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Congress weighs curbs on state 'iTaxes'

A state-by-state fight over taxing iTunes and other digital downloads shifts to Washington, where Apple, AT&T, Electronic Arts, and others want the feds to step in and slap limits on state governments.

Digital 'iTax' download tax map
Caption: 23 states and the District of Columbia currently tax digital downloads, but critics say 11 lack explicit legal authorization. Graphic courtesy of the Sutherland Asbill & Brennan law firm.

If there are two things state tax collectors seem to agree on, the first is that finding more money could really come in handy right now. The second is that taxing iTunes and other digital purchases might just do the trick.

A new proposal in the U.S. Congress is, however, designed to curb many of these "iTaxes," which have popped up all over the country in the last three years. Currently, some 23 states and the District of Columbia levy sales taxes in one form or another on e-books, music, apps, ringtones, and other digital downloads.

The bill, sponsored by Reps. Rick Boucher (D-Va.) and Lamar Smith (R-Tex.), is part of a broader effort by technology firms and telecommunications providers to push back against what they view as tax agencies that are unreasonably singling out electronic purchases with unfair, expensive, and confusing rules.

Apple, AT&T, Electronic Arts, Cox Communications, Verizon, T-Mobile, and Time Warner Cable are among the companies that have endorsed the legislation, saying that "fast-paced technological and commercial changes are making it increasingly difficult, and in some cases nearly impossible" to comply with "confusing and conflicting" state tax laws.

Even cloud-computing applications, which might seem straightforward enough, can create tax headaches for Internet companies. New York and Utah both tax cloud computing, but New York taxes it based on the address of the customer, while Utah calculates rates based on where the server is located.

"It is definitely a growing problem as states that are adopting legislation each take a different approach to the issue," says Stephen Kranz, a partner at the Sutherland Asbill and Brennan law firm who tracks state legislation. "As electronic delivery of content and services grows, so too will the problems associated with multiple and discriminatory state and local taxation."

"Tax administrators say that a ringtone is the digital equivalent of tangible personal property. What do they think it is? A doorbell?"
--Steve DelBianco, executive director, NetChoice

Other states have singled out downloaded music for tax rates reserved for "telecommunications services" that are more costly than sales tax rates, Kranz says. Some rates can even go as high as 15 or 20 percent. (Industry figures from 2006 show (PDF) that the average telecommunications tax on wireless is 10.94 percent, far higher than the 6.94 percent average nationwide rate for sales taxes.)

Opposition to the legislation introduced last week, titled the Digital Goods and Services Tax Fairness Act, is likely to come from state and local officials concerned that Washington might slap unreasonable limits on their tax collection procedures.

Neal Osten, who oversees federal-state tax issues for the National Conference of State Legislatures, said on Wednesday that he has not yet reviewed the bill. The National Governors Association did not immediately respond to a request for comment. Scott Peterson, executive director of the multi-state Streamlined Sales Tax Governing Board, said his organization has not been asked to take a position on it.

Boucher, one of the measure's two sponsors, represents a rural Virginia district that's been targeted by Republicans for a takeover this fall by State Senate Majority Leader Morgan Griffith. Lending his support to a lower-tax measure is likely to help Boucher, who said the bill was necessary because "unfair, multiple, and inconsistent taxation of these digital goods and services will increase costs for U.S. businesses and make them less competitive in the global economy."

Perhaps the most controversial part of the Boucher-Smith bill is the section that says only those iTaxes on downloads that have been formally approved by state legislatures are valid. That would end what critics describe as the controversial practice of state tax collectors stretching century-old legal definitions to permit levying iTaxes without any actual authorization.

CNET first described the phenomenon in a 2006 article, which cited examples like Kentucky's law that did not explicitly permit iTaxes. Nevertheless, Jill Midkiff, a spokeswoman for the Kentucky Department of Revenue said at the time, "Music is included because music downloads fit the definition of personal property."

Since then, 10 states and the District of Columbia now say digital content is tangible personal property, even though their legislatures have never made that clear. Those states are Texas, Arizona, Colorado, Connecticut, New Mexico, Louisiana, Alabama, Idaho, Hawaii, and Maine, according to the Sutherland law firm's research. (Thirteen other states tax digital downloads based on specific laws instead of administrative interpretations.)

"Tax administrators say that a ringtone is the digital equivalent of tangible personal property," says Steve DelBianco, executive director of the NetChoice coalition, whose members include AOL, eBay, and Yahoo. "What do they think it is? A doorbell? You can't let a tax administrator who never has to stand for reelection deem things as 'taxable.'"

Another portion of the bill prohibits taxes on "digital medical services, digital education services, or digital energy management services."

A third section would prevent "multiple or discriminatory taxes" on "digital goods or digital services." That amounts to a preemptive strike against state and local governments that might decide that digital purchases should be taxed at, say, two or three times the normal sales tax rate.

Thanks to an all-but-forgotten law that expires on November 1, 2014, such electronic-only taxes currently are prohibited. But once the moratorium expires, states will be free to levy discriminatory taxes unless the Boucher-Smith bill is enacted.

"Legislation like this is necessary because tax administrators have been so aggressive in reaching for new taxes on digital goods and services," DelBianco says. "With the expiration of the moratorium in 2014, nothing will stand in their way." (The National Taxpayers Union also likes the bill, calling it an "excellent" first step.)

State tax collectors haven't exactly been idle. They've been trying to force Amazon to turn over purchase records in North Carolina; attempting to force retailers to become tax-tattlers in California and Tennessee; and putting the squeeze on affiliate programs in Colorado. The Direct Marketing Association sued Colorado last week, saying its law requiring out-of-state retailers to turn over purchase history information is unconstitutional.

Meanwhile, Rep. Bill Delahunt, a Massachusetts Democrat, introduced a bill last week that seeks to compel retailers like Amazon to collect sales taxes.

The Boucher-Smith bill "removes one avenue for states to tax Internet commerce at oppressive rates," says Kelly Cobb, government affairs manager for Americans for Tax Reform, which runs the Stop eTaxes Web site. "However, the battle over the next year will be fought with those who look past digital goods and just want to tax everything online, despite the constitutional violations."