Digital Goods Taxation: The Legal Framework
Nearly every state is facing unprecedented budget challenges. As a result, state revenue departments, Governors, and legislatures are considering, recommending, and enacting new taxes on digital goods and transactions. State taxation of intangible products—often referred to as “digital goods”–such as, downloadable e-books, movies, music, software and other services and information delivered electronically will undoubtedly impact sellers and consumers.
Sales Tax Framework
To understand the basis for the policy positions and correlative advocacy efforts around the issue of digital goods taxation, the following section provides an overview of sales and use tax concepts, the classification and characterization of digital goods, and the various forms of digital goods tax legislation.
A. Sales and Use Tax Basics
Forty-five states, Puerto Rico and the District of Columbia impose a retail sales tax and a compensatory use tax; only Alaska, Delaware, Montana, New Hampshire, and Oregon do not impose such taxes. States may call their respective sales and use taxes by other names (e.g., Arizona’s “transaction privilege tax”, Hawaii’s “general excise tax”), but those taxes generally function in the same manner as other states’ sales and use taxes. Most states authorize their local governments to impose sales and use taxes that are identical to the state-level tax. In addition to state-level taxes, approximately 8,000 local jurisdictions impose their own sales tax.
1. Authority to Impose Tax
States that impose sales and use taxes require the seller of a taxable item to collect the tax from the buyer. The legal liability for sales and use tax varies by state, and may be imposed on the seller, buyer, or both. Sellers are allowed (or required) to pass sales and use taxes onto consumers as a separate line item on a bill. An out-of-state seller only has to collect tax if that seller has “nexus” with the state imposing the tax. “Nexus” means a level of contacts with the taxing state that satisfies minimum requirements imposed by the U.S. Constitution. In the sales tax context, “nexus” means physical presence in the taxing state as evidenced by the presence of instrumentalities such as offices, employees, or inventories. This threshold is based on a legal precedent set by Quill Corp. v. North Dakota, 504 U.S. 298 (1992).
The implications of Quill’s physical presence requirement are often minimized or misunderstood. That is, only vendors with a physical presence in a state that imposes tax on digital goods must collect tax. Because of Quill’s physical presence requirement, in-state companies are at a competitive disadvantage as compared to out-of-state companies that do not have to collect tax. For example, if two digital goods vendors sell an e-book for $10.00, a vendor located in a state with a 5.5% sales tax would have to add $.55 to its invoice when it sells an e-book to an in-state customer. An out-of-state vendor would not be required to collect the tax. If price is a priority for the purchaser, he or she may choose the out-of-state company to avoid sales tax over time. In the worst-case scenario, the purchaser may buy the e-book from an illegal outlet or from a pirated source. Thus, imposing sales tax on e-books and digital goods in general arguably provides an incentive for digital piracy.
2. Tax Classification of Digital Goods
Historically, most states have imposed sales tax only on transactions involving “tangible personal property,” (e.g., shoes, tools and computers). States generally do not tax services or intangibles. Sales of digital goods, however, often involve a hybrid of deliveries (e.g., a digital file, ongoing software updates, customer service, etc.), which fall somewhere on the continuum between tangible personal property and services/sales of intangibles. States and taxpayers have historically disagreed on whether a purchase of a digital good is the sale of tangible personal property or the sale of intangible coded information. The distinction is determinative of taxability as states tax sales of tangible personal property but generally do not tax the sale of a service or an intangible.
The confusion surrounding how to classify digital goods is neither a new or resolved issue for the states and taxpayers. In the early days of the software industry, states were successful arguing that software transmitted on tangible storage media (e.g., floppy disks) should be taxed as tangible personal property. Eventually, and after much litigation, many states amended their definitions of “tangible personal property” to expressly include all prewritten computer software. This was the status of the law with respect to sales tax on software at the time when the digital goods market began to shift from selling software on disk to downloadable products. States are now attempting to modify their statutes to address electronically delivered content.
B. Sales Tax Compliance Impacts on the Digital Industry
Like all businesses that collect sales tax from their customers, sellers of digital goods expend substantial effort to comply with state and local sales tax laws. These laws require vendors to discern answers to a multitude of questions: the appropriate taxing jurisdiction entitled to impose tax; the character of the item being sold to determine whether it is taxed by the jurisdiction; the return filing and remittance requirements for the jurisdiction; the appropriate rate and exemptions offered by the jurisdiction; and answers to many other tax compliance questions. The following will provide an overview of the issues involved when addressing these essential compliance concerns.
1. Characterization
a. “Digital Goods” Defined
“Digital goods” is a common term used in the sales and use tax context that broadly refers to goods and services delivered or accessed electronically. Depending upon a specific state’s sales tax laws, digital goods may include items such as downloadable or streaming movies and music, electronic greeting cards, digital photographs, greeting cards, video games, digital codes, subscriptions to digital serials, and so forth. At its broadest, the term can be read to include digitally delivered services (e.g., information services, data processing services).
b. Authority
The first—and often, most complex—inquiry for digital goods vendors is how a state characterizes a particular digital good. With respect to the issue of characterization, it must be noted that there are two distinct statutory regimes under which the states may impose sales tax on digital goods. Specifically, whether a state classifies a digital good as tangible personal property will depend, in part, on whether the state is a member of the Streamlined Sales and Use Tax Agreement (“Agreement”). The Agreement is a model state law that contains substantive and administrative rules intended to simplify state and local sales and use tax regimes and thereby reduce the tax collection burden borne by business. Currently, twenty-three states have enacted legislation that substantially or partially conforms to the Agreement's terms (additional states are expected to follow suit). The Agreement, which we reference throughout the remainder of this memorandum, has had a substantial impact on how states impose sales tax on software and digital goods. Specifically, the Agreement contains definitions of “prewritten computer software” and “specified digital products” that have application to the current discussion. In general, the Agreement provides a framework to tax digital goods. Specific information about the various definitions in the Agreement can be found at www.streamlinedsalestax.org.
States that are not members of the Agreement have or are not adopting their own unique approach to taxation of the digital world. Some states specifically enumerate that the sale or use of digital goods are taxable transactions. Other states have not codified digital goods into their statutes specifically while still other states have issued guidance via their revenue or treasury divisions that the state regards digital goods to be either taxable (tangible personal property) or non-taxable (intangible and/or provision of services).
2. Sale Sourcing
Once a digital product is characterized, vendors must next decide where to source each digital sale. Like the question of characterization, the complexity surrounding the format of a particular digital good muddles the issue of where to source sales. Specifically, the confusion over what is being sold makes it difficult for the digital goods industry to determine the appropriate jurisdiction to which the sale transaction should be sourced.
There is no comprehensive scheme governing the sourcing of sales for tax purposes. As a result, more than one jurisdiction can claim authority to impose tax on a single sale of a digital good, service or intangibles. The Agreement (which only applies in the twenty-three member states) provides rules for how transactions will be sourced for state purposes. The Agreement provides a hierarchy based on destination-based sourcing for sales of tangible personal property, digital property, and services. Local jurisdictions, however, may elect origin-based sourcing. For further discussion of how the Agreement’s general sourcing rule applies to sales of digital products, please see Appendix B.
For both Agreement-member and non-member states, digital goods vendors must determine the proper state characterization of the digital good being sold in order to appropriately source the transaction. The determination of how to source these transactions is fact-intensive and is based on the nature of the thing being sold. Characterization and sourcing thus go hand-in-hand. If, for example, the state treats the transaction as one where the purchaser receives prewritten software, the transaction would likely be sourced to the physical location of the customer. Conversely, if the state characterizes the transaction as the sale of a service, the transaction would likely be sourced to the location where the benefit of the service is received, which may or may not be the same as the customer’s location. These inquiries are particularly complex in the context of digital sourcing as it is often impossible to know where the customer is located or where the benefit of a product is received by the customer. Unfortunately, only after the appropriate sourcing has been determined can the vendor evaluate whether and how the jurisdiction imposes tax.
The complex issue of tax characterization is an essential component of the digital tax inquiry because how an item is characterized for tax purposes (e.g., as tangible personal property, services, a hybrid form, etc.) will not only determine—at a base level—whether the item is subject to tax but also, how the sale will be sourced. Characterization necessarily drives sourcing. The characterization of an item as tangible personal property, services or something else will determine how a sale is to be sourced. Additionally, how a state characterizes items may impact the rate of tax that the state will impose on such items.
3. Exemptions
As a final point on tax compliance, identifying products that are exempt from tax can be difficult. Most sales tax statutes exempt purchases of tangible products that are incorporated into a final tangible product for resale. Unfortunately, as states have addressed digital goods taxation they have failed to provide the same broad based exemptions for digital products that are purchased by vendors for incorporation into digital products for sale. Existing resale exemption statutes were adopted before the advent of digital products and may need to be modified to ensure that digital content is not subject to tax pyramiding. For the states that are members of the Agreement, the definition of “specified digital products” (Sect. 332(d)(1)) says that a statute imposing tax on digital goods only imposes tax on sales of products to an end user. This mechanism is intended to prevent tax pyramiding. Unfortunately, states that have taxed digital have failed to adapt the end user protection.
C. Digital Goods Legislation
Forty-eight states dealt with or continue to face budget deficits totaling $165 billion, which constitutes approximately one-quarter of all state budgets. Thirty-three states already project budget deficits for 2011. To replace lost tax revenue, many states have enacted or are considering new sales and use taxes on transactions involving digital goods. Although the proponents of such legislation argue that taxes on digital goods would promote a more fair and equitable tax system by taxing substantively similar items regardless of the method of delivery, the impetus of digital goods tax legislation is ultimately to raise revenue.
Since 2007, twelve states have enacted legislation imposing sales and use tax on digital goods. New Jersey was the first state to expressly tax digital goods in the fall of 2007. In 2008, eleven additional states considered legislation to impose tax on digital goods with five of those states adopting new taxes on digital. As of the third quarter of 2009, thirteen states considered legislation to impose taxes on digital goods, of which six of those states adopted new taxes on digital. In the last two years, eleven states have adopted such taxes. Despite this trend, new taxes on digital goods were defeated outright in seven states. For your reference we have provided a description of the approach taken by each state (see Appendix A).
See also: Appendix A & B