Published August 2015
In the last century, American retail has been disrupted by waves of innovation.The introduction of modern grocery stores; the rise and decline of shopping malls; the advent of “big-box” retail; each altered the playing field, producing huge economic effects and yielding new winners — and losers.
Today, retail is in the midst of another revolution: the rise of Internet sales, or e-commerce. The convenience of the online experience has shifted decades-old purchasing patterns, and younger people are particularly enthusiastic. By one estimate, Americans aged from 25 to 33 spent an average of $563 online in a single quarter of 2014.
In the U.S. alone, Internet retail sales reached $263 billion in 2013, accounting for 8 percent of all retail sales. Technology consultant Forrester Research estimates that e-commerce sales will rise to a total of $414 billion or 11 percent of all retail sales by 2018.
But as with earlier innovations, e-commerce has produced controversies. Many Internet retailers do not collect sales taxes on their sales, giving them an implicit price advantage over their brick-and-mortar competitors — not a small issue for companies often operating on paper-thin margins.
And, obviously, government revenues are affected as well when a substantial amount of retail activity avoids sales taxes.
Today, 45 states impose state sales taxes; 38 levy local sales taxes as well (Exhibit 1).
|Status||Number of States||States|
|No state or local sales tax||4||DE, MT, NH, OR|
|State sales tax; no local tax||8||CT, IN, KY, ME, MD, MA, MI, RI|
|Local sales tax; no state tax||1||AK|
|State and local sales taxes||37||All Others|
Source: The Tax Foundation
States with sales taxes also impose a corresponding “use tax” at the same rate. Use taxes are intended to put in-state retailers on an equal footing with out-of-state competitors, so that the same amount of tax is collected and paid regardless of where the purchase takes place. (Generally, if a Texas business or resident pays sales tax on an item in another state and brings it into Texas, the sales tax already paid is credited against any use tax due.)
Legally, use taxes are due from the purchaser even if the seller does not collect them. Compliance with use taxes is largely voluntary, however, and unsurprisingly, it tends to be extremely low for purchases by individuals. Businesses tend to be more aware of their responsibilities to remit use tax — and are also more likely to be audited for compliance.
Among the states with sales taxes, whether state, local or both, tax rates vary widely. The Tax Foundation reports Texas' state sales tax rate of 6.25 percent is 12th-highest in the country, while its average combined state and local rate (8.15 percent) is 11th-highest.
In Texas, the sales tax provides more than half of all state tax revenues (Exhibit 2).
Roll over the chart for specific values.
Source: Texas Comptroller of Public Accounts
As of March 2014, the U.S. had nearly 10,000 distinct sales tax jurisdictions, with as many as 1,515 in Texas alone, the highest number of any state by far. The Texas Legislature has authorized cities, counties, transit authorities and special-purpose districts to impose a local sales and use tax of up to 2 percent in addition to the current 6.25 percent state tax.
In the online world, however, jurisdictional boundaries can be traversed instantaneously. And in the case of online shopping, that’s exactly what’s happening.
But while e-commerce is a relatively recent innovation, differing state and local sales tax environments in a nation with extensive interstate commerce have caused complications for decades.
In the 1967 case National Bellas Hess v. Department of Revenue of State of Illinois, the U.S. Supreme Court ruled that states could not require out-of-state businesses to collect and remit sales and use taxes while conducting business in the state solely through common carriers such as the U.S. Postal Service and UPS. The court sent a clear message that a state could impose collection responsibilities on an out-of-state business only if the business had a physical presence in that state. This became known as the “physical presence” rule.
With the 1977 ruling in Complete Auto Transit, Inc. v. Brady, the Supreme Court established a four-part test to determine when a state may impose a tax responsibility on a person engaged in interstate commerce. A particularly significant part of this test was the requirement that there be a “substantial nexus,” or connection, between the state and the entity.
In the same year, the court’s decision in National Geographic Society v. California Board of Equalization affirmed that the physical presence rule applied to the “substantial nexus” requirement established by Complete Auto.
The rule was affirmed yet again by the Supreme Court in 1992 with Quill v. North Dakota. The state had attempted to require an out-of-state office supply company to collect sales tax using an “economic” nexus standard, based on its mail-order sales in North Dakota.
According to the Quill decision, defining substantial nexus using the physical presence rule “firmly establishes the boundaries of legitimate state authority to impose a duty to collect sales and use taxes.” The court also noted, however, that since Congress regulates interstate commerce, it could change the standard via federal law.
After all these years, Quill is still the most significant Supreme Court ruling affecting online sales, although it predates the era of online shopping.
Thus, because of Quill, some out-of-state online merchants can legally avoid collecting and remitting taxes on their sales to in-state customers, creating a fundamental competitive disadvantage for in-state brick-and-mortar stores — and revenue losses for state and local governments.
Some researchers have attempted to estimate the value of uncollected taxes on out-of-state sales. In 2009, a University of Tennessee study estimated the nation’s total loss of state tax revenue due to untaxed online sales would rise to $11.4 billion in 2012. It estimated that Texas would lose out on nearly $1.8 billion in use tax revenue in that year.
Other researchers, however, believe the Tennessee study substantially overstates the potential revenue gain from taxing out-of-state online sales. Another analysis estimated nationwide uncollected taxes due to e-commerce at between $3 billion and $4.8 billion in 2012, with Texas' gap pegged at between $247.2 million and $394.1 million.
When people discuss e-commerce, Amazon is the first name likely to come up, and for good reason. The online merchant dwarfs its online competitors, accounting for an astonishing 23 percent of all U.S. online retail sales in the second quarter of 2014.
Amazon founder Jeff Bezos was entirely aware of the Quill decision when he started selling books from a garage in Washington State. The company has made strategic decisions over the years to minimize its physical presence throughout the nation, and thus its obligation to collect sales and use taxes, even as it expanded its operations and offerings enormously.
In 1996, Amazon inaugurated a new business model in which it pays commissions to persons with websites any time people visiting their sites “click through” to Amazon and makes a purchase. These “affiliates” are not Amazon employees; they include bloggers, small businesses and fundraising organizations.
One high school hockey team’s fundraising flier caused the New York State Department of Revenue to begin investigating Amazon’s affiliate model. The team asked the public to make Amazon purchases by clicking through its own website so it could receive commissions. New York believed the program established the required “nexus” to impose collection responsibilities on Amazon.
In 2008, the New York legislature updated the state’s tax code to specify that out-of-state sellers using a commission arrangement with New York residents must collect and remit sales and use taxes if the agreement generates more than $10,000 from New York referrals in the preceding year. The law allows out-of-state sellers to avoid the collection responsibility if they secure statements from New York affiliates that the latter are not engaged in soliciting sales on behalf of seller.
Overstock.com had a similar business model, and both Amazon and Overstock challenged the New York law in court as a violation of Quill. The law was upheld by New York’s highest state court, and the U.S. Supreme Court subsequently declined to hear the case. Thus, for the time being, laws such as New York’s remain valid.
According to a 2014 survey, at least 12 states have adopted some form of affiliate or “click-through” nexus through administrative action, while another 12 have done so through legislation. In addition, Vermont has passed a click-through law it plans to implement when at least 15 other states have adopted similar legislation.
Meanwhile, Amazon has attempted to limit the impact of affiliate legislation. The company severed its relationships with affiliates in six states — Arkansas, Colorado, Maine, Missouri, Rhode Island and Vermont — upon their passage of affiliate nexus legislation (Exhibit 3). It also negotiated agreements with some states to delay its tax collection responsibility.
In all, Amazon now collects sales taxes in 24 states. The company has a physical presence — a warehouse or other facility — in 18 of them, including Texas.
|Amazon Collects Sales Taxes in These States...||Which Feature...|
|Affiliate Nexus Legislation||Amazon Affiliates||Amazon Physical Location||Notes|
|California, Connecticut, Kansas, New Jersey, Pennsylvania||Yes||Yes||Yes||New Jersey passed affiliate nexus legislation most recently.|
|New York, North Carolina, Michigan, Minnesota, Illinois, Georgia||Yes||Yes||No||New York became the first state to pass affiliate nexus legislation in 2008. Michigan did so most recently, in January 2015.|
|Washington, North Dakota, Nevada, Massachusetts, Arizona, Indiana, Kentucky, Maryland, Tennessee, Texas, Virginia, Wisconsin, Florida||No||No||Yes||These states require Amazon to collect sales taxes under the current Quill/physical presence rule.|
Source: Amazon; Institute for Local Self-Reliance; San José State University; TaxJar
Colorado responded to Quill with a 2010 law that allows out-of-state sellers either to collect and remit taxes on in-state sales or to report them to the Colorado Department of Revenue and notify purchasers that use tax may be due.
Colorado believes its use tax collections may increase if purchasers are informed of the law and the state has the information it needs to follow up with them. Because no seller is forced to collect and remit taxes, but can instead choose to provide sales information to the state, Colorado believes the law meets the requirements of Quill.
An organization called the Direct Marketing Association (DMA) is challenging Colorado’s law on several grounds, including Quill. The case, DMA v. Brohl, is currently pending before the 10th Circuit Court of Appeals.
States also have worked together to sort out their post-Quill difficulties. For nearly 15 years, many have attempted to harmonize their sales and use tax policies and procedures, including those for online commerce, through the Streamlined Sales and Use Tax Agreement (SSUTA).
SSUTA is designed to reduce the burden on sellers by requiring member states to adopt uniform definitions for taxable goods and services, and to provide out-of-state sellers with access to software that reduces the complexities involved with differing state filing requirements. The theory is that these steps may persuade the Supreme Court or Congress to overturn Quill’s physical presence rule.
At this writing, 24 states with about a third of the U.S. population have joined in the SSUTA. Without buy-in from large states, however — and none of the five most populous states are participating, including Texas — the agreement is unlikely to gain much more traction.
Many states want federal legislation to address Internet sales taxation; 11 have already announced plans for the additional revenue should a federal law be enacted.
The most prominent recent federal effort to overturn Quill and address Internet sales is the Marketplace Fairness Act of 2013, S.743, which passed the Senate but ultimately died in the 113th Congress (2013-2015). Essentially the same bill has been refiled in Congress as S.698.
The act, supported by organizations such as the National Conference of State Legislatures (NCSL), the Tax Foundation and the National Governors Association, would establish federal guidelines for sales by out-of-state retailers without a physical presence in a state, and simplify tax procedures within states. States would have the choice of joining SSUTA or modifying their existing tax systems in accordance with minimum standards outlined in the bill.
At an October 8, 2014 hearing of the Texas House Ways and Means Committee, Comptroller staff testified that state government could gain $800 million annually if a bill such as the Marketplace Fairness Act became law; Texas local governments would gain $200 million.
Another potential bill, the Online Sales Simplification Act (OSSA), has been proposed but not, at this writing, formally introduced by the chair of the U.S. House Judiciary Committee. OSSA would address Internet sales through a concept called “hybrid-origin sourcing.”
This would require states to change their laws so that the seller’s state (the origin state) generally would determine taxability and the amount of tax due, as opposed to the purchaser’s state of residence (the destination state). Sales tax revenue collected by the origin state would be transferred to the destination state via an agreement and system established by the states, thus creating a “hybrid” tax system.
Currently, most states with sales and use taxes employ “destination sourcing,” considering the tax on all sales to be due at the buyer’s location. Texas, by contrast, generally uses “origin sourcing” for sales within the state, and destination sourcing for sales by out-of-state sellers.
OSSA is opposed by groups such as NCSL and the Tax Foundation because it would require a massive restructuring of state tax laws, policies and procedures, and because it would require individuals in one state to pay taxes at rates set in other states.
Furthermore, OSSA doesn't eliminate the key problem of competitive disparities among sellers: in-state sellers would be forced to collect and remit taxes at different rates than those charged by out-of-state sellers.
Yet another approach to Internet sales taxation is embodied in the Remote Transactions Parity Act (RTPA), introduced in Congress on June 15 as H.R. 2775. The RTPA, which has garnered the support of groups such as NCSL, incorporates some features of the Marketplace Fairness Act but offers greater audit protection for small businesses.
As online shopping continues to grow, and the associated business models evolve, some clarifying federal legislation or updated guidance from the Supreme Court seem inevitable.
Indeed, in early March 2015, Justice Anthony Kennedy — who sat on the court that decided Quill — used a concurring opinion in DMA v. Brohl to indicate he believes the court made an error in its Quill ruling, and that it is high time to rectify it:
The Internet has caused far-reaching systemic and structural changes in the economy, and, indeed, in many other societal dimensions… Given these changes in technology and consumer sophistication, it is unwise to delay any longer a reconsideration of the Court’s holding in Quill. A case questionable even when decided, Quill now harms States to a degree far greater than could have been anticipated earlier.
As Justice Kennedy notes, the landscape for sales and use taxes across the U.S. is more complex and more subject to technological change than ever before — and this is likely to remain the case, as the Internet becomes faster and more ubiquitous. These changes have major implications for states that rely heavily on sales tax revenues.
But the way forward is unclear until Congress or the Supreme Court take action. FN
In 2015, the Texas Legislature passed House Bill 855, which requires state agencies to publish a list of the three most commonly used Web browsers on their websites. The Texas Comptroller’s most commonly used Web browsers are Google Chrome, Microsoft Internet Explorer and Apple Safari.