In a world of rapidly evolving technology, e-commerce transactions have become the norm. While the term e-commerce initially referred to Internet-based sales of physical items, recent years have given rise to a new breed of purely electronic transactions including cloud computing, digital downloads, streaming entertainment, and information services, which have further complicated the already-complex sales and use tax landscape.
Taxation of purely electronic transactions is often confusing, if not downright uncertain, as most state tax legislation is based on the idea of a physical sale or use occurring in a particular state. With technology advancing so rapidly, state tax laws, which depend on lengthy legislative processes, lag behind. The result is that states’ approaches vary widely, with some taxing agencies attempting to stretch statutes to encompass transactions that were inconceivable when the laws were originally adopted.
While federal rulings and laws provide some foundational guidance, the real understanding for tax practitioners comes from comprehensive state-by-state analysis of e-commerce taxation. Here, we take a high-level look at understanding nexus and determining the taxability of purely electronic transactions.
Nexus, which arises from a retailer’s sufficient physical presence in a state, determines whether an online retailer is required to collect sales tax from out-of-state customers. The U.S. Supreme Court has established that a seller must have a physical presence in a state for the state to obligate the seller to collect sales and use tax for that state. The seller can have this presence because of its own property or activities in the state or because of the property or activities of a third party that establishes or maintains the out-of-state seller’s market in the state.
The first question for e-commerce transactions, as in all transactions involving out-of-state sellers, is whether the seller’s contacts with or activities in the state are sufficient to establish nexus there. The Internet Tax Freedom Act effectively precludes a state from claiming sales and use tax nexus if the “sole ability to access a site on a remote seller’s out-of-state computer server is considered a factor in determining the remote seller’s tax collection obligation.” The location of third-party servers in the taxing state—as when the seller contracts with a third party to house remotely accessed software or other cloud computing, streaming, or electronic services on its server—could potentially give rise to a claim of nexus, however. It’s important to note that purely e-commerce transactions raise potential nexus considerations for both sellers and purchasers.
Unfortunately, approaches to nexus are inconsistent between states, and very few states have established clear nexus rules for dealing with the wide variety of e-commerce transactions. Consequently, practitioners must determine nexus on a state-by-state basis and calculate their clients’ tax obligations accordingly.
To understand the tax implications of purely electronic e-commerce transactions involving digital goods, downloaded and remotely accessed software and apps, as well as Web-based services, the parties to the transaction must determine whether the state treats the particular transaction as a sale or use of taxable property, a service, or an intangible. There is little uniformity between states in characterizing these transactions, and a determination of whether a taxable “sale” or “use” occurred generally depends on how the state characterizes an item and whether the sale or use of a taxable item occurs within the state.
Sales and use taxing statutes generally provide that the sales tax applies to the sales price, and the use tax to the purchase price, of tangible personal property and a number of enumerated services. Intangibles typically are not taxed.
With purely electronic transactions increasing dramatically and states’ treatment of these types of transactions all over the map, it’s critical—and challenging—for practitioners to stay abreast of the implications of new legislation on a state-by-state basis.
To this end, there are a number of sources of professional information available that provide technical details, analyze states’ treatment of electronic commerce transactions, and cover recent nexus developments. Practitioners can review the available options and determine if there is an information solution that meets their specific needs.
While there is no doubt the world of e-commerce will continue to advance, and state tax legislation will struggle to keep up, practitioners can arm themselves with the knowledge necessary to effectively serve their e-commerce clients.
Rebecca Newton-Clarke, J.D., is a senior editor/author for the Checkpoint system website within the tax and accounting business of Thomson Reuters, where she has written articles about state and local taxes (SALT) for more than fourteen years. A former attorney, Rebecca worked in the SALT services group at PricewaterhouseCoopers in New York City and at the Florida Department of Revenue, where she worked on various multistate initiatives, including the Streamlined Sales Tax Project. Rebecca authored and contributed to several topics on the Checkpoint Catalyst research website.