Updated December 2, 2008

Taxing Internet Sales / Leveling the Playing Field

Keeping Tennessee's Money in Tennessee while Supporting Local Businesses.

The sales and use tax is the single largest source of funding for Tennessee state and local government.

In order to fund our roads, schools, parks, libraries, law enforcement, emergency response and other public structures adequately we need to be really efficient at collecting those taxes.

But according to a study done at UT, Tennessee is missing out on about $300 million of revenue from out-of-state sales to Tennesseans. Because of a Supreme Court ruling, states cannot require merchants to collect sales taxes unless they have more business connection with the state than electronic communications and delivery services. All states that have sales taxes also have use taxes that are identical except the use tax is supposed to be paid by the buyer after the point of sale.

Most Tennesseans are not aware of their use tax obligation. Of 3.1 million individual taxpayers in Tennessee, fewer than 1,400 filed use tax returns last year. Fewer than 1,100 businesses did. Many honest citizens know about the use tax but don’t keep track of their purchases well enough to prepare a return. Others figure that their out-of-state purchases are not enough to catch the attention of the Department of Revenue. Some also calculate that if the Department does pursue them, they will only have to pay the tax (no penalty), so they presume they’re better off waiting to be caught than voluntarily paying what they might never be compelled to pay.

Some out-of-state businesses exploit this situation to gain a price advantage over Tennessee businesses. By doing so, they make tax avoidance and evasion a core element of their business plans. That is unacceptable corporate behavior and must stop.

The Internet Parity Act, SB1741/HB1947, as amended, will improve collections by requiring out-of-state sellers who do not collect sales tax to notify their customers at the time of purchase that they may owe sales (use) taxes to Tennessee. They will also be required to report annually to each purchaser and to the state Department of Revenue the total of use tax-eligible purchases. These measures will provide taxpayers the information they need to pay their taxes and to monitor the compliance of the vendors they patronize. Vendors may avoid the reporting requirement by collecting and remitting the sales taxes.

The revenue this will produce can be used to avoid layoffs of state employees and cuts to critical state functions.

Purchasers who elect to patronize Tennessee businesses instead of out-of-state businesses, will help the local economy and still increase state revenue.

This is not a new tax. It is only improving collections for a tax that is already on the books. Failure to pass this bill would, in effect, be continuing to enable tax evasion.

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.

Show your support for our state government and the revenue options needed to fund vital services by clicking 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.

Three Approaches to Solving the Problem

1. Require out of state vendors to report use tax

Require out of state vendors to report use tax that is due to both the consumer and the Department of Revenue.

2. 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.

3. 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.