Updated December 2, 2008

Taxing Internet Sales / Leveling the Playing Field

Allowing many internet-purchased items to avoid the sales tax introduces a host of inequities in the tax system. First, in order to make up for the difference, the sales tax must be raised on the remaining items in the tax base. This places an undue share of taxes on consumers who don't have or use the internet. The internet sales loophole also puts Tennessee merchants at a disadvantage to their out-of-state and internet-only competitors. TFT supports efforts to close the internet-shopping loophole, putting out-of-state merchants and in-state merchants on a level playing field.

What does it mean that the Tennessee sales tax is "use tax?"

Technically speaking, the Tennessee sales tax is a "use tax." This means that end-user is ultimately responsible for paying the tax. While Tennessee relies on the merchant to collect the tax, it is technically paid by the purchaser. In fact, if you were not charged a sales tax, such as with internet purchases, you are legally supposed to report those purchases and pay the tax yourself directly to the state.

If you feel so motivated, you can click here to complete Tennessee's on-line Consumer Use Tax Return. Of course, few people ever actually file this return. As a result, if the merchants don't collect the sales tax, the state will likely never see it. The one exception is cars and boats bought out-of-state, and then registered in Tennessee. Because these purchases have to be registered, it is easy to collect the "use" tax after they are brought into the state. This is not the case with TVs, furniture, groceries, and other out-of-state purchases.

But don't some internet merchants already charge the sales tax?

Frequent internet shoppers may notice that some internet merchants are already charging the Tennessee sales tax. The reason for this comes down to a legal concept called "nexus." Basically, if a company has any physical presence in the state of Tennessee (buildings, stores, etc.), then it is obligated to collect the Tennessee sales tax, regardless of whether the purchase was made in a physical store or on the web.

That's why the web sites of Books-a-Million, Circuit City, Office Depot, and other large chains typically charge the Tennessee sales tax. However, if you buy from an on-line merchant based in California that has no physical operations in Tennessee, then they are not obligated to collect the sales tax.

Two Approaches to Solving the Problem

1. Broadening the Definition of Nexus: A Partial Fix

New York has recently changed their definition of what it means to have "nexus" in the state in order to force more internet merchants to collect the sales tax. In short, they have done so by broadening the definition of "nexus" to include, not just actual bricks-and-mortal operations, but also contractual arrangements with other businesses, that have in-state bricks-and-mortar facilities, for the purposes of directing sales to the internet merchant.

Amazon.com is one of the often-cited examples of this. They have no physical operations in New York, but they have contracts with in-state businesses to place Amazon.com links on their web sites. They then pay those in-state businesses a commission based on the sales made through those links. Under the new law in New York, this qualifies Amazon.com as having "nexus" in the state, since these contractual arrangements mean that the in-state operations are acting as agents of Amazon.com, steering business to its web site.

Shortly after the law passed in early 2008, Amazon.com filed suit against the state of New York to challenge the new law. In the meantime, the sales tax is now being collected on sales made through the Amazon site to people residing in the state of New York. The taxes are legally obligated to be paid by the customers in New York regardless of the outcome of the suit, and thus, will likely not be refunded even if the law is struck down. What is being disputed is whether Amazon.com is required to collect the sales tax from the customers in the first place.

The advantage of this approach is that it can be adopted in Tennessee immediately, without waiting for any federal action. Doing so would help plug some of the revenue loss, while adding additional fairness to the tax system. Amazon.com's competitor Books-a-Million is already collecting the Tennessee (and New York) sales tax... so should Amazon.com. Based on preliminary estimates, enacting this reform could help the state collect $40 million annually by simply enforcing laws that are already on the books.

While this is a good first step, broadening the definition of nexus will not solve the problem of the many smaller, out-of-state merchants selling into Tennessee via the internet. They have no such contractual arrangements, and are thus untouchable even with the broader definition. It will take a more comprehensive approach to solve the bigger problem, as is being proposed under the Streamlined Sales Tax Project (see below). However, this broader change will require federal action and significantly more time.

2. The Streamlines Sales Tax Project: A Comprehensive Solution

Why can't Tennessee require all merchants selling into Tennessee to collect the sales tax? This is where the US Supreme Court comes in. In short, the court has ruled that it would be an undue burden on merchants to require them to keep track of the differing sales tax laws, legal definitions, and tax rates in the tens of thousands of taxing jurisdictions that on-line shoppers are likely purchasing from.

Since then, a number of states have joined together in what is known as the Streamlined Sales Tax Project. The goal of the project is to address the concerns outlined by the Supreme Court. Once the issues are solved, they will request a new ruling from the Supreme Court so that states can start applying the sales tax to internet purchases.

Some of the problems are easy to address. For example, the differing sales tax rates from city-to-city and state-to-state can be solved with a fairly simple database accessible to all on-line merchants. In addition to tracking different rates (presumably by zip code), it would also know which states and cities exempt certain purchases like food and clothing.

The tougher problem to solve is the differing tax definitions from state-to-state, the multitude of tax holidays, and other complicating factors. While it would be easy for a database to know that State X exempts grocery food from the sales tax, the database would not be able to easily tell what State X legally defines as food. Some states consider corn chips to be groceries while others do not. There are a wide array of professional services, medical expenses, and other purchases that are also frequently exempt from the sales tax. Their legal definitions also vary from state to state.

As a result, the second major goal of the Project is to get each of the participating states to adopt a uniform set of legal definitions for food, clothing, health care, professional services, and more. States can still exempt certain items from the sales tax, but within the context of a standardized set of definitions. Once the states are using the same legal definitions, the database can take care of tracking the differing rates and exemptions.

Once again, after a critical mass of states have adopted the Streamlines Sales Tax guidelines, they intend to go back to the US Supreme Court asking for a new ruling. The Project is also pursuing a track to get Congress to change the law.

Visit the Streamlined Sales Tax Project's web site for more.