State and Local Taxation of Electronic Commerce: The Forging of Cyberspace Tax Policy

Prebut, David S., Rutgers Computer & Technology Law Journal

INTRODUCTION

The development of the information superhighway(1) is transforming traditional business practices and creating new competitive industries for the global economy. A major component of the information superhighway, the Internet, has vast potential for conducting electronic commerce and is currently generating significant tax policy implications at the federal, state, and local levels of government. Current tax principles, however, are not easily applied to the attributes of electronic commerce. Accordingly, taxing authorities must implement new and innovative taxing structures for electronic commerce so as not to hinder the progress of the Internet and the information superhighway.

This article analyzes the current development of state and local cyberspace tax policy, as electronic commerce is on the brink of becoming one of the most significant economic stimulants of the century. The discussion will begin by tracing the development of the Internet from its inception as a military project to its current use as a tool to facilitate electronic commerce. This article will then discuss how the judicial, executive, and legislative branches of the federal government have reacted to the state and local tax implications of electronic commerce. The federal judiciary may craft initial tax policy by applying existing tax law to cases involving electronic commerce.(2) The executive branch, particularly the Department of the Treasury, can generate tax policy initiatives.(3) Only Congress, however, may introduce and pass tax legislation combining both tax law and tax policy.(4) Finally, this article discusses the possible future of cyberspace tax law and policy and examines the Internet Tax Freedom Act which is currently pending in Congress.(5)

I. THE RISE OF THE INTERNET

The Internet, short for interconnected networks, is an international aggregation of computer and communication networks that includes the users of the network and the resources available on the network.(6) Though not an entity in and of itself, the Internet is a dynamic group of networks that is constantly changing as users enter and exit.(7) Instead of a central computer or central control location, the Internet has a standard method of transmitting data among different networks.(8) Information is able to travel over the multibillion dollar telephone networks thereby creating a virtual network running on top of the existing physical network of the telecommunications companies(9)

The Internet was originally a networking concept developed by the United States Department of Defense Advanced Research Projects Agency in 1969 designed "to allow computer scientists and engineers working on military contracts all over America to share expensive computers and other resources."(10) Initially, its intent was to connect a small number of large national networks, such as universities and high-tech Department of Defense contractors.(11) By 1978, however, the network had adopted a standard protocol thereby becoming more adept at connecting a larger number of smaller networks and had expanded its access capabilities to include a much broader class of networks.(12) Built on an existing foundation of standard interoperable protocols and technologies, the entire infrastructure of the Internet now constitutes a level playing field on which all companies, small and large, seek innovative applications and new technologies that add value to the existing framework.(13)

Expanded use and popularity of the network in the 1980s came about when the Department of Defense began to relax its hold on the existing network and the National Science Foundation ("NSF") began to develop a high-speed network of its own.(14) The National Science Foundation's network ("NSFnet"), which later evolved into the Internet, created supercomputer centers to link regional networks of research and academic sites.(15) Quickly, use of the NSFnet expanded beyond its research origins to include universities, government agencies, corporations, and the public at large.(16) By 1995, the Internet had evolved from an academically and governmentally supported enterprise to a commercially dominated and supported enterprise.(17)

Commercial application of the Internet has been further developed by the creation of the World Wide Web ("Web").(18) The Web is a navigation tool "for locating and accessing information presented in graphic form available on the hard drives and other storage facilities of computers known as Web servers on the Internet."(19) The Web allows a user to access information in a multimedia format using color, graphics, audio, and video.(20) As the Internet has become more user-friendly, traditional communication methods, such as the telephone, are being replaced. Likewise, the business community is quickly integrating this new technology into its everyday business practices.

II. ELECTRONIC COMMERCE

Electronic Commerce refers to the use of computer networks to facilitate transactions involving the production, distribution, sale, and delivery of goods and services in the marketplace.(21) Although largely associated with the buying and selling of goods and services, electronic commerce also improves the efficiency at which business is conducted.(22) Helpful applications of electronic commerce include electronic data interchange technology ("EDI"), electronic mail ("e-mail"), electronic bulletin boards, electronic funds transfers, and online approaches to traditional business activities such as advertising and marketing.(23)

The Internet already connects approximately 50 million to 60 million people.(24) Industry leaders predict that the Internet will develop into a legitimate marketplace and could grow to connect close to 550 million people by the year 2000.(25) Although electronic commerce has not grown as originally hyped or promised, its potential is enormous.(26) In 1995, according to the Interactive Services Association,(27) Internet access and online services revenue accounted for between $1.6 billion and $2.2 billion in revenues(28) while the Internet and online equivalent of mail-order sales of tangible personal property accounted for about $500 million.(29) By the year 2000, however, revenues from Internet access and online services are projected to reach to between $7 billion and $ 10 billion while the Internet and online equivalent of mail-order sales of tangible personal property are projected to reach $6.6 billion.(30)

The projected growth of the Internet and electronic commerce will serve to stimulate the United States economy and generate new federal, state, and local tax revenues.(31) The growth of cyberspace should result in higher corporate profits, increased sales of new products and services, and expanded use of telecommunication services.(32) State and local taxing authorities, therefore, must be cautious about how electronic commerce is taxed.(33) Currently, taxes are assessed on services that provide either access(34) or content(35) in a nonuniform manner and at inconsistent rates.(36) A fledgling industry today, electronic commerce promises to be a powerful and lucrative industry tomorrow.(37)

III. THE FEDERAL RESPONSE TO ELECTRONIC COMMERCE

A. Judicial Response

Cyberspace tax policy begins in the judicial branch of government with the application of existing tax laws to the attributes of electronic commerce. The question of whether a state may assert nexus over an out-of-state vendor engaging in electronic commerce with its residents implicates the Commerce Clause(38) and the Due Process Clause of the Fourteenth Amendment.(39) Before a state may assert nexus and impose taxes on an out-of-state vendor, it must demonstrate that its tax comports with these constitutional restrictions.

The Due Process Clause requires that a vendor have "minimum contacts" with a state such that the vendor's "connections with a State are substantial enough to legitimate the State's exercise of power over him."(40) The Commerce Clause, alternatively, forbids a state from placing an undue burden on interstate commerce.(41) A vendor, therefore, must have a "substantial nexus" with the taxing state before the state may impose and collect taxes from it.(42) "Accordingly, while a State may, consistent with the Due Process Clause, have the authority to tax a particular taxpayer, imposition of the tax may nonetheless violate the Commerce Clause."(43)

In the seminal case on Constitutional nexus, Quill Corp. v. North Dakota,(44) the United States Supreme Court considered the issue of whether a state could require a company that solicited sales only by mail order catalogs to pay a use tax on sales made into that state.(45) In its decision, the Court reconsidered its holding in National Bellas Hess, Inc. v. Department of Revenue,(46) which held that a substantial nexus requires that the vendor have a physical presence in the taxing state for purposes of both the Due Process Clause and the Commerce Clause.(47) During its reconsideration in Quill, however, the Court bifurcated its Constitutional nexus analysis, as it overruled the due process holding of National Bellas Hess and affirmed its Commerce Clause holding.(48) While a Commerce Clause analysis still requires physical presence in the taxing state, due process can be satisfied by a relatively low level of economic activity and does not require a physical presence.(49) The Court, in Quill, recognized the importance of a clear and concise rule to provide certainty to both taxpayers and taxing authorities.(50)

The result of Quill, other than the creation of a bright-line, safe harbor nexus requirement, was the proper application of the doctrine of stare decisis.(51) The Court, however, did not explain how substantial a vendor's presence must be in the taxing state to satisfy the substantial nexus requirement.(52) Consequently, Quill provides limited guidance for Internet activity, and its application to cyberspace is just beginning.

In CompuServe, Inc. v. Patterson,(53) the United States Court of Appeals for the Sixth Circuit held that defendant Patterson's subscription to CompuServe's online service, in itself, provided sufficient minimum contacts under the Due Process Clause for Ohio courts to assert personal jurisdiction over him.(54) Recognizing the action as a question of first impression, the court applied the test for minimum contacts adopted by the United States Court of Appeals for the Sixth Circuit(55) and held that Ohio courts had personal jurisdiction over the defendant because the defendant purposefully contracted with CompuServe to market his product.(56) As this case exemplifies, traditional standards of exercising personal jurisdiction may be based upon contacts established by electronic commerce.(57)

In Maritz, Inc. v. CyberGold, Inc.,(58) the United States District Court for the Eastern District of Missouri considered the issue of whether the maintenance of a Web site(59) that is accessible by anyone on the Internet, and that is apparently maintained for general use, rises to the level of solicitation necessary to provide minimum contacts for exercising personal jurisdiction over a nonresident corporation.(60) Relying on the five-part test for measuring minimum contacts applied by the United States Court of Appeals for the Eighth Circuit,(61) the court in Maritz stated that through its Internet activities, the plaintiff, CyberGold, purposely availed itself of the privilege of doing business in Missouri and could reasonably anticipate a lawsuit.(62)

Alternatively, in Bensusan Restaurant Corp. v. King,(63) the United States District Court for the Southern District of New York held that New York did not have personal jurisdiction over a defendant, for purposes of the Due Process Clause,(64) when the defendant's only connection with New York was the establishment of a Web site that could be accessed from anywhere.(65) The court held that the mere fact that someone in New York may access information on the Internet about a product in Missouri is not the equivalent of advertising, promoting, or selling that product in New York.(66) The court then distinguished its holding from that in CompuServe by explaining that, in CompuServe, the defendant specifically targeted Ohio by subscribing to the service offered by the plaintiff, CompuServe, and signing an agreement with CompuServe to sell software over the Internet.(67) Unlike the Missouri defendant in Bensusan, the Texas defendant, in CompuServe, "reached out" from Texas to Ohio to establish the necessary contacts to satisfy Due Process.(68)

Courts have successfully begun to incorporate the new medium of electronic commerce into the preexisting standards of Due Process. Thus far these standards have been applied to establish the limits of' a state court to impose its jurisdiction on an out-of-state person rather than its jurisdiction to tax.(69) Nevertheless, cases such as CompuServe, CyberGold, and Bensusan are the starting point for establishing a nexus for taxing electronic commerce. The judicial response to cyberspace tax policy is limited by the facts of the cases presented to it and the existing law of the jurisdiction. In time, cases with the appropriate facts will develop for adjudication which, in turn, will develop the Commerce Clause requirement of substantial nexus. In addition to nexus concerns, entities conducting electronic commerce must also consider the sourcing of the transactions(70) and their respective classification.(71) Unless Congress, which may respond to administrative policy set by the executive branch, takes an active role in providing the necessary certainty for cyberspace tax policy, the state and local taxation issues surrounding electronic commerce will remain unsettled.

B. Executive Response

In light of the economic impact that electronic commerce will certainly have on both the United States economy and the global economy, the United States Department of the Treasury issued a discussion paper to identify issues which may exist or will likely arise and to solicit public comment in an effort to "reach an international consensus on how to deal with cross-border Internet transactions "(72) The discussion paper, entitled Selected Tax Policy Implications of Global Electronic Commerce(73) (the "Treasury Discussion Paper"), recognizes the rapid technological and social changes brought about by what is referred to as the Global Information Infrastructure(74) and attempts to stimulate proactive public discussion. If the technologies developing are to reach their maximum potential, a framework for analysis must be established which will emulate traditional tax policies without impeding the growth of electronic commerce.(75)

A common theme underlying the various discussions is the need to adapt and reinterpret existing tax principles, in the context of current technological developments, rather than levying new taxes.(76) New concepts may only be necessary in extreme cases. Another general consideration emphasized is neutrality. Neutrality requires that "the tax system treat economically similar income equally, regardless of whether earned through electronic means or through more conventional channels of commerce."(77) Accordingly, if such tax systems are neutral, the rules would not affect economic choices and would allow market forces alone to determine the success or failure of electronic commerce.(78) Moreover, the Treasury Discussion Paper asserts that neutrality is best achieved through existing principles in lieu of new or additional taxes.(79)

The discussion paper raises substantive and administrative issues concerning the impact …

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Publication information: Article title: State and Local Taxation of Electronic Commerce: The Forging of Cyberspace Tax Policy. Contributors: Prebut, David S. - Author. Journal title: Rutgers Computer & Technology Law Journal. Volume: 24. Issue: 2 Publication date: Summer 1998. Page number: 345+. © 1999 Rutgers University School of Law - Newark. COPYRIGHT 1998 Gale Group.

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