Traps for the Unwary: Taxation of Digital Products

Recently, I presented at a webinar hosted by Strafford Publishing on the subject of sales and use tax on digital products and services.  It almost goes without saying that the interstate sale of digital products—whether books or software—is complicated, if for no other reason than it requires analyzing the sales and use tax consequences of such transactions based upon forty-five states’ (and the District of Columbia’s) sales tax laws, which were adopted long before the advent of the digital age.  For example, the starting point for sales tax analysis in most states is whether the transaction involves the sale of “tangible personal property.”  Is a digital product such as a digital book that is downloaded by the customer tangible personal property?

The states do not provide for uniform treatment of the taxability of digital products from state to state, nor are all digital products taxed similarly within a given state.  Colorado, for example, taxes digital books and music, but does not tax digital software.  Twenty-five states tax digital books, music and videos, while thirty states tax prewritten software.

What makes analysis in this field even trickier are the different methods of delivery of digital products and the various pricing plans under which such products are sold.  For example,  under one delivery method, the seller provides the buyer an electronic access code to permit the buyer to download the digital product at the buyer’s convenience.  For a sale such as this, in addition to analyzing whether the underlying product is taxable, the seller must also determine whether the sale of the access code is taxable at the time of such sale.  The SSUTA, of which there are 24 member states, treats the sale of a “digital code” that entitles the purchaser to download a taxable digital product as a taxable transaction.  See Section 332(G).  But not every state, of course, is a member of the SSUTA and non-member states do not always follow this principle.  For instance, the non-member states of Texas, New York, and Illinois treat the sale of such access codes as tantamount to selling a gift card.  These states treat the sale of a gift card or access code as the sale of an intangible.  It is only when the gift card is redeemed that a taxable sale of tangible personal property has occurred.  See, for example, Ill. General Information Letter ST 10-0052-GIL (June 4, 2010).

The law is even cloudier if the seller sells for one price a “bundle” of rights to access not only a taxable product but also a non-taxable product.  For example, in Tennessee Department of Revenue, Revenue Ruling No. 12-11 (July 24, 2012), the Department of Revenue considered whether a bundled service that provided access to both reference books and computer simulation programs at a single price was taxable.  The Department noted that access to digital books is taxable, while access to the software is not taxable.  Nevertheless, because the provider charged one price for these products, the Department held that the entire “bundled” product was taxable.  This ruling falls in line with New York’s so-called “Cheeseboard Rule,” in which tax was due on the entire purchase price where a seller was selling for one price tax exempt cheeses together with a taxable cheese board.  See 20 NYCRR 527.1(b).

The conclusions that can be drawn are that a retailer of digital products should determine the taxability of the products it sells based on the nature of the products sold and the method of access or delivery of the products.  In addition, a seller should consider whether to sell its products for a “bundled price,” or to price its products separately, when selling distinctly taxable or nontaxable items such as software and other digital products.  If one price is charged, the seller is likely liable for tax on the entire price.

After An Earlier Veto, Texas Enacts Nexus-Expanding Legislation In Response To Dispute With Amazon Over Distribution Center

As many readers may be aware, last October, the Texas Comptroller issued a $269 million assessment against Amazon.com for uncollected use tax for the period December 2005 to December 2009. News reports indicated that the assessment was based primarily on the grounds that a related entity, Amazon.com KYDC LLC, operates a distribution center in Irving, Texas (near the Dallas/Forth Worth airport). Amazon disagrees with the assessment, and later sued to obtain the Comptroller’s audit file containing information regarding the basis for the assessment.

July 19 marked the latest volley in the battle between Amazon.com and the State of Texas. Other e-commerce sellers and direct marketers should now ensure that they do not suffer collateral damage.

In response to the contentious dispute that had developed between the State and Amazon, the Texas legislature introduced a number of bills in its 2011 legislative session intended, in effect, to make clear that Amazon.com is obligated to collect and remit Texas use tax. One version of such legislation made its way to Texas Governor Rick Perry in late May, only to be vetoed by the Governor, who has expressed opposition to Amazon nexus legislation. The Texas legislature, however, re-inserted the nexus-expanding language from the bill Perry vetoed into a broad budgetbill, SB 1, which passed in late June.

Governor Perry, after waiting until the final day on which he could act, signed SB 1 on July 19. The bill includes various revisions to the Texas Tax Code that appear to be intended to subject a retailer to an obligation to collect Texas use tax if the retailer uses a distribution center in the state which is maintained by a related company (or even an agent of the retailer), such as was the case for Amazon. The new provisions are broadly-written and arguably redundant in many respects, suggesting that the legislature wanted to be certain that the new law encompasses any conceivable legal arrangement between a retailer and distribution company. (Or, perhaps more cynically, the legislature wanted to be certain that the law covers whatever legal arrangements Amazon, specifically, may have with its distribution center.) Thus, the law provides that a retailer is “engaged in business” in the State, and thus obligated to collect use tax, if the retailer:

• maintains or uses in the state, either directly or indirectly, or through a subsidiary or agent, a distribution center or any other physical location where business is conducted;


• derives receipts from the sale of tangible personal property situated in the state;


• holds a substantial (50% or greater) ownership interest in, or is owned in substantial part by, a person who maintains a location in the state from which business is conducted, if:


• the retailer sells a similar product line under a similar trade name as the in-state entity; or


• the in-state entity promotes or facilitates sales or otherwise assists the retailer in maintaining market in the state, including by receiving returns; or


• holds a substantial ownership interest in, or is owned in substantial part by, a person that maintains a distribution certain or similar facility in the state and delivers property sold by the retailer to consumers.

See Texas Tax Code § 151.107(a)(1), (3), (7), (8). SB 1 also amends the definition of “retailer” to include a person who, under an agreement with another person, (A) is entrusted with possession of tangible personal property in which the other person has title and (B) is authorized to sell the property without additional action by the person having title.Id. § 151.008(b)(6).

While apparently drafted in a manner intended to target Amazon, Internet retailers and direct marketers that contract with a Texas business or use a Texas location, particularly for distribution purposes, should review the law and consult with their counsel to determine if they may be affected by new definitions. Given the high stakes battle between Amazon and the State, other companies could be caught in the cross-fire or even be targeted themselves. Best not to become an unwitting victim.

The Lone Star State Follows a Different Path Regarding Nexus

Bucking the trend of other states, Texas’ Governor recently vetoed proposed legislation to expand the scope of the Texas sales and use tax law regarding collection of sales and use tax. The proposed legislation—HB 2403—was approved by both houses of the Texas legislature, but vetoed by Governor Perry on May 31. This legislation was not as aggressive as that in other states that have recently adopted nexus legislation. (Illinois, Connecticut, Arkansas and Vermont are examples). It merely provided that a retailer has nexus with Texas if it has an affiliated company that operates a distribution center in Texas or if an affiliated company located in Texas performs services on behalf of the retailer or sells under the same brand name as the retailer. This was in part directed at the Amazon situation in which an affiliate of Amazon.com operated a distribution center in the state of Texas (that reportedly led to a $269 million assessment of sales tax by the Texas Comptroller of Public Accounts).

A piece of good news for sellers of digital goods does result from the legislature’s work on the bill. The legislation, as introduced, also provided that use by a remote seller of a website on a server in Texas from which digital goods are sold or delivered creates nexus. However, the House Committee that first reviewed the bill removed the language before submitting the bill to the full House for a vote. This may signify that such activity does not create nexus in Texas. But, before embarking on any such activity in Texas, a seller of digital products should examine carefully the Texas law and applicable constitutional cases in light of the proposed sales activity.

It is also noteworthy that Texas is not yet done. The legislature has before it in committee a Bill—HB 1317—that would be similar to the recently-enacted Arkansas and Connecticut laws that provide for a presumption of nexus for any retailer that pays a commission or other consideration to a company located in Texas which provides a link to the retailer’s website. While the legislature adjourned on May 31, it was back in session last week and this week to consider various budget-related issues, and may reconvene yet again. It may be that this click-through legislation would be deemed legislation that the legislature will be permitted to consider under its authorization for reconvening.

Stay tuned to developments in Texas.

UPDATE: SB1, currently under review by the legislature, has been amended to include the nexus legislation vetoed by the Governor on May 31, as discussed above.  We will track the progress of the Bill and keep you posted concerning any further developments.

May News Roundup: Michigan Repeals MBT; Louisiana Proposes Click-Through Nexus Legislation

On Wednesday, Governor Snyder signed into law Michigan’s new corporate income tax, which will replace the Michigan Business Tax. The new corporate income tax, effective January 1, 2012, uses a single factor (sales) for apportionment purposes and has a flat rate of 6%. However, despite the repeal of the MBT, the new corporate income tax will retain the economic nexus standard of $350,000 in gross receipts, which we have written about previously here. Any business with a physical presence of at least one day in the state would also be required to report the corporate income tax. Unlike the MBT, however, P.L.86-272 applies to the tax and provides some protections, as we have most recently written about here. Internet sellers and direct marketers should consult their tax counsel regarding the significance of the new tax and its impact on their businesses.

In other news, this week, the Louisiana legislature threw its hat into the ring of states proposing click-through nexus laws with H.B. 641. We have written previously about nexus-expanding legislation throughout the country here and here. Although Vermont and Texas legislatures recently passed their own versions of the law, as of this writing, the governor in each state has yet to sign the bill. We will keep you posted as developments arise.

Have a safe and festive Memorial Day, all!

Additional States Introduce Affiliate-Nexus Legislation

On March 2, an Internet-affiliate nexus bill was introduced in the Arkansas State Senate (SB 738). Arkansas joins Arizona, California, Connecticut, Hawaii, Illinois, Massachusetts, Minnesota, Mississippi, New Mexico, Tennessee, Texas, and Vermont, as the thirteenth state this legislative season to consider such a measure. Nearly all of the bills -- with the exception of Illinois’s HB 3659, which was passed by the Illinois legislature and is now awaiting signature or veto by Governor Quinn, and Connecticut’s SB 5545 -- are patterned directly upon the New York affiliate nexus law enacted in 2008 and challenged in court, so far unsuccessfully, by Amazon.com. In other words, 11 of the 13 proposed laws create a rebuttable presumption that an out-of-state Internet retailer is obligated to collect and remit the state’s sales and use taxes if the retailer enters into an agreement with an in-state resident (an “affiliate”) pursuant to which the affiliate places a link from the affiliate’s website to the retailer’s site, and the retailer realizes at least $10,000 in sales to customers referred to it by the affiliate’s links. The presumption can be negated by proof that the in-state affiliates did not engage in any in-state solicitation on behalf of the retailer.

In its November 2010 ruling, the Appellate Division of the New York Supreme Court found that the ability of a retailer to rebut the presumption of solicitation was an important factor in determining that the New York law is not unconstitutional on its face. The Court, however, remanded the case for further proceedings on the issue of whether the law violates the Commerce Clause and Due Process Clause as applied to specifically to Amazon. As the ongoing proceedings in the New York case make clear, the constitutionality of such “New York-style” affiliate-nexus legislation is far from resolved.

At the same time, it is worth noting that the Illinois and Connecticut bills differ from the New York law in that neither bill provides that the presumption that a retailer must collect sales and use tax as a result of having in-state Internet affiliates may be rebutted. Imposing an irrebuttable presumption of nexus is highly suspect under both the Commerce Clause and Due Process Clause. Without a rebuttable presumption in place to protect retailers, Illinois and Connecticut would subject Internet retailers to burdensome state tax collection obligations when the retailers are effectively doing nothing more than advertising. For that reason, the progress of each of these bills bears watching. Stay tuned.

Arbitration Clauses, Class Actions and State Tax

What a funny combination of terms. You might be asking what state tax has to do with arbitration and class action suits. Two recent court decisions illustrate the connection.

In particular, a “bad day” for a corporate executive is receiving the complaint and summons for a class action lawsuit. While there have been fewer class action lawsuits in connection with state taxes than there have been in other areas of the law, the plaintiff’s bar has looked at state tax as a development opportunity and has commenced suits for inappropriate collection of state taxes. The basis commonly used for such a suit is that the state’s unfair and deceptive trade practices statute is violated by the collection of sales tax if such tax is not due. For example, a company might be collecting tax on food in a state in which food is not taxable. A better example would be collecting tax on Internet access, which is prohibited under a federal statute, the Internet Tax Freedom Act, 47 U.S.C. § 151n (1998) (“ITFA”), as amended, unless a state is grandfathered.

AT&T found out the hard way about class action lawsuits in the state tax area. It was collecting tax on Internet access services. Under the ITFA, it was prohibited from collecting such tax in all but a few states. Thus, as I wrote in my blog post of September 17, 2010, AT&T was slammed with a class action lawsuit, and settled for payment of millions of dollars of attorneys’ fees and other costs.

AT&T also recently discovered that there is a way to preclude such class action suits, at least in Texas. In particular, AT&T provided in its agreements with customers that the exclusive basis for resolving all disputes relating to its service was arbitration. When a class action lawsuit was brought against AT&T by Texas consumers for collecting tax on Internet access charges less than $25.00 (Texas, a grandfathered state, imposes tax only on Internet access charges in excess of $25.00 per month), AT&T filed a motion to dismiss the suit based on the arbitration clause in its agreement. Construing the clause broadly, the U.S. District Court for the Southern District of Texas ruled in the case of Stephen T. Johnson v. AT&T Mobility, LLC (12/21/2010), that the clause should be read to include disputes regarding the collection of sales and use tax. Thus, the court dismissed the class action lawsuit and stated that each customer would be required to bring its own dispute in arbitration. If such decision is sustained on appeal, it will significantly limit AT&T’s exposure.

Whether an arbitration clause will in all instances require potential plaintiffs to present their claims in private arbitration rather than public litigation will depend upon a number of factors, but any company doing business with consumers should consider the use of arbitration clauses as a means to resolve disputes. This, of course, is particularly appropriate in the case of a telecom company, but it can be used for Internet retailers and other direct marketers, as well.

A Reminder About The State Tax Implications of Passive Partnership Interests: U.S. Supreme Court Declines To Review State Court Ruling That Mere Partnership Interest Creates Income Tax Nexus

E-commerce companies that have affiliates doing business as (or even just investment interests in) partnerships or other pass-through entities in states in which the e-commerce company has no direct presence should be aware that such partnership interests may be deemed to create income tax nexus for the company.  A number of state laws and regulations provide that ownership in a pass-through entity establishes nexus for the owner.  See, e.g., 34 TAC Sec. 3.586(c)(13) [Texas]; 830 CMR 63.39.1(8) [Massachusetts]. To date, state tax tribunals have agreed. See, e.g., Shell Gas Gathering Corp. #2, N.Y. Tax Appeals Tribunal, DTA Nos. 821569 and 921570 (Sept. 23, 2010).

Furthermore, on January 25, 2011, the United States Supreme Court declined a petition asking the Court to review a Kentucky Appeals Court decision that an out-of-state corporation was properly required to pay Kentucky state income tax, despite the fact that its only connection to Kentucky was its interest in a partnership that was engaged in business in the state.  Asworth, LLC v. Kentucky Department of Revenue, 2009 WL 3877518 (Ky. App. Ct. Feb. 10, 2010), review denied (Ky. 2010) and cert denied, U.S. Supreme Court Dkt. 10-662 (Jan. 25, 2011).  While mere passive ownership in a partnership that generates revenue from activities in a state would not, by itself, be enough to subject the partner-owner to nexus for sales and use tax purposes, the Supreme Court’s refusal to review the Kentucky decision leaves undisturbed the position taken by many states that owners of an interest in a pass-though entity can be compelled to report state income tax.

Magazine Publishers Beware of the New Washington B&O Tax Law

As previously discussed in our blog post dated May 24, 2010, several states have taken the position that the Quill nexus standard applies only to sales and use tax.  State courts in New Jersey (Lanco, Inc. v. Director, Division of Taxation, 188 N.J. 380, 908 A.2d 176 (2006)), West Virginia (Tax Commissioner v. MBNA America Bank, 220 W.Va. 163, 640 S.E.2d 226 (2006)), and South Carolina (Geoffrey, Inc. v. South Carolina Tax Commission, 313 S.C. 15, 437 S.E.2d 13 (1993) (cert denied, 114 S.Ct. 550 (1993)) have held that economic presence (i.e., sales to the state without a physical presence in the state) is sufficient to establish nexus for state income tax.   As written in the May 24 blog post, there are other decisions (e.g. Commonwealth Edison v. Montana, 453 U.S. 609, 101 S.Ct. 2946 (1981)) that apply the Quill/Bellas Hess physical presence test to taxes other than sales tax.

By legislation, other states have adopted a gross receipts tax based on economic presence.  The Ohio Commercial Activity Tax, the Michigan Business Tax and the Texas Margin Tax are examples.  Recently, the State of Washington amended its B&O Tax, which is a gross receipts tax, with regard to the “service classification,” to require an economic nexus standard, based upon the level of service revenues to Washington.  Washington has taken an expansive view of businesses subject to the service revenue classification, which now includes businesses that publish periodicals or magazines with respect to the advertising income that such publications derive.  Since the nexus standard is quite low, this is likely to be a “sleeping dog” for most publishers.

Perhaps the limiting feature for national publications is the fact that the sourcing provisions of the new law would source advertising revenues to Washington for B&O purposes only on the basis of where the purchase orders for such advertisements were issued.  Sourcing is not based on traditional apportionment factors such as payroll and property costs.

Publishers who do not have a physical presence in Washington would have a potential constitutional challenge to the new statute.  In particular, as discussed in the prior blog post, Quill/Bellas Hess should be read to apply to gross receipts taxes, so (we would argue) that the physical presence test of Quill/Bellas Hess should apply.  Indeed, in Tyler Pipe Industries, Inc. v. Washington State Department of Revenue, 483 U.S. 232, 107 S.Ct. 2810 (1987), the U.S. Supreme Court found that the B&O Tax could be imposed on an out-of-state company because it had sales representatives operating in Washington and therefore was making a market in Washington.  While the Court did not cite to Quill or its predecessor Bellas Hess, it did cite as support for its holding National Geographic Society v. California Board of Equalization, 430 U.S. 551 (1977), which in turn relied on Bellas Hess.  Sales representatives under Quill and Bellas Hess create a physical presence.  Thus, if a publisher does not have sales representatives who operate in Washington, it should consider a potential constitutional challenge to any imposition of B&O tax on its advertising revenues.

NEXUS: Quill Physical Presence Test Should Apply to Gross Receipts Taxes

Since National Bellas Hess, Inc. v. Illinois Department of Revenue, 386 U.S. 753 (1967), was decided in 1967, states have attempted to avoid the physical presence test of nexus that the National Bellas Hess case established.  Thus, in the 1980’s, the Pennsylvania Department of Revenue argued that that our client, L. L. Bean, Inc., was required to collect Pennsylvania sales and use tax on all of its sales into the state because the mail order industry had changed since National Bellas Hess was decided.  The Pennsylvania Commonwealth Court squarely rejected this challenge to National Bellas Hess.  L. L. Bean, Inc. v. Department of Revenue, 516 A.2d 820 (Pa. Cmwlth. 1986).

Similarly, the State of California threatened assessment of 300 direct marketers on the ground that they had nexus with California because of their use of 1-800 numbers and acceptance of credit cards.  On behalf of the Direct Marketing Association, Brann & Isaacson sued in federal court, and the Ninth Circuit issued a judgment in favor of the DMA, on behalf of its members, declaring that in the absence of a physical presence in a state, a company is not liable for sales and use tax in that state.  DMA v. Bennett, 916 F.2d 1451 (9th Cir. 1990), cert. denied, 500 U.S. 905 (1991).

The states’ next test case, Quill v. North Dakota, 504 U.S. 298 (1992) (Brann & Isaacson filed an amicus curiae brief on behalf of the DMA in Quill), was yet another unsuccessful effort by the states to overrule and/or limit the physical presence test.

The states’ latest efforts to limit the nexus test under the Commerce Clause by adoption of an economic presence test to measure nexus for gross receipts tax should also be rejected.

Michigan (in the Michigan Business Tax (“MBT”)), Ohio (in the Ohio Commercial Activity Tax (“CAT”), Texas (in the Texas Margin Tax), and Washington (most recently in the May 2010 amendments to its Business and Occupation Tax), however, have asserted that the Quill physical presence test does not apply to gross receipts taxes, but is limited to sales tax.  Citing a footnote in the Quill decision, these states argue for a different standard; namely that the mere economic presence of a taxpayer by sales into the state should create nexus.

The states fail to recognize, however, the U.S. Supreme Court’s decision in Commonwealth Edison Company, et al. v. State of Montana, 453 U.S. 609, 101 S.Ct. 2946 (1981), which applied a physical presence test to a gross receipts tax.  In that case, the Court addressed the standard to apply to a Montana severance tax on coal extracted from Montana mines, which was a gross receipts tax.  Although the Court upheld the constitutionality of the tax, the Court noted the physical presence standard for determining  nexus.  In particular, the Court cited National Bellas Hess as the standard for finding nexus.  The physical presence test of National Bellas Hess doctrine was confirmed in the Quill case in 1992.

The states’ argument also ignores the fair relation prong of the Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 279 (1977) test.  The fair relation prong requires that there be a fair relation between a tax and the benefits conferred upon the taxpayer by the State.  Although the Court has not required a detailed accounting of the services the states provide in order to be able to tax, the taxpayer must be engaged in some activity in the state in order to be subject to tax.  Thus, in Oklahoma Tax Commission v. Jefferson Lines, Inc., 514 U.S. 175 (1995), the Court defined the fair relation prong as follows “Complete Auto’s fourth criterion asks only that the measure of the tax be reasonably related to the taxpayer’s presence or activities in the state.” (Id. at 200, citing Commonwealth Edison Company v. Montana as setting forth the applicable standard).  Clearly, if the taxpayer lacks any physical presence in the state, the fair relation prong of Complete Auto cannot be satisfied.

In short, Complete Auto, Commonwealth Edison Company, and Oklahoma Tax Commission provide one basis to resist a state’s gross receipts tax enforcement efforts against online companies and direct marketers that lack a physical presence in the state.