Arthur Andersen – Report on Cyber Taxation

Overview

Partners from Arthur Andersen explain how the taxation of Cyberspace has become such an important issue as the promise of unbounded commerce conducted on the Internet changes all of the rules for the taxing of sales transactions.

Executive Summary – The Internet Phenomenon

Electronic commerce is on the verge of reinventing social and commercial relationships. In an information age, the Internet vastly expands the potential to instantly transfer a wide range of goods and services to anyone, anywhere, at any time. Electronic commerce revenues may exceed $150 billion by the year 2000.

The emergence of the Internet as a new mass communications channel will fundamentally transform how we work, play, learn, shop, and socialize. According to a Nielsen Survey, over 40 million people currently use or have access to the Internet in the United States and Canada. The number of American households that have access to the Internet increased from .2 percent in 1993 to 14 percent in 1996. An estimated 300 million people will utilize the Internet on a worldwide basis by the year 2000.

Some of the most important business services and consumer items lend themselves to Internet Commerce, including computer software, telecommunications, movies, magazines, music albums, financial transactions, video conferencing, newspapers, educational and training materials, E-mail, games, and business databases.

Among the most common electronic transactions will be:

  • Electronic transfer of software: More than $40 billion worth of software was sold through retail stores in the U.S. last year. Worldwide, software sales are expected to exceed $150 billion by 2000. The ease and speed of the electronic transfer of software promises to transform the way consumers make purchases. In fact, Microsoft has already announced its decision to ship software via electronic downloading directly to the consumer.
  • Video on demand: Currently the video rental business in the US totals $12 billion in revenue–of which $3 billion is for late fees. In addition, the motion picture business at theaters totals an additional $6.5 billion. Yet clearly, electronic transmission via computers or cable television is a much more efficient distribution channel.
  • Information databases: The sale of legal, medical, scientific, business, and other technical information is a $22 billion industry in the U.S. The availability of sophisticated computer search technologies and daily updating of information makes electronic distribution a particularly attractive alternative to information provided in “tangible” reports.
  • Online stock trading: In 1996, 1.5 million investors traded stocks online. Industry analysts expect the number to increase to 10 million accounts by 2001–with over $500 billion in mutual fund money managed online.

The State of Cybertaxation

Clearly, as the importance of the Internet as a channel of commerce continues to grow, states will have to decide whether to institute sales taxes–and if so, how? The problem lies in the outdated tax systems of most states, which were designed to tax tangible goods. Presently, states are trying to impose a mid-twentieth century tax system on a technologically advanced 21st century service industry. For example, the current state tax system can easily be applied to a software package sold in a retail outlet, but the rules become unclear when that same software is sold and transferred electronically.

Nonetheless, the taxation of electronic commerce is not a future issue, but a current reality:

  • Currently, 40 states impose a sales tax on the “transmission” component of electronic commerce–interstate and/or intrastate telecommunications.
  • About one-half impose a sales tax on specific categories of on-line “content” such as the electronic transmission of canned software or cable television.
  • About one-quarter impose a broader-based sales tax on numerous categories of on-line “content” such as electronic information or computer services.

A significant obstacle in addressing cybertaxation is determining “nexus”– a companys “presence” in a particular tax jurisdiction. It is possible for a company to conduct business in several states, but have an actual physical presence in just one state. States are currently grappling with how to determine nexus for companies that conduct business electronically in several tax jurisdictions.

Another problem is how to source sales over the Internet. With electronic commerce, a vendor can be located physically in one jurisdiction, the product or service can be stored on a computer server in a second state, the consumer can reside in a third state, and the consumer can access the information from a fourth state. Which state (or states) has the jurisdiction to tax the transaction? Furthermore, for many Web transactions, the vendor may be unaware of the state the consumer resides in since Web addresses (such as consumer@aol.com) typically do not identify the state of residency or commercial domicile.