Logging On to Cyberspace Tax Policy
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 a) Internet and online service technology; b) the nature
of the various types of businesses providing Internet and/or online services;
c) the nature of the various types of transactions that take place over
the Internet and proprietary subscriber networks; d) the applicability,
if any, of current state tax laws to this new and rapidly evolving Industry;
e) whether and how such laws can be implemented in the Internet and online
services environment; and f) what state tax approach would best serve the
interests of the states and the Industry.
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
A. Internet and Online Activities
Generally, members of the Industry are engaged in the sale of "access
services" and/or "content."
1. 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.
a. According to Industry vernacular, generally
1) An Internet Service Provider (ISP) is a business
providing access to the Internet.
2) An Online Service Provider (OSP) is a business
providing access to a proprietary subscriber network. Many OSPs also provide
their customers the ability to access the Internet. ISPs and OSPs generally
provide their services in return for the payment of subscription and/or
2. Content consists of information and services delivered electronically
via the Internet or proprietary subscriber networks to the public.
a. Content is made available to the public by OSPs, by some ISPs, and via
the World Wide Web sites of third-party "Content Providers."
b. The cost of most content provided by OSPs and ISPs is included in their
subscription and/or usage fees.
c. A limited number of Web site operators provide content for a fee which
they bill directly to the consumer.
d. Some sales of content would be treated as taxable sales of tangible personal
property if delivered other than electronically, e.g. downloaded videos,
music, books. This market is extremely limited at the moment.
B. Mail-Order Sellers
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
1. are simply major users of the Internet and proprietary subscriber networks
in marketing their wares over those electronic facilities,
2. are protected by traditional constitutional restraints upon the states,
3. are subjected to traditional state use tax collection requirements,
4. bill their customers directly for their sales.
C. Nexus (Taxing Jurisdiction) Considerations
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
D. Relationship to Telecommunications Carriers
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.
E. Locating Sales
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.
III. Economic Significance of the Industry
A. Economic Benefits
Internet and online services hold enormous potential for reducing customer
costs, improving business productivity, and expanding access to information,
for consumers, businesses and students. The growth of Internet and online
services will generate significant benefits to business and household users
as well as employment opportunities in individual states and localities.
2. Recent Employment Experience
For example, Internet and online services-related employment in five of
the seven Task Force member companies grew from approximately 3,500 in 1993
to approximately 9,500 in 1995, an annual growth rate exceeding 60 percent.
B. Sizing the Internet and Online Service Market
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.
1. Estimated revenues from Internet access and consumer online services
ranged between $1.6 billion and $2.2 billion in 1995, according to two industry
research firms. Despite all the attention the Internet and online services
have received, they still represent a very small proportion (less than 0.8
percent) of total communication services revenue (including telephone, television
and radio broadcasting, and cable and other pay-television services).
2. Revenues for Internet access services in 1995 totaled approximately $250
million, according to SIMBA Information, Inc. and Jupiter Communications.
3. Revenue estimates for consumer online services in 1995 ranged from $1.2
billion (SIMBA Information, Inc.) to $1.8 billion for ìonline content
packagingî (Jupiter Communication). Most consumers use online services
principally for electronic mail and accessing information.
4. Content, which traditionally was 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 (SIMBA Information,
Inc.), or less than 0.5 percent of spending on television, network radio,
and magazine advertising.
5. The Internet and online equivalent of mail-order sales of tangible personal
property in 1995 totaled approximately $500 million (SIMBA Information,
Inc. and Forrester Research), or less than 0.4 percent of consumer mail-order
C. Growth Potential
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.
1. By 2000, revenues from subscriptions and advertising for Internet access
and consumer online services are projected to grow to between $7 billion
(SIMBA Information, Inc.) and $14 billion (Jupiter Communications). Projections
also differ on the mix of subscription and advertising revenues.
2. By 2000, the Internet and online equivalent of mail-order sales of tangible
property is projected to reach $6.6 billion by Forrester Research. This
would represent less than 5 percent of mail-order sales.
3. The growth of Internet and online services will generate new sources
of tax revenues for states from expanded employment, increased profitability
from business productivity improvements, and expanded use of telecommunication
IV. Industry Observations
A. Distinctions Between Telecommunications Services and the Industry's
1. The essence of the Industry's services is not telecommunications
2. While telecommunications-like services may be a component of Internet
and online services, it is a minor one. Other components, such as file
transfers, information access and retrieval, and protocol conversions which
allow communication with a variety of users, are the true essence of Internet
and online services.
3. Underlying transmission services provided by telecommunications carriers
are already subjected to specific taxes by many states.
4. Internet and online services fall within the Federal Communications
Commission's definition of enhanced services, rather than that of basic
B. Irrelevance of Location
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 sellerís business operations. Such a seller may
be able to operate in a stateís market effectively from far beyond
the stateís borders, where it may be immune to the stateís
taxing jurisdiction. Any government seeking to require tax collection by
such a seller faces a formidable challenge.
C. Industry's Potential Role
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.
D. Looking Before Leaping
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.
E. Tax Elements
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 userís 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.
F. Consistent Definitions
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.
G. Uniform Rate in Each 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
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:
A. Adoption of uniform definitions among the states;
B. Establishment of a single rate, within each state, of any applicable
C. Recognition of 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
D. Attribution, to the extent possible, of any applicable tax to the state
into which the sales are billed.
The subject of nexus needs rethinking insofar as it pertains to the complex
environment that characterizes the Internet and Internet-based transactions.
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
Logging On to Cyberspace Tax Policy
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
On the other hand, some states are already taxing receipts from such Internet
and online services in one way or another. These statesí 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 statesí 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:
1. To present a clear picture of the Industry
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. Whatís 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
2. To demonstrate the potential economic significance of the Industry
to the states
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
The growth of Internet and online services will also be important to every
stateís 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.
3. To identify legal constraints and logistical issues affecting the
states' abilities to tax Industry transactions
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.
B. Locating Sales
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 Industryís 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.
4. To propose optional approaches to the taxation of Internet and online
services, keeping in mind the primary goals of achieving simplicity, uniformity,
and fairness in the manner in which the states tax the Industry
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
II. Industry Background
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.
A. The Underlying Technology
1. The Internet
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")
In 1986 the National Science Foundation (NSF) developed its high-speed network
to allow researchers access to NSFís 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 ìthe Internet.î 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.
2. The World Wide Web
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
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 ìWeb sitesî which
are a collection of Web documents usually consisting of a ìhome page,î
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.
B. Internet and Online Activities
Generally, members of the Industry are engaged in the sale of "access
services" and/or "content."
1. Access Services
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
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
3. Sample Internet Service Provider Business Model
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.
Dial-ups and Direct Connections
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
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.
Content Made Available By the ISP
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
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.
C. Economic Significance of the Industry
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 services marketplace has enormous potential, but the
current level of revenues is small both in absolute dollars and as compared
to non-electronic sales of communication and information services.
1. Current Size of the Market
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
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
2. Projected Size of the Market
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
3. Effects on Tax Revenues
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
A. Use of Internet and Online Services by Mail-Order Sellers of Tangible
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.
B. Internet and Online Services Distinguished from Telecommunications
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.
Whatís 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 Industryís 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  between or among points specified by the user,
 of information of the user's choosing,  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
1. Online Services
An online service fails all three of these tests for defining a telecommunications
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.
2. Internet Services
Internet access services fail to meet two of the three requirements of a
In this case as well, the provider does not deliver information between
points of the userís 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.
3. Congressional Intent
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 ìinformation serviceî as ìthe offering
of a capability for generating, acquiring, storing, transforming, processing,
retrieving, utilizing, or making available information via telecommunications.î
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
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.
4. Sound Public Policy
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 stateís 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 Industryís 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
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
IV. Nexus (Taxing Jurisdiction)
A. Electronic Commerce and Nexus Considerations in General
"Nexus" means "contact." For state tax purposes, "taxable
nexus" means sufficient in-state contact to subject an out-of-state
seller to the taxing jurisdiction of a state. In state tax circles, however,
"nexus" is often used to mean "taxable nexus," and it
will be so used here.
Both businesses and the states need meaningful, uniform nexus standards
for the electronic marketplace. A well-structured, rational and uniform
approach to nexus issues and state taxation affecting the various participants
in electronic commerce is critical to all parties. Establishing such an
approach now may well be the key to achieving the full commercial potential
of the electronic marketplace.
There is no statutory authority and little case law that specifically addresses
Industry nexus matters. There is, however, a well-developed body of nexus
standards pertaining to out-of-state sellers of tangible personal property.
The "substantial presence" standard recently established by the
United States Supreme Court has equal applicability to sellers in the electronic
The jurisdictional reach of the states for transaction tax purposes is limited
by the Due Process and Commerce Clauses of the United States Constitution./37
Only those businesses that have sufficient contact with a state may be
subjected to such taxes by that state.
B. Constitutional Limitations
The determination of what is "sufficient" in-state contact to
establish taxing jurisdiction depends primarily upon interpretation of the
Due Process and Commerce Clauses of the United States Constitution. In
its 1992 decision in Quill v. North Dakota, 504 U.S. 298, the United
States Supreme Court set forth guidelines to be used in making such a determination.
1. Due Process Considerations
For all practical purposes, Quill eliminated the Due Process
Clause as a protection against a state's taxing jurisdiction for any out-of-state
seller who purposefully seeks to make sales into that state. The Court
concluded that such activities, so long as they are more than minimal, afford
fair warning that the state may tax the seller./38 Furthermore, this holding
is widely viewed as the Court's invitation to Congress to do something,
under the authority of the Commerce Clause, to establish a rational approach
to state taxation of interstate commerce.
The Quill ruling reduced the Due Process threshold for nexus to such
a de minimis level that the Clause now appears to provide little
2. Commerce Clause Considerations
The Quill decision did provide protection on another basis, however,
holding that, under the Commerce Clause, a state is prohibited from requiring
an out-of-state seller of tangible personal property to collect and remit
use tax applicable to its taxable sales unless it has a "substantial
nexus" with the state. It ruled that the sending of mail-order catalogs
into a state plus the ownership of four floppy disks of mail-order software
there did not constitute such a contact. The Quill Court also rejected
the state's arguments that an "economic presence" in the form
of mere efforts by a remote seller to extract business from within the state
constituted the "substantial nexus" required to subject the seller
to the state's taxing jurisdiction.
In defining ìsubstantial nexus,î the Court adhered to the physical
presence bright-line test contemplated in its 1967 decision in National
Bellas Hess v. Illinois, 386 US 753, upon which the mail-order industry
had been relying. It found such a test in the area of state sales and use
taxation to be useful to encourage settled expectations and to protect interstate
commerce against undue burdens.
The Quill decision provides absolute protection against a state's
taxing jurisdiction for out-of-state sellers of tangible personal property
if their in-state activities are limited to the making of sales by means
of mail-order catalogs, by telephone, by Internet or by any combination
thereof. This means that, if they have no substantial nexus in-state, they
are not subject to the state's taxing jurisdiction.
C. A Physical Presence Standard Applied to Providers of Internet and
Online Access Services Alone
An ISP's or OSP's physical presence in a state will often consist of nothing
more than its POP or POPs, the means by which it provides local access to
the Internet or to private networks, and a POP may consist of nothing more
than a small computer or other piece of electronic equipment. The in-state
presence of a POP or POPs appears to be a fragile basis upon which to assert
taxing jurisdiction, as some states do. Such a contact does not constitute
a ìsubstantialî contact; rather, it constitutes only a "de
minimis" contact, one that is too insubstantial to support
In any event, state taxing authorities should be wary of treating POPs
as substantial contacts because such treatment may compel the Internet and
online service provider to move its POPs from one state to another when
feasible. The costs of such moves may impede the growth of the Industry.
Furthermore, state reliance upon POPs for taxing jurisdiction may be comparable
to constructing a tax system on quicksand in that the increasing use of
satellite or other wireless technologies may eliminate any need for POPs.
State tax policy should take into account the unique nature of the Industry,
not only as it exists today but as it is evolving from minute to minute.
D. A Physical Presence Standard Applied to Internet and Online Service
Providers Who Also Make Electronic Sales of Content
A seller's in-state selling activities can trigger nexus for all of
its sales, even those to which the in-state activities do not pertain./39
This could mean that any nexus triggered by a service provider's sales
of services would extend to its sales of content. For example, a service
provider may have an in-state substantial physical presence in the form
of in-state sellers of its subscription services, causing it to be required
to collect any applicable use tax on its sales of content, e.g., newspapers,
books, music. In no event, however, should the nexus of the service provider
constitute, in and of itself, nexus for third-party sellers of content
from whom its subscribers make purchases and who themselves have no substantial
nexus in the state.
E. A Physical Presence Standard Applied to Electronic Sales of Tangible
For use tax collection purposes, traditional mail-order sellers of tangible
personal property should benefit from the Quill physical presence
standard when they sell over the Internet. As long as the vendor does not
have a substantial physical presence in the destination state, its sales
of goods and services do not trigger nexus there regardless of the mode
Under the physical presence standard, a vendor of tangible personal property
over the Internet or a private online network has nexus in only those states
where it has a substantial physical presence in the form of owned or rented
real or tangible personal property and/or in which representatives, agents
or employees act on its behalf. State taxing authorities have been applying
alternative nexus theories to other types of remote sellers, and appear
to be planning to do so to Internet and online sellers of tangible personal
property. Thus, the states may present arguments that nexus over an out-of-state
Internet/online vendor can be established through (1) the sellerís
affiliation with an in-state corporation or (2) an agency or representational
relationship between the vendor and the Internet and online service provider.
1. Nexus Through Affiliation: Background
Nexus through affiliation is based upon an unsubstantiated belief that
it is appropriate to attribute to the out-of-state seller the in-state contacts
of its parent, subsidiary or brother-sister affiliate. Though several states
have tried, no state has succeeded in establishing taxing jurisdiction over
an out-of-state seller on the sole basis of a relationship with affiliates
that themselves had a nexus in the state. These failures should reduce
the likelihood that states will continue to pursue the affiliated nexus
theory. Three typical cases are the following:
1. In SFA Folio Collections, Inc. v. Bannon, 217 Conn. 220, 585
A.2d 666 (1991), Connecticutís revenue department claimed that, primarily
because Saks Fifth Avenue Stamford, Inc. (Saks-Stamford) had nexus in the
state in the form of the stores that it operated there, its mail-order affiliate,
SFA Folio Collections, Inc. (Folio), was required to collect use tax on
its taxable sales into the state. The state relied solely upon the relationship
rather than upon any proof that Saks Stamford was performing any in-state
activities on behalf of Folio. The state's Supreme Court struck the effort
In Current, Inc. v. [California] State Board of Equalization, (SBE),
29 Cal. Rptr. 2d 407 (1st Dist. 1994), the Board claimed that, because Deluxe
Checkprinters, Inc. had a nexus in the state and because its wholly owned
mail-order subsidiary, Current, Inc., sold many of the same items as its
parent, the subsidiary was required to collect use tax on taxable sales
into the state. The California Court of Appeal ruled against SBE. Here
the state relied solely upon the relationship rather than upon any proof
that the parent was performing any in-state activities on behalf of the
In SFA Folio Collections, Inc. (Folio) v. Tracy, 652 N.E.2d
693 (1995), the Ohio Department of Revenue similarly claimed that the out-of-state
mail-order seller, Folio, must collect use tax on its taxable sales into
the state solely by virtue of its relationship to an affiliate, Saks Fifth
Avenue of Ohio, Inc. (Saks-Ohio) that operated stores in the state. In
this case, the Department relied upon a statute specifying that a seller
had taxable nexus if it "Maintains a place of business within this
state . . .operated by . . . a member of an affiliated group . . . of which
the seller is a member . . . ." The state's Supreme Court ruled that
the Departmentís interpretation of the statute was erroneous and
that Folio did not have taxable nexus in the state.
2. Nexus Through Agents, Representatives, or Independent Contractors:
In general, nexus will be created for an out-of-state vendor by activities
engaged in on the vendor's behalf by parties who qualify as agents in the
traditional sense, i.e., acting under the direction of, operating on behalf
of, and carrying the authority of the "principal"/vendor. In
some instances, the U.S. Supreme Court has stretched this agency concept
for tax purposes to sweep in "sales representatives" and "independent
contractors" whose in-state activities are performed for the benefit
of the vendor with its knowledge but not necessarily under its direction
and not necessarily with any particular ìagencyî authority
from the vendor in the traditional sense./43 The law is unclear as to whether
such activities must be sales activities in order to trigger nexus./44
It is certainly clear, however, that the absence of any agents, representatives,
independent contractors or other substantial physical presence immunizes
a seller against a state's taxing jurisdiction.
F. Possible State Positions and Likely Results Regarding Nexus Based Upon
Agency and Affiliation
One or more states may present an argument that
1. Third-party sellers of tangible personal property and/or content into
a state via an electronic service will be subject to the use tax collection
requirements of the state if the ISP or OSP has a substantial physical presence
in the state.
The states' reasoning will be that the service provider is a representative
of the seller. This is a weak argument. It is based upon the contention
that the presence of the service providerís POP has a different tax
consequence than does the presence of the telecommunications facilities
over which mail-order sellers have traditionally enjoyed tax immunity while
selling into a state./45
As noted earlier, ISPs and OSPs enable subscribers to access the Internet
or private network. After gaining access, the subscriber may visit any
of a myriad of electronic stores, information services, or vendors. The
Internet and online service provider does not control the "online"
movements of the subscriber and generally has no way of identifying or tracking
the subscriber's online purchases, especially when the subscriber makes
such purchases while on the Internet.
Gaining Internet and online access and acquiring content or tangible personal
property from a third-party vendor are separate and distinct transactions.
Making sales over the facilities of a telephone company that is subject
to a state's taxing jurisdiction does not trigger nexus for the out-of-state
vendor; making sales over the facilities of a similarly situated Internet
and online service provider should not do so either./46
2. An ISP or OSP should be liable for collection of use taxes attributable
to third-party vendors' sales of content and/or tangible personal property
This possibility is not based upon the reality of the world of state taxation,
and there is no law to support it. The service provider is merely an intermediary
between the third-party vendor and the subscriber. Under the current status
of the law, the seller is responsible for collecting tax for any state in
which it has nexus, and intermediary common carriers (e.g., railroads, trucking
companies, or delivery companies, such as United Parcel Service, Federal
Express, or the U.S. Postal Service) that deliver the goods for the seller
cannot be held responsible for any tax with respect to the transaction of
sale between buyer and seller.
G. A Physical Presence Standard Applied to Third-Party Content Providers
States may argue that, for use tax collection purposes, third-party
content providers do not qualify for the same protection as sellers of
tangible personal property. This position would be based upon the contention
that, since the Quill decision deals specifically with sales of tangible
personal property, it does not offer a safe harbor for sales of products
or services delivered electronically./47 The states may also argue that
Quill affords no Commerce Clause protection against taxes of any
type other than sales and use taxes. Indeed, the South Carolina Supreme
Court agreed with such a narrow interpretation of Quill. As we shall
establish below, however, such arguments rely upon an economic presence
theory that has no merit.
H. Nexus Based on Economic Presence
The states can be expected to renew the "economic presence"
argument that was made in Quill. The argument is that an out-of-state
seller's direction of regular and systematic sales solicitation efforts
toward a state constitutes a substantial nexus with the state, thereby subjecting
the seller to the use tax collection requirements of the state. The U.S.
Supreme Court rejected the argument in Quill, refusing to repudiate
its rejection of a substantially similar contention twenty-five years earlier
in National Bellas Hess, Inc. v. Department of Revenue of Illinois/48.
Although attempts may be made to limit the purview of Quill to
mail-order sales of tangible personal property,/49 its protection should
apply equally to sales of services and content over the Internet.
V. Situsing Sales
The Supreme Court has established a practical method of determining the
tax situs of telecommunications services for transaction tax purposes.
In Goldberg v. Sweet, /50 it approved use of the consumer's service
address to situs receipts from a telephone call, assuming that either the
origin or destination of the call takes places within the state./51 One
should not jump to the conclusion that such an approach could be applied
to the Industry's sales of subscription services or content without significant
modification. The reason is that determining the origin or destination
of such transactions is generally not possible since the geographical locations
of buyer and seller (subscriber and service provider) are irrelevant inthe Internet and online service provider's business model. Nevertheless,
a practical agreement between the Industry and the states to rely upon the
subscriber's billing address as the equivalent of the service address in
determining the situs of a sale could solve most problems in this area.
VI. Issues at Hand
A. Industry Expertise
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.
B. Nexus Limitations
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.
C. Consistent Definitions
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 ìbundledî 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 ìcarve outî 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
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.
E. Local Taxes
The Industry is concerned about the mind-boggling problems presented by
local taxation in the form of many different taxes, business licenses and
fees/52 imposed by thousands of taxing jurisdictions./53
The administrative and compliance burdens associated with local-level taxes
are extraordinarily cumbersome for even a well-established, traditional
business to manage. Having to comply with a myriad of city, county, transit
district, and other local taxes, and cope with inconsistent and disparate
rules regarding the taxability of various transactions and the geographic
incidence of tax could jeopardize development of the electronic marketplace
more than any other requirement. The cost and inconvenience of contending
with even the threat of inappropriate local taxation cannot be justified.
With input from the Industry, the administration of local taxes must be
F. Clear Policy
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.
G. Lack of Uniformity Among States
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 ìtax on taxî 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 involves subjecting the same transaction to more than
one tax, e.g., a stateís application of two different taxes to the
same transaction or two statesí 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 subscriberís 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 Industryís 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
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
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
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
15/Occasionally, an ISP will rely upon another ISP's POPs in providing its
16/See CommerceNet/Nielsen Media Research Recontact Study, published August
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,
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
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.
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
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.
37/A federal statute, Public Law 86-272, further limits the reach of the
states with respect to taxes based upon corporate net income of sellers
of tangible personal property. This White Paper does not address matters
pertaining to income taxing jurisdiction.
38/In Bensusan Restaurant Corp. v. King, 96 Civ 3992 (S.D.N.Y., 9/9/96),
an owner placed an advertisement for his Missouri jazz club, The Blue Note,
on an Internet Web site located on a server in Missouri. The owner of a
New York establishment that was also called The Blue Note sued in a federal
district court in New York to stop the Missouri owner from using the same
name. But that court held that the Missouri owner was not subject to the
personal jurisdiction of New York. The Court said that the placing of the
advertisement on the Web site did not rise to the level of the minimal connection
required by the Due Process Clause as a prerequisite to his being subject
to New York's jurisdiction, and that this was true even though the advertisement
was accessible by residents of New York. Although the case involved personal
jurisdiction rather than taxing jurisdiction, the same analysis of the Due
Process Clause applies to both. The Court distinguished this case from
CompuServe Inc. v. Patterson, 89 F.3d 1257 (6th Cir., 7/22/96; rehrg.
denied 9/19/96). There, another federal court held that a Texas attorney's
contacts with Ohio, which were almost entirely electronic in nature, did
rise to the level of the minimal connection required by the Due Process
Clause to establish personal jurisdiction over him. That court found that
the attorney had entered into a written contract with CompuServe under which
he marketed his computer software product in other states, sending it regularly
to CompuServe's Ohio system and using CompuServe's Ohio facility as his
distribution center, thereby purposefully availing himself of the privilege
of doing business in Ohio. [The contract provided for the application of
Ohio law.] The Court specified that it was not holding that the attorney
would, by virtue of his use of CompuServe's services, be subject to suit
in any state where his software was purchased or used, that question not
being before the Court.
In other cases involving personal jurisdiction, two different federal district
courts held that foreign corporations were subject to the jurisdiction of
states in which their sole contacts were through the Internet. In Inset
Systems, Inc. v. Instruction Set, Inc., 95 Civ 1314 (D.C. Connecticut
4/17/96) and Maritz, Inc. v. Cybergold, Inc., 96 Civ 1340 (S.D.C.
Missouri 8/19/96), the Courts concluded that the plaintiffs purposefully
directed their advertising efforts toward the states, via the Internet,
for the purpose of doing business within the states, thereby subjecting
themselves to the states' jurisdiction. The Cybergold Court cited
both Inset and CompuServe approvingly.
See National Geographic Society v. California Board of Equalization,
430 U.S. 551 (1977), in which the activity of Society employees operating
out of in-state offices to make nontaxable sales of advertising triggered
a nexus that resulted in the Society's being required to collect and to
remit to the State of California use tax applicable to the Society's mail-order
sales of tangible personal property into the state. Nonetheless, a New
York State Administrative Law Judge has recently held that the in-state
activities of independent advertising agents who had their own offices in
the state did not constitute nexus for the seller even though the seller's
employees made some 20 non-sales trips into the state during the audit period.
Matter of NADA Services Corp., Administrative Law Judge, February
1, 1996. Whether this constitutes a correct interpretation of the National
Geographic decision is open to question.
39/An exception to this general statement: Delivery in the vendor's own
vehicles has been held to constitute such a physical presence for use tax
collection purposes by the supreme courts of several states. See Brown's
Furniture, Inc. v. Dir. of Revenue, Supreme Court of Ill., 171 ILL2D
410, cert. denied, U.S. Sup. Ct., Dkt. No. 96-94, 10/7/96; Good's Furniture
House, Inc. v. Iowa State Board of Review, Iowa Supreme Court, No. 85-827,
2/19/86; and In the Matter of State Sales Tax Liability of Webber Furniture,
South Dakota Supreme Court, 4/9/80. The United States Supreme Court laid
the groundwork for such decisions in Miller Brothers Co. v. Maryland,
347 U.S. 340 (1953), when it ruled that the state did not have taxing jurisdiction
because, among other things, in-state deliveries using the seller's vehicles
were only occasional in nature.
40/In an earlier decision involving a substantially similar factual situation,
Bloomingdale's By Mail, Ltd. v. Commonwealth Department of Revenue, 567
A2d 773 (1989), the Pennsylvania Department of Revenue had based its nexus
claim on an agency relationship between the affiliates rather than upon
their being members of the same affiliated group. The stateís highest
court found that the Department had not proven the existence of such a relationship
and that nexus did not, therefore, exist on the part of the out-of-state
41/The Board had also relied upon a statutory provision, Revenue & Taxation
Code Section 6203(g) that defined "Retailer doing business in this
state" to mean and include "Any retailer owned or controlled by
the same interests which own or control any retailer engaged in business
in the same or a similar line of business in this state." The Court
ducked the issue by ruling that the two corporations were engaged in "substantially
dissimilar" activities. Nevertheless, the 1995 legislature repealed
the provision effective 1/1/96.
42/See Scripto v. Carson, 362 US 207 (1960), in which the activities of
independent contractors triggered nexus, and Tyler Pipe Industries, Inc.
v. Washington Department of Revenue, 438 US 232 (1987), in which the court
agreed with the conclusion that a "showing of sufficient nexus could
not be defeated by the argument that the taxpayer's representative was properly
characterized as an independent contractor instead of as an agent."
43/See Multistate Tax Commission Nexus Program Bulletin 95-1 and commentary
thereon, e.g. COST's statement opposing adoption of the Bulletin (See State
Tax Notes, March 25, 1996, p. 973) and "MTC Nexus Bulletin 95-1 Goes
Beyond Existing Law," State Tax Notes, April 15, 1996, p. 1168, wherein
extensive reference is made to Standard Pressed Steel Co. v. Department
of Revenue, 419 U.S. 560 (1975), Tyler Pipe, supra, and Scripto, supra.
44/See Quill, supra.
45/California businesses were so concerned about the danger of such a potential
state position that they successfully sought protective legislation in 1994.
Section 6203(j) of the California Sales and Use Tax Law now provides that
"For purposes of this section, 'engaged in business in this state'
does not include the taking of orders from customers in this state through
a computer telecommunications network located in this state which is not
directly or indirectly owned by the retailer when the orders result from
the electronic display of products on that same network.
The exclusion provided by this subdivision shall apply only to a computer
telecommunications network that consists substantially of on-line communications
services other than the displaying and taking of orders for products."
This provision became effective January 1, 1995 and will expire December
31, 1999 unless legislatively extended.
46/Their delivery of content over the Internet or a private online network
is analogous to delivery via common carriers, such as the United States
Post Office, UPS or Federal Express and should not trigger nexus.
47/386 U.S. 753 (1967).
48/See, for example, Geoffrey v. South Carolina, 437 S.E.2d.13 (9/22/93),
in which the South Carolina Supreme Court ruled that an out-of-state subsidiary
had nexus in the state in the form of intangible trademarks and trade names
that were licensed to its in-state parent as well as in the form of in-state
accounts receivable and so was subject to the taxing jurisdiction of the
state. That case involved only income tax jurisdiction, however, and is
highly suspect even though the U.S. Supreme Court refused to review it.
Its rationale was specifically rejected by an Administrative Law Judge
in Cerro Copper Products, Inc. v. State of Alabama Department of Revenue,
DOR ALJ Div., No. F. 94-444, 12/11/95.
50/488 US 252 (1989).
51/A credit provision protected the taxpayer, in that case, against multiple
taxation. The decision has no value for purposes of determining nexus since
nexus was acknowledged by the taxpayer in the case. The discussion here
has validity only in instances in which the remote seller is subject to
the state's taxing jurisdiction.
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.