MTC Analysis of Internet Tax Freedom Act

Under the House version of the Internet Tax Freedom Act, major online services would be exempt in the majority of states from corporate income, franchise, capital stock, and gross receipts taxes, reports the Multistate Tax Commission in its analysis of the bill.

What is the scope of the exemption from state taxation in the House version of the Internet Tax Freedom Act (H.R. 1054)? For one thing, America Online, CompuServe, Prodigy, and the Microsoft Network would be exempt in the majority of states from corporate income, franchise, capital stock, and gross receipts taxes, and Michigan's single business tax.

That is before any consideration of the proposal's impact on state telecommunications and sales and use taxes.

The Multistate Tax Commission (MTC) has released to interested public officials its first comprehensive analysis of H.R. 1054 as reported out of the House Commerce Telecommunications Subcommittee and the House Judiciary Commercial Law Subcommittee in identical form in October (see 97 STN 198-27). The House sponsor of the bill is Rep. Christopher Cox, R-Calif.

First, it should be noted that the MTC's voting member states decided this summer that the commission would not take a position for or against the proposed national moratorium. The MTC's role in this particular national policy discussion is solely that of providing technical analysis of the effects of the legislation to interested public officials. "We believe that this information is useful to persons with differing views on the legislation, both its supporters and opponents," said MTC Executive Director Dan R. Bucks.

H.R. 1054 states that no state or political subdivision thereof may impose, assess, collect, or attempt to collect, any tax on: (1) access to, or use of, the Internet or online services; (2) the transmission or communication of data by or through the Internet or online services; (3) the use or consumption of data acquired through or accessed via the Internet or online services; and (4) transactions made through the Internet or online services.

The bill would provide for a minimum six-year national moratorium on such taxation. According to MTC staff reading of the bill language, ifthe president never issued recommendations to Congress concerning state taxation of the Internet, then the national moratorium would not end unless Congress repealed the legislation.

I. Taxes (Reasonably) Clearly Preempted

According to the MTC analysis, state collection of the following  taxes appears to be prohibited by H.R. 1054.

Telecommunications taxes -- including gross receipts and sales taxes, and local franchise and right-of-way fees -- would be eliminated on the sale of leased line services used to transmit Internet and online service information, including specialized information such as corporate "intranet" data, electronic data interchange (EDI) transactions data, and credit card approval data. "The impact on telecommunications taxes likely would increase as Internet telephone service replaces traditional phone service," the analysis says.

Regular corporations would appear to be exempt from corporate income taxes and corporate franchise taxes measured by net income derived from providing Internet-related or online services, including basic telecommunications services devoted to carrying Internet or online service traffic.

According to the MTC analysis, this impact would result because, unlike in previous versions of the House bill, the provision preserving income taxes is conditioned on such tax being "the same tax generally imposed and collected in the case of all other business entities in that state." By definition, corporate income and franchise taxes are not imposed on noncorporate entities such as partnerships and sole proprietorships. They usually also are not imposed on limited liability companies or S corporations, and in many states they are not
imposed on other business entities such as financial institutions, insurance companies, and public utilities.

Under H.R. 1054, businesses would be exempt from franchise taxes, gross receipts taxes, and possibly capital stock taxes derived from providing Internet-related or online services unless "all other business entities" were subject to "the same tax."

Michigan's single business tax and the New Hampshire business enterprise tax also could not include in their base receipts the provision of Internet-related or online services, according to the MTC analysis. This is because H.R. 1054's preservation of income, franchise, and similar taxes does not extend to operational value-added taxes such as these. However, in its analysis the MTC notes that the bill's preservation of undefined "fairly apportioned business license taxes" might be argued as protecting these taxes.

What Does This Mean?

The sets of state taxes that MTC has determined would reasonably clearly be pre-empted under H.R. 1054 would exempt America Online, CompuServe, Prodigy, and the Microsoft Network from a majority of state corporate income, franchise, capital stock, and gross receipts taxes. The portion of any corporation that delivers content or transmits information or data, including advertising, through the Internet and online services also would be exempt from the same set of taxes in most states, according to the MTC.

According to the analysis, the scope of the exemption would extend to Internet and online service business activity of telecommunications companies, such as regional Bells, AT&T, MCI, Sprint, and
WorldCom. The exemption also would extend to media companies, such as the Wall Street Journal Interactive, NBC, and Time-Warner/CNN; companies that operate value-added networks for EDI, such as GE Information Systems; and information service providers, such as Lexis/Nexis and Dow Jones News/Retrieval.

What else? The portion of any corporation that receives gross income from services provided over the Internet or computer-based telecommunications networks would be exempt from this same set of taxes, according to the MTC staff analysis. This could be a wide-ranging tax exemption, staff noted. For example, banks could claim an exemption for any receipts related to automated teller machines (ATMs) -- i.e., customer use fees -- and airlines could claim an exemption for fees received from other airlines in connection with the operation of their reservation systems.

Two more sets of state taxes would be pre-empted under the House version of the Internet Tax Freedom Act, according to the MTC analysis. Gaming excise taxes would be eliminated on any gambling activity in which the gambling machines are tied together through a computer network, such as computerized video poker or slot machines, electronically controlled keno, and electronic off-track betting. Also, existing sales taxes on Internet access services, online information services, Web site hosting services, and the like, would be repealed.

II. Taxes Subject to Credible Legal Challenge

According to the MTC analysis, the House version of the Internet Tax Freedom Act would provide a credible legal basis for taxpayers to challenge several existing state tax situations. 

MTC staff believes one such situation would be the obligation to collect use taxes due on goods and services delivered or ordered via the Internet or other online services -- even where the seller has clear physical presence not related to the Internet in the customer's state. What this means is that under the proposal, a mail-order company could challenge its obligation to collect use taxes on a shirt orderedfrom its Web site at its headquarters by a customer in a state where it also has a warehouse.

Why? The version of H.R. 1054 that unanimously passed both House subcommittees contains an express prohibition on the assertion of nexus
on the basis of Internet- or online-services-related property or personnel. For example, according to the MTC's reading of the bill, states could not assert nexus over America Online if its only presence in the state was a building containing computer servers and modems and the personnel operating them.

H.R. 1054 also would provide a credible legal basis for taxpayers to challenge an obligation to pay use taxes on goods and services ordered over the Internet or online services, according to the MTC analysis. Another situation? Sales taxes on sales made in local stores where the retailer uses computer-network-based "point of sale" technologies -- such as scanners and debit/credit card approval terminals tied into cash registers -- and has placed the ownership and operation of those cash registers in the hands of a separate
corporation that actually does the retail selling.

Property and sales and use taxes on any property used to transmit or process data from the Internet or online services -- including corporate intranets using TCP/IP protocols -- for companies other than Internet or online service providers also could be challenged under H.R. 1054, according to MTC staff reading of the bill. An example of this situation cited by MTC staff would be computers used by banks to access electronic credit bureau data or electronic investment information services.