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E-commerce commission struggles with sales tax decision

With only four months left until it has to report to Congress, the Advisory Commission on Electronic Commerce still has critical decisions to make regarding when and how Net commerce and services should be taxed.

Paul Harris With only four months left until it has to report to Congress, the Advisory Commission on Electronic Commerce still has critical decisions to make regarding when and how Net commerce and services should be taxed.

The 19-member commission begins a two-day meeting in San Francisco this afternoon--its second-to-last meeting before it has to deliver recommendations to Congress. It is scheduled to discuss proposals on international taxes and tariffs on remote sales including e-commerce, taxes on Net access, and the so-called digital divide between technology "haves" and "have nots," which the federal government is trying to remedy through telecommunications taxes.

Congress created the panel as a part of the Internet Tax Freedom Act, which was passed last year and set a three-year moratorium on "discriminatory" taxation of online transactions and access providers.

But the commission is not simply issuing an opinion on whether or not the Net should be a tax-free zone. The members are treading into complex constitutional and legal territory that could impact the revenue streams of the country's more than 30,000 state and local jurisdictions, as well as the burgeoning e-commerce sector and Main Street U.S.A. establishments that now compete with online shops.

In an interview with CNET, commission member Paul Harris, a Republican member of Virginia's House of Delegates, said the panel is likely to reach consensus on a number of issues in the next four months, such as banning taxes on Internet access and prohibiting tariffs on Net-based transactions.

But Harris said that a consensus on the tough issue of standards for when e-commerce companies should be required to collect and remit sales taxes to states, for example, could prove more elusive to the commission.

"The sales tax issue is by far the most contentious issue facing the commission," Harris said.

The commission is meeting as the Internet in general and e-commerce in particular are experiencing tremendous growth. Jupiter Communications, for instance, projects that consumer spending online will grow to $78 billion in 2003 from $14.9 billion this year and $7.8 billion last year.

But as e-commerce grows, it's taking an increasing portion of consumer spending away from traditional retailers. A Jupiter study suggests that more than 90 percent of online sales come at the expense of offline retailers.

The shift in consumer spending to online merchants could hit state and local governments hard, because unlike offline retailers, Web stores typically don't pay sales taxes on their transactions. Although e-commerce makes up only a small portion of retail sales today, that's changing quickly, and the sales tax issue could become more critical as e-commerce transactions grow.

Some state government officials worry that if a large part of those purchases remain exempt from sales taxes, states will be faced with revenue shortfalls that will force them to cut services.

Specifically the commission will try to set uniform standards--which could be adopted by Congress--regarding what constitutes a business's physical presence in a state and therefore invokes requirements that the company collect and remit sales or use taxes. The question then is not so much whether states will be able to charge tax on e-commerce transactions, but which transactions will incur a sales tax and how states will be able to collect the tax.

Mail-order companies, for example, are not required to collect and remit local and state sales taxes from nationwide buyers unless they have a physical presence, known as having "nexus."

Supreme Court decisions have set out a range of criteria for nexus, from having a warehouse to a sales team in the state.

But in the age of the Internet, the nexus standard has been murky, with advocates arguing over whether a computer server or even a Web page constitute a point of presence within a state.

Large catalog companies, such as Spiegel, usually voluntarily collect the taxes for all states regardless of nexus because they have a presence in many territories.

E-commerce companies, by contrast, frequently have more concentrated operations., for example only collects sales tax in Washington state, where it has its headquarters, and in a handful of states, such as Delaware, where it has distribution centers. Customers in California, Texas and other states don't pay sales taxes when they buy items from Amazon. Harris said the nexus issue has divided the commission into two factions.

One faction, led by Virginia Gov. James Gilmore, who See Newsmaker: Building the Silicon Dominion chairs the commission taxes, wants a narrow reading of nexus, so that only companies with a "substantial" physical presence in a state would be subject to the state's sales taxes. Gilmore even has gone so far as to propose a "tax-free zone" on the Internet where all e-commerce sales would be free from sales taxes.

Headed up by Utah Gov. Mike Leavitt, the other faction proposes more of a status quo on the nexus issue. Although few do it, consumers are technically supposed to pay use taxes on transactions where they do not pay sales taxes. Leavitt's proposal would set up a third-party system that would collect both sales and use taxes and distribute them to states.

Harris, who is a member of the Gilmore-led faction, said that trying to collect sales taxes on Net transactions is shortsighted and could be prohibitively difficult for small and medium-sized firms that are selling on the Net. He added that states don't need the money, because they have enjoyed billions of dollars in surplus revenues in recent years.

"I think that it's far too early in the new economy to impose large and complex tax requirements on small businesses," he said.

The commission requires a two-thirds vote to pass a proposal. But Harris suggested that neither faction has the votes to pass its proposal on sales taxes.

"I don't sense that there's any consensus on the nexus requirements," he said.

One way around nexus has been the adoption of so-called use taxes, which are collected from customers on the "use of tangible personal property."

Historically such taxes are hard to enforce and widely ignored, however, and there is little reason to think they would be more successful online.

At issue is a 1993 Supreme Court decision, Quill Corp. vs. North Dakota, which found that the commerce clause of the Constitution prohibits "states from compelling out-of-state mail-order houses to collect use taxes on sales to in-state residents."

As a result, mail-order companies cannot be forced to collect so-called use taxes. The Quill decision also could derail attempts by states to apply any e-commerce use taxes.

One way the commission might deal with the sales tax issue is to simply ignore it for now. Harris said the commission is forming a consensus on extending the three-year moratorium on new Internet taxes put in place by the Tax Freedom Act for another five years.

The areas where the commission has achieved some consensus don't represent major achievements, either.

For example, erecting tariffs on international exchanges would go against the general free-trade direction of the U.S. government. And the Federal Communications Commission has already said that it will oppose taxes on Internet access, since access providers already pay such taxes to the nation's Universal Service Fund, which subsidizes phone service for rural and low-income residents and Net connections for schools and libraries.