New electronic technologies, particularly the communications technologies associated with the Internet, have effectively eliminated not only state, but national, borders on the information highway. As a result, transactions are at risk of being subjected to tax in more than one state, or indeed, in more than one country.

I. Federal Tax Issues.

A. Policy Issues. Electronic Commerce poses significant tax policy and administration issues:
 

1. Neutrality - Ideally the tax rules applicable to Electronic Commerce should not place it at a disadvantage to other forms of trade.
2. Administrative Complexity - The decentralization of the Internet makes it difficult to track, monitor and collect tax with respect to Internet transactions.
3. Disintermediation - The loss of traditional third party intermediation (for example, the banking system) results in an increased difficulty in tracking and enforcing tax liability. The loss of withholding agents is a central issue.
4. Auditability - The ability to monitor the Internet challenges tax administrators at all levels.

B. Substantive Tax Issues.

Basic Framework for International Taxation.

1. For federal tax purposes, all domestic U.S. entities and businesses are taxed on all income regardless of situs, subject only to credit or treaty limitations on income derived from foreign sources.
2. Foreign entities, however, are taxed only on their U.S. source income to the extent that the income is sourced in this country.

Source of Income Concepts. The source of income concept plays an essential role in international taxation because the country of source generally has a right to tax income whereas the country of residence generally avoids double taxation through a credit system or an exemption system.

Tax Treaties. United States tax treaties generally give the resident’s country an unlimited right to tax income while limiting or eliminating the source country’s right to tax unless the non-resident is somehow "present" for tax purposes in the source country. In the tax treaties, this concept of presence takes the form of "permanent establishment." A permanent establishment is a more or less a fixed place of business or abode which permits the source base country to exert taxation rights over income attributable to that business.

Sourcing of Electronic Commerce. Electronic Commerce complicates the issue because the nature of Electronic Commerce transactions makes it difficult to identify the source or where the activity occurred. For example, does telecommunications or computer equipment owned or used by a foreign person engaged in Electronic Commerce create a fixed place of business of the foreign person in the United States or other tax jurisdiction? Does the fact that a foreign enterprise is using a U.S. based Internet provider create a physical presence for tax purposes?

Classification of Income. Another difficulty relates to the classification of income: What is a "sale" vs. a "license" of software for instance? Recently proposed regulations have gone a long way to address this issue on computer software (Proposed Treas. Reg. Section 1.861-18, 61 Fed. Reg. 58, 152 (XIII) 1996), however they do not fit neatly into the traditional treaty format.

Definition of Service Income. Another significant issue is when will payments be attributed to sales of goods as opposed to service income. The sourcing rules are different for these types of income.

Controlled Foreign Corporations. One danger to the U.S. revenue system is the potential ability of controlled foreign corporations ("CFCs") to use the Internet to shift offshore substantial income and other activities without being subject to U.S. tax jurisdiction.

Allocation of Income. Another profound problem is the allocation of income among a number of jurisdictions. The problem arises when a single activity is conducted in multiple jurisdictions (e.g. an Internet based worldwide research and design process, engineering or consulting contract).

Summary. The sourcing and allocation of income on a worldwide basis as to Electronic Commerce is an extremely difficult issue that neither the applicable law nor the treaty regimes have begun to address.

For an excellent discussion of these issues see as a reference Selected Tax Policy Implications of Global Electronic Commerce, Department of the Treasury Office of Tax Policy, November 1996 (available on the Worldwide Web at http://www.ustreas.gov.)

II. State Taxation Issues.

State tax considerations present much the same issues as federal tax considerations. Two issues dominate the state tax analysis -- "nexus" for tax purposes and "situs" of income. 

1. Nexus. Nexus is the threshold test that must be met before a state may tax income or transactions. Nexus is a Latin term and means a link or connection with the taxing state. Nexus is different for income tax and sales and use tax purposes. Current concepts used to establish nexus for taxation purposes do not fit in the Electronic Commerce era. Under current case law, some sort of physical presence is required for nexus for sales and use tax, but not for income tax. (National Bellas Hess, Inc. v. Dept. of Revenue of Illinois 386 U.S. 753 (1967); Quill Corp. v. North Dakota 504 U.S. 298 (1992)).
2. Agency. A state may have nexus to tax based on the presence of agents or representatives of the taxpayer in the jurisdiction. (National Geographic Society v. California Board of Equalization 430 U.S. 551 (1977); Scripto Inc. v. Carson 362 U.S. 207 (1960)).
3. Presence of Intangibles. Recent cases suggest presence of intangibles may give rise to nexus. (Geoffrey, Inc. v. South Carolina Tax Commissioner 437 S.E.2d 13 (S.C., 1993)) [license of trade name to an in-state user creates income tax nexus for the non-resident].
4. Internet and Nexus. The states may seek to exploit the agency concept to find that use of an Internet provider may create physical presence and nexus in a state where the provider has a physical location.
5. Situs Issues. States typically require multistate service providers to source receipts to the state having the greatest proportion of income-producing activity, as measured by costs of performance. This will not be an easy calculus for a vendor of services over the Internet. Does a seller of information services source its sales to the state where its headquarters is located, its database is located, or where its Internet Service Provider is located? Because the costs of performance method for sourcing receipts relates back to the industrial age, it is not readily adaptable to the sale of services. Thus, an increasing number of states might be expected to develop "market sourcing" regimes for such sales.
6. Public Law 86-272. An intriguing income tax concern is the effect of Electronic Commerce on the protections offered by Public Law 86-272 15 U.S.C. § 381 et seq. The law limits a state’s power to impose income taxes on out-of-state sellers of tangible personal property which confine their in-state activities to solicitation of sales. Taxpayers that accept orders within the state exceed the protection granted by the statute. The use of electronic data interchange (EDI), a means of processing orders between commercial enterprises, may be construed as an in-state acceptance of orders. A state may contend that the posting of a home page with an Internet Service Provider having an in-state presence, the instantaneous acceptance of orders provided by EDI, and the receipt of immediate payment is the equivalent of accepting an order in the state of the customer’s location.
7. ITAA. An excellent source of information regarding state and local tax issues applying to Electronic Commerce and to information technology generally is the Information Technology Association of America. The contact there is Ms. Carol Cayo. The address is Suite 1300, 1616 N. Fort Myer Drive, Arlington, Virginia 22209-3106. Phone (703) 284-5352. Fax (703) 525-2279. E-mail address: ccayo@itaa.org. ITAA has recently released an extremely important report titled Straight Talk: Internet, Tax and Interstate Commerce on December 17, 1996. This report is available from the ITAA.
8. The State of the Law. The law is extremely unsettled in this area.
   
   1. General Rule. Probably a majority of the states (including Georgia), do not tax electronic services because they are regarded as tangible personal property and state statutes do not extend to services that would include on-line and Internet access. Creeping moves in this direction continue, however.
   2. States Which Tax Electronic Commerce. Some states have a specific tax on information services or treat Internet service providers as subject to existing telecommunications tax. Notably these include Connecticut, Florida, New Jersey, South Carolina, the District of Columbia, Ohio and Texas which tax Internet service providers or various ancillary functions.
   3. Expanded Nexus. Some states are asserting expanded income tax nexus based on licensing of software into the state (e.g. Iowa).
   4. Cities get into the Act. Recently, cities such as Chicago and Spokane have threatened to tax Internet service providers and others engaged in Electronic Commerce.
   5. Federal Legislation Proposed. Representatives Cox and Wyden have recently proposed legislation which would pre-empt state and local power to tax in all these areas.