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Targeting State Taxes

Can technology or legislation resolve the issue of who should pay taxes to whom?

1Aug

Taxes aren't often considered a strategic weapon. But they are if you're Micro Warehouse Inc. The Norwalk, Connecticut-based direct marketer of computers derives some $2 billion in annual revenue from catalog and Internet sales to consumers in 50 states, yet it collects and remits sales tax in only 5. In the other 45, it's up to the consumers to remit the tax on their income tax forms. Consequently, Micro Warehouse can, in effect, charge 5 to 8 percent less than its competitors in those states. "We have a competitive advantage," concedes Laurence H. Midler, the company's senior vice president and general counsel.

This advantage is completely legal, courtesy of two U.S. Supreme Court decisions--one in 1967 and one in 1992--that ruled a business must collect and remit a state's sales and use taxes only if it is physically located in that state. Micro Warehouse has this "nexus" in 5 states, where its headquarters and warehouses are located. A competitor, RadioShack Corp., however, has nexus in all 50 states. That has Ronald Parrish crying foul. It's created an "erroneous perception that our products cost more," says the vice president of industry and government affairs at the $4.8 billion consumer electronics retailer. "And if we're selling the same model computer as a Web retailer for what appears to be 6 percent more because of the sales tax, then we're clearly not going to be able to compete against them." Obviously, argues Parrish, "what we've got here is an uneven playing field."

Leveling that field is no simple matter. There are 7,600 different state and local jurisdictions in the United States, levying a bewildering array of sales and use taxes. The Internet has only complicated matters. A 1998 federal law outlawed new taxes on online retail transactions, which reached $7 billion in the first quarter of 2001. The result has been a multisided tug of war over who has to pay taxes to whom.

On one side are entrepreneurial dot-coms and catalog companies that argue they cannot possibly afford the financial burden of collecting and remitting state sales and use taxes in non-nexus jurisdictions. The national bricks-and-mortar retailers, on the other hand, contend they are at a competitive disadvantage because they must add a sales tax to their products. Meanwhile, the states maintain that a substantial portion of E-commerce tax does not find its rightful way into their tax coffers, because consumers never pay it when they buy goods from remote sellers. And with estimates that the 45 states with sales and use taxes will lose $5.6 billion in uncollected taxes in 2004, according to Forrester Research Inc., there is some substance to their argument.

Working out a compromise will take years. "Five years would be pretty optimistic," says Ben Isaacson, executive director of the Association for Interactive Media (AIM), a New York­based Internet and interactive media industry trade organization. "But if we don't make changes in a rational way now, and just continue to let the states operate with an antiquated system, it will be a detriment to the entire corporate world."

THE VARIOUS STAKES

What AIM considers most rational is absolute simplification of existing state sales and use tax laws. "We want one rate per state, irrespective of local jurisdictions," says Isaacson. "You can't expect the grandma in Idaho who sews quilts for sale online to collect and remit taxes to 7,600 taxing jurisdictions. Nor can you expect her to invest in expensive software that supposedly would do it for her."

Corporate members of AIM, such as Omaha Steaks, Buy.com, CDNow, CatalogCity.com, and Fingerhut Cos., a subsidiary of Federated Department Stores, agree. Adopting such a system, says Frank Julian, operating vice president and tax counsel at $18 billion Federated Department Stores, would "considerably reduce the expenses we incur in collecting tax." Currently, he adds, "it costs a retailer 3.5 percent of the tax collected just to collect the tax." In addition, such a system would "vastly reduce our exposure to errors for overcollecting or undercollecting. Right now, [we] have zero margin of error in this regard."

Not everyone views the single -tax solution as the best option. "It looks simple in theory, until you consider all those local jurisdictions that have issued bonds to build a stadium or, in the case of New York City, stave off bankruptcy," says James Eads, a partner at Ernst & Young in McLean, Virginia, and a specialist in E-commerce tax policy. "Does New York State tell New York City it has to cut its tax rate to comply with the state's single rate? How, then, will the city guarantee payment of the bankruptcy bonds?" asks Eads, who, as a member of the National Tax Association's electronic commerce tax project, scrutinized the strategy.

Neal Osten, director of commerce and communications at the National Conference of State Legislatures, which represents all 50 states, agrees. "We have a problem with the single rate, because of the political fight it would require to get it passed in the state legislatures," he says. To date, however, 12 states as well as Washington, D.C., have independently adopted a single rate for all commerce. In Michigan, for example, the rate is 6 percent, and in Maryland, it's 5 percent.

STREAMLINER BLUES

What many states hope will ultimately resolve the problem, says Osten, is "technology that is certified by the states to do the collecting and remitting for companies." Such technology, in fact, already exists, thanks to a pilot program by the Streamlined Sales Tax Project (SSTP), an initiative undertaken by 39 state governments to simplify and modernize sales and use tax administration.

The program, which was scheduled to kick off in four states (Kansas, Michigan, Wisconsin, and North Carolina) last month, will test the use of a certified service provider to collect and remit sales tax for companies on their behalf. Three tax calculation and administration software firms--Pitney Bowes Inc., Esalestax.com Inc., and Taxware International Inc.--have been chosen to house their software on the Internet to allow all retailers to collect and remit sales and use taxes, regardless of their geographic nexus. And by installing certified providers (and paying their fees), the states will relieve corporate taxpayers of responsibility for underremitting or failing to remit sales and use taxes unless there is a clear case of fraud or misrepresentation. "We're going to prove that technology can solve this dilemma," says Jon Abolins, vice president of tax and government affairs at Salem, Massachusetts-based Taxware.

Not everyone is as sanguine. "The question for me is how merchants will interact with the technology," says Isaacson. "There doesn't seem to be a simple 'plug and play' model for all companies to incorporate this system into their own E-commerce systems." Abolins agrees--to a point. "For situations where there is no standard interface, as in the case of companies that have developed their own tax-billing software, they would have to link their technology to ours, which would not be easy or inexpensive," he says. "But the states are saying they would pay for this systems integration--at least the states that support the SSTP."

Therein lies the rub: Only 15 states have passed SSTP legislation, which gives their departments of revenue the authority to work with other states to collect sales and use taxes as well as the ability to enter into contracts with certified service providers. Holdouts include 4 leading technology states--California, Massachusetts, Virginia, and Colorado--that see the taxation of Internet commerce as squeezing the revenues of their top technology companies. A study by University of Chicago economist Austan Goolsbee gives these concerns some weight, indicating online spending could decrease by as much as 30 percent if sales taxes were levied across the Internet, involving all 50 states. Meanwhile, other states, such as Florida, have chosen to remain neutral on the issue.

NO FREE LUNCH

Even if the pilot proves successful, some states may never line up behind the SSTP, or they may take years to follow suit. In the interim, Isaacson says, states should attack the problem at its root--the consumers. The majority of consumers, he explains, "think, erroneously, that the Internet Tax Freedom Act [passed by Congress in 1998 to prevent states from adopting new Internet-specific taxes] made the Internet tax-free. It didn't. Consequently, nobody knows they're supposed to remit the sales tax come April 15. The issue lies with them."

A few states, such as Maine, New Jersey, and North Carolina, do have a line on their income tax return forms reminding consumers to report taxable out-of-state purchases. But they are the exception, not the rule. And it's not like consumers are anteing up, anyway. "New Jersey has had a line item for out-of-state purchases for several years, and has collected a fairly modest amount of money," says Eads. "Who remembers what they bought online eight months ago?"

What most states, as well as many corporations, want to avoid is federal intervention. One of the main aims of the SSTP, in fact, is to prove that the states can solve their own tax problems. Congress can, in theory, intervene, since both the U.S. Supreme Court cases that established nexus in the first place--1967's National Bellas Hess v. Illinois and 1992's Quill Corp. v. North Dakota--were based on the interstate commerce provision in the U.S. Constitution. "The nexus question is at the heart of the SSTP, and Congress has the power to deal with the nexus question," explains Eads. And if the SSTP, or anything else, he adds, "succeeds in making the collection of state taxes simpler, and there is no longer a burden to do so, then Congress has the power to require the collection of the taxes."

Before that happens, he says, finance executives should realize that "the time to pick sides is now. CFOs must get involved in this debate and say to their elected officials that fundamental reform is needed. No one knows which outcome will prevail, and right now there are too many [proposals] to ignore."

There is a bright side, however: If all sides on the issue can come to a fair and equitable resolution, states may lower their tax rates if they're able to recoup all that lost tax revenue from remote sellers. Too good to be true? "One can only hope," says Eads. 

--Russ Banham is a contributing editor of CFO.

NO TOLLS ON THE INTERNET

The brouhaha over the collection and remittance of state sales and use taxes is made more contentious by several bills now before Congress that seek to extend the Internet Tax Freedom Act, a 1998 law preventing states from adopting new Internet-specific taxes for three years. the ITFA expires in October.

One of the bills, S. 512, sponsored by Sen. Byron Dorgan (D­N. Dak.), would couple a four-year extension of the act with provisions to allow states to form an interstate compact to collect taxes on remote sales once certain conditions are met, such as more-simplified tax codes and greater ease of compliance. Right now, remote sellers do not have to collect and remit the taxes. Another set of bills, introduced by Sen. Ron Wyden (D­Oreg.) and Rep. Christopher Cox (R­Calif.), would extend the act for five years without the additional provisions. Some congressional leaders, such as Sen. John McCain (R­Ariz.), favor a permanent extension of the act.

Meanwhile, Sen. Max Baucus (D­ Mont.), chairman of the Senate Finance Committee, and former finance chair Sen. Chuck Grassley (R­Iowa) have co- authored a letter to the Congressional Budget Office, asking for a study on how consumers and businesses would fare under additional Internet sales taxes.

In a press release, Grassley later pointed out: "It is up to us to decide whether to let state and local governments require businesses to collect sales taxes on certain Internet purchases. This is a big decision. It affects how much consumers pay when they order a book or a sweater online. It affects how much state and local governments collect for their public initiatives. It affects the bottom line of those doing business on the Internet. We have to go into this equipped with all the facts."

With all indications pointing to an extension of ITFA, it appears Congress will have more time to gather those facts. -- R.B.

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