July 12, 2007

Limiting State Taxes to Companies "Physically Present" in the State: Don't Be Fooled, It's Not as Reasonable as It Sounds

Congress Could Help States Rely on Sales Taxes for Remote Sales

The growing popularity of online retailing over the past several years created a lively debate over the proper role of the government in the online marketplace. One of the most contentious areas of debate revolves around the application of sales taxes to internet sales. Current interpretations of the U.S. Constitution do not allow a state government to require out-of-state companies (companies that are not "physically present" in the state) to collect sales taxes when they sell products or services to residents of the state. These "remote sales," which are often telephone, catalogue, or internet sales, generally go untaxed as a result.

More than a third of all state revenues come from sales taxes currently. These sales tax receipts are forecast to decline in the following years as more and more people switch from shopping at physical stores, which can be required to collect sales taxes, to online retailers based in other states, which cannot be required to do so. This double standard not only deprives state residents of sales tax revenue, but greatly disadvantages physical stores, who must charge higher prices as a result of the sales taxes they pay.

The Supreme Court's 1992 ruling in Quill V. North Dakota was the most recent explanation of this rule. The Court found that mastering the complex sales tax system for every state and county in the union would be an unfair burden on business. However, this same ruling also provided the solution: Congress could grant states the power to require remote sellers to collect sales taxes, and states could facilitate this by simplifying and standardizing their sales taxes. Since the decision, fifteen states have joined the Streamlined Sales and Use Tax Agreement, which unifies the sales tax statues in member states. Senator Michael Enzi (R-WY) has introduced the bill required to give states this new power. There is no good justification for allowing the status quo to continue. Senator Enzi's bill would bring a great deal of fairness to state tax systems.

Congress Might Make It Harder for States to Tax Income of Businesses from Remote Sales

That limitation holds for sales taxes. But when it comes to corporate income taxes (or other types of business activity taxes), the U.S. Supreme Court has never said that the business in question must be "physically present" in the state to be subject to taxation. Business interests have tried to establish such a rule in the courts, but have failed so far, and the Supreme Court recently refused to hear two cases where this argument was made.

However, Congress created a physical presence rule legislatively in 1959, banning states from taxing the income from the sale of physical goods to a state resident if the business itself is not "physically present" in the state. That law is still on the books, and Senators Chuck Schumer (D-NY) and Mike Crapo (R-ID) are sponsoring legislation to extend this rule to other types of sales (like the sale of services). The legislation, called the Business Activity Tax Simplification Act of 2007 (or BATSA) mirrors bills that have been introduced for several years.

While the "physical presence" rule might sound sensible, it actually includes a maze of loopholes and leads to all sorts of absurd results. For example, say a company takes orders from a location in State A and ships its products from State A. It could sell 90 percent of its products to customers in State B and send hundreds of trucks and thousands of salespeople into State B but it still can't be taxed by State B. Another indefensible result of the "physical presence" standard is that some corporate income is never taxed at all.

Perhaps most alarming to state taxpayers, extending the "physical presence" rule would also mean giving even more tax advantages to large out-of-state corporations that are selling services to people in the state over in-state business owners, who can't hide behind this rule to reduce their tax bills.

For more information on the "physical presence" rule and how it can harm state residents, see the ITEP paper on this topic.


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