Since its development and implementation in the mid-60s, the Internet has been mostly free from regulation and government control, though by the mid-1990s, some local and state governments began taxing Internet-related activities.

The Internet Tax Freedom Act (IFTA) of 1998, while continuing sales taxes on online purchases, stopped the spread of Internet taxes, though some tax regimes in 10 US states were grandfathered. The Act was deemed necessary because there are over 30,000 individual tax-imposing jurisdictions in the US that could have assessed a variety of taxes on Internet-related services. Note: Online sales taxes are generally assessed using the same methodologies as for mail order and phone orders.

Despite the title of the Act, Internet activities are not completely devoid of all taxes, as almost all online transactions in the U.S. are subject to some type of tax. Sales taxes can be imposed on virtually all sales of goods conducted online and states can assess net revenue/income taxes on an online service provider, while being prevented from also assessing a gross receipts tax on that service provider.

The debate on Internet taxes centers around competing arguments on the greater benefit to the economy and overall tax revenues. Those proposing taxing Internet activities, such as the Streamlined Sales Tax Governing Board (SSTGB) and e-Fairness (representing retail and real estate industries), are proponents of the Streamlined Sales and Use Tax Agreement (SSUTA) that would tax Internet activities identically to the corresponding non-Internet activities are taxed, providing local and state governments with essential tax revenue streams, and unlikely to hinder Internet commerce. Opponents of taxing Internet activities argue that overall economic activity resulting from the incredible growth of Internet commerce has indirectly contributed more to local and state government tax revenues that direct taxes would, plus the trade, communications and exchange of knowledge fostered provide exceptional benefits to the community in general.

Given the complex nature of these tax issues, any firm conducting its business over the Internet should consult with their CPAs, professional tax preparer or business advisors to determine the tax implications on their activities.

Types of Taxes Assessed on Internet Activities

- Telecommunications tax

Several states assess relatively high Telecommunications Taxes on Internet access charges, viewing access as a telecommunication service. However, there is a wide disparity in taxes assessed various access methodologies, including phone, ISDN, DSL, cable, wireless and satellite, that can (potentially) unfairly penalize certain business types over others.

- Internet access tax

While there is no federal tax on Internet access charges paid to Internet Service Providers (ISPs), many states do assess taxes on access charges. However, the definitions of these charges and the relevant taxes vary significantly from state-to-state, resulting in a wide variety of tax rates and assessment methodologies. In fact, some states consider access charges to be service fees and exempt these fees from taxation. As noted above, 10 states had certain Internet tax programs grandfathered under ITFA.

- Bit tax

The Bit Tax, which has been proposed by a number of countries, assesses a tax based on the volume of data exchanged, irregardless of type (i.e. telephony, voice, data, images or other content). Because there is not comparable tax on offline businesses, the Bit Tax is not allowed in the US under IFTA.

- Bandwidth tax

Another type of Internet tax that is prohibited by IFTA is the Bandwidth Tax that would assess a tax on a graduated scale based on the speed of a customer’s Internet connection. Again, this tax has no counterpart in offline businesses, so cannot be assessed in the US under IFTA.

- Franchise tax

Because local and state governments have generally assessed a Franchise Tax on utilities and cable television operators, consideration is being given to applying Franchise Taxes to ISPs and/or their customers. However, because a Franchise Tax could result in customers being assessed numerous franchise taxes, such a tax was prohibited under IFTA. In addition, the ISPs would have to address possible franchise taxes in thousands of local and state jurisdictions.

- Email tax

The United Nations has in the past considered proposing an e-mail tax, in an effort to raise funds to boost Internet technology access to poor countries.^[3] Citing a “knowledge gap” between the United States and underdeveloped countries, proponents of e-mail taxes believe that its potential redistributive effects make it an ideal tax for implementation on a global scale. According to a report by the United Nations Development Program entitled “Globalization With a Human Face”, Internet users are mostly males located in the United States, a situation UN researchers suggest puts the world’s undeveloped countries at risk of being left behind in a race for knowledge.^[4] “The literally well connected have an overpowering advantage over the unconnected poor, whose voices and concerns are being left out of the global conversation,” the UNDP said in a 1999 press release. To “rectify the imbalance” between Internet users and non-users, the report’s authors proposed a “tax of one US cent on every 100 lengthy e-mails” which they believed would generate $70 billion a year. Imposition of e-mail taxes by the U.S. government or any of its political subdivisions is banned by the Internet Tax Freedom Act.

Internet Taxation Issues

In addition to debates over the types of taxes that can or should be assessed on Internet activities, there are issues as to what constitutes taxable activities and transactions, as well as to what taxing jurisdictions have the authority to tax these Internet activities. IFTA prohibits taxation of most, though not all, Internet activities, while the assessment of sales taxes (implicitly allowed under IFTA) has been mainly determined through court cases. The crux of the sales tax argument has been the “nexus” or legal physical presence in a taxing jurisdiction of the seller. Generally, collection of sales tax on a seller with no physical presence in a state has been deemed to violate the Commerce Clause of the US Constitution and has therefore been prohibited.

The nexus issue is further complicated by the distributed, boundary-less nature of the Internet with the location of an ecommerce firm’s offices, servers and telecommunications gear having an impact on their tax status in a given locale or state. Some states only assess sales tax when both the service and billing occur in the state, but with accounts remotely accessible by customers on a global scale and Internet transactions routed through numerous jurisdictions, determining the nexus of the transaction is extremely difficult, thus making the taxing determination and enforcement even more difficult.

In addition, the type of fee collected, whether an administrative or set-up fee versus a recurring monthly charge affects the tax impact, as does the nature of the transaction (i.e. whether a service or physical product was delivered). Specific states assess taxes differently based on these factors, making the tax determination even more complicated.

With the diverse tax determinations, based on a myriad of factors, and the dispersed locations of the parties to the transactions, collection of taxes on Internet transactions also poses a unique set of challenges to local and state governments. There are issues as to whether the initial service provider, any intermediary or the end-user should pay the tax, as well as how the tax collection can be enforced. The highly publicized law suite of Amazon versus New York state on collection of sales taxes is a case in point, as to how these various issues can be interpreted and argued between the interested parties.

Further information on Internet taxation in specific locales should be obtained from CPAs, professional tax preparers and business consultants knowledgeable on these complex issues.

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