States seek levies on digital-media downloads

By Declan McCullagh and Anne Broache
Staff Writers, CNET News.com
April 13, 2006 4:00 AM PDT

Internet shoppers accustomed to tax-free purchases from Apple Computer's iTunes Music Store soon may be in for an unpleasant surprise.

State legislatures and tax officials, eager to find new ways to boost government spending and curb budget shortfalls, are eyeing the burgeoning market for digital downloads as a potentially lucrative source of revenue.

A CNET News.com analysis shows that 15 states and the District of Columbia now tax downloads of music, movies and electronic books. Some high-tax states such as California do not levy the same charge on iTunes downloads, but that could soon change.

"More states are beginning to tax downloaded products," said Steve Krantz of the Council on State Taxation, which represents companies that do business in many states. "Some are doing it through specific legislation. Others are doing it through the interpretation of previous law."

Does my state tax digital downloads?

While most states still only tax "tangible" online purchases, others are making exceptions for digital downloads, according to CNET News.com research.

Click a state above to learn more about that state.

Alabama

State statute/proposal

Alaska

Alaska has no sales tax

Arizona

Arkansas

California

"Sales tax applies to tangible personal property--things you can hold, touch, feel, see--and downloaded music is not considered to be tangible personal property."

- Anita Gore, spokeswoman, State Board of Equalization

State statute/proposal (pdf)

Colorado

Connecticut

Delaware

Delaware has no sales tax

Florida

"Sales tax is not due because sales tax generally applies to the sale of tangible things, and when music or other content is downloaded, nothing tangible is generally received. Thus, no sales tax is due. However, note that if the same content were sold on a disc or in some other tangible form, it would be subject to sales tax, as there would now be tangible personal property that the tax would apply to."

- Renee Watters, chief of public information, Department of Revenue

State statute/proposal

Georgia

"We don't impose sales and use tax on digital goods."

- Charles Willey, spokesman, Department of Revenue

State statute/proposal

Hawaii

Idaho

State statute/proposal (pdf)

Illinois

"If you download Microsoft Word, it's taxable...if you download "Walk the Line" by Johnny Cash, we don't consider that software (or taxable)."

- Mike Klemens, spokesman, Illinois Department of Revenue

State statute/proposal

Indiana

"Digital goods purchased via the Internet are treated the same as software purchases, and therefore, they are subject to sales tax."

- Stephanie McFarland, spokeswoman, Indiana Department of Revenue

State statute/proposal (pdf)

Iowa

Kansas

Kentucky

"We tax digital downloads of computer software and music as tangible personal property."

- Jill Midkiff, spokeswoman, Kentucky Department of Revenue

State statute/proposal (pdf)

Louisiana

State statute/proposal (pdf)

Maine

State statute/proposal

Maryland

State statute/proposal

Massachusetts

"We do not tax downloads of digital goods; we consider it information, and we don't tax information."

- Tim Connelly, spokesman, Massachusetts Department of Revenue

State statute/proposal

Michigan

"We do not have a sales tax on an actual digital download. If you were to, say, purchase something that was prewritten computer software that was, in essence, delivered electronically, then we would, but not on something from, say, iTunes."

- Caleb Buhs, spokesman, Department of Treasury

State statute/proposal

Minnesota

Mississippi

State statute/proposal

Missouri

State statute/proposal

Montana

Montana has no sales tax

Nebraska

Nevada

New Hampshire

New Hampshire has no sales tax

New Jersey

"(Digital downloads) are not (taxed) at the moment, but there is a pending proposal."

- Tom Vincz, spokesman, New Jersey Department of Treasury

State statute/proposal (pdf)

New Mexico

New York

"(Downloads of) music, movies, pictures, graphic files, that type of stuff is not taxable."

- Michael Bucci, spokesman, New York State Department of Taxation and Finance

State statute/proposal

North Carolina

"There is no tax like that (on digital downloads) here?I can't say there won't be on in the future, but for now, there is not one."

- Kimberley Brooks, spokeswoman, North Carolina Department of Revenue

State statute/proposal (pdf)

North Dakota

State statute/proposal (pdf)

Ohio

"We do not (tax downloads of music, etc.). Software, we do tax, if it's electronic transfers of prewritten computer software."

- Gary Gudmundson, spokesman, Ohio Department of Treasury

State statute/proposal

Oklahoma

Oregon

Oregon has no sales tax

Pennsylvania

"If you buy music on a CD, the CD is tangible personal property; it's subject to tax. If you download it, our interpretation was it's not taxable because it's not tangible."

- Steve Kniley, spokesman, Pennsylvania Department of Revenue

State statute/proposal

Rhode Island

State statute/proposal

South Carolina

"Unlike computer software delivered in the form of a computer diskette or magnetic tape, computer software sold and delivered by electronic means cannot be seen, weighed, measured, felt, touched or is not otherwise perceptible to the senses."

- Ruling, South Carolina Department of Revenue

State statute/proposal

South Dakota

Tennessee

Texas

"Except as otherwise provided by this chapter, the sale or use of a taxable item in electronic form instead of on physical media does not alter the item's tax status."

- Texas tax code

State statute/proposal

Utah

"The sale, rental or lease of prewritten computer software constitutes a sale of tangible personal property and is subject to the sales or use tax, regardless of the form in which the software is purchased or transferred."

- Utah state code

State statute/proposal

Vermont

State statute/proposal

Virginia

"(Digital downloading) is not a taxable transaction and has never specifically come up as proposed legislation to tax digital downloads."

- Joel Davison, spokesman, Virginia Department of Taxation

State statute/proposal

Washington

"We have to determine whether the seller has nexus in Washington, but if we get by that point, then sales of song files, and prewritten software files, are subject to sales tax here."

- Gary Davis, tax information and education manager, Washington State Department of Revenue

State statute/proposal

West Virginia

State statute/proposal (doc)

Wisconsin

State statute/proposal

Wyoming

State statute/proposal

Washington, D.C.

This means that more Americans will be obligated to pay more every April 15 because of a concept known as the use tax. If your home state taxes digital downloads, those levies are generally collected either when purchases are made or on tax day, depending on the location of the Internet retailer.

One reason that music and movie downloads have largely escaped the notice of tax collectors is that, until recently, the market was relatively small. But the dizzying success of iTunes and such rivals as Yahoo Music Unlimited and eMusic.com has exposed a rich vein of untapped revenue. Hollywood studios raised the stakes even higher this month by announcing plans to sell movies over the Internet that buyers can keep.

Digital sales of music tripled from 2004 to 2005, leaping from $400 million to $1.1 billion worldwide, according to the International Federation of the Phonographic Industry, a trade association known as IFPI. The U.S. recording industry estimates that domestic sales totaled $503 million last year, but that figure doesn't include movies, e-books, online video games and other forms of digital media.

That remarkable growth has prompted states like Kentucky to revisit their laws and impose new taxes on media downloads. "Music is included because music downloads fit the definition of personal property," said Jill Midkiff, a spokeswoman for the Kentucky Department of Revenue.

"(Taxing downloads is) antiproductive and anticonsumer, and hurts the business. This would be a huge blow against iTunes and the studios that are finally realizing they have to sell their movies online."

--Llewellyn Rockwell Jr., president
Ludwig von Mises Institute

Similar proposals are on the horizon, with Internet companies tracking tax expansion efforts in New Jersey, Vermont and Rhode Island. New Jersey Gov. Jon Corzine, a Democrat, proposed in his budget (click here for PDF) that "downloaded music and videos" be taxed starting Oct. 1. The state tax agency expects legislation to be introduced in June.

Of the 15 most populous states that, together, represent more than half of the U.S. population, three--Texas, Indiana and Washington state--tax media downloads, according to a News.com survey. In addition to the nation's capital, the lesser-populated states that impose such taxes are Alabama, Arizona, Colorado, Hawaii, Idaho, Kentucky, Louisiana, Maine, New Mexico, South Dakota, Utah and West Virginia, according to an industry lawyer.

These states typically say taxing digital-media downloads is a matter of treating physical shopping and online purchases the same. Buying a CD at Tower Records is taxed, the argument goes, so why should a stream of bits from iTunes or Walmart.com be tax-free?

Taxpayer advocates don't accept that premise, saying it represents an unfair addition of tax laws. "It's antiproductive and anticonsumer, and hurts the business," said Llewellyn Rockwell Jr., founder and president of the Ludwig von Mises Institute, a free-market think tank in Auburn, Ala. "This would be a huge blow against iTunes and the studios that are finally realizing they have to sell their movies online."

Music defined as software
Tax collectors in some states where the law does not explicitly permit taxes for downloaded media have invented ways to expand the tax base, anyway.

"Should administrators (interpret tax laws) in the dark? If changes are made in the legislature, we can duke it out as a tax increase."

--Steve DelBianco, executive director
NetChoice

In Kentucky and Washington, state law does allow the taxation of computer software. Washington law defines software as "a set of coded instructions designed to cause a computer...to perform a task," which tax officials have interpreted to include music, movies and e-books.

"We use that same rationale on other types of files, such as music files or video files," said Gary Davis, the state's tax information and education manager. "We view them as similar because they cause some action by a piece of hardware to play them."

Davis recited aloud the definition of computer software from Washington's tax law and said he believed that data files, like an executable program, cause a computer to "perform a task." He said, "I think it's our policy that that's exactly what a music file does in order to hear it."

That definitional elasticity has alarmed online retailers, which say states are interpreting tax laws in ways never envisioned by elected officials or the general public. They would rather see the issue decided openly in state legislatures than behind closed doors by tax agencies.

"Should administrators do it in the dark? If changes are made in the legislature, we can duke it out as a tax increase," said Steve DelBianco, executive director of the NetChoice coalition, which counts eBay, Oracle, Orbitz, VeriSign and Yahoo as members. "The legislatures have to do it in the daylight."

Next page: A 1992 court ruling's lasting impact 

States seek levies on digital-media downloads

 Previous page

Causing additional concern is the Streamlined Sales Tax Project, a multistate effort to develop uniform standards for taxation and straighten out some of the notorious convolutions of state tax laws.

Like Washington state, many participating states have adopted the project's standardized definition of computer software (click here for PDF).

Some, however--namely Michigan, Minnesota, Nevada, Iowa and North Carolina--have yet to expand that definition to include other electronic media.

"We do not have a sales tax on an actual digital download," said Caleb Buhs, a spokesman for the Michigan Department of Treasury. "If you were to, say, purchase something that was a prewritten computer software (program) that was in essence delivered electronically, then we would. But not on something from, say, iTunes."

Buhs said he did not know of any plans in Lansing, the state's capital, to follow Washington state in broadening the definition of computer software to raise additional tax revenue.

The tactic of reinterpreting legal terms to increase the tax base is hardly limited to state officials. The Internal Revenue Service drew opposition in 2004, when it suggested reinterpreting a Spanish-American War tax on "telephonic" communications in a way that could cover Internet phone calls. After opposition from a congressional Republican and the Internet industry, the IRS quietly abandoned the proposal.

"We'd like the exemption to continue. We don't use any state or physical resources other than the networks over which the digital goods travel, so it's pretty hard to justify their requirement to tax at the state level on digital sales."

--David Pakman, CEO
eMusic.com

The prospect of the dozens of states participating in the Streamlined Sales Tax Project, expansively interpreting the meaning of "computer software," worries some of the project's supporters, who fear the potential of a public backlash against the broader effort. Digital-media downloads are already addressed with a separate definition, they say, and should not be shoehorned into a category intended to cover only executable code.

In February, two top officials from the bipartisan National Conference of State Legislatures wrote a letter to the project's organizers, criticizing tax collectors' loose definitions (click here for PDF).

"We were concerned to learn that at least one state tax department has extended the state's definition of tangible personal property to include digital goods," wrote Texas State Senator Leticia Van de Putte and Iowa Speaker of the House Christopher Rants, co-chairs of the legislature conference's task force on electronic commerce taxation. "The task force believes that the decision to tax or not tax any item should be decided by each state's elected policymakers and not through departmental or administrative interpretation."

Scott Peterson, executive director of the Streamlined Sales Tax Governing Board, said he believes that the NCSL letter was referring to legal reinterpretations by Kentucky tax collectors. He added that the topic may be discussed at the board's meeting in Indianapolis, set to begin April 17 (click here for PDF).

"There is no debate about the ability of the Kentucky legislature to tax the sale of digital downloads," Peterson said. "The question is, 'What is the proper method for a state to tax digital downloads?'"

Krantz, of the Council on State Taxation, is coordinating a tax working group that includes Comcast, Microsoft and Amazon.com. He says multistate businesses have proposed a tightly worded definition of digital media to the Streamlined Sales Tax Project. "We're currently in negotiations over that proposal," Krantz said.

A 1992 court ruling's lasting impact
Not every business that offers music, movies or games over the Internet would be required to collect taxes right away, even if many more states begin to change their rules. That's because of the legal concept called "nexus," which means that a company can be taxed by a state only if it has a business presence there.

Nexus is why Seattle-based Amazon.com does not have to collect taxes on shipments to California, a state where the company has no office locations or substantial business presence. Nor is Amazon required to collect taxes on the e-books it sells for about $7 to $20 each.

In a 1992 case called Quill v. North Dakota, the U.S. Supreme Court affirmed the requirement of nexus, saying only Congress had the power to change those rules.

That decision has given rise to two classes of online sellers. Apple and Wal-Mart, in one class, have physical stores all over the country and could be required to collect sales taxes if each state mandated it. But companies without as many storefronts or offices, like Yahoo and eMusic.com, would be immune.

"eMusic is not required to collect state or federal taxes of any nature from our Internet customers; thus, we do not," said David Pakman, chief executive of the the New York-based music service provider.

The company had a 12 percent share of the music download market for computers running Microsoft Windows software as of January, according to NPD Group analyst Russ Crupnick, behind iTunes' 68 percent market share and in front of Napster's 4 percent.

"We'd like the exemption to continue," Pakman said. "We don't use any state or physical resources other than the networks over which the digital goods travel, so it's pretty hard to justify their requirement to tax at the state level on digital sales."

Backers of the Streamlined Sales Tax Project believe that once taxes are simplified, Congress can be persuaded to require retailers to collect taxes on sales even to out-of-state residents. Two bills that would do that--and effectively override the Supreme Court's 1992 decision--are pending in the Senate.

Until the federal government changes the rules, though, the political tussle over taxing digital downloads will continue in state capitols. Last year, Democratic Wisconsin Gov. Jim Doyle proposed a tax on iTunes purchases, with his administration calling it an "issue of tax equity." Republicans pledged to defeat it, and they ultimately prevailed.

"The Joint Finance Committee voted not to include that provision in the budget," Eva Robelia, a spokeswoman for the Wisconsin Department of Revenue, said this month.

That could be a harbinger for similar initiatives in other states.

"To have bureaucrats making these decisions is much worse than having our state legislature do it," Rockwell of the Mises Institute said. "But it's very bad no matter who does it."