Internet Sales Tax – Good Customer Service or Bad for Business

Internet Sales Tax – Good Customer Service or Bad for Business

In a May, 2005 California appellate court case, California Board of Equalization v. Borders Online Inc. No. SC OHA 97-638364, Cal. Tax Rptr. ¶ 403-191, (Cal. SBE Sept. 26, 2001)[1], the Cal Stet BOE argued that Borders Online, Inc. ("Borders Online"), an out-of-state corporation, is obligated to collect California state use tax on sales of tangible products which are shipped from it’s out-of-state locations to California residents. Borders, Online, Inc.[2] Traditionally, under federal law, on-line retailers, including those with a local presence have been able to avoid the collection and processing of sales tax if the on-line retailer was a “true” internet based business. The Courts held that Borders Online has sufficient contacts with California customers to permit it to impose this obligation by virtue of the fact that Borders, Inc., an affiliated but distinct entity, agreed to and did accept returns from Borders Online’ customers at Borders, Inc.'s brick and mortar stores located in California. Due to this ruling Border’s On-Line, Inc. must make a choice that will affect it’s customers; Continue to offer the return policy that will allow items to be returned to it’s stores therefore requiring the collection and processing of sales tax in every state it has a retail outlet, or requiring that all Borders On-Line returns be made only through the mail thereby risking the alienation of customers but saving them anywhere from 5-10% in state and local sales tax.

This article will discuss the relation of the Borders, Inc. and Borders On-Line, Inc. case to other state and federal case and statutes and how the precedence established by this California ruling will change the laws related to e-commerce sales and use tax collection decisions in California by traditional retailers who also have e-commerce operations. This article will also cover how similar rulings that have occurred in other states contribute to the challenge of creating a national on-line tax collection method for both traditional retailers and exclusively e-commerce companies. Finally, this article will also discuss the federal legislation that is currently in affect that was designed to help the states and the companies doing business in those states balance the need to collect and report sales tax in accordance to state laws and prevent these laws from creating a costly operating burden on internet commerce companies.

The ability of states to require remote sellers to collect and remit use tax on merchandise sold to a state’s residents have been restricted since 1967 by two key U.S. Supreme Court decisions. In 1967, the Court ruled that an Illinois statute requiring an out-of-state mail-order business to collect and pay use tax on goods purchased for use in Illinois violated the Due Process Clause of the U.S. Constitution and created an unconstitutional burden on interstate commerce (National Bellas Hess, Inc. v Department of Revenue of Ill, 386 U.S. 753)[3]. In a subsequent use tax collection case, Quill Corp. v. North Dakota, 504 U.S. 298 (1992)[4], North Dakota filed an action in state court to require an out-of-state mail-order house to collect and pay use tax on goods purchased from it for use in North Dakota.

Originally, the use tax collection problem concerning remote sales dealt primarily with mail order catalog sales. At that time the inability to collect the use tax was troublesome, but was not critical to state budgets. In recent years, however, the growth of transactions made over the internet has substantially increased the number of remote sales going on nationwide and there is concern among many of the 45 states (and the District of Columbia) that levy sales and use taxes, that the ever-increasing volume of purchases over the internet and by mail is seriously eroding sales and use tax revenue in their states and that this erosion will increase exponentially over time.

Similar to laws in all other states in the United States, the California Rev. and Tax Code §6203[5] imposes a "use tax collection obligation on 'every retailer engaged in business in [California] and making sales of tangible personal property for storage, use or other consumption in this state…'". The California Board of Equalization held that as a result of its contacts with the forum, Borders Online was a retailer engaged in business under the Tax Code, and hence obligated to collect use tax on its sales to California residents.

Under the Tax Code (6203(c)(2))[6], a retailer is engaged in business in California if it (1) has a representative or agent (2) operating in California under its authority, (3) who, in California, engages in selling, delivering, installing, assembling or taking orders for tangible property.

In the original 2001 Borders Online[7] case and the subsequent appellate case in 2005, the California Board of Equalization held that, by virtue of its agreement to handle returns for Borders Online, Borders, Inc. was an authorized representative of Borders Online present in California. This conclusion was reached by noting the preferential treatment to on-line customers based on the return policy posted on the Borders Online web site.

The Board of Equalization also found that Borders, Inc. was engaged in "selling" within the meaning of the Tax Code by virtue of its agreement to handle returns for Borders Online.

Said the Court: “[W]e conclude that, when accomplished through an authorized representative, the taking of returns constitutes "selling" under subdivision (c)(2) of Section 6203.[8] Because neither the Sales and Use Tax Law in general, nor Section 6203[9] in specific, contains a definition of "selling," following the accepted canons of statutory construction, we construe this term according to its common usage. In other words, "selling" is inclusive of all activities that are an integral part of making sales.”

“When out-of-state retailers that make offers of sale to potential customers in California authorize in-state representatives to take returns, these retailers acknowledge that the taking of returns is an integral part of their selling efforts. Such an acknowledgement comports with common sense because the provision of convenient and trustworthy return procedures can be crucial to an out-of-state retailer's ability to make sales. This is especially evident in the realm of e-commerce.”

The California Board of Equalization accordingly held that Borders Online was obligated to collect use tax on its sales to California residents, finding that its contacts with California, via its return policy, were sufficient to satisfy the requirements of Quill Corp. v. North Dakota, 504 US 298 (1992).[10]

In Quill,[11] the US Supreme Court overturned a ruling by the North Dakota Supreme court that compelled the Quill Corporation to collect and pay sales tax on all sales generated within the State of North Dakota. In the case presented before the US Supreme Court, the North Dakota Supreme court, in their original ruling against Quill[12]opted to decline the rules set out in National Bellas Hess, Inc. v Department of Revenue of Ill, 386 U.S. 753.,[13] because "the tremendous social, economic, commercial, and legal innovations" of the past quarter century have rendered the Bellas Hess holding "obsole[te]." 470 N. W. 2d 203, 208 (1991).[14] Under Bellas Hess, such vendors are free from state imposed duties to collect sales and use taxes. The U.S. Supreme court decided that they must either reverse the State Supreme Court ruling or overrule the original Bellas Hess decision. In the Quill[15] Case, the US Supreme court agreed with much of the State Court's reasoning, however their decision to overturn the state court ruling was made easier by the fact that the underlying issue was not only one that the Supreme Court felt Congress would be better qualified to resolve, but they also explained that Congress has the ultimate power to resolve. The court found “No matter how we evaluate the burdens that use taxes impose on interstate commerce, Congress remains free to disagree with our conclusions.”

In recent years Congress has considered legislation that would "overturn" the Bellas Hess[16] rule. Its decision not to take action in this direction may, of course, have been dictated by the Supreme Courts decision of holding in Bellas Hess that the Due Process Clause prohibits States from imposing such taxes on foreign (out of state) corporations. With the Supreme Courts decision to overturn the State of North Dakota’s ruling in Quill,[17] the Supreme Court stated that “Congress is now free to decide whether, when, and to what extent the States may burden interstate mail order (and now e-commerce) concerns with a duty to collect use taxes.

The Supreme Court stated “The collection of state sales and use taxes for purchases made by state residents from out of state corporations that do not have a physical presence in the taxing state and those companies who do no more than communicate with customers in the State by mail or common carrier as part of a general interstate business and are not by state or federal law (Bella Hess and Quill) to be considered by state governments as to be required to collect and report those state taxes is an on-going issue at the state and federal level.”[18]

On August 9, 2001 at a U.S. Senate Finance Committee Public Hearing on Cyber shopping and Sales Tax[19] the committee recognized the growing complexities which traditional multi-state brick and mortar vendors were experiencing with the collection and reporting of local sales taxes as well as growing concerns the states were having about use tax collections from catalog and Internet vendors. The basic idea that was being discussed was to legislatively overturn the Bella Hess[20] and Quill[21] rulings by creating an expanded responsibility on remote sellers to collect and remit use taxes to the state jurisdiction where the product was destined for, or as a second option, create a simplified sub-federal sales and use tax system that would eliminate intra-state diversity in sales and use taxation, and standardize administration across all of the states. Under this proposal the states would agree to move to one tax rate per state that was revenue neutral, and business would join with state and local government to find suitable legislative vehicles to make it a reality.

Some of the participants in this plan also hoped that the sales and use tax simplification would also lead to other tax reforms, e.g. agreement on a uniform final consumption tax base. In response to the growing concerns, speculations, and criticisms by the states about Internet taxing methods, and based on recommendations from the committee, Congress passed the Internet Tax Freedom Act (ITFA)[22] in 1998, imposing a three-year moratorium on new Internet taxes. The moratorium prohibited state and political subdivisions from imposing multiple and discriminatory taxes on electronic commerce, which affect out of state vendors who had no brick and mortar presence in a state. The ITFA also provided that taxing jurisdictions may not impose taxes on Internet access unless such taxes were generally imposed and actually collected prior to October 1, 1998, meaning that taxes on fees paid to Internet Service Providers such as AOL may not be imposed, unless these fees were taxed prior to the ITFA’s passage.

The ITFA[23] was a response to the need to keep states and localities from imposing an overlapping mess of taxing systems that could be harmful to the development of the Internet and new entrepreneurship. As there are over 7,500 state and local tax jurisdictions in the United States, Congress felt the administrative burden of levying these taxes would be unreasonable.

The ITFA[24] also created the Advisory Commission on Electronic Commerce to consider and advise on the tax handling of electronic commerce. In 2000, the Commission made a majority proposal to Congress that failed to receive the necessary amount of votes required under the Act, a two-thirds supermajority, and in response on November 28, 2001 Congress extended the Internet tax moratorium for an additional three years.

On November 1, 2004 the ITFA’s moratorium expired and with the Senate at a standoff on legislation (S. 150, the Internet Tax Nondiscrimination Act of 2003)[25]that would permanently extend the Internet Tax Moratorium and ban some Internet access taxes, concerned with, among other things, the bill’s definition of “internet access,” a group of four senators proposed a 2-year extension as a compromise at a Senate press conference on November 20, 2004. As a condition of this extension in the Senate, the house proposed the Streamlined Sales and Use Tax Administration Act, House Bill 5504, in 2004. [26]

According to the bill, "This act simplifies the sales tax and use tax administration in order to substantially reduce the burden of tax compliance for all sellers and for all types of commerce."[27] Under the proposal the bill would allow each State Treasurer to enter into the streamlined sales and use tax agreement with one or more states, certify the State’s compliance with the agreement, and take any other action necessary to participate in the agreement. The Department of Treasury also would be able to take action reasonably required to implement the Act, including promulgating rules and procuring goods and services with other states. The bill would require the appointment of four people to the governing board of the agreement. The State delegation would include a member or former member of the Senate or an employee of the Senate or the Senate Fiscal Agency; a member or former member of the House of Representatives or an employee of the House or the House Fiscal Agency; the State Treasurer or a designee; and the Governor or a designee. Legislative appointments would be jointly made by the legislative leaders of both parties.

With each state having their own delegation, the delegation would be responsible to represent the State at all meetings of the board and would vote on the State’s behalf in certifying service providers (agents performing sellers' sales and use tax functions); certifying automated systems (computer software that calculates the tax imposed by each jurisdiction on a transaction and determines the amount to remit to the appropriate state); establishing performance standards for multi-state sellers; participating in the issue resolution process; determining compliance of petitioning states; and taking other actions necessary under the agreement. The delegation would report on a quarterly basis to the appropriate legislative standing committees on the board’s activities and would recommend amendments to State statutes necessary to comply with the agreement. In addition delegation would appoint a business advisory council of up to eight members to consult with it on streamlined sales and use tax matters.

A foreign seller could participate under the agreement only by registering in the central registration system provided for by the streamlined sales and use tax agreement. A seller registered under the agreement would be registered in each of the member states, but sellers also could register individually with other states. A seller could cancel its registration under the agreement at any time, but would remain liable for remitting taxes collected to the appropriate states. By registering, a seller would agree to collect and remit sales and use taxes for all taxable sales into the appropriate State.

“A registered seller would have to agree to one of the following models for purposes of

collecting and remitting sales and use taxes under the agreement:

Model 1: The seller uses a certified service provider to act as its agent to perform all of the seller’s sales and use tax collection functions, other than its obligation to remit sales or use tax on its own purchases.

Model 2: The seller uses a certified automated system to perform part of the seller’s sales

and use tax collection functions, but retains responsibility for remitting the tax.

Model 3: The seller has sales in at least five member states, has annual sales of $500

million or more, has a proprietary system that calculates the amount of tax due in each taxing jurisdiction, and has entered into a performance agreement with the member states

establishing a tax performance standard for the seller. For this model, "seller" includes an

affiliated group of sellers using the same proprietary system.

Model 4: Any other system approved by the Department of Treasury.”[28]

If this bill was in place, Congress will probably require companies over a certain revenue threshold to collect other states' sales taxes. To implement this, cooperating states are working to simplify their tax rules for online sales to make tax collection more feasible. Probably smaller businesses and organizations will be exempted because of the hardship and expense involved. Larger retailers will need to use software, such as Taxware and Alalara AvaTax[29] that calculates sales tax according to ZIP code for the state to which goods are shipped..

Despite the passage and continued extensions to the ITFA[30] the enforcement of state sales and use tax laws on e-commerce and their related brick and mortar divisions and the consideration of Sales and Use Tax Administration Act, House Bill 5504[31], sales and use tax cases and laws continue to wind its way through different state courts and governments.

In 2002, an Arkansas state law[32] was passed that tested the distinction of e-commerce operations versus brink and mortar operations by the same companies. The law authorized the collection of sales tax from e-commerce sites that have affiliated stores in Arkansas. In this case an affiliate store is a store that acts as an “agent” by performing services for its e-commerce cousin, such as accepting returns and exchanges for products bought on the Web site -- a common arrangement among retailers with web sites (and similar to what Borders Books and Borders on-line was doing prior to the California case). The context for the Arkansas law suggest that having the physical presence of such an affiliated store creates a nexus for the online site, and thus qualifies as an entity subject to state sales tax. Tax officials in Arkansas say that most of the 50 or so e-commerce sites they’ve identified as being liable under the new law, all have registered with the state, indicating their willingness to pay the taxes on sales made to Arkansas residents.

The passage and use of this law in Arkansas led to similar laws in other states. The state of Minnesota,[33] whose statute is more detailed than that of Arkansas, argues that these so-called clicks-and-mortar arrangements are similar to out-of-state manufacturers that have independent representatives or agents making sales and service calls in the state. Their law says the presence of in-state agents creates a nexus that has long allowed the state to tax such manufacturers. “The theory in Minnesota is that these companies are complying with the law because the advantage of being able to offer customers both online service and retail affiliates outweighs the costs involved in the process of collecting and reporting Minnesota sales tax.”[34]

While waiting for Congress to come up with a fair and enforceable Federal Streamlined Sales and Use Tax regulation, State legislatures through out the United States continue to test and try various laws and rules to ensure the collection of sales tax in their states from brick and mortar operations that have an e-commerce presence.

Conclusion

In response to the ruling in California, Borders On-Line, Inc. later removed the in-store return offer from its site, but continued to take such returns and to advertise the shopping site in its stores. In late 2005 Borders turned over the operation of its online store to web retailer Amazon.com (NASDAQ: AMZN). Borders paid the tax bill -- some $167,000 -- for 1998 and 1999, but then applied for a refund. The denial of that request by the California Board of Equalization led to the legal actions that resulted in the appeals court ruling. The ruling could result in additional tax liabilities stretching to 2001, when Borders struck the outsourcing deal with Amazon.[35]

As a result of the various state laws and the stalled legislations in Congress, a few large retailers are collecting sales tax now in multiple states in exchange for a guarantee of future immunity in case a state would ever file a suit against them for sales taxes due. But no state is likely to go after a small organization -- especially one that doesn't have a physical presence in multiple states -- since the costs of a suit would greatly outweigh any potential gain.

Ultimately the implications from the Border’s case and other cases around the country could be significant for large web retailers like Amazon, which manages online sales for a number of brick-and-mortar merchants and could be seen as having a presence in a number of states as a result. The question of how best to handle sales taxes online remains an open one. For years, the argument against such a national tax has been that putting it in place would be detrimental to the online retail industry. However, with Web-based retail growing at a double-digit rate for several years in a row and now making up more than 5 percent of all sales in some categories, that argument grows less persuasive each day to the states that are losing out on sales tax revenues.

William E. Ferguson

[1] California Board of Equalization v. Borders Online Inc. No. SC OHA 97-638364, Cal. Tax Rptr. ¶ 403-191, (Cal. SBE Sept. 26, 2001

[2] California Board of Equalization v. Borders Online Inc. No. SC OHA 97-638364, Cal. Tax Rptr. ¶ 403-191, (Cal. SBE Sept. 26, 2001

[3] (National Bellas Hess, Inc. v Department of Revenue of Ill, 386 U.S. 753)

[4] Quill Corp. v. North Dakota, 504 U.S. 298 (1992)

[7] California Board of Equalization v. Borders, Online, Inc.
SC OHA 97-638364 56270 (Cal. Board of Equalization, September 26, 2001)

[10] Quill Corp. v. North Dakota, 504 US 298 (1992)

[11] Quill Corp. v. North Dakota, 504 US 298 (1992)

[12] Quill Corp. v. North Dakota, 504 US 298 (1992)

[13] Bellas Hess, Inc. v Department of Revenue of Ill, 386 U.S. 753 (1991)

[14] Bellas Hess, Inc. v Department of Revenue of Ill, 386 U.S. 753 (1991)

[15] Quill Corp. v. North Dakota, 504 US 298 (1992)

[16] Bellas Hess, Inc. v Department of Revenue of Ill, 386 U.S. 753 (1991)

[17] Quill Corp. v. North Dakota, 504 US 298 (1992)

[18] Quill Corp. v. North Dakota, 504 US 298 (1992)

[19] http://www.andrew.cmu.edu/~rs9f/finance_8_9_01.doc.)

[20] Bellas Hess, Inc. v Department of Revenue of Ill, 386 U.S. 753 (1991)

[21] Quill Corp. v. North Dakota, 504 US 298 (1992)

[22] H.R. 3709, the Internet Nondiscrimination Act of 2000. (2000)

[23] H.R. 3709, the Internet Nondiscrimination Act of 2000. (2000)

[24] H.R. 3709, the Internet Nondiscrimination Act of 2000. (2000)

[25] H.R. S. 150, the Internet Tax Nondiscrimination Act of 2003 (2003)

[26] HB 788 Streamlined Sales & Use Tax Act (2004)

[27] HB 788 Streamlined Sales & Use Tax Act (2004)

[28] HB 788 Streamlined Sales & Use Tax Act (2004)

[29] https://www.taxware.com/ & http://www.avalara.com/index.cfm/page/Products

[30] H.R. 3709, the Internet Nondiscrimination Act of 2000. (2000)

[31] HB 5504 Streamlined Sales & Use Administrative Tax Act (2004)

[33] http://www.house.leg.state.mn.us/hrd/issinfo/sssstp.htm

[34] http://www.house.leg.state.mn.us/hrd/issinfo/sssstp.htm

[35] Javad Heydary, an E-Commerce Times columnist, is a Toronto lawyer licensed to practice in both Ontario and New York and is the managing editor of Lawsof.com.