Taxing Digital Transactions and Virtual Goods

by Joseph D. Poole

In the last few years, an ever-increasing number of states have sought to tax internet-based transactions.  Generally, a company that has a “brick and mortar” presence in a state must withhold sales tax from all purchases that residents of that state make, whether those purchases are made in a store or online.  However, a state cannot require a company to withhold taxes when there is no such “brick and mortar” presence in the state.  This rule can be and generally is applied to digital downloads.  However, new legislation in the U.S. Senate could enable states to impose an obligation to withhold sales tax on companies that don’t have any physical presence in the states.

Background

In 1992, the US Supreme Court held that a state could not require a company to withhold sales or use taxes if the company did not have a physical “nexus” with the state.  Generally, in these instances, the residents of a state are supposed to declare the goods they purchased from out of state and (depending on the tax) pay the tax to the state themselves.  Most states are highly skeptical regarding whether or not their residents comply with such requirements.

In Quill Corp. v. North Dakota, North Dakota tried to impose a use tax on Quill Corp. (“Quill”), a seller of office equipment and supplies.  Quill had no physical presence in North Dakota but sold more than a million dollars a year in office equipment in the state via mail order catalogs.

The Supreme Court noted that while Quill benefited from the economic climate that North Dakota fostered, these actions did not justify North Dakota burdening interstate commerce in violation of the Commerce Clause of the U.S. Constitution.

Generally, the Supreme Court will find that a tax is not in violation of the Commerce Clause so long as the tax “(1) is applied to an activity with a substantial nexus with the taxing State, (2) is fairly apportioned, (3) does not discriminate against interstate commerce, and (4) is fairly related to the services provided by the State.”  The nexus requirement is a “means for limiting state burdens on interstate commerce” and thus requires a physical presence within the state.

Some states have gotten around the nexus requirement by pursuing online retailers that pay state residents commissions – however, this has led to tensions between online retailers and states, with some retailers threatening to eliminate those contacts that create the nexuses.

Proposed Legislation

Because the basis for the limitation on sales and use tax comes from the Commerce Clause, an act of the U.S. Congress could remove said limitation.  Within the past year, two such bills have been introduced in Congress:  the Marketplace Fairness Act proposes to permit states to collect taxes from online retailers that gross $500,000 or more in annual sales, and the Marketplace Equity Act proposes to permit the same but only for businesses that gross up to $1,000,000.

Stores that have “brick and mortar” presences in every state while simultaneously doing significant online sales have lobbied hard for legislation like the Marketplace Fairness Act.  Companies like Wal-Mart, Best Buy, and Home Depot argue that taxing their online sales while not taxing the online sales of Amazon, Overstock.com, and eBay place them at a significant disadvantage in the online marketplace and that this unreasonably deprives states of revenues.  While “brick and mortar” stores acknowledge that they use more of a state’s infrastructure (police, fire, etc.) than online stores and that they enjoy certain substantial advantages over online stores (such as community presence, immediate stock, and easy returns), they maintain that treating them differently than online-only stores in the virtual marketplace is unfair.

Traditionally, online retailers have fought efforts to impose on them obligations to collect sales and use taxes.  Most of the major online retailers have come out against the Marketplace Fairness Act and the Marketplace Equity Act.  They point out that, given the burdens involved in observing the various tax laws of fifty different states, at the very least, the cutoff for applicability of such legislation should be $10,000,000 in gross revenue.

Amazon, on the other hand, uses a commission system that creates a nexus sufficient to satisfy the Quill standard, and thus has been struggling with various states regarding its online transactions for some time now.  As a result, Amazon now supports the Marketplace Fairness Act, but only if all smaller retailers will be held to the same standards.

The Effect of Proposed Legislation on Digital Transactions

Digital transactions include anything from digital downloads of movies and music, to microtransactions in video games.  Many of these purchases are already being taxed in some states.  However, one of the limits on the taxation of such purchases has been the lack of a nexus for companies with no physical presence in a state.

Should the Marketplace Fairness Act become law, companies that deal strictly in direct digital media (e.g., music, movies, downloadable content) could be taxed in a new way.  This added burden could be highly problematic for independent developers and could limit distribution paths to only those capable of handling the overhead associated with dealing with the various tax systems of different states.

Furthermore, if digital transactions become taxable, interesting questions will arise with regard to the taxation of microtransactions such as those that are common in video games. Nowadays, most video games utilize microtransactions whereby players can pay actual money for virtual items within the games.  Without Quill, it seems solely up to the individual states to determine which digital products they will tax and which they will exempt.  However, in an age of microtransactions, where game developers are making money from selling virtual goods, it may be only a matter of time before people will be required to pay real taxes for virtual items that they are purchasing with real money.

Whether or not the Marketplace Fairness Act or the Marketplace Equity Act become law, no one disputes the fact that the marketplace is changing.  States will continue to try to collect revenues from any possible source – even more so in these difficult economic times.

Joseph D. Poole is an associate at Pierce Law Group LLP and works in the areas of entertainment law and intellectual property law.
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