Internet Taxation Themes

1. Internet Taxation Themes Legal Research, Issues, and Practice Cyberspace Cyrus Daftary & Todd Krieger April 1st, 2013

2. Agenda • Tax Policy • ‘Net’ Tax Themes • Practical Tips – Ways to Argue • Questions & Answers

3. Taxation on the Internet • The taxation rules currently in force do not take into account the technological progress in the delivery of services and changes that are necessary in order to prevent loss of tax revenue and distortion of competition.

4. Tax Policy - in the 18th Century • In the 18th century Adam Smith articulated the following four principles of taxation as follows: • Equality • Convenience • Certainty • Economy

5. Tax Policy – Following the Great Depression • Sales tax was enacted during the Great Depression to boost state and and local government revenues. • In 2012, it accounted for 33% of all state and local revenues generated – estimated to be valued in excess of $194B.

6. Tax Policy – Today • Reduce tax burden • Simplify compliance • National sales tax • Flat tax • Obama tax reduction / increase

7. Taxation and Jurisdiction • In the U.S. there are 7,600 taxing authorities comprised of states, cities, towns, counties, transportation districts and other special local jurisdictions that impose tax for transactions that occur within their boundaries.• States - 46• Cities - 4,696• Counties - 1,602• Other jurisdictions - 1,113

8. Why Do We Have Taxes? • Fund Social Security, highways, healthcare, education, public safety, defense, war, social services (i.e. food stamps, housing), etc. • Should we tax the Internet sales? • US e-commerce sales in 2012 were estimated to be $225B. Up by ~15% from last year. • Apple’s App Store generated $9B in revenue in 2012 ( a 33% increase from 2011)

9. Core Tax Concepts Indirect and Direct Taxation Nexus: Sufficient connection with a state to allow taxation Situs: Location of the transaction Permanent Establishment: International standard for taxable presence

10. Nexus • Taxable presence for state taxation embodied within the “Nexus” concept • Definition of Nexus - Level of activity in a state that must occur before tax can be imposed - Sufficient activity or “Nexus” is defined by statute and federal and state court decision • Rules vary from state to state • Level of activity required to assert Nexus varies by the type of tax (e.g. income tax, sales & use) - Nexus generally exists if: • Income is derived from sources in the state • Property is owned or leased in a state • Personnel are employed in a state • Capital or property is located in the state

11. NexusThe 2000 State Tax Survey • Purpose of Nexus is to justify levying a tax. • Problem – No consistent application of meaning • “Substantial Nexus” – Significant physical presence. • “Economic Nexus” – No universal definition. • Concept evolved after Geoffrey case in 1994. • Ambiguities as to meaning. • Economic connection and/or activities for a period of time as opposed to physical presence.

12. Nexus - Basis for Sales Tax Quill Corp. v. N. D. (U.S. Supreme Court 1992) • In an attempt to assert a use tax collection responsibility on mail order retailers, some states enacted statutes that defined “retailer” or “vendor” to include those who solicit sales in such a manner that a state’s market is systematically or purposefully exploited. • However, the Supreme Court determined in Quill that the Commerce Clause barred North Dakota from requiring an out-of-state mail-order company to collect and pay use tax on goods sold to state residents when the company had no outlets, sales representatives, or other significant property in the state. • Quill thus established a bright-line rule that allows a state to require out-of-state mail-order companies having a physical presence in the state to collect a use tax, but does not require those who communicate with customers in the state by mail or common carrier to collect such tax.

13. Quill Summary & Application • Under Quill, a company must have a “substantial physical presence” in a state before that state may require it to collect and remit sales/use tax. • Attribution, Affiliate Nexus • Activities and presence of an affiliated corporation in a state can be attributed to a separate legal entity for the purpose of establishing Nexus • “Bricks-and-clicks” • In-store advertisements for website, or vice versa • Website coupons for in-store sale items, or vice versa • Return of items purchased through website to bricks-and-mortar location

14. Situs • Situs of the transaction – question is to identify where a transaction occurs • eCommerce transactions are typically thought of as the most difficult to situs • Situs rules vary by jurisdiction • eCommerce transactions are generally considered to be services and are typically sourced in one of the following ways: • State of origin (location where service is performed) • State of destination (location of the customer) • Proration (based on use of service in multiple states) • State of predominate use

15. Permanent Establishment • Taxable presence in the international tax context refers to permanent establishment (“PE”) or U.S. trade or business. • Tax treaties define PE as the carrying on of the business of the enterprise through a fixed place of business. • PE generally exists if: • Place of management or branch office • Factory or mine • Activity not remote from the actual realization of profits • In the absence of a treaty, IRC defines taxable presence as “US trade or business” • Income effectively connected with a U.S. trade or business subject to U.S. Tax • Level of activity must be considerable, continuous and regular

16. Debates over Internet Taxation • Sales and use tax system • VAT system • Income tax system • Collection & enforcement

17. Sales and Use Tax • Erosion of a state’s tax base for shifts in spending patterns pitted against states that can benefit from income tax collected from Internet firms. • In NY, Amazon.com is not subject to NY’s 8% sales tax but Barnes and Noble is subject to the sales tax. It effectively discounts Amazon.com’s prices by 8%. • Examples: • CT phase out on computer and data processing services S&U tax • FL does not tax charges on online services • MA repealed sales tax on Internet services • NJ does not tax charges on online services • OH taxes Internet services as taxable information services • TX taxes Internet services as taxable information services or data processing services

18. VAT • VAT is a tax collected at every stage of product. When products cross international boundaries, a complicated set of issues arise: • Who collects the tax? • Who remits the tax? • What country does the ultimate consumer live in? • Destination country or residence of the consumer keep the tax?

19. International Taxation • International taxation based on principles of territory or “connection” with a jurisdiction • What creates jurisdiction? Location of server? • Deriving income from a jurisdiction? Where is the customer? • Where to book the transaction? Shift profits freely? • What type of income generated? • How to determine the transfer price?

20. International Tax Advantages for Technology Companies • Technology companies have more intangible assets than brick-and-mortar counterparts • Allows for greater flexibility in setting up company structure • Can defer U.S. tax indefinitely until it is brought back into the country • Apple legally allocates about 70% of its profits overseas • Google pays an effective tax rate of 2.4% overseas

21. Google’s Overseas Tax Strategy http://tmtfree.hd.free.fr/albums/files/TMTisFree/Documents/Economy/InsideGoogle.swf

22. Compliance & Enforcement • Lack of paper trail • Conversion of tangible to intangible • Electronic cash technology eliminates identity and promotes concealment • What constitutes books and records?

23. Tax Policy on the Internet • Foster growth and innovation yet achieve fairness. • Some people believe that taxation of Internet transactions will stifle the growth of e- commerce; some feel the Internet continues to threaten brick and mortar companies and many will no longer be around.

24. U.S. Fed Tax Policy on the ‘Net’ On July 1, 1997, the White House issued a “White Paper” that declared “the United States believes that no new taxes should be imposed on Internet commerce.” The White House took the position in the White Paper that “the same broad principles applicable to international taxation … should be applied to sub-federal taxation. No new taxes should be applied to electronic commerce, and states should coordinate their allocation of income derived from electronic commerce.”.

25. Internet Tax Freedom Act ITFA – Internet Tax Freedom Act No federal taxes placed on Internet access or E-Commerce for three years while restricting individual states from enacting new taxes on E-Commerce Three Year Moratorium• Internet Access • Multiple or Discriminatory Taxes Advisory Commission on Electronic Commerce • 19 members 8 state/local government 8 business/consumers 3 federal executive branch representatives

26. Internet Tax Freedom Act (cont) • Two of the fundamental purposes of ITFA were to ensure the continued growth of the Internet and to prevent multiple or discriminatory taxes which could potentially stifle the growth of E-Business. • The highlights of ITFA included: • No federal taxes on Internet access or E-Commerce; • Declared that the Internet should be a tariff free zone; • Established an advisory commission – the Advisory Commission on Electronic Commerce; • Three year moratorium on multiple or discriminatory taxes on E-Business; and • Three year moratorium on new taxes on Internet access fees.

27. Internet Tax Freedom Act (cont) There were numerous complicated tax issues surrounding E-Business transactions such as selling and distributing software on the Internet that ITFA / ACEC could have helped address. Some of the issues included: • Who is the customer? • Where does the customer live? • Was the transaction a sale of tangible property, services, or intangible property? • Which jurisdiction has the authority to tax the sale? • What on-line activities constitute sales for sales tax purposes? • When may a state impose a sales or use tax on on-line activities? • What constitutes nexus (a taxable level of business activity) within a taxing jurisdiction?

28. Extending the Moratorium • President Bush signed into law S. 150 on 12/03/04 – the Internet Tax Non-Discrimination Act which extended the Moratorium until 11/01/07. President Bush signed into law the Internet Tax Act Freedom Amendments Act of 2007 (H.R. 3678) which extends the moratorium seven more years. • Intent was for the U.S. to work aggressively through the EU and WTO to keep electronic commerce free from tariffs and discriminatory taxes – as well as avoid federal taxes.

29. What’s Next • Debate as to whether or not to permanently extend the extension on the Moratorium. (Expires 11/1/2014) • With the current economic state, Obama’s economic stimulus – tax dollars are needed. • Rep Bill Delahunt (MA) lobbied last summer to tax sales over the Internet. • Are ‘Net’ taxes a good or bad thing? What do you think the impact will be? Who benefits and loses? • Streamlined Sales Tax Project • Enabling Legislation • Expand Nexus requirements

30. Sales Tax Overview • In the United States, the primary transaction tax that is charged on the sale of goods and sometimes services is the sales tax. • Sales taxes are imposed by state and local governments and are charged to the consumer, but they are collected and paid by the vendor. • An exception to this rule exists when the vendor does not have a physical presence in a state. • In this case, the consumer is responsible for the sales tax payment (known as a use tax). Internet sales use tax valued at $3.5B in 2010.

31. Sales Tax Overview • The growth in electronic commerce allows companies to make retail sales directly to consumers through the Internet. • Forty five states and the District of Columbia impose a sales tax upon retail sales of tangible personal property and enumerated services. • The obligation to collect, report and remit sales tax falls upon the selling company if it has Nexus with the taxing state. • The average sales tax rate throughout the country is approximately 6%.

32. Sales Tax Collection in the US

33. Sales Tax Challenges • Business distortions caused by sales taxes • Amazon v. B&N • Consumers of companies with a small tax footprint may be able to purchase tangible personal property and enumerated services at a lower total cost. • Accordingly, these companies enjoy a competitive advantage in the marketplace over companies that are required to collect, report and remit sales tax.

34. What is SSTP? • A group of representatives from 44 states met to develop a Model Act for a uniform sales and use tax act – went into effect 10/1/05. See (http://www.streamlinedsalestax.org/) • Project started through suggestion of ACEC and National Governors Association • Mission: develop measures to design, test and implement a sales and use tax system that radically simplifies sales and use taxes (uniform tax bases, sourcing rules, rates). • Focus: improving sales and use tax administration systems for both Main Street and remote sellers for all types of commerce.

35. Motivation for SSTP • “We can no longer rely on a Depression-era sales tax system in a digital, 21st century economy and we can’t expect Congress or the Supreme Court to bail us out of the mess we’ve created. Cooperative state action to simplify state and local sales taxes may be the only way to save them.” - Illinois Senator Steve Rauschenberger, former co-chair of the NCSL task force. • “Our revenues are not keeping up with economic growth, so we face a budget shortfall while most other states enjoy surpluses. One reason is that the sales tax base just keeps shrinking. Electronic commerce will only make that problem worse.” - Tennessee Representative Matthew Kisber

36. Participating States (32) Alabama Arkansas Illinois Indiana Iowa Kansas Kentucky Louisiana Maine Maryland Michigan Minnesota Mississippi Missouri Nebraska New Jersey Nevada North Carolina North Dakota Ohio Oklahoma Rhode Island South Carolina South Dakota Tennessee Texas Utah Vermont Washington West Virginia Wisconsin Wyoming States Participating in SSTP • Observer States (6) • California • Colorado • Connecticut • Georgia • Idaho • Pennsylvania

37. Marketplace Fairness Act • Proposed legislation introduced in Senate on November 9th, 2011. • Recently endorsed by 75 Senators to be included in next budget. • Law would allow states to collect use tax on purchases shipped into the state • Before a state can collect the tax, they must either simplify their sales and use tax laws, or participate with SSTP • In many states' views, enforcement of an existing tax is better than levying a new tax on their constituents.

38. Marketplace Fairness Act Purpose of the Law • Brick-and-mortar stores have a physical presence in many states, and therefore, subject to more tax • In 2010, Amazon’s effective tax rate was 10% less than Target’s • Amazon has actually voiced support for the law citing the requirement for sales tax collection simplification Opposition • States with no sales tax generally opposed the measure • Senate Finance Committee Chariman, Max Baucus, questioned Congress’ power to authorize courts in one state to enforce state sales tax laws in a different state

39. Preventative Measures – Begin to Create a Tax Footprint • Any possible situs of a transaction that may determine tax jurisdiction:- Access location (may not be readily identifiable)- Customer’s billing address as utilized by the seller of eCommerce service- Customer’s billing address as utilized by the eCommerce facilitator- Location where customer uses the service (location of download may be different than location of use)- Address of vendor’s corporate headquarters- Vendor’s branch or division address- Vendor’s web page location- Vendor’s processing center- Other third party provider location

40. Ways to Minimize Tax Liability • Server locations • Fulfillment locations • Locations where technical people are providing services • Call center locations • Understand the criteria for Nexus creating activities • Document policies and procedures associated with record keeping; required information for tax purposes

41. Conclusion • There is little guidance as to how to tax e- business transactions • Companies must rely on existing statutes and case law developed when commerce was dependent on ‘bricks and mortars’. • Major issues for companies engaging in eBusiness are:- When can a state tax the company? (Nexus) - Where is the electronic transaction sitused?

42. Question & Answer