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Overview of the Problem

Dramatic Growth in Electronic Commerce and Internet Transactions

The rapid growth in Internet access and usage has opened up a 24-hour virtual global marketplace for goods and services that is creating a revolution in the way businesses operate. This swiftly changing technology has the potential to fundamentally alter the nature of marketing, ordering, invoicing, billing, and customer service. Because the costs of entry into this new market are relatively low, it is accessible to virtually any business with the desire and creativity to exploit it.

Electronic commerce is in its infancy and hard data describing its scope is difficult to come by. Industry estimates of the scope of electronic commerce vary widely. According to a survey by Nielson Media Research and CommerceNet, almost 79 million people over the age of 16 used the Internet in the first 6 months of 1998, up from 58 million from the previous 9 months. Of those users, 20 million made online purchases-double the figure from the previous 9 months. Globally, there were more than 400,000 active commercial websites at the beginning of 1998, more than double the amount at the beginning of 1997.

By far the largest component of electronic commerce is business-to-business trade. In the United States, business-to-business electronic commerce in 1998 was expected to more than double the level of its activity in 1997. In Texas, Internet-related businesses are expected to provide the fastest job growth rates in 1999.

The potential for growth in the use of the Internet to advertise, sell, and deliver goods and services has caused tax administrators worldwide to consider the ramifications of these new business methods on income and sales tax bases and on compliance and the administration of tax law.

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Government Units Are Concerned that Transactions Over the Internet May Go Untaxed

Prior to the October, 1998 enactment of the Internet Tax Freedom Act, several states had been taxing Internet access charges[6] and, virtually all states imposed sales and use tax on taxable items (goods and services) sold over the Internet in a manner similar to the taxation of catalog sales. In both situations, vendors are required to collect sales or use tax from their customers when the vendor has "substantial nexus" in the destination state to which the product is shipped[7].

States are concerned that the less visible electronic trail of Internet transactions will lead to lower compliance and possibly substantial reductions in state tax collections.

However, businesses are required to self-assess use tax and are regularly audited for such taxes. Because most electronic commerce is business-to-business, the substantial majority of Internet transactions will be audited and policed in the ordinary course of use tax audits under existing law.

These concerns, however, focus on the use of the Internet for conventional sales transactions. Less attention has been paid to the taxation of the businesses that service the Internet such as service providers and designers, and the taxation of their transactions with others. The Group closely examined Texas treatment of such service providers.

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Businesses Are Concerned that Internet Transactions May be Subjected to Multiple Taxation.

Traditional state sales and use tax systems were designed decades ago to tax sales of tangible personal property. It is relatively easy to determine where and when such sales of tangible property take place, and to accurately tax them.

In the past ten to fifteen years, as state budgetary problems have grown, several states have adopted sales and use taxes on selected services[8]. Most states, including Texas, presume services are not taxable, unless specifically taxed. Many services which involve direct contact with readily identifiable tangible property (such as real property repair and remodeling or motor vehicle repair) are fairly easily identified, i.e., the time and place where the service is rendered are inextricably tied to the corresponding tangible property. In those situations, characterization, timing and sourcing of taxable transactions is relatively easy.

For taxable services which are not closely tied to identifiable tangible property, such as Texas' sales and use tax on data processing services and information services, it is increasingly difficult to identify a specific location and (occasionally) a specific time. Substantial controversy has ensued in Texas over the "service benefit location" where data processing services and information services are taxable[9]. Indeed, the line between data processing and information services has become increasingly blurred, even as taxpayers and the Comptroller have attempted to find a clear way to distinguish between them.

Internet transactions, which originate at one computer and can interact with many computers all over the world (typically without the user's knowledge of where the interacting computers are located) dramatically complicate the sourcing and characterization of potentially taxable services. One given Internet transaction may electronically "touch" or interact with computers, servers, switches and other electronic equipment in several jurisdictions. This raises a host of thorny questions:

  • Does each jurisdiction in which such electronic equipment is located have taxing jurisdiction over each transaction involving with that equipment?
  • When several different jurisdictions have contact with an Internet transaction, which jurisdiction's characterizations of the transaction apply? What rules apply if several such characterizations are inconsistent with one another?
  • What rules govern if differing (i.e., inconsistent) tax laws of characterization sourcing, etc. apply?
  • Can one transaction be taxed several times, in different jurisdictions, in different ways?
  • Are the compliance issues extraordinarily complicated for the average business?

Businesses and individuals are constitutionally entitled to protection from multiple taxation. That protection can be quite difficult to identify and fashion for Internet transactions.

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Texas is One of the Very Few Jurisdictions to Tax Internet Services Transactions.

Virtually all states impose tax upon sales of goods, regardless of how the sale is consummated-in a department store, through a catalog order, or over the Internet.

Texas is one of the few states that applies sales and use taxes to data processing services and information services[10]. A number of states, including Texas, tax Internet access charges. However many states specifically prohibit or have repealed most taxes on Internet services and/or Internet access.

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Bundled Transactions Complicate Tax Analysis

With increasing frequency, service providers are lumping several services together for the convenience of their customers. This service "bundling" is pronounced where many service providers now make available forms of telecommunication, "free" software or "shareware," advertising, games, educational services, electronic messaging, and more. Frequently these services are marketed for one single periodic payment by customers, a type of "one stop shopping." Competition on the Internet is resulting in a significant increase in bundling and a major expansion of the types of bundled services.

This bundling complicates Texas tax analysis significantly, as some services are taxable while others are not. Allocating the single periodic charge between the taxable and nontaxable components, and then among taxable services requires special consideration.

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The U.S. Congress Imposed A Moratorium on Internet-Related Taxes

After months of debate, the United States Congress enacted the Internet Tax Freedom Act (the "ITFA")[11] on October 21, 1998. A "plain English" summary of the ITFA is attached as Exhibit B. This legislation adopts a three year moratorium on certain aspects of taxation of the Internet while a special Advisory Commission on Electronic Commerce ("ACEC") studies how the federal and state governments should tax Internet transactions. Existing taxes imposed by Texas were exempted from the moratorium, and remain in effect.

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The Business Community Perceives Texas Tax Statutes as Unfriendly to Industry Because it is One of Only a Few States Taxing Internet Services. Texas Sales Tax on Internet Services Transactions Raises the Cost to Texas Businesses of Competing, and Risks Losing Jobs to Lower Tax (or No Tax) Jurisdictions.

From an economic development perspective, the most notable features of the newly burgeoning Internet-related businesses are mobility and profitability.

Internet-related businesses are extraordinarily mobile, both in theory and practice. The Internet opens new possibilities for service providers to relocate their operations without degrading customer service, which many ordinary individuals are taking advantage of as "telecommuters." Those businesses that work intimately with the Internet (such as designers, web administrators and programmers) are often the most aware of these possibilities and most eager to take advantage of that mobility. The challenge to communities to attract and retain such persons is greater and more complicated than the traditional economic development tasks of attracting large manufacturing plants or other more permanent installations.

At the same time, these Internet-related businesses offer the possibilities of high profits and rapidly growing earnings. Their employees and owners tend to be highly educated and well paid, and thus specially attractive to the community.

If a jurisdiction gains a reputation for being hostile to any mobile businesses, it runs a risk that those businesses, and corresponding jobs in the technology industry, locate themselves elsewhere. It would be unfortunate if Texas, despite its strong base of high technology businesses, were to fail to attract and retain its share of Internet-related businesses.

In recognition of the importance to economic growth of Internet-related businesses, legislative or administrative activity to insulate all or portions of Internet transactions from further taxation has already been adopted in Alabama, Arizona, California, Colorado, Connecticut, Florida, Georgia, Illinois, Kentucky, Massachusetts, Missouri, New Jersey, New Mexico, New York, Oklahoma, Pennsylvania, Virginia, Washington, and Wisconsin.

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  1. Connecticut, District of Columbia, Iowa, New Mexico, North Dakota, Ohio, South Dakota, Tennessee, Texas and Wisconsin.
  2. Quill Corp. v. North Dakota, 504 U.S. 298(1992) discussing nexus of remote sellers.
  3. See, 1998 Multistate Corporate Tax Guide, Panel Publishers, Vol. II, p. II-85, and related chart pp.II 100-II 105(listing different categories of services taxed by various states).
  4. See Title 34 Texas Administrative Code Section 3.330(f) which provides the "service benefit location" rule. See also Comptroller's Hearing No. 26,321 (1991) (if the taxable item sold is a taxable service, the derivation in Texas of direct or indirect benefit from the service provided constitutes a use for Texas use tax purposes); Comptroller's Hearing No. 33,164 (1997) (proof as to multi-state benefit must go to each specific transaction entered into); and Comptroller's Hearing No. 31,134 (1994) (service providers claiming a partial or full exemption from the Texas sales or use tax based upon a multi state benefit must present the exemption certificates required by Administrative Code Section 3.330 within 60 days of written request by the Comptroller). Contrast Comptroller's Hearing No. 27,621 (1993) (requirement that taxpayer must furnish completed exemption certificates within 60 days of the Comptroller's request in order to avoid taxation only applies to sales of goods and not to sales of services, prior to amendment of the corresponding statute).
  5. See Title 34 Texas Administrative Code Section 3.342(g). Disputes over the interpretation of the "service benefit location" rules have been frequent. See Comptroller' Hearing No. 35,899 (1998) and Comptroller's Hearing No. 34,700 (1997) (where an information service is used to support the making of broad, overarching business decisions, the service is presumed to be used where those decisions are made even though the effect of those decisions may be in other parts of the country); Comptroller's Hearing No. 30,052 (1995) (where purchaser's internal business records could not substantiate the amount of benefit derived at locations outside of Texas, the service is presumed to be used at the principal place of business of the purchaser; pro rata allocation of purchased service to retail outlets outside of Texas, standing alone, is not sufficient evidence); and Comptroller's Hearing No. 27,621 (1993) (as to mailing lists, Texas client's use of a non-Texas name on the mailing list derives exactly the same benefit in Texas as would the use of a Texas name).

  6. Only six other states tax data processing generally (Connecticut, District of Columbia, Ohio, Pennsylvania, Rhode Island, South Dakota). A few other states tax data processing in certain limited contexts: California (only for changes to the format of customer provided information but not to original information developed from customer provided information); and Utah (only if the object of the purchaser's bounty is the computer output as opposed to the rendition of a service).

    The states which impose sales and use tax on at least some component of information services include: Arkansas (as to credit reporting services); Connecticut (as to credit reporting services); District of Columbia; Idaho (as to sales of statistical reports, graphs or any information produced or compiled by a computer); Maryland (as to credit reporting services); Massachusetts (as to sales of generalized information but not to customer specific information); Nevada (as to mailing lists); New York (as to sales of non-personalized information); Ohio; Pennsylvania (as to credit reporting services); South Dakota; Vermont (as to mailing lists); and Washington (as to credit reporting services and mailing labels).

  7. Public Law 105-277.