Logging On to Cyberspace Tax Policy
Executive Summary
I. Introduction
The purpose of this white paper (hereinafter "the White Paper") entitled
"Logging On to Cyberspace Tax Policy," is to initiate discussions with the
nation's tax policymakers about state and local transaction tax issues affecting
the Internet and online services industry (the "Industry"). The White Paper was
prepared on behalf of and in conjunction with a Task Force of Interactive
Services Association ("ISA") member companies by Ernst & Young LLP./1
The Industry is important to the nation's economic growth and to individual
states' economic development in that it promises to grow dramatically in the
near future. Utilization of the Internet and proprietary subscriber networks/2
will provide increasingly significant consumer benefits, including improved
access to information, lower prices and increased business efficiency.
Much uncertainty exists as to the manner in which state and local taxes should
be applied to the Industry. The uncertainty results from a lack of understanding
of
The White Paper seeks to educate policy makers about the technology upon which
the Industry is based and about the unique nature of the Industry, as well as to
present practical and equitable recommendations which can serve as a basis for
construction of a uniform, consistent and fair tax scheme. The recommendations
are summarized in Section V, below.
II. Industry Background
Generally, members of the Industry are engaged in the sale of "access services"
and/or "content."
Retailers selling tangible personal property over the Internet and proprietary
subscriber networks are essentially mail order sellers who deliver their goods
to an identifiable address. The White Paper assumes that mail-order sellers:
The United States Supreme Court has ruled that states have taxing jurisdiction
over only those out-of-state sellers of tangible personal property who have
nexus (sufficient physical contact) with the state. When a transaction involves
a sale that is delivered electronically, the seller's lack of any physical
contact whatsoever with the state should insulate it from the state's taxing
jurisdiction./3
Generally, customers of ISPs and OSPs purchase telecommunications capacity from
telecommunications carriers in order to gain access to the Internet and online
services. ISPs and OSPs also purchase underlying transmission capacity from
telecommunications carriers to operate their businesses. All of these parties
pay taxes on such telecommunications services provided by the telecommunications
carriers.
Internet and online services, by their nature, are not designed with
geographical boundaries in mind. This severely limits the Industry's ability to
comply with tax administration requirements based upon locating either the
source or the destination of electronic transactions. When a sale is
delivered electronically, the ISP, OSP or Content Provider often cannot
determine the physical location of the sale's destination. This can be true
even if the Provider itself happens to be subject to the taxing jurisdiction of
the state of the user.
Internet and online services are experiencing rapid growth, but it is important
to recognize that the industry is still relatively young. The Internet and
online service marketplace has enormous potential, but the current level of
revenues is quite small both in absolute dollars and relative to
non-electronic sales of communication and information services.
Internet and online services are projected to grow rapidly during the next five
years, assuming that those services can continue to develop in the unimpeded
manner that they have over the past few years.
The states will often be unable to determine the locations of sellers over the
Internet and proprietary subscriber networks. In fact, the nature of the
Internet and online technology makes the physical location of the seller
irrelevant to the seller's business operations. Such a seller may be able to
operate in a state's market effectively from far beyond the state's borders,
where it may be immune to the state's taxing jurisdiction. Any government
seeking to require tax collection by such a seller faces a formidable challenge.
Only through close cooperation between the Industry and the policy makers can
there be hope of designing and implementing an effective tax system that takes
into account the unique nature of the Industry.
The Industry is concerned that if the states move too quickly, they will risk
creating, rather than resolving, major problems. Since relatively small amounts
of tax are currently at stake, there is time to work together to develop a fair
and efficient tax system. Such a system should ensure uniform application and
consistent administration of any tax while allowing the development and
expansion of the Industry. A deliberate and cooperative approach will avoid the
dangers that lurk in precipitate and uninformed action on the part of the
states, dangers that could hinder the development of the Industry.
The Industry believes that the only type of tax that can be applied effectively
to Internet and online transactions will be a transaction tax that is imposed
upon the purchaser, not upon the Industry; that, in the absence of better
information as to the location of the purchaser, a seller should be allowed to
rely upon the billing address to identify the state whose tax will apply; and
that the billed charges should be used to determine the amount of the end user's
tax liability. New developments, such as the increasing use of electronic cash
to pay billed charges, can be expected to produce new tax collection and
allocation challenges. The Industry stands ready to work with the states in a
cooperative effort to meet those challenges.
Inconsistency among the states in defining and applying terms defeats the
possibility of achieving uniform, fair and efficient administration of any tax.
Cooperative efforts must, therefore, concentrate on creating one set of
definitions for states to adopt, and those definitions must be interpreted
consistently from state to state.
The greatest threat to the type of tax system contemplated here is any
requirement that a remote seller must account for a multiplicity of taxes at
lower levels of government. Relieving the Industry of such a requirement is the
key to obtaining the Industry's cooperation to produce an effective tax
administration capability for the states with respect to electronic sales.
Such relief is a vital prerequisite to achieving the purposes set forth herein.
V. Recommendations
State tax rules should be uniform, fair, certain, and administratively simple.
They should not discriminate against electronic commerce or Internet-based
transactions, and they should not hinder economic growth. The development of tax
rules applicable to the Industry should be pursued with deliberation to ensure
the achievement of these goals. Specifically, it is the position of the ISA
White Paper Task Force that, if the states adopt a tax system applicable to the
Industry, that system should call for the following:
The above recommendations are intended to address the concerns of tax
policymakers, on the one hand, and the Industry, on the other. Their
implementation, however, can be accomplished only through close cooperation
between the Industry and the policymakers. Time is of the essence. The line of
communication is open.
An Interactive Services Association Task Force White Paper /5
I. Introduction: Goals and Purposes
It is almost impossible to pick up a magazine or newspaper or turn on the
television or radio anywhere in the Western world without hearing something
about the Internet or the World Wide Web. There is no shortage of hype or jargon.
Phrases like "information superhighway," "digital convergence," "interactive
television," "cyberspace," and "information age" are commonplace. In the United
States, policymakers at all levels are taking an interest in the Internet and
its potential to do everything from making American industry more competitive to
improving the quality of education. The predicted growth in the electronic
marketplace is staggering. The business promise is tantalizing. Once the
Internet and proprietary subscriber networks/6 are utilized by most Americans,
revolutionary changes will occur.
The excitement surrounding the world of electronic commerce has not escaped the
attention of state and local tax authorities, whose initial reactions have been
mixed. While some states appear not to have addressed the issue at all thus far,
others have interpreted existing transaction-tax statutes as not being
applicable to the Internet and online services industry (the "Industry"), and
still others have decided to study the Industry carefully before leaping to
conclusions. The latter states appear to be motivated by a desire to encourage
the development and growth of in-state Industry members.
On the other hand, some states are already taxing receipts from such Internet
and online services in one way or another. These states' initial reactions
appear to be motivated by concern about enforcement and compliance issues,
concern about the adequacy of the tax base, and a desire to collect additional
tax revenues.
The new electronic marketplace is in a relatively early stage of development.
Technology standards are still evolving; pricing methodologies and markets are
still being developed and tested. Pioneer sellers who seek to capitalize upon
the opportunities that electronic marketing presents cannot be certain of
success. But, without a coordinated effort between government and the Industry,
there will be a mixed bag of state and local tax consequences that will hamper
the development of this emerging Industry.
The states' ability to offer guidance as to how, whether, and under what
circumstances the Industry will be taxed is hampered by the constantly changing
nature of the Industry. It is also difficult to fit into existing statutory
molds services that were never contemplated when the tax statutes were enacted.
It is time for policymakers and the Industry to work together to achieve
rational, uniform and fair taxation.
The Task Force seeks to initiate that process with the White Paper. The focus,
recommendations and conclusions of this study pertain only to transaction-type
taxes. Such taxes are borne by the ultimate consumer. It is not the intent of
this paper to suggest that the Industry itself should be exempted from taxation.
The fact is that all members of the Industry are already subjected to a myriad
of state and local taxes, including income, franchise, property, payroll, and
business license taxes.
The goals of the White Paper are fourfold in nature:
Presenting a clear picture of the rapidly-growing, dynamic Industry is, in some
ways, like trying to change a tire while driving down the street. As the
technology upon which the Industry is based develops and improves, the number of
subscribers continues to grow. As a result, the Industry faces market demands
for improved services, such as quicker response times, simpler search
techniques, and better security. Industry members are meeting such demands by
forming strategic alliances among themselves to expand the range of services
available to their subscribers.
Moreover, Internet and online services are unique because they exist outside the
scope of the traditional telecommunications industry, which is itself subject,
in many instances, to state tax systems that are obsolete in that they were
designed when the telecommunications industry was an extensively regulated
nationwide monopoly. No such monopoly now exists.
Customers of Internet and online service providers purchase telecommunications
capacity from telecommunications carriers in order to gain access to Internet
and online services. What's more, Internet and online service providers
themselves purchase underlying transmission capacity from the carriers to
operate their businesses. Telecommunications carriers also provide the conduit
for transmitting information, data, or products from service providers to their
subscribers. While the Industry uses this conduit to accomplish its purposes,
its business is distinct from that of the telecommunications industry.
The growth of Internet and online services will be increasingly important to
every state's economic development. The Industry itself is investing tremendous
sums of money to improve its capabilities. As it does so, derivative benefits
will accrue to many other businesses, such as those that provide equipment,
personnel and services to the Industry. In addition, in-state businesses that
take advantage of the efficiencies made possible by Industry services will grow
and prosper. States whose tax policies do not impede the Industry's growth will
themselves experience increased prosperity. Technological opportunities will
naturally migrate to states that are tax friendly. Recognizing this, some states
are considering the possibility of shaping their tax policy to provide tax
incentives to the Industry in the form of such things as enterprise zones,
tax credits, and exemptions for research and development activities. The growth
of Internet and online services will also be important to every state's consumer
opportunities and educational programs. States and communities can encourage the
use of such services by providing low tax rates and exemptions to the Industry.
The services will open new possibilities to residents in rural as well as urban
areas, often without increasing the demand for physical infrastructure.
Encouraging the use of Internet and online services as part of educational
programs will provide students with vitally needed skills. On the other hand,
states and communities that inhibit the use of Internet and online services
through burdensome taxation and compliance requirements will place their
residents and businesses at a competitive disadvantage, ultimately stunting the
growth of local economies.
The United States Supreme Court has ruled that, under the Commerce Clause of the
United States Constitution, states have taxing jurisdiction over only those
out-of-state sellers of tangible personal property who have nexus
(sufficient physical contact) with the state./7 The Court's concern about
protecting the free flow of interstate commerce applies equally to all types of
sales, whether made electronically or by mail, whether they involve sales of
tangible personal property or sales of services. Thus, when a transaction
involves a sale that is made and delivered solely by electronic means, the
seller's lack of physical contact with the state insulates it from the state's
taxing jurisdiction. This is true regardless of whether the sale involves
tangible personal property or services.
An Internet or online service provider often does not know the geographical
location of its customer. Thus, even if the service provider is subject to the
taxing jurisdiction of a state, it may be unable to determine which of its sales
over the Internet or proprietary network have a destination in that state. The
reason is that Internet and online services, by their nature, are designed and
operate without reference to geographical boundaries. This severely limits the
Industry's ability to comply with existing state and local tax administration
requirements that are based upon locating either the source or the destination
of electronic transactions./8
Furthermore, once a subscriber has gained access to the Internet through the
facilities of an Internet or online service provider, the provider cannot know
which sites the subscriber visits on the Internet. This means that any thought
of imposing tax collection responsibilities on the service provider with respect
to third-party Internet sales should be dismissed.
Any tax system for the Industry should seek to achieve simplicity, uniformity
and fairness. Both the states and the Industry need reliable uniform taxation
guidelines in order to determine whether, how and/or upon whom any tax should
fall and how it is to be collected. Furthermore, both need a simple taxing
system that is easy to administer and to comply with, and that does not place an
unreasonable burden on the resources of either. In addition, neither wants state
and local tax obligations to hinder the growth of the Industry. The system must
encourage electronic entrepreneurs to enter the electronic commercial forum,
thereby contributing to the development of the electronic marketplace.
The development of rational tax policy can be accomplished only if readers of
this document understand the nature of the Industry. This section seeks to
explain how the Industry operates, the services that it offers, how those
services differ from telecommunications services, and why its services should
not be subjected to the same taxes as telecommunications services./9
It is the hope of the Task Force that policymakers, once equipped with an
understanding of the Industry and of the world of electronic commerce of which
it is a part, will work with the Industry to achieve a tax system that is
simple, uniform and fair.
The Internet is an international network of computer networks that is not, as a
whole, owned or operated by any single entity./10 It is made up of many networks
of various sizes. All of the computers on the Internet communicate with one
another through one communication protocol commonly known as TCP/IP
(Transmission Control Protocol/Internet Protocol).
The Internet began in 1969 as an experimental project of the Advanced Research
Project Agency (ARPA), and was called "ARPANET." It linked computers and
computer networks owned by the military services, defense contractors, and
university laboratories that were conducting
defense-related research.
From its inception, the Internet was designed to be a decentralized,
self-maintaining series of links between computer networks, capable of rapidly
transmitting packets of data without direct human involvement or control, and
having the ability to re-route communications automatically if one or more
individual links suffered damage or became otherwise unavailable, perhaps as a
result of war. These features allowed vital research and communications to
continue even if portions of the network were down. As it evolved, the ARPANET
came to be called the Defense Advanced Research Project Agency ("DARPA") Internet.
In 1986 the National Science Foundation (NSF) developed its high-speed network
to allow researchers access to NSF's new supercomputer sites and provide a
faster medium for data transmission between the sites. The sites were located
throughout the country to reduce total distance from each participant university
to the closest site. Because the sites were then tied together, a professor at
any university had the ability to contact any one of the supercomputer sites.
Other government agencies, including NASA and the Department of Energy, also
developed high-speed networks for the use of their researchers and personnel.
NSF's network (the "NSFNET") developed into the technical backbone of the
Internet, whereupon, in 1990, the ARPANET was no longer in use./11
Having reached far beyond its research origins in the United States to encompass
universities, corporations, and people throughout the world, the NSFNET is now
called simply "the Internet." As increasing numbers of private network companies
establish links, called "gateways," to the Internet for their private subscriber
online services, there is no limit to the extent to which the Internet can expand.
Data transfer on the Internet occurs primarily between a "client"
(e.g., a personal computer) and a "server," or "host" computer. The client
computer initiates a request for data and the server computer responds to, or
serves, that request. In order to serve the needs of client computers, host
computers are typically running and connected to the Internet 24 hours a day,
while client computers, particularly home or other individual computers, are
connected only intermittently.
The Internet has always been rich in content, but, until recently, not very
user-friendly. Because of this constraint, it had limited commercial
applications until the development of Web technologies, beginning in mid-1993.
The World Wide Web ("WWW" or "the Web") was designed at the European Particle
Physics Laboratory ("CERN") in Switzerland. In general terms, the Web environment
provides a user-friendly graphical interface./12
The Web environment allows access, with the click of a mouse, to a vast array of
data anywhere in the world. By simply clicking on a word, phrase or image, the
user can retrieve this data without knowing where it is located. This type of
active text is called HyperText. Clicking on the HyperText activates a link
(commonly known as a "marker") that contains instructions pointing to the
location of the data anywhere on the Internet. A coding language called HTML
(HyperText Markup Language) is used to create these links to different locations
on the Internet. The World Wide Web contains a multitude of "Web sites" which
are a collection of Web documents usually consisting of a "home page," which may
in turn link to other pages./13
Every Web site has a unique Internet address, called a URL
(Uniform Resource Locator) in the file system of a specific Internet server.
Because Web sites are linked together via Hypertext markers and share a common
appearance, they seem to be joined together seamlessly, even though, in reality,
they are scattered all over the world.
The Web was at one time viewed as just another method for arranging or
cataloging Internet content. Now, however, the huge and growing population of
Web sites itself requires cataloging. This problem has been addressed by the
creation of tools known generically as search engines, which pursue information
across the Web from a predefined set of objectives (e.g., a keyword search) and
browsers, which are software programs resident on the user's computer that allow
the user to view information located in databases connected to the Web. Internet
and online service providers are increasingly supplying such tools to subscribers.
Generally, members of the Industry are engaged in the sale of "access services"
and/or "content."
Access services are those services that enable a customer to get onto the
Internet and/or proprietary subscriber networks easily (for example, by simply
dialing a phone number). In general, an Internet service provider ("ISP") is a
business providing access to the Internet, while an online service provider
("OSP") is a business providing access to and content available on a proprietary
subscriber network. Many OSPs also provide their customers with access to the
Internet. ISPs and OSPs generally provide their services in return for the
payment of subscription and/or usage fees.
While content has been available via proprietary subscriber networks for years,
it is becoming more widely accessible via the Internet and WWW. Yet, revenues
from sales of content are only modest in comparison with their potential.
Content is made available to the public by OSPs, by some ISPs, and via Web sites
of third-party content providers. It consists of information and services
delivered to the public electronically via the Internet or proprietary
subscriber networks. Such services include travel, data processing, brokerage,
sports, and entertainment services; information includes items traditionally
delivered in tangible form, but which can now be delivered directly to the
user/consumer through his/her computer, e.g. newspapers, books, and music.
The following is an example of the way in which an ISP may operate. It is not
meant to be all-inclusive. An OSP may, in many ways, operate in a similar manner./14
The ISP's Internet access services are available to subscribers on a nationwide
basis by way of a national Point-of-Presence ("POP") network which extends to
virtually every major market. A POP typically consists of a leased room with
modems and routing equipment that may be either owned or leased by the ISP./15
There are generally no employees at any POP location. In the event that technical
difficulties occur at a POP, the ISP tries to correct the problem via remote
access. If this is not successful, it sends a technician to correct the problem.
A local POP provides the subscriber with access to the Internet via a local
phone number, as described below.
The ISP has two types of accounts: "dial-up" accounts, mostly for individuals,
who need only intermittent connections; and "direct connection"
(or dedicated-line access) accounts, mostly for business organizations, which
need continuous connections.
The ISP's dial-up account subscribers initiate access to the Internet on their
computers. A program instructs the computer to dial the ISP's POP at the
designated local access number. A transmission provider such as a Regional Bell
Operating Company ("RBOC"), a local exchange carrier or an interexchange carrier
maintains the connection between the subscriber's computer and the ISP's POP.
The transmission carrier bills the subscriber for the use of this connection in
the same manner that it bills for telephone calls. The subscriber pays
applicable state and local taxes on this connection charge.
Once connected to the POP, the subscriber is routed either through one or more
telephone company central offices to the ISP's "Hub," which consists of
high-speed data transmission equipment or to the ISP's Hub through a dedicated
link. Once connected to the Hub, the subscriber may be routed through one or
more telephone company central offices to the ISP's main operations center.
All communications (i.e., transmission) charges incurred beyond the POP are paid
by the ISP. The ISP pays applicable state and local taxes on these charges,
which become a cost of doing business and may affect its pricing structure.
The ISP's main operations center verifies the subscriber's identification and
password, whereupon the subscriber is routed back to the local POP and assigned
an Internet Protocol Address. The subscriber may then be routed from the local
POP through the Hub to a Network Access Point ("NAP") for access to the Internet.
A NAP, operated by a transmission carrier, consists of an electronic interchange
through which traffic is routed to final destinations.
The same steps apply, with some modifications, to a direct connection
subscriber, which generally maintains a dedicated connection between its place
of business and the ISP's POP. No authentication process is required of such a
subscriber, whose dedicated connection can be established on either a
"point-to-point" or a "frame-relay" basis.
A point-to-point subscriber leases both the connection from the subscriber's
place of business to the telecommunications carrier and the connection from the
carrier to the ISP's POP. The carrier bills the subscriber directly for its
services plus any applicable state and local taxes, just as would be the case on
any telephone bill. A frame-relay subscriber leases only the connection from
its place of business to the telecommunications carrier, while the ISP leases the
connection from the carrier to the POP. Here, again, the ISP pays applicable
state and local taxes to the carrier.
The ISP's core business is that of providing Internet access to subscribers for
a fee. In an effort to attract subscribers, ISPs frequently offer various other
products and services, such as Electronic mail ("E-mail") - This provides for
the exchange of messages among individuals anywhere in the world via the Internet.
Ability to create a custom Web site - Each of an ISP's subscribers can establish
a Web site on the Internet by entering specific data into an electronic
"template" provided by the ISP. The ISP's software uses this data to create the
Web site. More sophisticated subscribers can use HTML to create Web sites
without any ISP processing. 1-800 telephone services - These services are
offered for two purposes: 1) to enable callers to speak with the ISP's customer
service representatives regarding the ISP's products and services, and 2) to
make the ISP's Internet access services available to those subscribers who are
not located near a POP.
Various Internet software tools - These are software programs that enhance the
value of the ISP's services to the user. They may include e-mail management
software and filtering software that allows subscribers to control their
children's access to inappropriate content on the Internet.
Access to the WWW via search engines and browsers.
While potential use of the electronic marketplace is huge, actual usage of the
Internet and online services is currently relatively limited. A recent survey of
households in the United States and Canada revealed that only 17 percent of
individuals over the age of 16 had used the Internet during the previous six
months, 13 percent had used the World Wide Web, and only 14 percent of those
users, or 1.8 percent of the total population had purchased anything over the
Web./16 Most Internet and online subscribers currently use the Internet
principally to obtain e-mail capability and to browse information content./17
According to two industry research firms, SIMBA Information, Inc. and Jupiter
Communications, estimated domestic revenues from Internet access and consumer
online services ranged between $1.6 billion and $2.2 billion in 1995./18 Revenue
estimates for Internet access and consumer online services come from three
sources: subscription revenues for Internet access, subscription revenues for
consumer online services, and advertising revenues.
Revenues for Internet access services in 1995 totaled approximately $250 million
in 1995. /19
Revenue estimates for "online content packaging" in 1995 ranged from $1.2 to
$1.8 billion. /20
Content, which traditionally has been supported by subscription revenues from
online services, is increasingly being supported by advertising revenues as more
content moves to the World Wide Web. Ad spending on the World Wide Web and
online services totaled $131 million during
1995./21
Despite all the attention Internet and online services have received, they still
represent a small amount of revenue compared with revenue from communication
services. The $1.6 to $2.2 billion of revenues from Internet and online services
in 1995 represent only 0.8 percent of the $265 billion total communication
revenues (including telephone, television and radio broadcasting, and cable and
other pay-television services) in 1994./22 Advertising revenues from the World
Wide Web and online services represented approximately 0.3 percent of total
spending on television, network, radio, newspaper and magazine advertising./23
The Internet and online equivalent of mail-order sales of tangible personal
property in 1995 totaled approximately $500 million./24 Online sales of tangible
personal property involve the sales of such items as computer products, records,
books, apparel, and gifts and flowers./25 As a percent of traditional consumer
mail-order sales, the $500 million of Internet and online sales of tangible
personal property represent less than 0.4 percent of the $130 billion of
consumer mail order sales in 1994./26
While today's market for Internet and online services is relatively small, the
Industry is projected to grow rapidly during the next few years.
Estimates vary as to the extent to which revenues from Internet access and
online services will grow by 2000. One major research company projects a total
figure of $7 billion;/27 another projects $14 billion. /28 Projections also
differ as to the mix of subscription and advertising
revenues.
By 2000, the Internet and online equivalent of mail order sales of tangible
personal property is projected to reach $6.6 billion./29 This would be less than
5 percent of current consumer mail order sales, which constitute only 4 percent
of retail sales and only 2 percent of consumer
services./30
The growth of Internet and online services will generate new state tax revenues
from expanded employment, higher corporate profits from business productivity
improvements, and expanded use of telecommunication services. Internet and
online services will become an increasingly important source of employment in
individual states and localities. For example, Internet and online
services-related employment in five of the seven Task Force members grew from
approximately 3,500 employees in 1993 to approximately 9,500 employees in 1995.
This represents an annual growth rate exceeding 60 percent. Growth of this type,
which will generate both individual income and employment tax revenues, can be
expected by states that attract businesses through Industry-friendly tax and
business policies.
The growth of Internet and online services will affect other industries that are
important to state and local governments and their revenues. For example, the
growth of Internet and online services has contributed to a doubling of the
growth rate in telephone access lines in recent years. Telephone access lines
grew at a 4.6 percent annual growth rate in both 1994 and 1995, compared to only
2.3 percent in 1988 and 1989./31 Since telephone access and usage is currently
heavily taxed at the state and local level, this growth is already producing
additional tax revenues for state and local governments.
In addition, the growth of Internet and online services will increase the
productivity of many different businesses, making them more competitive in the
global economy and expanding U.S. sales of new products and services. Increased
profitability and investments as a result of the Internet and online industry
will also increase state tax revenues.
States should be careful not to rush to tax the small, but growing, Industry
before establishing rational and fair tax rules. The growth of the Industry will
depend upon a reasonable tax regime that does not impose higher burdens on
Internet and online services than on other types of services. The current usage
level of Internet and online services does not justify state concern about lost
revenue.
III. True Essence of the Industry
Retailers who sell tangible personal property over the Internet and proprietary
subscriber networks are similar to mail-order sellers who deliver their goods to
identifiable addresses. This activity encompasses sales of mail-order-type items
such as clothing and household goods ordered via an electronic catalog but
delivered by traditional means such as the postal service or common carriers.
For example, once online, a subscriber may purchase a T-shirt from a third-party
seller. The T-shirt is then delivered to the subscriber via the United States
Postal Service. This paper assumes that mail-order sellers:
are simply users of the Internet and proprietary subscriber networks in
marketing their wares over electronic facilities;
are protected by traditional constitutional restraints upon the states;
are subjected to traditional state use tax collection requirements; and
bill their customers directly for items sold.
Some ISPs and OSPs may also make sales of tangible personal property via the
Internet or proprietary subscriber networks. Any sale of tangible personal
property by an ISP or OSP is separate and distinct from its sales of access
services or content. The ISP or OSP makes a separate additional charge to its
subscriber for these sales of tangible personal property.
Some states are applying existing telecommunications taxes to Internet and
online services. This amounts to trying to fit a square peg into a round hole.
There are structural differences between the two kinds of services. One critical
distinction is that the Internet and online service provider often does not know
and cannot determine the point of origin or destination of the service being
received by the end user. This makes it virtually impossible to apply a
telecommunications tax that distinguishes, as it must, between interstate and
intrastate transactions. What's more, Internet and online services are easily
distinguished from telecommunication services based simply upon the fact that
what most subscribers use the Internet for has nothing to do with telephony.
Rather, most Internet subscribers use the Internet as a means of accessing
information.
The Industry's position that Internet and online services are not
telecommunications services is supported by definitions and determinations
included in the federal Telecommunications Act of 1996 (1996 Act)./32 That Act
defines the term "telecommunications service" as "the offering of
telecommunications for a fee." It defines "telecommunications" as "the
transmission
[1] between or among points specified by the user,
[2] of information of the user's choosing,
[3] without change in the form or content of the information as sent and
received." A service is a telecommunications service only if it meets all three
separate requirements. Neither the Internet nor any online service does so, as
we demonstrate below./33
An online service fails all three of these tests for defining a
telecommunications service.
An online service does not transmit information between or among points
specified by the user. It permits the user to choose the location of the user's
terminal or computer, but not the location from which the online service
emanates. Online services operate on a client-server model,
whereas telecommunication services operate on a peer-to-peer model.
An online service does not enable users to transmit information of their own
choosing. Instead, its essence is the interactive storage, retrieval, and
processing of information through electronic means. The fact that this is
accomplished across a transmission link, usually a telephone line, does not
transform the service into a telecommunications service.
Finally, the information provided by an online service is nearly always altered
in some way during the delivery to the end user. For example, documents and
files are stored in online databases in compressed form to make the best use of
available storage space; they are expanded or decompressed when delivered to the
user.
Internet access services fail to meet two of the three requirements of a telecommunications service. In this case as well, the provider does not deliver information between points of the user's choosing. Internet access services, like an online service, operate on a client-server model. The user may choose the client end of the communications path but has no choice about the server end. The user generally does not know or care about the geographic location of the host computer from which desired information emanates.
In addition, information transmitted between the Internet access provider and the user changes in form and content during the transfer. It is stored in as many different formats as there are kinds of computers.
The fact that Congress did not intend Internet and online services to be classified as telecommunications services is evidenced by the plain wording of the 1996 Act, which makes it clear that the services offered by Internet and online service providers are not telecommunications services. While the Act gives the Federal Communications Commission (FCC) authority to levy a surcharge on providers of telecommunications services only, the same provision authorizes the Commission to give the proceeds of these surcharges to providers of either telecommunications services or information services. If Congress had intended to authorize the Commission to impose a surcharge on providers of information services as well as on providers of telecommunications services, it would not have differentiated between the two in this manner. Texas has recently recognized the distinction, ruling that Internet access services are information services, not telecommunications services./34
The 1996 Act defines "information service" as the offering of a capability for generating, acquiring, storing, transforming, processing, retrieving, utilizing, or making available information via telecommunications. The protocol conversion capabilities of Internet and online access providers constitute such an information service in that they provide the means to process and transform information via telecommunications for use by the Internet. The other online functions provided by Internet and online service providers (e.g., bulletin boards and e-mail) offer the capability of generating, processing, storing, and retrieving information via telecommunications. Still other functions, such as news retrieval and stock quotations, offer the capability of acquiring, retrieving, utilizing or making available information via telecommunications.
Each state may have its own definition of an "information service," which may bear no relationship to the definition in the 1996 Act. However, Congress has acknowledged a difference between activities conducted by Internet and online service providers and activities which it has defined as telecommunications services. Most importantly, Congress has mandated that the two types of services receive different tax treatment. The states should follow suit.
For the following reasons, sound public policy dictates that Internet and online services be outside the definition of telecommunications services.
First, imposing a telecommunications tax on these services would have the unfair effect of taxing them twice. Internet and online service providers use the facilities of telecommunications carriers to deliver their services; these carriers are generally already subject to the state's telecommunications tax and, therefore, will pass the tax along to the Internet and online service providers in some form.
Second, officials at all levels of the federal government, from the FCC Chairman to Members of Congress, to the Vice President and the President himself, have made plain their view that all governmental policy should be designed to facilitate the rapid growth of the Industry. Any
unfair or unreasonable tax imposed at any level of the Industry's activities by any level of government would simply impede such growth.
Third, any decision that Internet and online services are telecommunications services would undermine the long-standing distinction made by the FCC between "basic services" (which were to be subject to regulation), and "enhanced services," (which were not to be subject to regulation).
This demarcation has several benefits. Foremost is the fact that it frees the more dynamic enhanced services field from any possible inhibitory effects of regulation, while at the same time it provides for continued public interest regulation of the basic communications services upon which
our national telecommunications industry is founded. Internet and online access services are enhanced services under the basic/enhanced dichotomy./35
Furthermore, the 1996 Act charged the Federal Communications Commission Federal-State Joint Board on Universal Service to recommend a new set of universal service support mechanisms. Such mechanisms are to be explicit and sufficient to advance the universal service principles
enumerated in the 1996 Act (e.g., to ensure quality telecommunications services at affordable rates to consumers, including low-income consumers, in all regions of the nation, including rural, insular, and high-cost areas). The Joint Board was to define the set of telecommunications services that should be supported by those mechanisms. In so doing, the Joint Board (which included 20 representatives from 13 states) determined "that the provision of Internet service does not meet the statutory definition of a 'telecommunications service.'"/36
VI. Issues at Hand
The Task Force believes that success in making tax sense out of the Industry's
activities depends upon the policymakers' attainment of a certain level of
electronic marketplace expertise. The Industry believes that now is the time for
it to help in this regard, since no significant exodus of commerce away from
local retailers to the electronic marketplace has yet taken place. There is
time, therefore, for policymakers to look before they leap, to become
sophisticated about the Industry, and to accomplish state purposes rationally
and constructively without hindering the Industry's potential for rapid
development.
State and local tax authorities worry that existing limitations on their
jurisdictional reach will result in a significant reduction in their tax bases
as more and more consumers purchase goods and services in the electronic
marketplace. Such a concern on the part of the states is misplaced. Electronic
commerce will not erode a state's existing tax base; it is similar to mail order
commerce in that it simply allows the state to tax only those transactions that
they are entitled to tax.
The earlier nexus discussion highlights the fact that remote sellers of tangible
personal property into a state via the Internet or private network are beyond
the jurisdictional reach of the state. This is as it should be. Tax authorities
should accept the fact that remote sellers of tangible personal property selling
online are functionally equivalent to remote mail-order vendors. Remote online
vendors should be afforded the same nexus protection as offline vendors.
Many states are already attempting to impose their existing transaction taxes on
the Industry. In doing so, these states are defining Internet and online services
inconsistently and are finding that Internet and online services cannot easily
be categorized under existing definitions. And the Industry is finding that, as
the states continue to try to shoehorn Internet and online services into
existing definitions of taxable services, the result is an application of tax
that is inconsistent, confusing and unfair.
Inconsistency among the states in defining and applying terms defeats the
possibility of achieving uniform, fair and efficient administration of any tax.
Cooperative efforts between the Industry and the states must, therefore,
concentrate on creating one set of definitions for states to adopt, and those
definitions must be interpreted consistently from state to state.
Further, it is imperative that those definitions clearly and accurately describe
the Industry and be easily applied to it. A principal concern of the Task Force
is that arbitrary or inaccurate tax distinctions will be drawn between the
various components of the Industry; for example, that the taxable nature of an
Internet or online service will depend upon whether it is purely an access
service, or access is "bundled" with other services such as a browser or
electronic mail capabilities.
It is not very useful to create definitions for the access versus content
provided by an ISP or OSP and then attempt to "carve out" different tax
treatment for each. Today, very few, if any, ISPs sell only access to the
Internet. Competition in the marketplace has forced most, if not all, ISPs to
bundle access services with some amount of content (e.g., a news service).
Likewise, access to a proprietary subscriber network, the Internet, and content
are all made available by OSPs to their subscribers for a bundled price.
Bundling of access services and content for a single subscription fee also
fosters use of Internet and online services in that less sophisticated
subscribers are not overwhelmed by being forced to make many decisions from an
"a la carte" menu of separately priced services each time the subscriber
attempts to access the online service. Absent full exemption from tax for
Internet and online services, the Industry and the states must work together to
create useful definitions which accurately describe the Industry and which can
be applied consistently from state to state.
Absent a rational, uniform taxing scheme which is appropriate for the Industry,
the states will continue to face formidable impediments to identifying and
locating providers and receivers of services and content, establishing taxing
jurisdiction over these parties, and collecting applicable tax.
Because the Industry has evolved rapidly in the marketplace, because state
legislatures often do not respond quickly to new tax challenges, because state
taxing authorities are saddled with trying to fit existing tax laws to changing
situations, and because each state faces each challenge within the parameters of
its own requirements as opposed to the overall requirements of states as a group,
there is no clear or uniform policy as to how the Industry will or should be
taxed among the states. Several states have begun to review the issue. The Task
Force appreciates the time and effort some states are devoting to identifying
and resolving the taxation issues facing the Industry. The Task Force believes
that the states and the Industry, working together, will benefit from a review
of Industry-related issues and that such cooperation between the parties will
result in a rational tax policy for the Industry.
As previously noted, several states are currently asserting that Internet and online service providers are subject to various of their state and local transaction taxes. Uniformity among the states imposing such taxes is scarce. This disparity among the states in their treatment of identical or similar services represents a significant impediment to the development of the Industry due to the following:
Pyramiding of taxes
Pyramiding of taxes, i.e., the charging of "tax on tax" occurs when a purchaser, e.g. an Internet and online service provider, is required to pay one type of tax on a purchase (e.g., of telecommunications carrier services) and another tax (e.g., a sales tax) on a subscription fee that includes the tax paid earlier.
Multiple Taxation
Multiple taxation involves subjecting the same transaction to more than one tax, e.g., a state's application of two different taxes to the same transaction or two states' application of their similar taxes to the same transaction. The absence of established situs rules regarding the taxation
of transactions occurring via the Internet or a private network (such as those rules governing the situs of traditional offline sales of tangible personal property) creates such a possibility. This is simply unacceptable to the Industry. It is, therefore, essential that, as suggested above, a
practical agreement between the Industry and the states be reached wherein Industry members may rely upon a subscriber's billing address in determining the situs of a sale.
VII. Conclusion and Recommendations
The Industry offers the states an opportunity to establish a tax scheme uniquely fitted to the Industry. That scheme should be characterized by uniformity, clarity, fairness, ease of compliance and ease of administration. It should contemplate appropriate exemptions to preclude multiple
taxation and tax pyramiding. It should also provide certainty as to when and whether any tax applies, who should pay it, who must collect it, how it should be collected, and what state is entitled to it.
The nature of the Industry's activities poses serious tax administration problems for the states and comparably difficult compliance problems for the Industry. Only by working together can the entities hope to establish an appropriate atmosphere in which their respective interests are
protected. For the states, that interest is to protect revenues; for the Industry, it is to enable the Internet to grow, to flourish and to achieve its full potential as a new medium. Before imposing or determining the rate of any transaction taxes on Internet and online services, states should
consider the beneficial impact that the increased productivity spurred by Internet and online usage will have on income tax revenues.
The sponsors of the White Paper want to make their position very clear, to wit: the growth of Internet access and online services should not be impeded either by expansive interpretation of existing tax laws or the imposition of new taxes on the Industry. However, if states do impose
taxes on Internet and online services, they should adopt uniform definitions among the states;
establish a single rate, within each state, of any applicable tax;
recognize the fact that the only type of tax that can be applied effectively to purchases made over the Internet or proprietary subscriber networks will be a tax on the purchaser with respect to the purchase transaction itself; attribute, to the extent possible, receipts from the sale of Internet and online services to the state into which the sales are billed; and
rethink nexus standards insofar as they apply to the Internet and Internet-based transactions.
The Industry urges policymakers to move quickly to become fully acquainted with the Industry in order to avoid premature actions that could jeopardize its future. Cooperative efforts between the states and the Industry can result in a proper approach to problems associated with the Industry, thereby protecting the best interests of both the states and the Industry. Time is of the essence. The line of communication is open.
1/This Executive Summary is copyrighted by the Interactive Services Association and its state online taxation white paper task force. With proper attribution, it may be quoted or reprinted. Companies having representatives on the Task Force include America Online, Inc., AT&T,
CompuServe Inc., GE Information Services, Inc., IBM, Microsoft Corporation, and NETCOM On-Line Communication Services, Inc.
2/For purposes of this paper, the term "proprietary subscriber network" refers to networks that are proprietarily or corporately owned but which make their services available to the public for fees. Private or intracompany networks, sometimes called "intranets," are outside the scope of the
White Paper.
3/ The White Paper explores the question of whether a Point of Presence (POP) in the form of readily movable equipment (e.g., a computer, modem or router) subjects a remote ISP or OSP to the taxing jurisdiction of a state for transaction tax purposes. The White Paper does not
address the question of whether a POP subjects a remote ISP or OSP to the taxing jurisdiction of a state for income tax purposes or a local taxing jurisdiction for property tax purposes.
4/The focus, recommendations and conclusions of the White Paper pertain only to transaction-type taxes. Such taxes are typically viewed as being a cost of doing business that is passed on to the ultimate consumer. It is not the intent of this paper to suggest that the Industry itself should be exempted from taxation. The fact is that all members of the Industry are already subjected to a myriad of state and local taxes, including income, franchise, property, payroll, and business license taxes.
5/This white paper (hereinafter "the White Paper") is copyrighted by the Interactive Services Association ("ISA") and its state online taxation white paper task force. With proper attribution, it may be quoted and reprinted. Companies having representatives on the Task Force include
America Online, Inc., AT&T, CompuServe Inc., GE Information Services, Inc., IBM, Microsoft Corporation, and NETCOM On-Line Communication Services, Inc. The White Paper was prepared by Ernst & Young, LLP on behalf of and in conjunction with the Task Force.
6/For purposes of this paper, the term "proprietary subscriber network" refers to networks that are proprietarily or corporately owned but which make their services available to the public for fees. Private or intracompany networks, sometimes called "intranets," are outside the scope of the
White Paper.
7/See Quill v. North Dakota, 504 U.S. 298 (1992).
8/Some observers contend that state and local taxation issues faced by the Industry are not unlike those faced by the Cellular telephone industry at its inception. That view is inaccurate for at least two reasons. First, though a new technology was being employed, wireless cellular services
were substantially similar to existing wireline telephone services. By way of contrast, Internet and online services utilize both existing and new technologies to provide unique services. Second, although wireless technology presented new challenges to the geographical sourcing of receipts
for tax purposes, the fact that the Cellular industry maintained geographical data made it possible for the Cellular industry and the states to agree informally upon a rational attribution method. Internet and online services are designed to operate without regard to geographical boundaries.
The Industry seeks to work with the states in identifying an appropriate approach for situsing Industry sales.
9/For excellent reviews of the Industry and of Industry-related activities, see Sections 2 and 3 of "Selected Tax Policy Implications of Global Electronic Commerce," Office of Tax Policy, Department of the Treasury (November 1996), and "The Nature of Cyberspace" in the findings of
fact in the decision of the U.S. District Court Eastern District of PA, in ACLU v. Janet Reno, No. 96-963, 6/11/96.
10/A network consists of two or more computers that communicate with each other by means of telephone lines, satellite links or other technologies. The networks that comprise the Internet are themselves owned and operated by individual organizations that "are administratively
independent from one another. There is no central, worldwide, technical control point. Yet, working together, these organizations have created what to a user seems to be a virtual network that spans the globe." M. Meeker & C. Depuy, The Internet Report 1-9 (1996).
11/See Wessells, Arnold & Henderson, Industry Report, " Internet Opportunities: Access, Service and Content"; May, 1995.
12/Technically, the WWW is a subset of Internet servers that support the HyperText Transfer Protocol (HTTP), which is the set of rules that is generally adopted by participating networks to control the transfer of most documents traveling over the Web.
13/For example, the ISA's home page (http://www.isa.net) provides information about the organization, as well as links to the home pages of its members and other related information.
14/There are, nevertheless, differences between ISPs and OSPs that are not addressed here.
15/Occasionally, an ISP will rely upon another ISP's POPs in providing its service.
16/See CommerceNet/Nielsen Media Research Recontact Study, published August 13, 1996.
17/See USA Today, October 9, 1996.
18/SIMBA Information, Inc., "Online Services: 1996 Review Trends and Forecast" and additional telephone conversations, and Jupiter Communications, Inc., www.jup.com.
19/Ibid.
20/Ibid.
21/SIMBA Information, Inc., "Online Services: 1996 Review Trends and Forecast" and unpublished information.
22/U.S. Department of Commerce, Bureau of the Census, Annual Survey of Communication Services: 1994.
23/Advertising Age, Sept. 2, 1996.
24/SIMBA Information, Inc. and Forrester Research, Inc.
25/Forrester Research, Inc.
26/Direct Marketing Association, 1996 Statistical Fact Book.
27/SIMBA Information, Inc.
28/Jupiter Communications.
29/Forrester Research, Inc.
30/Direct Marketing Association, 1996 Statistical Fact Book. Consumer services include financial, legal, tax return, etc. services.
31/US Telephone Association's "1996 Statistics of the Local Exchange Carriers."
32/1996 Act, Pub. L. No. 104-104, 110 Stat. 56. The 1996 Act amends the Communications Act of 1934, 47 U.S.C. §§ 151 et. seq.
33/This section briefly sets forth the ISA's position concerning the distinction between telecommunications services, on the one hand, and Internet and online services, on the other. For a full discussion of this matter, see Comments of the Interactive Services Association before the
Federal Communications Commission Federal-State Joint Board on Universal Service, April 12, 1996; CC Docket No. 96-45.
34/See the September 1996 issue of "Sales Tax Update," by John Sharp, Texas Comptroller of Public Accounts.
35/The FCC adopted a regulatory scheme under the Communications Act of 1934, as amended, that distinguishes between the common carrier offering of basic transmission services and the provision of enhanced services. This scheme is embodied in Section 64.702 of the Commission's
Rules, 47 CFR Section 64.702. Specifically, "the term enhanced services shall refer to services, offered over common carrier transmission facilities used in interstate communications, which employ computer processing applications that act on the format, content, code, protocol or
similar aspects of the subscriber's transmitted information; provide the subscriber additional, different, or restructured information; or involve subscriber interaction with stored information." Enhanced services are not regulated under Title II of the Act.
Basic services, on the other hand, are defined as the common carrier offering of transmission capacity for the movement of information. Basic services are regulated under Title II of the Communications Act of 1934.
36/In the Matter of Federal-State Joint Board on Universal Service, CC Docket No. 96-45, FCC 96J-3, (November 8, 1996), Section IV.C.3. paragraph 69.
52/Business licenses and fees are included here because many of them have the same effect as taxes.
53/According to Taxware International, Inc. there are more than 6,000 taxing locations and 65,000 potential tax jurisdiction combinations in North America. See Taxware International, Inc. www.taxware.com.
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