Section Review

Taxation of e-commerce: The Due Process vs. the Commerce Clause

Michael N. Rubin is a senior tax consultant with PricewaterhouseCoopers LLP in Boston.

Editor's Note: This article is an updated version from that appearing in the printed edition of Vol. 6 No. 2. of Section Review. This version includes editorial changes that were not made prior to printing.

Over the past 10 years, electronic commerce ("e-commerce") has been growing at an enormous rate. With discount travel agents, bargain retail Web sites (i.e. Amazon, E-Toys, etc.) and online auctions like E-bay and Yahoo, more and more people are conducting their personal business from the comfort of their home. While consumers enjoy this added convenience, many states and localities across the country are working diligently to monitor these transactions for the purpose of increasing their tax revenues via sales and use taxes.

E-commerce has brought many new issues to the area of state and local taxation. Many states and local townships impose a sales and/or use tax on products and services that are purchased or used within their jurisdictional boundaries. Sales tax is collected through retailers who add a surcharge (a percentage of the total purchase price) to the amount of the sale. This assessment is remitted to the state or locality as sales tax. In contrast, use tax is usually paid by the buyer after an item has been purchased out of state and then brought into the taxing authority's jurisdiction. Since the use tax relies on the buyer stepping forward voluntarily to pay the tax, states prefer mandatory sales tax collection from in-state vendors at the point of sale. In the past, these taxes were easier to collect (merchants were identifiable), but now transactions that take place over telephone wires and cable lines are more difficult, if not impossible, to track.

The purpose of this article is to detail the challenges states face when attempting to tax e-commerce. States are attempting to force remote sellers to withhold sales taxes when their residents make on-line purchases. This area of state and local taxation is a growing topic of interest due to the myriad of constitutional law issues that intersect the state's authority to require tax collection. The battle between local governments and consumers will only increase as Internet sales become a larger part of today's economy.

The main issue surrounding a government's authority to require a seller to collect sales taxes relates to having proper jurisdiction over the seller. This concept of "proper jurisdiction" becomes a hurdle that states and their localities must get past before tax collection can be imposed. E-commerce has made the jurisdiction issue quite tricky. The landmark case of Quill Corporation vs. North Dakota, 504 U.S. 298 (1992), breaks down the struggle between the Due Process Clause and the Commerce Clause. Both the Due Process test and the requirements of the Commerce Clause must be met.

For a state not to violate a seller's due process, the seller must have some "minimum contacts" with the taxing state. It must reach out and purposefully avail itself of the benefits of that state. A merchant will be considered to have the requisite contacts with a taxing jurisdiction if it owns property in that state or sends sales representatives into the locality. A seller who mails catalogues to or makes phone call solicitations in that state will be found to have purposefully availed itself of the state benefits (i.e. the seller seeks out the state's residents to make sales). See Quill Corp. The purpose of the Due Process Clause is to treat taxpayers fairly. A merchant that reaches out to a state's residents in order to sell products should understand that it is subject to a foreign jurisdiction's laws and regulations. The concept of fairness is the underlying theme in a Due Process analysis.

However, the due process requirement is only the first part of the jurisdictional analysis. Once a seller has availed itself of the taxing state (thus satisfying the Due Process Clause of the U.S. Constitution), a four-part test must also be examined to see if the Commerce Clause is satisfied.

The Commerce Clause states that substantial nexus must be present before a tax obligation can be imposed on an out-of-state merchant. Substantial nexus has been defined as having a physical presence within a state's jurisdiction. The Commerce Clause was enacted by Congress so that it could regulate interstate transactions. It was Congress's intent to ensure that no unfair or burdensome tax would be levied by a state, thus hindering interstate commerce. A state must satisfy a four-part test in order to force a remote seller to collect sales tax. This test was laid out in the U.S. Supreme Court case of Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977).

The U.S. Supreme Court in Complete Auto stated that a seller must meet the following four-part test:

1. The seller must have substantial nexus (physical presence) in state;

2. The tax cannot discriminate against interstate commerce;

3. The tax must be fairly apportioned; and

4. The tax must be fairly related to services provided by state.

Even though a merchant may satisfy the "minimum contacts" requirement of the Due Process Clause, it may not meet the burden of the Commerce Clause. Both must be complied with before sellers can be required to collect taxes in connection with their business. To the dismay of many states, under the Commerce Clause, it is almost impossible to force electronic sellers to collect sales tax. Most Internet sellers fail the first part of the test as they have no physical presence in that state. As discussed above, while sending mailings into a state may satisfy Due Process, it falls short of meeting the stringent requirements of the Commerce Clause.

This test laid out by the Supreme Court prevents the states from taxing many of the sales transactions that occur over the Internet. Vendors can be operating anywhere, including outside of the United States. Because of this, states have incredible difficulty tracking down sellers to determine if they fall within a state's jurisdiction.

Sales over the Internet can be transacted in many forms. Some products sold must be shipped through the mail (clothing, food, etc.) in transactions that closely resemble catalog purchases. However, other sales can result in the products being downloaded onto computers (such as music or video).

When an Internet sale occurs, the seller does not enter into a taxing jurisdiction. Usually, Web sites are maintained on computer servers - which store information required to run and maintain Web pages on the Internet - that are located in other states or even foreign countries. In addition, electronic sellers do not actually enter a state. For example, sellers will place advertisements on Internet Web pages that will attract buyers to visit a certain Web site. The merchant never actually connects with the purchaser's state. Thus, because no contacts with the state are established, the merchant is not required to collect sales tax under the Commerce and Due Process Clauses.

Finding these transactions may be impossible and is in any event quite time consuming. Purchases over the Internet happen instantaneously and often with no records or receipts changing hands. In these situations, even if a state could meet the four-part test of the Commerce Clause, it would more than likely not even know when the transaction occurred.

In an age where the economy is becoming more involved with technology, Internet sales are poised to increase greatly over the next 10 years. As more transactions are conducted online, states will be more determined to figure out a method to tax these sales. With the hurdles of the U.S. Constitution to overcome, many states could be fighting this issue for many years to come.

©2017 Massachusetts Bar Association