easily provide these services to any place in the world. The vast reach of the Internet increases the chances of interstate commerce. This increases the chance of states losing sales tax on interstate sales and may force states to assess a tax in the location of the service provider rather than the consumer.

Strategy for sales tax and use compliance

The inconsistency of state taxation of multistate companies makes tax compliance very difficult. Certain organizations such as the Multistate Tax Commission (MTC) are trying to create rules and guidelines that all states can adhere to. However, there is a lot of resistance to this process. (31)

The inconsistency is especially a problem for small vendors that do not have large staffs to handle compliance issues. Historically these vendors were restricted to intrastate commerce because of the barriers to entry into interstate commerce. However, mail-order and the Internet are opening up huge geographical markets to these sellers. Small vendors are faced with the choice of ignoring potential taxes on transactions outside their home states or incurring very substantial costs of compliance. The danger in ignoring possible taxes is the fact that there is no statute of limitations if returns are not filed. A vendor can find itself faced with an assessment for taxes going back for many years. If the tax is sales tax, the vendor will have lost the opportunity to collect the taxes from the buyers of its products or services.

Because of the current lack of consistency, companies will need to make determinations on a case-by-case and state-by-state basis. To simplify the process, a vendor company should first determine if it has nexus in a state. Only the largest companies will be taxable in more than a handful of states. Some may be taxable only in their home states. Once it has been established that nexus exists, a company will need to research the sales and use tax statutes on a state-by-state basis.

Current legislative proposals

Multistate taxation, especially in the area of sales and use tax, is an area undergoing rapid change. The growth of mail-order companies over the past few decades has resulted in aggressive state tax initiatives. Some of these initiatives have been found to be unconstitutional, but the revenue hungry states keep trying. The Internet further complicates the multistate tax picture. It brings with it an expanded ability for local companies to sell goods and services on a national and international basis. It also brings new types of transactions, which were not contemplated when state tax laws were written.

Legislative initiatives dealing with the changing landscape are coming from every state and from the federal government. States continue to try to find ways around Quill (32) so they can tax out-of-state retailers who do not have physical presence in the buyer's state. Retailers may be forced again and again to take states to court to defend against aggressive collection schemes.

In March 1997, a bill was introduced in the U.S. Congress entitled the "Internet Tax Freedom Act".(33) The purpose of this bill is "to establish a national policy against State and local interference with interstate commerce on the Internet or interactive computer services, and to exercise congressional jurisdiction over interstate commerce by establishing a moratorium on the imposition of exactions that would interfere with the free flow of commerce via the Internet, and for other purposes." (34)

The bill does not propose specific rules. It only proposes a moratorium on state or local government taxation of Internet or interactive computer services, or the use of the Internet or interactive computer services. The bill creates a consultative group to study the problems and to make recommendations. The intention is to present policy recommendations within two years.

It is unclear at this point what a moratorium means, since the bill preserves the right of state and local governments to tax Internet related activities. The bill preserves the right of taxation on net income derived from the Internet or interactive computer services. In addition, the bill does not apply to fairly apportioned business license taxes applied to businesses that have a business location in the taxing jurisdiction, and does not affect state and local authority to impose a sales or use tax on sales or other transactions effected by use of the Internet or interactive computer services. The bill requires that sales and use taxes be imposed in the same manner as those imposed on mail-order, telephone and other remote sales. (35)

On July 1, 1997, the Clinton administration issued a policy paper outlining its view of state taxation of Internet transactions.(36) "The Administration believes that the same broad principles applicable to international taxation, such as not hindering the growth of electronic commerce and neutrality between conventional and electronic commerce, should be applied to subfederal taxation. No new taxes should be applied to electronic commerce, and states should coordinate their allocation of income derived from electronic commerce. Of course, implementation of these principles may differ at the subfederal level where indirect taxation plays a larger role.

Before any further action is taken, states and local governments should cooperate to develop a uniform, simple approach to the taxation of electronic commerce, based on existing principles of taxation where feasible."

Nexus is an issue of great concern to out-of-state retailers. A theory being advanced in some states is that a Web server in a state gives a company using that server nexus. The California State Board of Equalization (SBE), which administers sales and use tax, and the Franchise Tax Board (FTB), which administers income tax, have both announced their opposition to making Internet providers subject to sales tax and unitary income tax. The SBE approved proposed changes to California BOE Reg. 1684, stating that a Web site in California does not create nexus. The new section says "An out-of-state retailer whose only contact with this state is the use of a computer server on the Internet to create or maintain a World Wide Web page or site does not constitute 'substantial nexus' with this state. No Internet service provider, on-line provider or other similar provider of Internet access services or World Wide Web hosting services shall be deemed the agent or representative of any out-of-state retailer solely as the result of the service provider maintaining a web page or site on a computer server that is physically located in this state."

This proposed section is interesting in that it highlights a real concern that presence on a server located in a state can cause nexus to occur. California is one of the less aggressive states when it comes to sales tax on intangibles and services. Other states may not be as forward looking in this regard.

While state tax administrators aggressively seek new tax revenues, especially sales tax revenues, from traditional transactions, there is a clear sense that Internet transactions should be left alone. This, at least, is the federal government's view, and the view of states such as California. It will take many years, however, for legislation to catch up with the new model for commerce introduced by the Internet. In the mean time, companies need to keep a wary eye on those states in which they potentially have nexus.

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1 Miller Bros Co v Maryland, 347 US 340, 74 S Ct 535, 98 L Ed 2d 744 (1954).

2 Mobil Oil Corp v Commr of Taxes, 445 US 425, 100 S Ct 1223, 63 L Ed 2d 510 (1980).

3 Complete Auto Transit, Inc v Brady, 430 US 274, 97 S Ct 1076, 51 L Ed 2d 326 (1977).

4 Mobil Oil Corp v Commr of Taxes, 445 US 425, 100 S Ct 1223, 63 L Ed 2d 510 (1980). See 32.42[2].

5 Pub L No 86-272..

6 International Harvester Co v Evatt, 329 US 416, 67 S Ct 444, 91 L Ed 390 (1947).

7 Moorman Mfg Co v Bair, 437 US 267, 98 S Ct 2340, 57 L Ed 2d 197 (1978).

8 Complete Auto Transit, Inc v Brady, 430 US 274, 97 S Ct 1076, 51 L Ed 2d 326 (1977).

9 Commonwealth Edison Co v Montana, 453 US 609, 101 S Ct 2946, 69 L Ed 2d 884 (1981).

10 See William J Pierce, "The Uniform Division of Income for Tax Purposes Act," 35 Taxes 747 (1957); See Eugene Corrigan, "Interstate Corporate Income Taxation--Recent Revolutions and a Modern Response," 29 Vanderbilt LR 423 (1970).

11 Some states weight sales, property and payroll equally. Some give sales a double weight.

12 The Taxation of Cyberspace, State Tax Issues Related to the Internet and Electronic Commerce, by Frieden and Porter, December 1996. Copyright 1996, Arthur Andersen Worldwide, SC., Section III.B.

13 Cal. Rev. & Tax Code 25136. "Sales, other than sales of tangible personal property, are in this state if: (a) The income-producing activity is performed in this state; or (b) The income-producing activity is performed both in and outside this state and a greater proportion of the income-producing activity is performed in this state than in any other state, based on costs of performance."

14 Taxation of Cyberspace, supra, Section III.B.

15 For instance, California Rev & Tax Code Sec. 25135 proivides that sales of tangible personal property are in this state if "The property (including unprocessed timber) is shipped from an office, store, warehouse, factory, or other place of storage in this state and (A) the purchaser is the United States government or (B) the taxpayer is not taxable in the state of the purchaser." The throwback rule is a basic part of UDITPA, and any adopting states will have a similar statute.

16 Taxation of Cyberspace, supra, Section III.B.

17 The Multistate Tax Commission (MTC) has issued regulations sourcing certain transactions of financial institutions in the customer's state rather than the intitution's state. About 20% of the states have adopted these regulations. Revenues from others industries such as broadcasting and publishing, telecommunications, and mutual funds are also beginning to move to a customer based sourcing of revenues. Taxation of Cyberspace, Section III.C.

18 California Form BOE-401-A

19 Quill Corp v. North Dakota, 504 US --, 112 S Ct 1904, 119 L Ed 2d 91 (1992). In Quill Corp, the taxpayer solicited sales only by mail order. North Dakota tried to require Quill Corp to collect sales tax on the sale made in North Dakota. The Supreme Court ruled against the state, saying that an out-of-state vendor was not required to collect sales tax where the vendor had no outlets, sales representatives, or other signficant property in the state. This case affirmed a previous ruling in National Bellas Hess v Illinois, 386 US 753, 87 S Ct 1389, 18 L Ed 2d 505 (1967).

20 See Current, Inc. City of San Francisco, Sup Ct Fed 9, 1993.

21 Ian Sprinsteel, State Taxes: A guide for the Besieged FO, August 1996.

22 All states except Alabama, and the few states that do not charge sales tax, assess a sales tax on canned software. Idaho, Iowa, Kentucky, Massachusetts, Nevada, New Jersey, North Dakota, Utah, and Virginia only tax canned software. Connecticut, Delaware, D.C., Hawaii, New Mexico, Pennsylvania, South Dakota, Texas, and Washington tax all forms of computer services. The remaining states tax a mixture of computer services. FTA Surveys Sales Taxation of Services, December 1996, Federation of Tax Administrators, Washington, D.C

23 FTA Surveys Sales Taxation of Services, December 1996, Federation of Tax Administrators, Washington, D.C.

24 See 34 TAC 3.308(b).

25 PA. Rev. Pronouncement 60.13(c)(iii).

26 IL Admin Code 86, 130.1935(a).

27 The Taxation of Cyberspace, supra.

28 CA Reg. 1502(f)(1)(D). "The sale or lease of a prewritten program is not a taxable transaction if the program is transferred by remote telecommunications from the seller's place of business, to or through the purchaser's computer and the purchaser does not obtain possession of any tangible personal property, such as storage media, in the transaction. If the transfer of a prewritten program is a nontaxable transaction, then the seller is the consumer of tangible personal property used to produce written documentation or manuals (including documentation or manuals in machine-readable form) designed to facilitate the use of the program and transferred to the purchaser for no additional charge. If a separate charge is made for the documentation or manuals, then tax applies to the separate charge."

29 Taxation of Cyberspace, supra, Section II.B, citing R. Scot Grierson, Tennessee, Connecticut Step up Efforts to Tax Internet Service Providers, State Tax Notes, Aug. 5, 1995, p. 401; S.C. Rev. Rul. #89-14 (July 17, 1989); 35 ILCS 630/2(c); Ind. Code 6-2.5-4-6; Kan. Stat. Ann. 79-3603(b)(1).

30 The Taxation of Cyberspace, supra, Section II. G.

31 The MTC Draft "Nexus Guideline for Application of a Taxing State's Sales and Use Tax to a Remote Seller" has met with much criticism. The AICPA’s response was very critical of the draft report.

32 Quill, supra.

33 Internet Tax Freedom Act, H.R. 1054 and S. 442. 105th Congress. A bill to amend the Communications Act of 1934.

34 Internet Tax Freedom Act, H.R. 1054 and S. 442. 105th Congress

35 Internet Tax Freedom Act, H.R. 1054 and S. 442. 105th Congress

36 A Framework for Global Electronic Commerce, Whitehouse policy statement issued July 1, 1997