Taxing Online Sales

On March 10, Illinois Gov. Patrick Quinn signed the Main Street Fairness Act, 35 Ill. Comp. Stat. 105/2 (2011), into law to collect sales tax revenues from a retail market traditionally beyond the states' reach ' the world of online commerce ' by focusing on the role of local online marketing affiliates.

Given Illinois' budget problems, the measure was hailed as a means for the state to collect taxes on online purchases ' and to help local brick-and-mortar businesses compete with online retailers.

But the measure has been harshly criticized by online merchants who contend it is an unconstitutional intrusion on interstate commerce, and by policy analysts who question its ability to raise tax revenues.

The 'Amazon.com Tax'

In 2008, New York began this trend by passing legislation requiring certain out-of-state online retailers to collect state taxes on purchases by resident consumers. N.Y. Tax Law '1101(b)(8)(vi) (2008). Under New York's law, dubbed the “Amazon.com tax” due to an ongoing challenge by the online retail giant (see, Amazon.com, LLC v. New York State Depart. of Taxation & Fin., 877 N.Y.S.2d 842 (N.Y. Supp. Ct. 2009), aff'd in part, modified in part, 913 N.Y.S.2d 129 (N.Y. App. Div. 2010)), online retailers who contract with in-state individuals and companies (known as “affiliates”) under certain marketing commission agreements are subject to sales-tax collection obligations.

Since then, 12 states have proposed similar tax legislation targeting online retailers, and three states (Rhode Island, Colorado and North Carolina) have enacted laws. With passage of the Main Street Fairness Act, Illinois becomes the fifth state to enact such legislation.

Much to the chagrin of legislators supporting this movement, prominent online retailers Amazon.com and Overstock.com (among others) have begun canceling affiliate programs in affected states rather than submit to the requirements of the new laws. This trend, if it spreads among online retailers, will have important repercussions for online marketers with business models dependent on commissions: They must either relocate or suffer significant earnings hits, which undermines the revenue-generation goal of these statutes. Moreover, while nobody expects online sales to diminish, legal challenges (current and future) to these statutes could re-sculpt the online sales landscape.

Constitutional Background

Virtually all states (and the District of Columbia) impose a tax on retail sales of goods and certain services, with the tax borne by the consumer but collected by the retailer and then remitted to the state. Most states also impose a parallel “use tax” for the privilege of using goods and certain services in the state that were not subject to local sales tax (e.g., because the goods were purchased out of state). Unlike sales tax, use tax is self-reported and the consumer pays the state.

Under the “dormant” Commerce Clause of the U.S. Constitution, a retailer located outside of the state, such as a mail-order or online retailer, cannot be compelled by a state to collect sales tax if the retailer does not have “substantial nexus” with the state. In the 1992 case Quill Corp. v. North Dakota, 504 U.S. 298, 314-15 (1992), the U.S. Supreme Court held that an out-of-state retailer has a “substantial nexus” with a state only if the retailer has a “physical presence” in that taxing jurisdiction.

Although a brick-and-mortar location with employees would satisfy the Quill standard, courts have wrestled with cases that fall short of such physical presence. Court rulings have included findings that mere advertising or shipping using a common carrier to a state is not enough to establish nexus and that “continuous local solicitation” is sufficient to satisfy the standard, even if the solicitation is done through independent contractors and agents. (See, Scripto, Inc. v. Carson, 362 U.S. 207, 210-12 (1960); Tyler Pipe Indus. v. Washington State Dep't of Revenue, 483 U.S. 232, 250 (1987).)

As one court has put it, physical presence “need not be substantial ' and it may be manifested by the presence in the taxing state of the vendor's property or the conduct of economic activities in the taxing state performed by the vendor's personnel or on its behalf.” Orvis Co. v. Tax Appeals Tribunal, 86 N.Y.2d 165, 178 (N.Y. 1995).

Use tax compliance is low, and enforcement is expensive and politically unpopular. As one alternative, several states (including Illinois) have amended their personal income tax returns to include an entry requiring self-reporting of use tax from online purchases.

But as the effectiveness of such measures is uncertain, states have pursued various theories to compel out-of-state retailers to collect local sales tax. In the case of affiliate nexus statutes, such as the recent Illinois statute, states have focused on the “agency” aspect of physical presence ' i.e., do the actions of affiliates in the state give an out-of-state retailer sufficient nexus with the state to compel the retailer to collect sales tax (or, if the retailer has not collected the tax, to make the retailer primarily liable for the sales tax it should have collected and remitted to the state).

Online Tax Laws

When New York enacted the first “Amazon.com tax” in 2008, legislators were mindful of the physical presence requirements of Quill and established a rebuttable presumption that if an out-of-state online retailer maintains commission agreements with New York residents or businesses that collectively generate over $10,000 in New York sales annually for the retailer, then that out-of-state retailer has a “physical presence” in the state.

New York says the physical presence of these affiliates in the state, coupled with the contractual commission relationship with the out-of-state retailer, creates the “physical presence” nexus for sales tax collection, while the $10,000 threshold helps establish the substantial nature of that presence.

An out-of-state retailer could rebut by offering evidence that the affiliate engages in advertising rather than business solicitation. Other states that have proposed or passed online sales tax legislation have studied, and in some cases emulated, New York's model include:

• Rhode Island and North Carolina have implemented online sales tax laws paralleling New York's tax, although Rhode Island's gross minimum revenue threshold for affiliates is only $5,000.
• Colorado's online sales tax law adopts a different approach from the New York model. The Colorado law applies to any “retailer that does not collect Colorado sales tax,” defined as any retailer that doesn't collect sales or use tax but sells goods to Colorado purchasers.
• Illinois' version of the law amended the statutory definition of “retailer maintaining a place of business in the state” to include any retailer holding a contract with an Illinois business or individual that pays commissions on property sales. The law requires that such contracts exceed $10,000 annually. However, unlike New York, Illinois' law does not provide a mechanism to rebut the presumption that merchants solicit rather than merely advertise.

[Editor's Note: On May 31, the California State Assembly passed AB 155, which would require online retailers to collect state sales and use tax. Statewide sales tax would extend to purchases from online retailers with a California presence, including those working with sibling companies with offices in California. The bill was effectively stopped when Gov. Brown vetoed the state budget on June 16, 2011. The bill returned to a Senate committee a week later, with a hearing set for this month.]

Short-Term Impact

In theory, these new laws require out-of-state online retailers to collect and pay state sales tax on online purchases residents make, recapturing lost tax revenue. In Illinois, legislators estimate the proposed legislation could generate over $150 million. In practice, however, online sales tax laws haven't increased sales tax revenues, and have hurt in-state business owners holding contracts with online retailers.

As mentioned earlier, Amazon.com and Overstock.com stopped operating affiliate programs in Rhode Island, North Carolina, Colorado and now Illinois, to end their “physical presence” there and maintain sales-tax free purchases. (With the pending legal challenge, Amazon did not terminate its affiliate program in New York and collects sales taxes on online purchases.) While these moves may protect the online retailers from sales tax collection obligations, they also harm in-state individuals and businesses that rely on those marketing commissions.

Of states that have rejected online sales tax legislation, several point to withdrawal of online retailers or harms to small business as a primary concern. (Gov. Schwarzenegger vetoed California's proposed sales tax measure in 2009, citing potential job loss and an announcement by Overstock.com to terminate affiliate agreements. In Virginia, legislation was vetoed at the committee level after the Department of Taxation concluded that such laws could actually decrease tax revenue for the state.)

Opponents argue that the economic effect of such a law contradicts the legislative intent in two ways. First, the state fails to collect additional sales taxes as online retailers terminate affiliate programs in the state. Second, local e-commerce businesses at best suffer reduced revenues or, at worst, fail, or relocate to a state with no such law. When state businesses lose revenue and jobs, state taxable income shrinks. The net result, opponents argue, is that the affiliate nexus laws, rather than creating the multi-million dollar returns promised by lawmakers, will diminish state tax revenues.

Long-Term Impact

Amazon.Com v. New York

In 2008, Amazon.com and Overstock.com sued New York, alleging third-party contractual relationships do not constitute “physical presence” in New York for taxation. In previous catalog and mail-order cases, courts found that commissioned sales brokers under the facts of those cases may be sufficient to create a “physical presence” under the substantial nexus standard, because they play a pivotal role in the retailers' ability to “establish and maintain” their market in the taxing jurisdiction (see, Scripto, 362 U.S. at 210; Tyler Pipe, 483 U.S. at 250; Orvis, 86 N.Y.2d at 181).

Online retailers argue, however, that the Internet is a fundamentally different commerce structure. Online retailers don't need a physical presence to “establish and maintain” a market, and activities of affiliates aim at funneling traffic to the retailer's own site ' which online retailers would argue is much more akin to advertising than to solicitation. Also, any sales affiliates facilitate are as likely to come from outside the affiliate's home state as from within it, making the affiliate's physical location a misleading indicator of in-state activity. The characterization of online retailers' affiliate relationships as either advertisement or solicitation will be a critical determinant of the law's constitutionality.

As of late June, that question remains unanswered. In 2009, New York's lower state court dismissed Amazon.com's declaratory judgment complaint, holding that affiliate relationships are enough to constitute a “substantial nexus” with New York, because the law requires agreements with New York residents and businesses, and the $10,000 minimum ensures those contracts are substantial.

Last November, the Supreme Court of New York Appellate Division upheld the law as constitutional on its face, but reinstated the case for further proceedings to determine whether the law, as applied to Amazon.com, violates the Commerce and Due Process Clauses.

Conclusion

Amazon.com is likely to appeal any decision upholding the law ' to New York's Court of Appeals and possibly to the U.S. Supreme Court. If the New York law is upheld, it will undoubtedly inspire similar laws nationally, and may dramatically alter the e-commerce landscape for businesses and consumers.

If these laws are held to be unconstitutional, online retailers and consumers will win, but a victory may come too late for in-state affiliates suffering from termination of affiliate programs.

On March 10, Illinois Gov. Patrick Quinn signed the Main Street Fairness Act, 35 Ill. Comp. Stat. 105/2 (2011), into law to collect sales tax revenues from a retail market traditionally beyond the states' reach ' the world of online commerce ' by focusing on the role of local online marketing affiliates.

Given Illinois' budget problems, the measure was hailed as a means for the state to collect taxes on online purchases ' and to help local brick-and-mortar businesses compete with online retailers.

But the measure has been harshly criticized by online merchants who contend it is an unconstitutional intrusion on interstate commerce, and by policy analysts who question its ability to raise tax revenues.

The 'Amazon.com Tax'

In 2008, New York began this trend by passing legislation requiring certain out-of-state online retailers to collect state taxes on purchases by resident consumers. N.Y. Tax Law '1101(b)(8)(vi) (2008). Under New York's law, dubbed the “Amazon.com tax” due to an ongoing challenge by the online retail giant ( see , Amazon.com, LLC v. New York State Depart. of Taxation & Fin. , 877 N.Y.S.2d 842 (N.Y. Supp. Ct. 2009), aff'd in part, modified in part , 913 N.Y.S.2d 129 (N.Y. App. Div. 2010)), online retailers who contract with in-state individuals and companies (known as “affiliates”) under certain marketing commission agreements are subject to sales-tax collection obligations.

Since then, 12 states have proposed similar tax legislation targeting online retailers, and three states (Rhode Island, Colorado and North Carolina) have enacted laws. With passage of the Main Street Fairness Act, Illinois becomes the fifth state to enact such legislation.

Much to the chagrin of legislators supporting this movement, prominent online retailers Amazon.com and Overstock.com (among others) have begun canceling affiliate programs in affected states rather than submit to the requirements of the new laws. This trend, if it spreads among online retailers, will have important repercussions for online marketers with business models dependent on commissions: They must either relocate or suffer significant earnings hits, which undermines the revenue-generation goal of these statutes. Moreover, while nobody expects online sales to diminish, legal challenges (current and future) to these statutes could re-sculpt the online sales landscape.

Constitutional Background

Virtually all states (and the District of Columbia) impose a tax on retail sales of goods and certain services, with the tax borne by the consumer but collected by the retailer and then remitted to the state. Most states also impose a parallel “use tax” for the privilege of using goods and certain services in the state that were not subject to local sales tax (e.g., because the goods were purchased out of state). Unlike sales tax, use tax is self-reported and the consumer pays the state.

Under the “dormant” Commerce Clause of the U.S. Constitution, a retailer located outside of the state, such as a mail-order or online retailer, cannot be compelled by a state to collect sales tax if the retailer does not have “substantial nexus” with the state. In the 1992 case Quill Corp. v. North Dakota , 504 U.S. 298, 314-15 (1992), the U.S. Supreme Court held that an out-of-state retailer has a “substantial nexus” with a state only if the retailer has a “physical presence” in that taxing jurisdiction.

Although a brick-and-mortar location with employees would satisfy the Quill standard, courts have wrestled with cases that fall short of such physical presence. Court rulings have included findings that mere advertising or shipping using a common carrier to a state is not enough to establish nexus and that “continuous local solicitation” is sufficient to satisfy the standard, even if the solicitation is done through independent contractors and agents. ( See , Scripto, Inc. v. Carson , 362 U.S. 207, 210-12 (1960); Tyler Pipe Indus. v. Washington State Dep't of Revenue , 483 U.S. 232, 250 (1987).)

As one court has put it, physical presence “need not be substantial ' and it may be manifested by the presence in the taxing state of the vendor's property or the conduct of economic activities in the taxing state performed by the vendor's personnel or on its behalf.” Orvis Co. v. Tax Appeals Tribunal , 86 N.Y.2d 165, 178 (N.Y. 1995).

Use tax compliance is low, and enforcement is expensive and politically unpopular. As one alternative, several states (including Illinois) have amended their personal income tax returns to include an entry requiring self-reporting of use tax from online purchases.

But as the effectiveness of such measures is uncertain, states have pursued various theories to compel out-of-state retailers to collect local sales tax. In the case of affiliate nexus statutes, such as the recent Illinois statute, states have focused on the “agency” aspect of physical presence ' i.e., do the actions of affiliates in the state give an out-of-state retailer sufficient nexus with the state to compel the retailer to collect sales tax (or, if the retailer has not collected the tax, to make the retailer primarily liable for the sales tax it should have collected and remitted to the state).

Online Tax Laws

When New York enacted the first “Amazon.com tax” in 2008, legislators were mindful of the physical presence requirements of Quill and established a rebuttable presumption that if an out-of-state online retailer maintains commission agreements with New York residents or businesses that collectively generate over $10,000 in New York sales annually for the retailer, then that out-of-state retailer has a “physical presence” in the state.

New York says the physical presence of these affiliates in the state, coupled with the contractual commission relationship with the out-of-state retailer, creates the “physical presence” nexus for sales tax collection, while the $10,000 threshold helps establish the substantial nature of that presence.

An out-of-state retailer could rebut by offering evidence that the affiliate engages in advertising rather than business solicitation. Other states that have proposed or passed online sales tax legislation have studied, and in some cases emulated, New York's model include:

• Rhode Island and North Carolina have implemented online sales tax laws paralleling New York's tax, although Rhode Island's gross minimum revenue threshold for affiliates is only $5,000.
• Colorado's online sales tax law adopts a different approach from the New York model. The Colorado law applies to any “retailer that does not collect Colorado sales tax,” defined as any retailer that doesn't collect sales or use tax but sells goods to Colorado purchasers.
• Illinois' version of the law amended the statutory definition of “retailer maintaining a place of business in the state” to include any retailer holding a contract with an Illinois business or individual that pays commissions on property sales. The law requires that such contracts exceed $10,000 annually. However, unlike New York, Illinois' law does not provide a mechanism to rebut the presumption that merchants solicit rather than merely advertise.

[Editor's Note: On May 31, the California State Assembly passed AB 155, which would require online retailers to collect state sales and use tax. Statewide sales tax would extend to purchases from online retailers with a California presence, including those working with sibling companies with offices in California. The bill was effectively stopped when Gov. Brown vetoed the state budget on June 16, 2011. The bill returned to a Senate committee a week later, with a hearing set for this month.]

Short-Term Impact

In theory, these new laws require out-of-state online retailers to collect and pay state sales tax on online purchases residents make, recapturing lost tax revenue. In Illinois, legislators estimate the proposed legislation could generate over $150 million. In practice, however, online sales tax laws haven't increased sales tax revenues, and have hurt in-state business owners holding contracts with online retailers.

As mentioned earlier, Amazon.com and Overstock.com stopped operating affiliate programs in Rhode Island, North Carolina, Colorado and now Illinois, to end their “physical presence” there and maintain sales-tax free purchases. (With the pending legal challenge, Amazon did not terminate its affiliate program in New York and collects sales taxes on online purchases.) While these moves may protect the online retailers from sales tax collection obligations, they also harm in-state individuals and businesses that rely on those marketing commissions.

Of states that have rejected online sales tax legislation, several point to withdrawal of online retailers or harms to small business as a primary concern. (Gov. Schwarzenegger vetoed California's proposed sales tax measure in 2009, citing potential job loss and an announcement by Overstock.com to terminate affiliate agreements. In Virginia, legislation was vetoed at the committee level after the Department of Taxation concluded that such laws could actually decrease tax revenue for the state.)

Opponents argue that the economic effect of such a law contradicts the legislative intent in two ways. First, the state fails to collect additional sales taxes as online retailers terminate affiliate programs in the state. Second, local e-commerce businesses at best suffer reduced revenues or, at worst, fail, or relocate to a state with no such law. When state businesses lose revenue and jobs, state taxable income shrinks. The net result, opponents argue, is that the affiliate nexus laws, rather than creating the multi-million dollar returns promised by lawmakers, will diminish state tax revenues.

Long-Term Impact

Amazon.Com v. New York

In 2008, Amazon.com and Overstock.com sued New York, alleging third-party contractual relationships do not constitute “physical presence” in New York for taxation. In previous catalog and mail-order cases, courts found that commissioned sales brokers under the facts of those cases may be sufficient to create a “physical presence” under the substantial nexus standard, because they play a pivotal role in the retailers' ability to “establish and maintain” their market in the taxing jurisdiction (see, Scripto, 362 U.S. at 210; Tyler Pipe, 483 U.S. at 250; Orvis, 86 N.Y.2d at 181).

Online retailers argue, however, that the Internet is a fundamentally different commerce structure. Online retailers don't need a physical presence to “establish and maintain” a market, and activities of affiliates aim at funneling traffic to the retailer's own site ' which online retailers would argue is much more akin to advertising than to solicitation. Also, any sales affiliates facilitate are as likely to come from outside the affiliate's home state as from within it, making the affiliate's physical location a misleading indicator of in-state activity. The characterization of online retailers' affiliate relationships as either advertisement or solicitation will be a critical determinant of the law's constitutionality.

As of late June, that question remains unanswered. In 2009, New York's lower state court dismissed Amazon.com's declaratory judgment complaint, holding that affiliate relationships are enough to constitute a “substantial nexus” with New York, because the law requires agreements with New York residents and businesses, and the $10,000 minimum ensures those contracts are substantial.

Last November, the Supreme Court of New York Appellate Division upheld the law as constitutional on its face, but reinstated the case for further proceedings to determine whether the law, as applied to Amazon.com, violates the Commerce and Due Process Clauses.

Conclusion

Amazon.com is likely to appeal any decision upholding the law ' to New York's Court of Appeals and possibly to the U.S. Supreme Court. If the New York law is upheld, it will undoubtedly inspire similar laws nationally, and may dramatically alter the e-commerce landscape for businesses and consumers.

If these laws are held to be unconstitutional, online retailers and consumers will win, but a victory may come too late for in-state affiliates suffering from termination of affiliate programs.