Tax-free Internet shopping may be at an end

Tax protester at San Francisco "tea party" gathering on April 15 holds up sign saying "IRS: We take $$$$$$ from working people to pay for big government."

(Credit: Declan McCullagh/CNET)

If a little-known but influential alliance of state politicians, large retailers, and tax collectors have their way, the days of tax-free Internet shopping may be nearly over.

A bill expected to be introduced in the U.S. Congress as early as Monday would rewrite the ground rules for mail order and Internet sales by eliminating what its supporters view as a "loophole" that, in many cases, allows Americans to shop over the Internet without paying sales taxes.

Currently, Americans who shop over the Internet from out-of-state vendors aren't always required to pay sales taxes at the time of purchase. Californians buying books from Amazon.com or cameras from Manhattan's B&H Photo, for example, won't pay sales taxes at checkout time that they would if shopping at a local mall.

"We will have the bill ready for introduction by next Monday," said Neal Osten of the National Conference of State Legislatures. "We finalized the language and now we're working out the remaining issues and adding some new provisions at the request of various stakeholders."

This is hardly a new debate: pro-tax officials and state governments have been pressing Congress to enact such a law for at least seven years. They argue that reduced sales tax revenue threatens budgets for schools and police, and say that, as a matter of fairness, online retailers should be forced to collect the same taxes that brick-and-mortar retailers do.

Even though those arguments have been unsuccessful so far, the National Conference of State Legislatures and its allies believe the recession has sliced into sales tax revenue so much that Congress will have to act. A report this week from the Rockefeller Institute says that sales taxes have declined by 6.1 percent, the largest decline in half a century.

"One of the big things the states have learned in the recession is they have declining revenues," said Scott Peterson, executive director of the Streamlined Sales Tax Project, which counts state politicians and tax collectors on its governing board. "We're very optimistic about Congress this year. We think we are within a day or two of finalizing the legislation."

The final legislation is expected to be introduced by Sen. Mike Enzi, a Wyoming Republican, and Rep. Bill Delahunt, a Massachusetts Democrat, who have championed similar proposals in the past. Delahunt's office on Wednesday confirmed he was interested; Enzi's did not respond.

On the other side are the Direct Marketing Association, the Electronic Retailing Association, and companies including eBay, L.L. Bean, and Overstock.com. One of their biggest objections to the idea of collecting sales taxes on out-of-state shipments is the dizzying complexity of state laws.

Take candy, which would seem to be a straightforward item to tax. It isn't. During a 2003 discussion of tax policy, a representative of Indiana, James Turner, noted that a proposed definition of candy would have taxed the Milky Way Midnight candy bar but not the original Milky Way bar.

But further investigation showed that Turner's counter-proposal would have treated "certain flavors of Pop Tarts" and Cookies and Twix Crunchy Cookie Bars as candy--but not Cookies and Snickers Crunchy Cookie Bars. Peanut butter Girl Scout cookies would be candy, but Thin Mints or Caramel deLites would be classified as food.

Bizarre distinctions like this, coupled with the existence of more than 7,000 different tax agencies, are why the U.S. Supreme Court ruled that out-of-state retailers generally couldn't be obligated to collect sales taxes unless Congress changes the law. The justices noted in a 1992 case called Quill v. North Dakota: "Congress is now free to decide whether, when, and to what extent the States may burden interstate mail order concerns with a duty to collect use taxes."

One exception to that rule is a legal concept called "nexus," which means a company can be forced to collect sales taxes if it has a sufficient business presence. If Amazon had an office in California, it already would be collecting sales tax for Golden State residents. (Another exception is the sale of cigarettes, which is covered by the Jenkins Act.)

In response to complexity concerns, the pro-tax forces have offered a proposal that they hope Congress can be persuaded to adopt. The concept is called the Streamlined Sales Tax Agreement, invented in 2002 by state tax officials hoping to straighten out some of sales tax laws' most notorious convolutions.

Since 2003, more than 20 states have signed on, either wholly or partially, to the agreement, meaning they agree to simplify their tax codes and make them uniform. If enough states participate, proponents believe it will be easier to convince Congress to make sales collection mandatory for out-of-state retailers.

"You'll see governors from states who are active participants pushing the Hill to move the issue forward--Kansas has been a long-standing leader. North Dakota, Iowa, Oklahoma, those are some with members on the governing board," said David Quam, director of the office of federal regulations at the National Governors Association. "The states have done the heavy lifting of coming up with a voluntary system that makes sense. Now it's Congress' turn to grant states the authority to collect this."

Representatives of the Streamlined Sales Tax Project are gathering in Washington, D.C. next month for a three-day governing board meeting, including a "lobbying day" that's scheduled for May 13.

Under existing law, the caveat is that online purchases from sites like Amazon and eBay only seem to arrive tax-free. Legally, however, purchasers are required to pay their own state's sales tax rate--the concept is called a "use tax"--and then voluntarily report the amount owed at tax time.

California residents, for instance, are now burdened with a sales and use tax of at least 8.25 percent. State law is strict: if Californians travel to a state with a 5 percent tax and shop there, the law requires them to cough up the 3.25 percent difference when they return. Online purchases are taxed as well.

But compliance is spotty at best. California's Board of Equalization estimates the state lost $1.34 billion in 2003 because residents aren't paying use taxes--and attributes $208 million of that to online purchases.

"There's no member of NRF that does not support" the forthcoming legislation, said Maureen Riehl, vice president of government relations at the National Retail Federation. "The sooner we can get it done the better, as far as retailers are concerned."

Online retailers tend to disagree. If the Streamlined Sales Tax Project (SSTP) were actually simple and easy for a shipper to work with, they might be more willing to compromise, but that may not be the case.

"The states are desperate for new revenue and I think they realize they're straying far from the simplification they originally promised," said Steve DelBianco, executive director of NetChoice, which counts as members AOL, eBay, NewsCorp, Oracle, Verisign, and Yahoo. "That creates an urgency on their part--to get the federal mandate before it becomes clear they have no intention to simplify."

"They have no real intention of simplifying or compensating sellers for the burdens of collecting," DelBianco said. "It's a shell game."

Among his complaints: That states are unwilling to compensate sellers for the burden of sales tax collection; that small businesses with minimal sales should be exempt; that only one state (as opposed to all states) should be able to audit a business; that participating states are not paying attention to the idea of simplification and are actually making definitions more complex.

"There has to be some oversight," DelBianco said. "These guys have demonstrated--the streamlined states have demonstrated -- an inability to stick to the streamlined promise. Only the U.S. Congress is going to be able to protect sellers from unreasonable burdens."

CNET's Stephanie Condon contributed to this report.