The Tax Man Eyes The Net

A House bill could sort out who will owe what to whom

During a recent visit to California, Utah Governor Michael Leavitt went online to order some food for delivery to his home. His Internet account was set up in Utah, the seller was based in New York, and the goods were shipped from New Jersey. Should he have to pay sales tax to one of those states? All of them? Or none?

With Internet sales expected to surge over the next decade, the answer will be critically important to both states and those who do business on the Web. To date, there are no clear rules setting out who--if anyone--should get those bucks. Instead, a crazy quilt of ad hoc taxes is beginning to plague E-commerce.

But a new congressional initiative may finally set some ground rules for both Internet and mail-order sales and resolve what could easily grow to a $20 billion controversy. The deal, proposed on Mar. 19 by Representative Christopher Cox (R-Calif.) and backed in principle by House GOP leadership and the White House, would require major trade-offs by both Net sellers and states. While Cox's plan will undergo alterations, it seems likely that Congress will act this year. And the proposal dramatically shifts the tone of the debate. "This thing has a pretty good chance of passing," says Frank Kelly, a vice-president at Charles Schwab & Co., which does much of its business on the Internet.

Under Cox's plan, industry, which now happily avoids most levies on Net sales, would agree to participate in a process that could lead to widespread taxes on E-commerce within three years. In return, it would get a consistent, 50-state regime of taxation. Net sales would be taxed at the same rate as mail order or Main Street transactions. And while states could set their own rates, each sale could be taxed only once. That would prevent a seller's state and a buyer's state from trying to tax the same sale. The details of Net taxation would be settled by a panel of industry and government officials that would send its recommendations to Congress by 2000.

For their part, states would accept a three-year freeze on new taxes on Net sales, as well as a permanent ban on taxing the monthly fees charged by Internet service providers. What's in it for the states? An end to the uncertainties that have dogged their efforts to tax both Internet and mail-order sales.

FAIR DEAL. In recent years, the battle over cybertaxes has sowed widespread confusion. Texas wants to tax Internet access fees for travelers who log on during brief stays in the state. California revenue officials argue that a company that has a Web page on a server located in their state would be required to collect California sales tax for purchases made on the site. Such revenue grabs have persuaded much of industry to accept the certainty of taxation in return for simplicity and equal treatment. "We want to make sure there is a fair, nondiscriminatory system," says Jill Lesser, deputy director for law and public policy at America Online Inc.

The Cox bill has widespread political support, though disagreements remain over details. But the plan has deeply divided business. Catalog sellers--who generally don't have to charge a tax on their products--see it as a backdoor way to hit them with new levies. "This seems somewhat devious," gripes Robert Edmund, CEO of Edmund Scientific Co., a Barrington (N.J.) direct seller of scientific equipment and optics. "We're looking at the tip of the iceberg here."

On the other side are Net sellers, who want to be treated the same as their mail-order rivals. State tax experts say they have a point: "If there is going to be a solution, it should address the entire issue of interstate sales," says Michael H. Lippman, a partner and tax expert at accountant KPMG Peat Marwick.

There's no doubt that for now, mail order is where the money is. According to the Direct Marketing Assn., catalog sales totaled more than $78 billion last year. No one knows how much business was done on the Net, though the White House estimates perhaps $4 billion. But the potential for growth of online sales is enormous. International Data Corp. predicts that Net sales will top $200 billion by 2002. That translates into more than $10 billion a year in potential state sales taxes. Throw in an additional $4 billion that could be collected from mail orders, and states could hike their sales tax base by a staggering 10% to 15%.

Governors argue that taxing Net and catalog sales is only right. After all, why should a local department store have to collect a 5% sales tax on a shirt while Lands' End can duck the levy by selling the same garment over the phone or through its Web site? Says Colorado Governor Roy Romer: "The tax should not depend on the way you buy it or from whom you buy it."

DEFINE "PRESENCE." For more than 30 years, however, the Supreme Court has held a different view. It insists that only companies with a physical presence in a state should be required to collect sales taxes. But the court has invited Congress to find a way for states to impose equitable taxes. Until now, it never tried.

With mail order, such presence has been easy to define. But E-commerce has raised issues that the courts never anticipated. Does the location of a computer server count? Says Mark Nebergall, vice-president for tax policy at the Software Publishers Assn.: "There's a mountain of uncertainty."

The battles over whether each individual state will choose to tax Net transactions--and what they'll do with the money--won't be fought in state legislatures until 2000. But for Washington, passage of the Cox bill would reflect a new reality: For all their flash and promise, sales on the Net are no different from selling a yo-yo at the five-and-dime.

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