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Sales Tax And The Internet: What's Next With Nexus

"If you drive a car, I'll tax the street, If you try to sit, I'll tax your seat. If you get too cold I'll tax the heat, If you take a walk, I'll tax your feet." -- Taxman, Beatles (and the immortal SRV)

"If you drive a car, I'll tax the street, If you try to sit, I'll tax your seat. If you get too cold I'll tax the heat, If you take a walk, I'll tax your feet." --
Taxman, Beatles (and the immortal SRV)

It should be no secret by now that the Internet represents a huge challenge for traditional distributors and resellers. If your business comprises connecting buyers and sellers, then you are in certain ways a broker. The problem is that in a market with perfect information, the job of a broker becomes increasingly difficult. Such was the case when a large group of mortgage lenders were enraged by a Fannie Mae decision to post real-time rate quotes on its Web site. The issue here is quite simplistic. If your job is about being an information conduit, and not a provider of value-added services, you should be afraid. (Yes, this applies to security analysts as well!) Not everyone agrees with this line of reasoning. In fact, some people believe that the Internet represents not much more than an extension of the telephone service. According to this theory, the Internet will empower the current market leaders to expand their presence. In a recent Web Week article, Robert Hertzberg noted, "the Web winners are much more likely to be existing distribution businesses that have embraced the new electronic medium and adapted it to their customers' needs, rather than brand-new entrants displacing an old guard of fuddy-duddies."

Some may be surprised to find that the old-line reseller has another foe that compounds the threat of the Internet. Based on current sales tax laws, companies that distribute their products directly to consumers via the Web are not responsible for local sales tax collection, except in the state in which they are physically located. Based on physical location, this rule provides an interesting advantage to the on-line merchant and applies equally to Web-based resellers such as (AMZN) and direct marketers such as Dell Computer (DELL ).

Perhaps we should start with a little history. The main precedent with respect to this issue is the catalog industry. Over the years, it has been determined that the Commerce Clause of the United States Constitution prohibits states from requiring merchants without a substantial nexus, or presence, from collecting tax on the states' behalf. Interestingly, this ruling does not eliminate the states' right to collect tax, and in most cases, the individual is expected to pay this tax as part of his or her annual income tax. However, this requirement is obeyed with as much respect as the first five miles an hour over the speed limit.

To be fair, the traditional retail merchant has a choice with respect to this 5%-8% pricing disadvantage. Some catalog vendors, and certain on-line merchants, have found that by creating a totally autonomous division for non-storefront sales they can evade the court's interpretation of nexus. However, in doing so, they forgo most of the benefits highlighted by Mr. Hertzberg. The retail merchant that moves on-line with a separate business unit cannot have any interaction between the individual operating units. This means the on-line URL cannot be advertised in the stores and the stores cannot accept returns from on-line or catalog sales.

We completed a informal survey of about 30 catalog companies that also have storefronts, and almost 90% of them had decided to bite the bullet and collect sales tax in any region where a store was present. This allows the retailer to leverage the full distribution and store base, as well as avoid the continual surveillance of the local tax boards. Most of these companies sell their own branded goods, and have the exact same prices in the stores and in the catalog. Companies that resell more commodity-like goods have a more difficult decision to make. If you move on-line with an integrated model, you suffer a 5%-8% price disadvantage relative to the pure on-line competition. If you go aggressively after the hybrid approach, you increase the likelihood of self-cannibalization and may raise customer concerns with regard to service.

One vendor who has chosen the hybrid approach is Barnes & Noble ( BKS). In order to compete aggressively on price with, Barnes structured its on-line site as a separate business entity. This allows the company to avoid tax collection in most areas, but also mandates that the company have no interrelationship between the two units. As you might expect, the Web site dictates that returns must go back through the mail and not to the stores. We believe this policy increases the likelihood that local physical store managers will view the on-line version as a threat. As a test, we called a physical store and asked the salesperson if we could return a book purchased on-line. The clerk passed us on to a manager who frustratingly informed us that he had nothing to do with the on-line site. When confronted about the enormous price difference on-line, he suggested we talk to "them" about it, referring to the on-line business unit. It is interesting that this manager described this operating unit of his own company as a third-party.

The nexus issue is not static, and as such, no company should expect the current state of affairs to remain intact. For instance, the on-line world raises many new issues with respect to nexus. Some claim that the ISP represents an agent of the on-line merchant and therefore creates a nexus for virtually every on-line reseller. We believe that this interpretation is too broad and will not prove valid. A second and similar argument is that the existence of mirror or caching servers creates nexus. This interpretation is harder to disprove, and we would not be surprised to see a large hosting presence emerge in any state that was willing to give on-line merchants immunity from local sales tax.

One area that is particular blurry is the sale of intangible bits through the on-line delivery of intellectual property such as music or software. The catalog world offers no precedent for digital sales delivery and it is unclear whether these sales will be treated as tangible property or intangible services. If viewed as tangible, the same rules we discussed herein should apply. However, if these are viewed as services, it is unclear what protection on-line software merchants will have from states seeking extra income. In an effort to minimize such potential taxation, CNET (CNWK ) has placed the server for its business in Oregon, outside of tech-hungry California.

Clearly, change is in the air. Many states are playing hardball by demanding that the direct reseller relinquish customer information so that the states can collect the tax directly from the consumer. This solution is unsettling to the reseller who fears that the consumer will view list distribution as a violation of privacy. Organizations such as the DMA (Direct Marketing Organization) are considering standard taxation policies which would make tax collection for direct marketers less onerous. In complying with such an agreement, the states would likely give up control and perhaps a few percentage points.

These Internet-related tax issues become even more complicated when you consider global commerce as opposed to simply cross-state. Many countries have intricate import and export tariffs that create huge discrepancies in the price of goods cross borders. Now consumers in Taiwan can buy CDs from CDNow at prices well below those of the local market, even when you take into consideration the high cost of international shipping. Look for the international parcel companies to get dragged into the morass as we search for answers to these complicated trade issues.

Some believe that the federal government should dictate that the Internet be free of taxation with respect to both services and commerce. They argue that if we don't create the proper incentives, we are likely to cripple the proper rollout of the information superhighway. We ask the following question, "If federal government mandated that all merchants collect local sales tax, would you go short Cisco (CSCO )?" If your answer is no, then you do not really believe that tax policies will adversely affect the construction of the Internet.

What is needed is simplicity. The federal government should quickly create a standard, simplistic, and comprehensive policy. The last thing we need is the for the architecture of the Web and the business strategies of on-line merchants to be dictated by tax evasion efforts. And we certainly do not need state tax collectors individually harassing on-line shoppers in an effort to collect the $1.23 that could have potentially accompanied a sweater sale.

J. William Gurley 1997-8. All rights reserved. The information contained herein has been obtained from sources believed to be reliable but is not necessarily complete, and its accuracy cannot be guaranteed. Any opinions expressed herein are subject to change without notice. The author is a general partner of Hummer Winblad Venture Partners (HWVP). HWVP and its affiliated companies and/or individuals may, from time to time, have positions in the securities discussed herein. Above the Crowd is a monthly feature focusing on the evolution and economics of high technology business and strategy.