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Causing additional concern is the Streamlined Sales Tax Project, a multistate effort to develop uniform standards for taxation and straighten out some of the notorious convolutions of state tax laws.
Like Washington state, many participating states have adopted the project's standardized definition of computer software (click here for PDF).
"We do not have a sales tax on an actual digital download," said Caleb Buhs, a spokesman for the Michigan Department of Treasury. "If you were to, say, purchase something that was a prewritten computer software (program) that was in essence delivered electronically, then we would. But not on something from, say, iTunes."
Buhs said he did not know of any plans in Lansing, the state's capital, to follow Washington state in broadening the definition of computer software to raise additional tax revenue.
The tactic of reinterpreting legal terms to increase the tax base is hardly limited to state officials. The Internal Revenue Service drew opposition in 2004, when it suggested reinterpreting a Spanish-American War tax on "telephonic" communications in a way that could cover Internet phone calls. After opposition from a congressional Republican and the Internet industry, the IRS quietly abandoned the proposal.
The prospect of the dozens of states participating in the Streamlined Sales Tax Project, expansively interpreting the meaning of "computer software," worries some of the project's supporters, who fear the potential of a public backlash against the broader effort. Digital-media downloads are already addressed with a separate definition, they say, and should not be shoehorned into a category intended to cover only executable code.
In February, two top officials from the bipartisan National Conference of State Legislatures wrote a letter to the project's organizers, criticizing tax collectors' loose definitions (click here for PDF).
"We were concerned to learn that at least one state tax department has extended the state's definition of tangible personal property to include digital goods," wrote Texas State Senator Leticia Van de Putte and Iowa Speaker of the House Christopher Rants, co-chairs of the legislature conference's task force on electronic commerce taxation. "The task force believes that the decision to tax or not tax any item should be decided by each state's elected policymakers and not through departmental or administrative interpretation."
Scott Peterson, executive director of the Streamlined Sales Tax Governing Board, said he believes that the NCSL letter was referring to legal reinterpretations by Kentucky tax collectors. He added that the topic may be discussed at the board's meeting in Indianapolis, set to begin April 17 (click here for PDF).
"There is no debate about the ability of the Kentucky legislature to tax the sale of digital downloads," Peterson said. "The question is, 'What is the proper method for a state to tax digital downloads?'"
Krantz, of the Council on State Taxation, is coordinating a tax working group that includes Comcast, Microsoft and Amazon.com. He says multistate businesses have proposed a tightly worded definition of digital media to the Streamlined Sales Tax Project. "We're currently in negotiations over that proposal," Krantz said.
A 1992 court ruling's lasting impact
Not every business that offers music, movies or games over the Internet would be required to collect taxes right away, even if many more states begin to change their rules. That's because of the legal concept called "nexus," which means that a company can be taxed by a state only if it has a business presence there.
Nexus is why Seattle-based Amazon.com does not have to collect taxes on shipments to California, a state where the company has no office locations or substantial business presence. Nor is Amazon required to collect taxes on the e-books it sells for about $7 to $20 each.
In a 1992 case called Quill v. North Dakota, the U.S. Supreme Court affirmed the requirement of nexus, saying only Congress had the power to change those rules.
That decision has given rise to two classes of online sellers. Apple and Wal-Mart, in one class, have physical stores all over the country and could be required to collect sales taxes if each state mandated it. But companies without as many storefronts or offices, like Yahoo and eMusic.com, would be immune.
"eMusic is not required to collect state or federal taxes of any nature from our Internet customers; thus, we do not," said David Pakman, chief executive of the the New York-based music service provider.
The company had a 12 percent share of the music download market for computers running Microsoft Windows software as of January, according to NPD Group analyst Russ Crupnick, behind iTunes' 68 percent market share and in front of Napster's 4 percent.
"We'd like the exemption to continue," Pakman said. "We don't use any state or physical resources other than the networks over which the digital goods travel, so it's pretty hard to justify their requirement to tax at the state level on digital sales."
Backers of the Streamlined Sales Tax Project believe that once taxes are simplified, Congress can be persuaded to require retailers to collect taxes on sales even to out-of-state residents. Two bills that would do that--and effectively override the Supreme Court's 1992 decision--are pending in the Senate.
Until the federal government changes the rules, though, the political tussle over taxing digital downloads will continue in state capitols. Last year, Democratic Wisconsin Gov. Jim Doyle proposed a tax on iTunes purchases, with his administration calling it an "issue of tax equity." Republicans pledged to defeat it, and they ultimately prevailed.
"The Joint Finance Committee voted not to include that provision in the budget," Eva Robelia, a spokeswoman for the Wisconsin Department of Revenue, said this month.
That could be a harbinger for similar initiatives in other states.
"To have bureaucrats making these decisions is much worse than having our state legislature do it," Rockwell of the Mises Institute said. "But it's very bad no matter who does it."
Online purchases from sites like Amazon.com or eMusic.com may seem to arrive tax-free. Strictly speaking, however, shoppers are required to pay their own state's sales tax rate--the concept is called a use tax--and voluntarily report the amount owed on tax day. Few do, a situation that state tax collectors are hoping to change.
In states like California that currently don't tax digital downloads, online shoppers don't have to worry about calculating use taxes. But if more states follow the lead of Texas and Washington state, which now tax online-media purchases, the reach of such taxes will steadily grow.
Editors: Mike Yamamoto, Zoë Barton
Design: Michelle White
Production: Daniel Judd, Andy Lottmann
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