The Tempest Over Taxes

The "too complex" excuse won't hold long

To tax or not to tax? That's one of the hottest questions in the e-commerce arena. On one side, governors and mayors argue that an avalanche of untaxed e-sales will drain billions from their coffers.

On the other side, Internet businesses and their political evangelists fret that new levies could quash the online revolution.

Until recently, the antitax camp held the upper hand, thanks to sympathy in Congress and some key Supreme Court decisions. But Internet businesses have also wielded a secret weapon--the fact that existing technology can barely handle tax collection on the billions of bits of information that make up Internet sales. Improved tax software from a host of companies will do a better job. But as e-commerce expands and evolves, fresh complexities will continue to challenge even the smartest software.

BURDENSOME. Complexity is not a new defense in the long struggle by businesses to thwart expanded sales taxes. In 1992, the Supreme Court ruled that mail-order companies couldn't be forced to collect sales taxes in states where they did not maintain a physical presence--meaning stores, warehouses, and the like. The courts said it was too great a burden for companies to navigate the thousands of different tax rules imposed by 7,500 states, cities, counties, and special authorities that tax purchases.

Well, the Internet is subject to those precedents--but the situation is even more complicated. In the e-commerce world, physical presence may be nothing more than software on a computer server. Products may be streams of digital bits. And payments could turn up as digital cash--untraceable to billing or delivery addresses that normally determine who pays a tax, and where.

Before grappling with these new issues, remember that Net commerce is already taxed. Despite a three-year moratorium on new levies, most states require buyers to pay tax on the goods they purchase online from companies located in that state. And many merchants who collect these taxes rely on software from vendors such as Taxware International Inc. in Salem, Mass., and Vertex Inc. of Berwyn, Pa.

But so far, the Supreme Court has exempted merchants from having to collect tax in states where they have no physical presence. That has been a boon to companies and their customers. And it has inspired companies such as Barnes & Noble Inc. to spin off their Net operations so they can court online customers without worrying about physical presence rules--except in states where they are headquartered.

Now, state governments are uncomfortable with the status quo. They weren't terribly troubled about lost revenues when e-commerce was in its infancy. Even in 1998, according to Ernst & Young, states missed out on about $170 million worth of taxes on online purchases, barely 0.1% of total sales-tax collections. But as e-commerce rings up more sales, the loss of those revenues will be harder for states to ignore.

HALF-BAKED. There are many obstacles, however, to boosting cross-state collection. One of the biggest is the jumble of product definitions and codes employed by different tax authorities. In New York, large marshmallows are considered taxable snacks, while little marshmallows are tax-exempt food. Plain doughnuts are tax-exempt in some states while jelly-filled ones are taxable. Clothes are taxable in most states. But in nine, they are not. And four of those exempt handkerchiefs.

No software today keeps track of all these absurdities. So retailers must manually match their products with their software vendor's categories. Federated Department Stores Inc., for example, has 40 codes for clothing that it must squeeze into Taxware's 12 categories. "That makes it very expensive and time-consuming," says Federated's tax counsel, Frank G. Julian.

Determining location and tax rates for purchasers is also a task. Software from Taxware breaks the U.S. into ZIP codes, assigns one of 1,500 product codes to goods and services, and then determines the tax for a particular product purchased by a buyer residing in a particular location.

Unfortunately, today's ZIP-code based approach is crude and can't account for the fact that in many states taxing districts don't match U.S. Postal Service codes. New software systems may succeed in putting every address in the right tax district. But what address should the software look for? Physical goods can be tied to the location to which they are shipped. But what if the product is a scrambled burst of bits that the buyer's personal computer downloads and reconstructs as a tune from Red Hot Chili Peppers? If the music is purchased by credit card, it's easy to figure the tax based on the billing address. But if the payment is in digital cash, such an address won't be available.

Governors hope software will resolve all these issues. And soon, to facilitate tax collection by merchants, states may start paying businesses' costs of calculating and collecting sales taxes. Governors have also vowed to simplify their agonizingly complex tax laws.

These steps will spur enhancements to tax software, which are already under way. Today, to keep its clients up to date on local regulations, the best that Taxware can do is to send merchants monthly computer disks with updated tax data. Later this year, Taxware plans to install its software on a remote server, which corporate clients will access over the Net. This will enable Taxware to immediately adjust its programs as states and cities revise their laws. Vertex may expand its own tax databases so they can be used as a platform for sophisticated collection tools. And if states actually start simplifying their arcane laws, developers will redouble their software efforts. Says Lisa Gilbertson, director of tax and financial issues for the International Mass Retail Assn.: "If we get uniformity, software should be able to handle [taxes] for any size business."

Software alone won't do the job, says Dan Bucks, director of the Multi-State Tax Commission, an organization that coordinates activities of state tax authorities. "You'd have to link sophisticated tax calculation software with a dependable and secure telecommunications and computer infrastructure," says Bucks.

On that score, larger computer companies are starting to weigh in with integrated tax solutions. IBM, for example, is testing a collection and remittance service with Danish toymaker Lego Group. Big Blue is still not ready to discuss its experiment in Europe. But sources familiar with the test say the software will split the cost of a product, remit the value-added tax to government authorities, and transfer the rest to Lego. Although the U.S. tax structure is different, such technology could be applied to American sales taxes as well.

TAX-MINING? Sophisticated new technology could substantially tilt the debate over cross-state Internet sales taxes. With software advances in mind, Utah Governor Michael O. Leavitt and the National Governors' Assn. have proposed employing "trusted third parties" to take over tax collection chores from individual e-tailers who handle it today. Such companies would have the ability to pull all the required information off a central computer and direct tax payments to the proper state.

But here, too, technology creates new problems even as it solves old ones. Consumer groups worry that third-party tax collectors would gather detailed information on buyers and what they purchase. Such data, aggregated on a single server, would become a tempting target for criminals--or marketers hoping to buy the data.

While these hurdles are high, they certainly aren't insurmountable. And states seem determined to make it worth the software developers' efforts. But once the glitches have been ironed out, politicians may find themselves back at the start of a long and circular conundrum: Do we want to tax e-commerce at all?

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