Web and Taxes
Frank J. Martinez, Esq.
First, the Athenians laid siege to the city of Eion, for they insisted on taxes being paid.
On October 21, 1998, former President Clinton signed into law the Internet Tax Freedom Act (ITFA), which, among its other provisions, prohibited taxing access to the Internet as well as new or duplicative taxes on electronic commerce. And on June 14, 2001, Senate negotiators reached an agreement extending the prohibition until 2006.
Originally, the ITFA was drafted to bar all taxation related to Web access and use and to all commerce transacted on the Web. However, frenzied lobbying from state and local lawmakers soon convinced Congress and the White House that making the Web a tax-free enterprise zone would have grave political repercussions. Under the current deal in the Senate, the states will be able to increase the collection of existing sales taxes, which for the most part go unpaid.
With the ITFA, state and local politicians realized that, if the proposed tax bans were made permanent, they would face a tax advantage instituted at the expense of their constituents’ brick-and-mortar businesses feared that a tax-free Web could, in effect, make every small business in America noncompetitive. For them, the issue was simply how local merchants could compete against an Amazon or Wal-Mart that didn’t have to charge tax.
In many ways, the ITFA raised more questions than it answered. Specifically, should access to the Web be taxable and should every part of the electronic economy be taxed? And who would make the tax-liable determinations? Not surprisingly, the answer you get depends on whom you talk to. Whatever happens, we know it’s going to be a mess to figure out. If the current tax legislation is any indication, Washington, under the guise of representation, will try to institutionalize its ability to tweak the tax code.
How does all this relate to design? Quite simply, if you work on the Web, or your work is posted directly to the Web, or you transmit your work over the Web, it’s entirely possible that some or all of these actions will create a tax liability. What will you do? Absorb the cost or pass it on to your clients? In short, these taxes will raise the cost of doing business on the Web. For designers who work as employees or in an employee-like arrangement with an agency, most forms of Internet taxation are a distant issue. This is because, other than their salaries, employee-designers do not receive any taxable income or benefits for their work. So, any tax liability on their part is limited to the most familiar federal and state income taxes. For designers who freelance or who have their own consultancies, however, the future isn’t so clear.
Likely to remain consistent, though, are the current practices of ensuring that taxes are paid by the ultimate consumer of the goods or services and that those taxes levied are not discriminatory in nature. Currently, a designer has no tax obligation when he provides services on a “wholesale” basis, i.e., for clients who, in ample, a package designer’s work is not sold directly to consumers, but rather, is sold to manufacturers who then put the work into the stream of commerce. In such cases, the tax burden is incurred, in the form of a sales tax, at the time of the final retail transaction. In reality, however, the original transaction is not entirely tax free, since the designer will pay one or more income taxes on his fee. In contrast, a designer who creates a design that is itself an end product sold to an end user, such as a Web site design, or an advertising design, may have some tax liability. Even then, it’s not absolutely clear what that might be, since currently, there are exemptions for certain types of promotional or advertising services.
The largest concern for every party involved is making sure that the taxes are as fair as possible and, in particular, that any taxes levied are “non-discriminatory.” In Internet tax language, a discriminatory tax is one that’s unfair because it’s a double tax – for example, one or more localities taxing the same transaction; or a tax imposed on an out-of-state company because, since it’s selling here, it should be taxed here, even in the absence of other business activities; or imposing a tax on an e-commerce transaction that, had it been an analogous brick-and-mortar company transaction, would not have been taxed. In fact, these concerns are so important that Section 1104(2)(A)(ii) of the ITFA extends the definition of “discriminatory tax” to include any tax by the state or local government on e-commerce that results in a tax rate on an e-commerce transaction that is different from a transaction concluded by another means.
In short, you can’t create new taxes or use different tax rates just because a thing is bought or sold on the Web. Even if the ITFA expires, these protections are so necessary that we are likely to see similar safeguards in any future state or federal tax laws. Some states have already realized how important this issue is and are actively studying ways to make their states more competitive.
In Texas, the non-binding report of the Texas Internet Tax Policy Working Group determined that the mere storage of Web pages or graphics should not be a taxable event. In addition, it determined that Texas, in order to compete, would have to change some policies, since an economic disincentive to the development of e-commerce and e-commerce infrastructure had been created in the state. For instance, the Texas Comptroller’s Office currently characterizes the following activities as being taxable: graphic design services such as the creation of logos and graphics for a customer’s Web page; scanning data into a computer-readable file; charging for the creation of HTML documents; updating and maintaining a customer’s Web page; storing a customers Web page on a server’ transmitting information between automated clearing houses and merchants; online educational classes; access to the Internet and providing information over the Internet; providing maps and proximity data, such as Global Positioning Services; the sale of software; the dissemination of customer’s information over the Internet, such as hosting of an auction or online personal ads. While some of these activities are likely to remain taxable, it’s easy to see that many of them create little incentive for designers and the business of design. Wisely, the Working Group has recommended that Texas rethink its tax policies.
In order to grasp the basics of the Internet tax issue, it’s necessary to understand the fundamental predicament underlying all taxes: The people who pay them aren’t usually the ones who decide what will be taxed and how the money will then be spent.
Contrary to common belief, the most vigorous proponents of taxing commerce on the Web aren’t faceless federal bureaucrats. The real culprits are local politicians and state representatives who, after consulting with their respective taxing authorities, become worried that their state or city will turn into some sort of on-shore duty-free zone. The amount of money at stake is staggering. The Federation of Tax Administrators, an organization composed of the leaders of each state office responsible for administering and collecting taxes, has estimated that the ten states that are still collecting an Internet access tax will have collected more than $75 million dollars a of fiscal July 2000. Current estimates put the total value of e-commerce sales at approximately $28 billion. By 2004, the value of e-commerce transactions is expected top $155 billion. In some states, since revenue from sales taxes represents up to a third of government income, preserving the ability to tax e-commerce is almost a life or death matter.
As originally drafted, the ITFA triggered concern in local governments that they would be permanently restrained in their ability to tax revenue from e-commerce activities. For example, the original moratorium contains the seeds of a permanent prohibition. Read together, Sections 1104(2)(A)(I) and (ii) of the ITF, if codified into future laws, could mean that property, goods, services, and information that are exchanged or used exclusively over the Internet will always be tax free, provided that there is no offline equivalent to the particular commercial activity. Under the current deal, the states would have five years to simplify how they levy and collect sales taxes. During this period, the states would also be required to create uniform definitions for the plethora of goods and services offered over the Internet, since uniform taxation requires uniform definitions. Furthermore, the states and Congress would have to agree on a country-wide sales tax rate, or, without such an agreement, each state would have to impose a uniform rate. In either case, Congress would have final approval. The good news for most designers is that businesses with $5 million or less in annual revenues would be exempt.
Currently, there are no fewer than a dozen bills pending in Congress dealing with e-commerce taxation. Of these, at least three seek to bar any present or future sales and use tax liability as well as any tax on access to the Internet. That’s right – some states already tax access to the Internet. At present, Hawaii, New Mexico, North Dakota, Ohio, South Dakota, Tennessee, Texas, and Wisconsin impose their regular sales taxes on Internet access. (Connecticut was scheduled to repeal its access tax on July 1, 2001 and South Carolina is in the process of deciding whether to abide by the moratorium.) The access taxes enacted by these states were in effect prior to the passage of the ITFA and continue to be enforced. The moratorium imposed by the ITFA applies only to states or localities that hadn’t yet enacted such a tax.
If you’re curious about the notion of a tax on access to the Web, be reminded that taxing telecommunications is not a new idea. Just look at your next bill for telephone, cellular, or cable TV service. Many consumer and tax liberation groups maintain that, since we already pay a tax for telephone usage, a tax on Internet access is really a form of double taxation. Unfortunately, your state tax commission has a maneuver to circumvent that argument. Most states classify your ISP as a communication or telephone service, a bit of legalistic sleight-of-hand that makes providing Internet service a distinct, independently taxable communications service. From a legal perspective, however, the major underlying principles have already been examined by the courts.
In 1992, in Quill Corporation v. North Dakota, the U.S. Supreme Court determined that a state tax authority did not have the legal basis to charge Quill’s clients sales tax on catalog sales of discounted office supplies since the company was headquartered and operated out of state. The court found that the act of mailing a catalog did not create a sufficient “nexus” or commercial presence in the state to justify the imposition of a sales tax. The same issue underlies the Internet tax debate. State tax authorities have recognized the similarity and have responded with surprising creativity.
Whether or not your work will be taxed depends on four main factors that relate to what you sell – a good or a service. If your work ends up as a tangible object, a good in tax parlance, its sale over the Internet will likely be a taxable transaction. On the other hand, if you provide a service, it’s not so clear that the sale of your work will be taxable. However, the very nature of the Web makes it difficult to distinguish one transaction from the other, since they’re basically just data packets being routed over telephone lines, and there are those who feel that the best solution is to tax any data stream that contains a commercial transaction.
Here are the questions that the interested parties are wrestling with. First, does each jurisdiction that maintains routers, switches, telephone, or optical lines have a right to tax the transaction since, in effect, it creates a nexus with the jurisdiction? Second, because a transaction may travel over many different jurisdictions, which state law will apply and how are inconsistencies in tax law and tax rates going to be resolved? Third, can one transaction be taxed several times, since each time a data packet is routed, it’s likely to be in a new jurisdiction? Fourth, what is the economic burden of complying with the law, as rational parties will seek the lowest transaction costs?
Taxing authorities are cognizant of the fact that a virtual business can be anywhere and can be moved very quickly. As can be imagined, since buyers and sellers will naturally seek the most favorable tax climate, proponents of taxing the data stream are in the minority. In the end, the answers to these questions will probably be found in the Quill case. Specifically, where do the buyer and the seller reside and does the seller have sufficient nexus with a state to result in an authority to tax? Technical interpretations aside, however, the 800-pound gorilla on the tax block is politics; the Constitution assigned Congress the right to regulate commerce, so politics is going to play a big role.
Surprisingly, differences in political philosophy have, until now, not been too evident. This is because both the left and the right wanted to wait until the Web was a fatter target. But real differences will become evident when the battle begins over who will have the right to tax, states or the federal government, and whether the federal government should have any role in regulating how those taxes are levied. The Clinton administration took a hands-off approach. During the recent presidential campaign, both Al Gore and Dick Cheney called for making the ITFA ban on the Web access taxes permanent. The Bush administration has voiced support for the current bipartisan deal to extend the moratorium. But since the election, no mention of whether the various states should be allowed to tax commerce on the Web and what the role or policies, if any, of the present administration will be. Because most of the benefit of such taxes is likely to go to the states, the administration might want to avoid the issue, characterizing it as “a local matter.”
Such an answer sidesteps the fact that the Web has no boundaries. Many designers sell their work across national borders, and the ascendancy of English as the language of business worldwide means that this trend is likely to grow. Will a state be able to tax a transaction between the U.S. and a European Union country, and how is the E.U. resolving the tax issue?
As in the U.S., political philosophy and local character are shaping the issue among E.U. members. The French in particular wish to see the E.U. as a federation of nation states, a states’ rights kind of E.U., with socialist goals. On the other hand, the Germans would like to see a central governing body with authority to harmonize laws and taxes, sort of a United States of Europe, with a strong central government. Like their American counterparts, tax regulators in the E.U. recognize that burdensome or unfair taxation is likely to drive e-commerce to friendlier climes. Thus, in view of the competing visions of the various members of the E.U., they find themselves discussing “home state” tax rates and ways of harmonizing administrative costs.
There’s also the question of whether non-E.U. suppliers of goods and services should be required to register with an E.U. taxing authority in order to do business in the E.U. In short, the organization is dealing with the same issues that we are confronting in the U.S. It appears, however, that the desire to make the Web a tax-free zone is not as strong as it is here. Thus, if you provide design services to foreign clients or you have offices in other countries, it’s probable that, sometime in the future, you will have to pay a value added tax, or VAT, which is supposedly based on the economic value of the activity. In contrast, if you sell your design services to a client in the U.S., that tax is likely to be in the nature of a sales tax derived from the cost of the services. In a way, the Web has done what the politicians couldn’t; it has removed national borders.
It’s almost certain that some form of Internet taxation will present itself. If you’re an employee, this won’t have too much of an effect on you. However, independent or freelance designers need to seek competent tax planning services if they wish to stay competitive. Usually, you can get such advice from a tax consultant, your accountant, or an attorney who understands taxes and the nature of design practice. Remember, it’s not just a matter of being large or small; most designers form some sort of business entity and regardless of your choice of organization, whether a sole proprietorship, limited liability company (LLC), or corporation, you will have a tax burden to reckon with. How a designer organizes and maintains his business will significantly affect his tax liabilities, and with the looming possibility of taxation of design services on the Internet, such advice becomes imperative.
©2004 The Martinez Group PLLC