Amazon positioned to win state tax battle

This was originally posted at Between the Lines. It was updated at 3:25 p.m. PDT with Amazon adding Hawaii to the list of states where it's pulled its Associates program.

Amazon.com is in a high-profile tax showdown with states over its Associates referral program and is likely to come out a winner either way.

Amazon has pulled its Associates program, which allows Web site operators to drive sales to the e-tailer in exchange for commissions of up to 15 percent, in North Carolina and Rhode Island. And on Tuesday, Amazon also added Hawaii to its hitlist, according to The Wall Street Journal.

States are hurting for revenue and are trying to force Amazon to collect sales taxes on its associates. Simply put, states are trying to treat associate Web sites as if they are physical assets of Amazon.

Amazon's response: Cut out associates in the states where tax bills are proceeding.

Providence Business News reported that Amazon cut its ties with business affiliates in Rhode Island over a bill that would force it to collect sales tax on referrals via authors or businesses in the state. Amazon had the same reaction to a similar tax-happy move by North Carolina. These battles will be fought state by state, depending on the return on Amazon's marketing dollars.

Bernstein Research analyst Jeffrey Lindsay summarizes the situation:

The issue is collection of sales taxes--several states are trying tactics developed by then-Gov. Eliot Spitzer in New York to try to force Amazon to collect sales taxes on online sales made in their states. In 2008, Spitzer argued (and the courts upheld his view) that if Amazon has affiliates in the state where sales were made, that counted as "in-state" presence, and sales taxes must be collected.

Amazon's response to the latest move by cash-strapped states hoping to follow New York's lead has been to terminate relationships with in-state affiliates in a rapidly escalating game of chicken. It is not clear where this game may end, but clearly, Amazon is prepared to tolerate some pain to maintain its sales tax collection exemption for the majority of states.

While loss of affiliates in some smaller states may not be an insurmountable problem, it now looks as if California may be next to impose the "affiliate rule," and this may be more difficult to circumvent. Even if the states prevail, however, we do not believe the impact upon Amazon will be large.

Given Amazon's response and states' desperation for tax revenue, it doesn't take a brain surgeon to figure this showdown will escalate. What would happen if Amazon just shut down its Associates program in all states?

Amazon could win. Think about it: If Amazon was really dependent on the Associates program for a huge portion of sales would it really just pull it that quickly? Amazon in its SEC filings doesn't break out revenue garnered from its referral program or its total expense.

However, Amazon does drop a few hints. In a blog post, Amazon says, "We pay out hundreds of millions of dollars per year to Web sites that advertise our products."

In other words, these commissions can add up:

In Amazon's SEC filings, it explains that the Associates program falls under its marketing spending line. According to Amazon's annual report:

We direct customers to our Web sites primarily through a number of targeted online-marketing channels, such as our Associates program, sponsored search, portal advertising, e-mail campaigns, and other initiatives. Our marketing expenses are largely variable, based on growth in sales and changes in rates.

To the extent there is increased or decreased competition for these traffic sources, or to the extent our mix of these channels shifts, we would expect to see a corresponding change in our marketing expense or its effect.

Marketing costs increased in absolute dollars in 2008, compared to 2007 and 2006, due to increased spending in variable online-marketing channels, such as our Associates program and sponsored-search programs.

While costs associated with free shipping are not included in marketing expense, we view free-shipping offers and Amazon Prime as effective worldwide marketing tools, and intend to continue offering them indefinitely.

The big question is whether Amazon's referral program accounts for the bulk of the company's marketing expense. For the year ended December 31, 2008, Amazon reported marketing expenses of $482 million, up from $344 million in 2007 and $263 million in 2006.

It's hard to quantify the connection between referrals and Amazon's sales, but chances are good that the company has word of mouth, habits, and low prices at its back these days. Simply put, if Amazon cuts its Associates program in every state, its marketing expenses would fall dramatically and ultimately boost earnings. And Amazon would likely land the sale, anyway. Meanwhile, these small businesses that like Amazon's commissions will be screaming at their state legislators.

JPMorgan analyst Imran Khan writes in a research note:

Although the affiliate network changes could result in some lost sales, Amazon will have the ability to shift marketing spend into other arenas. We think the company can continue to focus its marketing on the areas that deliver the best (return on investment), mitigating the impact of losing some affiliates.

The state tax flap is an interesting showdown, but Amazon has done the math internally. The e-tailer appears confident that it can win a game of chicken.