CompCon

To Tax Or Not To Tax Internet Transactions

By Ted Laliotis

This talk was a keynote address delivered at COMPCON ’97 on February 25, 1997, San Jose Hilton & Towers Hotel


Franklin (15589 bytes)Benjamin Franklin wrote in a letter to M. Leroy, in 1789, “….in this world nothing is certain but death and taxes”

However, there is a major difference between the two. Death is absolute, like a digital bit which is a one or a zero, you are either alive or dead. On the other hand, taxes is an analog function whose value depends on the philosophy and the greed of your government.

AllenWoody Allen said “On the plus side, death is one of the few things that can be done just as easily as lying down” however, we may not want to take taxes as easily as lying down.

In fact, Benjamin Franklin in another occasion wrote: ” Idleness and pride tax with a heavier hand than Kings and Parliaments. If we can get rid of the former, we may easily bear the latter”

We can’t control death, Dr. Kevorkian excluded, but we can control taxes by choosing our elected government officials, who in turn drive the government’s philosophy and define the level of greed, excuse me, I should have said “the level of spending” to be politically correct.

However, I am not here today to be politically correct. I am here to raise a number of questions and raise the level of awareness among all of you in the audience today on this very critical issue of Taxing or not Taxing Internet Transactions.

All of us in this room worked very hard for a long time to create the information technology which is fueling the greatest economic revolution since the industrial revolution of the previous century.

We can not afford to stand idle and let electronic commerce, the most potent component of this economic engine, be stifled by excessive government regulation and particularly, taxation of Internet Transactions.

My goal today with this presentation and the panel session that will follow at 2:15, is to analyze the issue of taxation of Internet transactions and provide all of us with the information on this issue so that each of us can formulate our own opinion and position and then take an active interest in influencing our elected representatives.

As we all know, the purpose of taxes in a society governed by democracy is to provide the financial resources for funding the government services that can be best provided collectively.

In our country, the United States, there are taxes levied by the Federal government, State government, and local government and those taxes fall in the general categories of income taxes, property taxes, and transaction taxes. While income taxes are predominately levied by federal and state governments, property and transaction taxes tend to be mostly in the domain of state and local governments, even though the federal government has been quite active in property and transaction taxes in the form of luxury item taxes, excise taxes, fuel and energy taxes as well as communication taxes such as the federal tax on your telephone bill. A recent article in the familiar publication “Communications of the ACM” on the subject of taxing Internet Transactions reflected the governments attitude in the article’s title: “If It Grows, Tax It”. The article continues, “Some people see the Internet as a world-wide free speech machine. Tax officials see it as a cash cow and as a potential tax-evasion machine”.

The bottom line is that government, at all levels, can get very creative in finding ways to levy taxes wherever they see an opportunity. Internet Transactions is such an opportunity and the question is should the industry stand idle and let government at all levels make their own decisions or should the industry take an active role early-on? Industry can play a key role to influence government’s decisions in a direction that will avoid tunnel vision and short sighted objectives in favor of the long term benefits for all concerned.

If electronic commerce is not stifled by excessive government regulation and taxation and is allowed to grow and flourish, every one will benefit because of the strong economic growth that it will produce. Jobs will be created, income taxes will grow, consumers will benefit, and local economies will be fueled, thus boosting the well known benefits of stronger real estate prices, and higher sales tax revenues. In other words, a WIN-WIN situation all around for consumers, the industry and the government.

If electronic commerce is burdened by excessive government regulation and taxation, it could very well be that the opposite result will be achieved. Given that it is technologically feasible for the industry to invoke the self-protective mechanism of virtual presence in cyberspace, it is possible that electronic commerce providers will operate out of cyberspace with virtual presence out of state and perhaps out of the country. This would not be a WIN-WIN situation but rather a LOSE-LOSE situation.

In a letter sent to White House advisor Ira Magaziner, the Internet Society, a leading international organization for the technical, economic, and policy development of the Internet, wrote that taxing businesses conducted on the Internet should not be done at this time because it could constrict an industry in its early stages of development. Martin Burack, executive director of the Internet Society wrote: “Governments appear to view electronic commerce on the Internet as a golden goose that will yield many eggs. We urge all to give the gosling the opportunity to grow to puberty before being asked to give up any gold”.

Electronic commerce is at the infancy stage of an explosive growth potential. It is at the infancy stage because industry standards for electronic payment systems, privacy, and security are still in the process of being developed. This is the right time for industry and government to work together towards a WIN-WIN situation in accommodating the needs of the industry besides a hands off policy on taxation.

As an example of the need for regulatory cooperation, in a press release last year, the Internet Architecture Board and the Internet Engineering Steering Group wrote “…ready access to adequate cryptographic technology is a key factor to the growth of the Internet as a motor for international commerce and communications. Security mechanisms are now being developed by the Internet Engineering Task Force to meet these needs and depend on the international use of such technology…. Governmental restrictive policies are against the interests of consumers and the business community and are largely irrelevant to issues of military security and provide only marginal or illusory benefit to law enforcement agencies”.

Estimates of consumer online transactions for the sale of tangible personal property in 1996 vary widely depending on which market research company’s numbers you read. However, it is in the order of $500 million, which is approximately 0.5% of consumer mail-order catalog sales. These numbers are projected by the same market research firms to be well into the double digit of Billions of dollars by the year 2000.

However, the full spectrum of electronic transactions besides revenues from the sale of tangible personal property includes revenues from Internet and proprietary subscriber network access services, revenues from content access fees, revenues from financial transactions, revenues from advertising services, and revenues from communications services. When all of those revenues are added up, the numbers could easily get up to the hundreds of billions of dollars by the year 2000.

Besides the Internet Society mentioned earlier, there are two other organizations spearheading efforts to promote the unimpeded growth of electronic commerce. Those are the Interactive Services Association, and the Association of Online Professionals.

The Executive Director of the Association of Online Professionals, Dave McClure, and a member of the Interactive Services Association Task Force on Online State Tax Committee, Tom Cook, will be on the panel that follows this talk at 2:15 pm to help dig deeper into the issue of taxing Internet transactions and I hope that you will join us.

The Interactive Services Association which represents major Internet and Online companies in a white paper released December 20, 1996 has taken the position that taxation of Internet transactions is probably inevitable. If so, they offer to work with the states in making taxation fair and uniform across the states born by the purchaser rather than the service provider. That may be logical since they represent online companies, but it is debatable by consumers and other online professionals.

The Association of Online Professionals is mounting an aggressive campaign to ban Internet taxation all together. James Butler, a leading online industry attorney who serves as counsel to the Association has said “States are not allowed to impose taxes that would improperly restrict interstate and international commerce”. Furthermore, the AOP is actively assisting the offices of Senator Ron Wyden (D-OR) and Representative Christopher Cox (R-CA) in drafting and gaining passage of new legislation to impose a federal moratorium on taxation of products and services sold online. A recent AOP press release states ” AOP believes that a federal ban on inappropriate state and local taxes would send a clear signal to the states and provide the first effective relief from taxes that have already begun to impact the growth and stability of online commerce”.

The Clinton Administration has developed a draft policy for Global ElectronicCommerce through an interagency working group chaired by Ira Magaziner, Senior Advisor to the President for Policy Development. Interagency participants included representatives from the Departments of Treasury, State, Justice and Commerce, the Council of Economic Advisors, the National Economic Council, the National Security Council, the Office of management and Budget, the Office of Science and Technology Policy, and the office of the US Trade Representative.

The current draft has been available for public comment and can be found on the web at www.iitf.nist.gov/eleccomm/exec_sum.htm

Some excerpts from the draft are as follows:

“The Clinton Administration firmly believes that all parties can gain from a non-regulatory, market-oriented approach to electronic commerce. By acknowledging the unique characteristics of the Internet and avoiding undue restrictions, governments can take advantage of a historic opportunity and contribute to the growth of electronic commerce worldwide.”

Major policy recommendations in the draft include:

1.   Establishing cyberspace as a duty-free zone

2.   Advocating for no new taxes on the Internet

3.   Allowing electronic payment systems to evolve
without premature government involvement

4.    Encouraging industry self regulation where
appropriate

5.    Enabling market forces to drive the
development  of technical standards

6.   Opposing non-tariff barriers which limit free
trade across the Internet, such as content
restrictions, discriminatory telecommunications
regulations, standards requirements, or
anti-competitive compulsory licensing
requirements

Furthermore, Deputy Treasury Secretary Lawrence Summers said: “We absolutely reject the idea that the Internet is some sort of golden goose whose feathers shoud be taxed”.

All of these recommendations and comments sound politically correct and very encouraging as far as the regulatory issues of Internet transactions. On the taxation issue however, we need to look at a white paper published by the Department of the Treasury entitled: “Select Tax Policy Implications of Global Electronic Commerce” that can be found at:http://www.ustreas.gov/treasury/tax/internet.html

I am quoting from the executive summary of this white paper:

“In order to ensure that the new technologies not be impeded, the development of substantive tax policy and administration in this area should be guided by the principle of neutrality. Neutrality rejects the imposition of new or additional taxes on electronic transactions and instead simply requires that the tax system treat similar income equally, regardless of whether it is earned through electronic means or through existing channels of commerce.

A major substantive issue raised by the new technologies is identifying the country or countries which have the jurisdiction to tax such income. It is necessary to clarify how existing concepts apply to persons engaged in electronic commerce. In addition, transactions in cyberspace will likely accelerate the current trend to de-emphasize traditional concepts of source-based taxation increasing the importance of residence-based taxation”.

Translation: US residents will probably be heading for Florida or other states that have no state income tax.

However, considering the global picture, we should keep in mind that currently the United State taxes income on the basis of both the source of the income and the residence of the person earning the income. US source income is subject to tax when earned by foreign persons as is the worldwide income of US citizens, residents and corporations. Source of income principles are generally similar worldwide. In general, the source of income is located where the economic activities creating the income occur. I the case of Internet transactions though it is not clear as to which of the following constitutes “economic activity” : the local modem of a service provider, commonly referred to as the point of presence (POP); the location of the server of the Internet Service Provider (ISP); the location of the server that holds the web page, the physical location of the warehouse that goods may be shipped from; or the physical location (residence) of the owner of the business. This picture will get even more complicated when standards for “digital” or electronic money are developed and transactions occur in such units in a global environment.

It should be pointed out that currently, the United States has comprehensive income tax treaties with 48 countries. The rules comprising those tax treaties generally tend to give the residence country an a greater right to tax income while limiting the source country’s right to tax. It is not clear cut or universal though, and as pointed out earlier the United States currently taxes income on the basis of both the source of the income and the of the income earner.

Complicated as all of this may sound, that is the good news because it deals with income taxes which we all expect to have to pay regardless whether the income is earned via electronic or traditional commerce. The bad news is when we start looking into sales tax considered by states. What is encouraging at the federal level at this point is that federal agencies are not openly advocating taxing service transactions or imposing sales or other value added taxes on the sale of tangible personal property. What is somewhat unsettling is that they are saying “no new taxes”, and of course, we have heard that before. This leaves the door open to interpretation as far as extending existing taxes to Internet transactions and services such as communications surcharges.

Perhaps the best assurance for not killing the goose before it matures and lays golden eggs is to support and assure passage of the federal legislation that I mentioned earlier proposed by Senator Wyden and Congressman Cox to impose a federal moratorium on taxation of products and services sold online. I hope that you will contact your elected officials and encourage them to support those bills.

But let us now turn our attention to what is likely to be potentially the big problem: sales and service taxation of online transaction by states and local governments.

States and local governments derive their revenues from a variety of sources which include income tax, sales tax, property tax and other fee for service taxes. All states and local governments have some sort of property tax. However, some states have income tax but no sales tax, such as Oregon, some states have sales tax but no income tax, such as Florida, and some states have both, such as California.

There are two problems here. Number one, there is no uniformity, and number two there is great dependency on sales taxes in some states, counties, and cities for their revenues and therefore, they are not likely to stand idle and loose their sales tax revenues.

Sales taxes would appear to be logical and straight forward because there exists the model of applying sales taxes to catalog or other mail order sales from out of state suppliers. The current model obliges the seller to collect from the buyer the sales tax required by the state of residence of the buyer and to remit that sales tax to the state of residence of the buyer. However, the United States Supreme court has ruled that states have taxing juristiction over only those out-of-state sellers of tangible personal property who have nexus (sufficient physical presence) with the state. You can see how some people will argue that some Internet transactions deliver goods electronically where there is no physical presence or contact with the state and therefore, the state has no taxing juristiction.

As it was pointed out earlier, it may be difficult to locate the seller, or even the buyer, in cyberspace. It may be difficult to establish nexus. It may be difficult to remit taxes if the seller is located in some third world country. It may be difficult to establish exchange rates when standards get established for e-cash or digital money, or electronic money, whatever you want to call it. And it may be impossible to even detect a transaction if privacy and encryption standards get developed without the government at all levels holding the keys to decryption and the rights to snoop in data bases.

Now, perhaps, we start to understand and raise the question: Is it really national security or is it the threat of loosing income that drives the government to want to control encryption and privacy standards?

And then we ask the next question: Considering the variability of taxing methods among the states, the dependency on taxes for survival by the states, the general lack of understanding of technology by the preponderance of legislators, and the privilege of legislators to pass any law they want, is there a concern that legislation may be enacted that will impede, if not suffocate, the development of electronic commerce in some states, or even in the United States.

The answer is YES, there is a tremendous concern.

The bottom line is that there is an unstoppable momentum, worldwide, to develop electronic commerce internationally. The highest and latest technology will be applied in a continuously evolving manner, as it always happens with technology. The United States is not the only source of technology. Europe, Japan and other far east countries can and will develop privacy, encryption, and e-cash standards, and there will be a faundamental change of paradigm as to how commerce is transacted, both within the United States and worldwide. It may take three years, or it may take thirteen years, or as probably will be the case, it will happen seamlessly and slowly over a long period of time.

Federal, states, and local governments have to realize that the change will occur with or without their concent. Their choices are:

A. Hang on to existing models and try to extend
the applicability of such existing models to
e-commerce.

B. Step back five feet, let go of the existing models,
and use their legislative powers to set up new
revenue derivation systems that will work with
and take advantage of e-commerce instead of
trying to work against it.

If they choose A, they will probably survive for a while but they will alienate and drive a lot of
businesses either underground, or out of state, or out of the country. This would be a
LOSE-LOSE situation

If they choose B, they will encourage businesses to stay and prosper within their jurisdiction rather than flee, physically or electronically.

I hope I have given you a lot of food for thought and I look forward to debating some of these issues during the panel session that will follow at 2:15