Updated at 7:25 AM PDT with new information about the status of the California tax bill.
A growing number of state politicians are proposing new laws to levy taxes on digital downloads, including music, video, and books, as a way to remedy budget pains.
Call it the iTunes tax.
Two years ago, a CNET News.com special report found that 15 states and the District of Columbia said that their laws and regulations meant that digital downloads should be taxed. A few months later, New Jersey joined that list.
Since then, more states have become tax-inclined. In 2008 alone, Indiana, Utah, and South Dakota have enacted laws reiterating their commitments to collect taxes on digital downloads, while Nebraska recently voted to send its governor a bill (PDF) that would tax downloads of books, movies, and music starting October 1. Others, including Wisconsin and Massachusetts, have formed groups to "study" new iTunes taxes.
"I wouldn't be surprised to see other states attempting to impose taxes on digital goods," said Stephen Kranz, an attorney who represents a group of Fortune 500 digital goods vendors opposed to new taxes. Kranz said he couldn't name the companies because irked tax administrators might retaliate by singling out his clients for audits.
One reason that music and movie downloads have partially escaped the notice of tax collectors is that, until a few years ago, the market was relatively small and state tax laws sometimes apply only to tangible goods. But their attitude has changed now that iTunes, Amazon.com, eMusic, Rhapsody, Wal-Mart Music, Yahoo Music Unlimited, and others have demonstrated that there is plenty of untapped revenue for tax-hungry politicians--underscored by reports like one in February stating that iTunes has sold more than 4 billion songs.
Arguably the most heated showdown is looming in California, home to an $8 billion deficit and lawmakers who are scrambling to do something about it. The state legislature is considering a bill proposed earlier this year by Democratic Assemblyman Charles Calderon, who represents a district east of Los Angeles. The bill calls for new taxes to sweep in "digital property," which "includes, but is not limited to, products like music, movies, and books."
Some opponents fear that broad definition could sweep up everything from electronic tax-preparation services to video games to advertising, causing new headaches for online retailers and their customers.
Backers of the new taxes--which, in California's case, include the AFL-CIO and associations that represent state, county, and municipal employees, teachers, firefighters, and county governments--contend they're necessary to offset budget deficits and to create parity with the physical versions of those products that would otherwise be taxed.
A recent analysis of that bill by the Assembly Committee on Revenue and Taxation said it's "imperative" for California to rewrite its tax laws to reflect an increased "amount of transactions in this state involving the electronic transmission of information and 'digital property.'" Calderon said that if California collected taxes on music downloads alone, it would collect $20 million a year in new taxes from state residents.
But opponents--including a wide array of Internet companies, retailers, local chambers of commerce, and the Motion Picture Association of America--argue the new fees will impair digital media sales and, at least in some cases, reduce the incentive of high-tech companies to do business in high-tax states.
Does my state tax digital downloads?
At the moment, Alabama, Arizona, Colorado, Hawaii, Idaho, Indiana, Kentucky, Louisiana, Maine, New Jersey, New Mexico, South Dakota, Texas, Utah, Washington, West Virginia, and the District of Columbia impose such taxes, according to research by CNET News.com and the California State Board of Equalization, which sets the state's tax rules.
Not all state legislators, however, have been so quick to applaud digital goods taxes. Last year, for instance, Iowa legislators agreed to strip out such a proposal by the state's Department of Revenue.
There's also lingering confusion over which state taxes what digital downloads. A list of frequently asked questions at the Web site for Electronic Arts, the video game maker, for instance, says it is also required to collect such taxes from residents of Pennsylvania, Minnesota, Connecticut, and Kansas. (EA did not respond to requests for comment about how it came up with its list.)
Making matters more complicated is that not all states have statutes explicitly stating their position on taxation of digital downloads.
"If a state wants to start taxing a product or service not previously taxed, they've got to enact new legislation, such as the Maryland computer services tax that was just repealed," said Steve DelBianco, executive director of NetChoice, which represents e-commerce companies like eBay and Yahoo. "But many of these states are hiding behind tax administrators who are anxious to create new taxes on so-called digital equivalents."Not so simple
Just because a state imposes sales tax on digital downloads, however, doesn't mean that a retailer will actually have to collect it.
That's because a 1992 U.S. Supreme Court case called Quill v. North Dakota says mail-order companies only have to collect sales taxes from customers who live in areas where they have a physical presence, or "nexus," such as a retail store, warehouse, or data center. So if a California resident buys a digital track from an online music store--say, Seattle-based Amazon--that has no physical presence in the state, a tax shouldn't show up on that order, even if California imposes sales taxes on digital downloads.
Because of those legal inconsistencies, however, opponents argue that the California bill will punish companies located in the state and provide a reason for them to move elsewhere. (Amazon operates a warehouse in neighboring Nevada, for instance.)
"In-state companies will be required to collect the new Internet tax while out-of-state companies will not," more than 200 companies and organizations argued in a recent letter to state legislators. "There will not be a level playing field with other states which will place in-state companies at a competitive price disadvantage." Apple and Wal-Mart, for instance, have physical stores all across the country.
If companies choose to exit California, then the state will actually see reduced tax revenue in the form of corporate and personal income taxes, the same group of opponents argued.
The California bill is also drawing cries of exasperation from the entertainment industry for a completely different reason: intellectual property theft.
In a separate letter opposing the bill, MPAA Vice President Vans Stevenson argued the adoption of an "expansive, unprecedented new Internet tax" will "likely encourage more digital piracy," which he said will lead to "lost jobs, lost sales, and lost tax revenues."
That consideration hasn't been lost on state politicians, either. In an op-ed piece published Sunday in the Sacramento Bee, Republican Michelle Steel, who represents a swath of southern California on the state Board of Equalization, argued that "new taxes encourage consumers to return to their nasty habit of illegally downloading music."
Kranz, for his part, said he believes the California bill, if passed, will be ripe for a legal challenge on procedural grounds. State law normally requires a two-thirds vote for approval of new taxes, but Calderon's proposal attempts to circumvent that by instructing the state Board of Equalization to set the new tax policy and, because of that, requiring only a majority vote.
Foes of new taxes argue that state regulators don't have the legal authority to set such rules in the first place and that allowing such a "back door tax" could set a dangerous precedent.
Update at 7:25 a.m. PST: The California download tax bill was narrowly defeated in a preliminary vote late Monday by the state assembly's Revenue and Taxation Committee, the San Jose Mercury News reports. But Calderon, its sponsor and committee chairman, is still trying to keep it alive. He expects to call up the proposal, which fell one vote short of the five votes needed for passage, for a "reconsideration" vote as soon as next week.
News.com's Declan McCullagh contributed to this report