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Arthur Andersen Report on Cybertaxation

The Arthur Andersen Report, The Taxation of Cyberspace, authored by Karl A. Frieden and Michael E. Porter, represents the first comprehensive study attempting to make sense out of the complex and critical taxation issues surrounding Internet commerce.

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Executive Summary - The Internet Phenomenon

Electronic commerce is on the verge of reinventing social and commercial relationships. In an information age, the Internet vastly expands the potential to instantly transfer a wide range of goods and services to anyone, anywhere, at any time. Electronic commerce revenues may exceed $150 billion by the year 2000.

The emergence of the Internet as a new mass communications channel will fundamentally transform how we work, play, learn, shop, and socialize. According to a Nielsen Survey, over 40 million people currently use or have access to the Internet in the United States and Canada. The number of American households that have access to the Internet increased from .2 percent in 1993 to 14 percent in 1996. An estimated 300 million people will utilize the Internet on a worldwide basis by the year 2000.

Some of the most important business services and consumer items lend themselves to Internet Commerce, including computer software, telecommunications, movies, magazines, music albums, financial transactions, video conferencing, newspapers, educational and training materials, E-mail, games, and business databases.

Among the most common electronic transactions will be:

The State of Cybertaxation

Clearly, as the importance of the Internet as a channel of commerce continues to grow, states will have to decide whether to institute sales taxes--and if so, how? The problem lies in the outdated tax systems of most states, which were designed to tax tangible goods. Presently, states are trying to impose a mid-twentieth century tax system on a technologically advanced 21st century service industry. For example, the current state tax system can easily be applied to a software package sold in a retail outlet, but the rules become unclear when that same software is sold and transferred electronically.

Nonetheless, the taxation of electronic commerce is not a future issue, but a current reality:

A significant obstacle in addressing cybertaxation is determining "nexus"-- a companys "presence" in a particular tax jurisdiction. It is possible for a company to conduct business in several states, but have an actual physical presence in just one state. States are currently grappling with how to determine nexus for companies that conduct business electronically in several tax jurisdictions.

Another problem is how to source sales over the Internet. With electronic commerce, a vendor can be located physically in one jurisdiction, the product or service can be stored on a computer server in a second state, the consumer can reside in a third state, and the consumer can access the information from a fourth state. Which state (or states) has the jurisdiction to tax the transaction? Furthermore, for many Web transactions, the vendor may be unaware of the state the consumer resides in since Web addresses (such as consumer@aol.com) typically do not identify the state of residency or commercial domicile.

To Tax or Not to Tax

The state taxation of electronic commerce is in its infancy, and there are many unresolved issues and statutory and regulatory ambiguities. There are already stark differences in approaches taken by various states, and this is creating considerable confusion and a lack of uniformity in state tax rules. Yet if a cohesive system of taxation is to be created, now is the time. Already, many states, including New York, Massachusetts, and Florida, are in the process of reassessing their approaches to the taxation of electronic commerce. The federal government has also recently issued a white paper on Internet commerce.

But finding answers won't be easy. States are caught between two conflicting forces--one to proceed cautiously so as not to adversely impact Internet commerce; and the other to take advantage of the revenue stream that cybertaxation could provide. Considering that sales taxes provide the bulk of state revenues in a majority of states, the outcome of this struggle could have enormous implications.

In some ways, electronic commerce would appear to be a prime candidate for state tax uniformity efforts. There is wide recognition among both states and business (a rare combination) that the state tax rules on electronic commerce are outdated, inconsistent, and potentially detrimental to industry. Consider the following: 70 percent of financial and tax executives believe that state and local tax rules governing electronic commerce are ambiguous; 50 percent believe this ambiguity is inhibiting their utilization of the Internet.

What Does the Future Hold?

The commercialization and taxation of the Internet and other forms of electronic commerce will be dynamic and chaotic over the next decade. Some states will impose far-reaching nexus rules, while others will adhere more closely to traditional "physical presence" standards. Some states will tax a full range of transmission and content-related Internet activities, while other states will limit their sales tax base to largely tangible personal property transactions. Moreover, there undoubtedly will be substantial litigation regarding issues such as what types of electronic commerce transactions are subject to tax, and what activities will create nexus in a state.

The debate over the state of taxation of cyberspace promises to be one of the defining state policy issues of the next decade. With over 6500 state and local sales tax jurisdictions in the US and Canada alone, complying with existing rules is already a major administrative task. And with new technologies and borderless and "real time" transactions associated with electronic commerce, these tax compliance responsibilities will undoubtedly become even more onerous. - ###


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