States may tax iTunes, other digital downloads

If you enjoy buying music from iTunes, movies from Amazon.com's Unbox, or computer software from anywhere, be warned: the halcyon days of tax-free digital purchases may be over.

With retail e-commerce sales now estimated to exceed $130 billion a year, and iTunes song purchases topping 5 billion, state politicians and tax collectors have begun to levy new fees on digital downloads.

Call it the iTax. In 2008 alone, at least nine states have considered digital download taxes, and at least five of those states have enacted them into law. Nebraska's governor signed a digital download tax bill into law in April, and a similar measure was adopted in Tennessee in June. As CNET News reported a few months ago, Indiana, South Dakota, and Utah also enacted digital download taxes this year.

The push stems from an odd legal quirk: because most states' tax laws were written long before the Internet existed, they may accidentally immunize downloads from taxation. This is the case even in otherwise high-tax states like California, where physical CDs are taxed heavily but iTunes downloads remain tax-free for now.

Tech industry groups like NetChoice, which counts eBay, AOL, and Yahoo as members, have been lobbying against the rise in so-called iTaxes--with limited success.

"With global warming and a world that's running out of oil, the last thing governments should do is add taxes on something that uses no oil and produces no carbon," said Steve DelBianco, executive director of NetChoice. "A digital download is the greenest way to buy music, movies, and software, since it requires no driving to the store, no delivery vans, and no plastics or packaging."

Politicians in Wisconsin and California attempted this year to impose taxes on digital downloads but were unsuccessful, according to Stephen Kranz, an attorney at Sutherland law firm who represents members of the digital media industry.

But other states may still consider new digital download legislation soon. "Massachusetts has a draft bill circulating around," Kranz said, and legislators in both Wyoming and Washington will be reviewing their download tax policies at the request of tax collectors.

Including Nebraska and Tennessee, there are 17 states, plus the District of Columbia, that tax digital downloads, according to our earlier research: Alabama, Arizona, Colorado, Hawaii, Idaho, Indiana, Kentucky, Louisiana, Maine, New Jersey, New Mexico, South Dakota, Texas, Utah, and Washington. (For more details, see our special report from 2006.)

The new Tennessee law (PDF) that taxes "the retail sale, lease, licensing, or use of specified digital products transferred to or accessed by subscribers or consumers" takes effect in January 2009. The Nebraska law, which taxes "sales of digital audio works (music), digital audiovisual works (movies, music videos, TV shows), and digital books," takes effect in October.

The increasing popularity of online merchants makes taxes on digital downloads an attractive source of revenue for politicians; last week, for instance, we reported that iTunes was the top music retailer in the United States for the first half of 2008.

And iTunes isn't alone: According to the trade association the International Federation of the Phonographic Industry, there are more than 500 legitimate digital music services worldwide. Digital sales account for 30 percent of revenues in the U.S. music market, the association reported this year.

The International Digital Publishing Forum has been tracking the steady growth of wholesale electronic book sales in the U.S., which reached $10,100,000 in the first quarter of 2008--up more than 25 percent from a year earlier.

The pitfalls of download taxes
Not all online vendors, though, would be compelled by state laws to collect digital download taxes from their customers. Under the legal concept of "nexus," a state generally may only tax a company that has a physical business presence within the state's borders. Translated, that means a company such as Seattle-based Amazon would not be required to collect taxes for the items it sells to San Francisco residents, even if California imposed a digital download tax.

The Supreme Court ruled in 1992 that nexus was required for mandatory taxation--unless Congress changed the law. Advocates of mandatory sales tax collection are now doing just that: related bills were introduced in both the House and Senate last year.

"Most of the proponents of the nexus legislation would concede that given this is an election year, it's unlikely the legislation will pass," Kranz said. He predicted that there will likely be an effort to revive the legislation next year.

Digital download taxes have also been criticized for running businesses out of state. Michelle Steel, a member of California's Board of Equalization, wrote in an editorial in April that if the state were to tax downloads, "Golden State retailers would be at a competitive disadvantage to out-of-state companies."

Democratic Assemblyman Charles Calderon has been pushing legislation in California to tax "digital property." The California Board of Equalization said in an analysis of Calderon's bill that if the state were to "adopt a regulation subjecting digital property transfers to the (Sales and Use Tax) Law, state and local revenues could increase by approximately $114 million annually."

Calderon's bill was defeated in a preliminary vote in April by the state assembly's Revenue and Taxation Committee. Tom White, Calderon's chief of staff, said the politician had not yet decided whether to pursue the measure in the next legislative session but probably will.

For those companies that do have a physical presence in many states--like Apple--it can be a logistical headache to comply with digital download tax laws in multiple states. That's because many states have varied definitions of what constitutes a digital download and how they may be taxed.

The Streamlined Sales Tax Project, a multistate effort to develop uniform standards for taxation, adopted in September of last year a specific definition of digital products, along with procedures for how they should be taxed, according to Scott Peterson, the project's executive director. For instance, "Digital Audio-Visual Works" is defined as "a series of related images which, when shown in succession, impart an impression of motion, together with accompanying sounds, if any."

The definition was first suggested by a group of multistate businesses. Twenty-two states have agreed to the project's standards, including eight of the 18 states that tax digital downloads. "I suspect we will see the next 14 attempting to address it in the next legislative cycle," Kranz said.

Industry representatives say the uniform definition won't lessen the tax burden shouldered by digital media companies, but may at least help eliminate some of the ambiguities and compliance problems.

Washington state law, for instance, does not explicitly permit the taxation of digital downloads, but the state taxes them anyway. Previously, the Washington Department of Revenue told CNET that it taxes downloads on the basis that they fall under the definition of computer software, which is taxable.

"As these technologies meet, there is this question of what is digital goods and what is software," said Drew Shirk, a legislative policy coordinator for the Washington Department of Revenue.

To answer those questions, the state legislature commissioned a committee, chaired by State Representative Ross Hunter, to provide a report to the legislature by the end of the year "to define where technology is today and how it should be taxed," Shirk said.

The committee is meeting on Tuesday to report its results.

More taxes coming soon?
Semantic disputes and other complications aside, the lure of easy revenues--especially if they can be sold to voters as a technical change in definitions rather than a tax increase--continues to lure politicians.

Wisconsin Gov. Jim Doyle promoted a digital download tax in the 2005-2007 budget, but it was not approved. The tax proposal was once again included in the Department of Revenue's 2007-2009 budget, according to Department spokeswoman Jessica Iverson, but was shot down a second time. The tax would have covered digital items, "provided that the non-electronic version of that item was not exempt," Iverson said.

The Wyoming legislature will also likely consider taxing digital downloads early next year, according to Dan Noble, the administrator of the excise tax division for the Wyoming Department of Revenue.

"The way our statute is currently we probably could tax them, but we should probably have the legislature have the final say," he said.

A number of large states, however, have yet to pursue this new line of revenue. Susan Burns of the New York Department of Finance said her employer made clear in 2007 that it does not tax downloaded music or movies (PDF) in two advisory opinions issued in response to an inquiry from Apple. "The sale of digital music delivered electronically to customers for download on their computers... constitutes the sale of intangible property and is not subject to sales or use tax," the music advisory states. Burns said the policy has not changed since the advisories were issued.

CNET News' Declan McCullagh contributed to this report