Get Ready for the iTunes Tax

Get Ready for the iTunes Tax

A legal fight between North Carolina and Amazon is the latest attempt by states to tax digital business

The  ever-louder ka-ching, ka-ching of online cash registers has many state governements rushing to skim off the top of the digital renaissance.

States’ attempts to tax digital business have many internet companies up in arms.

A recent legal standoff between North Carolina and online retailer Amazon shows that the industry is not going to go gently into taxation.

North Carolina is trying to audit the bookseller, suspecting that Internet shoppers owe it millions of dollars in unpaid taxes. Currently, online retailers only have to collect taxes if they have a physical presence in a particular state. Since retailers don't collect sales taxes, buyers are supposed to voluntarily pay them. Unsurprisingly, that's a check that few people write.

"This is really an issue of fairness and equity for small businesses, the brick-and-mortar, corner-store operations.," Kenneth R. Lay, North Carolina's secretary of revenue, said in a statement. "These businesses are at a competitive disadvantage when they have to collect sales taxes that other businesses do not."

Amazon is hitting back. In a filing in Seattle Federal District Court, the company said attempts by North Carolina to reveal the names and purchases of its customers violated the First Amendment. It also claims that it is an invasion of its customers’ privacy rights. Regardless of the legal merits, many have speculated that Amazon, which did not respond to calls for comment, is equally concerned about losing this important tax loophole.

The Amazon case mostly revolves around duties imposed on tangible goods. But other state governments are using a broader definition of "tangible" when it comes to taxes. If they get their way, the next time you buy the latest bestsellfer for your e-reader or newest chart-topper for your iPod, get ready to pony up a extra dough.

Oklahoma and Illinois are the latest in a growing list of states that have adopted or publicly flirted with imposing taxes on digital downloads in the last year.

Christened the iTunes tax by some as a nod to Apple's popular music service, these taxes are seen as a way by many states to close budget shortfalls. Since 2007, nearly 20 cash-strapped states have moved to rewrite their tax rules to encompass books and music that are downloaded digitally.

It's easy to see why. In Oklahoma, digital taxes are projected to net the state nearly $3.46 million, while Illinois’ recently shelved proposal was estimated to generate $10 million for a state struggling under a $13 billion deficit.

Among the iTunes tax adopters are Arizona, Colorado, Kentucky, Louisiana, Maine, New Jersey, and the District of Columbia, with similar proposals popping up periodically in California.

"It's picking up steam, because states are searching for what isn't currently taxed and seeing what they can tax," Bragen Cox, policy council for the eCommerce trade group Netchoice, told TheWrap. "Traditionally digital goods have not been taxed, but moving in this direction runs the risk of burdening online retailers with handling 50 state codes and over 7,000 different tax jurisdictions."

It's easy to see the appeal. In the good old, pre-internet days, states could tax sales of CDs and records, but many of those transactions have gone virtual. That doesn't mean the money is gone: In the last quarter of 2009 alone, e-commerce in the United States generated $35.9 billion, according to the U.S. Census Bureau.

"In the early days, there wasn't as much money to go after, and states wanted to encourage the growth of the Internet, so they were slow to tax," Daniel Castro, a senior analyst at the Information, Technology & Innovation Foundation, told TheWrap. "There are a lot of states that are changing their mind now, because they're seeing online sales go way up."

A few states, most notably North Dakota, have gone in the other direction, however, and are swearing off a digital levy. State Senator Dwight Cook, who authored the North Dakota law, said that his state was not operating in deficit.

"This is a tax on our citizens, but I think we are also sending a pretty positive message to the industry that this is a good state for the entertainment industry to consider doing business in," Senator Cook told TheWrap.

Beyond eliciting the ire of the music industry, it's not immediately clear that states have the legal authority to tax digital goods. Part of the problem is that states could not have foreseen the coming digital revolution when it came to establishing rules for taxing goods and services.

"These laws were written years before we've had this revolution in telecommunications area, so they are behind the times, but rushing to change them could have an unintended effect," said Jeffrey Davine, a tax attorney at Mitchell, Silberberg & Knupp.

The 1997 Internet Tax Freedom Act limits states ability to tax Internet activity. To get around that, states have been trying to bend existing laws to justify taxing digital products. This often requires them to re-classify them as tangible personal property, like a car, a house, or an old fashioned CD, which they  do have the authority to tax.

Aside from semantic complications, there's a 1992 Supreme Court case called "Quill Corp. vs. North Dakota," that limits states’ ability to tax goods purchased through the mail. In order to tax digital downloads, states have to establish that content providers have a presence or nexus in that state — something that can be challenging to prove as most Internet companies maintain a small, centralized presence in one or two states. These nexus requirements have led states such as New York and Alabama to argue that if a company like Amazon uses affiliates in their state to advertise its products, than they are free to tax downloads.

Besides being potentially unconstitutional, these kind of post-hoc rule changes draw fire from opponents of digital taxes.

"They are manipulating the laws so they can trap goods that are moving from out of state in a way that is harmful to the growth of online advertising," Cox said. "They are doing it in a way that is shortsighted."

The intricacy of the various tax codes have galvanized online retailers and various business groups to fight back against the states’ piecemeal efforts to take their cut of online sales. They're pushing for a tax that is streamlined, so that it will be roughly the same in every state, says Fred Nicely, tax council for Council On State Taxation (COST). So far over twenty states have signed on to establish a standard way for taxing digital goods.

Their concern is that it will unfairly burden smaller operators, not just the Amazon and Apples of the world. Fifty different tax codes could lead to logistical nightmares for small time operators forced to withhold taxes to comply with myriad tax rules.

Though taxing digital products is an increasingly sexy target, getting their proposals passed can face stiff opposition. In California, state Assemblyman Charles Calderon struggled to get his bid to tax digital products out of committee before ultimately putting it on the back burner in the face of voter discontent and fierce opposition from Republican legislators. Calderon's office would not rule out another effort to tax digital goods, but said no immediate plans were in the works.

Similarly, Illinois Governor Pat Quinn abandoned his move to tax digital products less than 24 hours after initially floating the possibility. Legislators had made it clear that they would oppose Quinn's plan.

Despite setbacks, experts who follow state efforts to tax digital goods predict that it is a trend that will only accelerate.

"These are no longer going to be novel laws. As states hear what other states are doing, more of these laws will be put on the books and quickly," said Cox.