Internet Sales Tax Fairness: A Tale of Three Proposals

Posted by Sheila Andrews on February 10, 2015

When the debate over Internet sales tax parity began, the Marketplace Fairness Act (MFA) was a simple solution for leveling the playing field between brick and mortar businesses and online retailers. However, as occurs in all things legislative, the simplest solution comes with some of the strongest objection.

The MFA as drafted would simply provide states with the ability to collect sales taxes on purchases made by people and businesses within their jurisdictions based on the tax rate applied to the buyer’s address. The benefit of such an approach, also called “destination sourcing,” is that it is simple and fair. The system under the MFA looks like this:

  1. The rate of tax is calculated based on the buyer’s address; 
  2. The tax is collected by the remote seller, and remitted back to the state of the buyer’s address.

Buyers, especially those in non-sales tax states, are not required to pay a tax beyond that mandated by their legal residency. The MFA also requires that online retailers are provided free software to perform the collections, remittance and proof of sales for auditing purposes that integrates into their Internet shopping cart systems. Additionally, online retailers doing less than $1 million in remote sales do not have to comply with the online tax collection.

Seems like a fairly easy approach that eliminates the unfair pricing advantage that online retailers have over physical store fronts. Yet, legislators, for reasons not entirely clear, have objected to certain details of MFA and have drafted two new proposals that have already slowed progress of the legislation.

One concern being expressed by some legislators is that MFA provides an exemption for small sellers, but brick and mortar stores do not get exemptions from sales tax collection unless they are in a no sales tax state. So the second proposal to emerge would phase out the exemption for small sellers over three years, but keep the “destination sourcing” principle. Proposal two, would look like this:

  1. The rate of tax is calculated based on the buyer’s address;
  2. The tax is collected by the remote seller and remitted back to the state of the buyer’s address:
    • In year one, all remote sellers doing less than $10 million in online sales are exempt.
    • In year two, all remote sellers doing less than $5 million in online sales are exempt.
    • In year three, all remote sellers doing less than $1 million in online sales are exempt.
    • In year four, no remote sellers are exempt.

Only a few layers are added into what is still a fairly direct solution to the Internet sales tax issue, but those are easy enough to incorporate into the legislation. Furthermore, the software being provided has the capabilities to incorporate these requirements into their systems. So why not stop there? Or as some elected officials might prefer, why stop there?

The third legislative option being proposed is called “hybrid-origin sourcing.” And no, it does not mean only states where all residents drive hybrid vehicles can participate, but it does make it pretty difficult for states to apply the new law. The system under the third proposal would look like this:

  1. Online retailers are determined to have a physical presence in a state depending on a series of factors, including where the largest amount of employees exist, whether they do business in a state for more than 30 days, and others.
  2. Online seller pays the tax rate on purchase based on state presence of the retailer.
  3. Retailer sends the tax rate collected to their state tax revenue department, along with the zip code of the purchaser that is provided at the time of sale.
  4. If the retailer’s tax rate is higher than that of the purchaser, the balance of the revenue is kept by the retailer’s state.
  5. Seller’s state then sends the amount, along with the zip code, to a newly formed Internet Fairness Tax Act tax revenue board, as required by the law.
  6. The law only becomes effective if each state participating in the opting-in to the program develops their board within 90 days.
  7. All members of the board are appointed by the governor.
  8. The buyer’s state IFTA board then keeps a portion of the revenue while remitting the rest to the buyer’s county of jurisdiction, as determined by their zip code
  9. States that do not currently have sales tax laws have the option of participating in order to receive tax revenues from purchases made by out-of-state buyers.

Of course, the third option raises the question of whether its authors are attempting to move the bill forward or actually muddy up the water, creating more questions than answers and mandating additional layers of state bureaucracy that are sure to bring objections.

On some level it is heartening that the debate last year as to whether Internet sales should be taxed has now morphed into an argument this year over how that tax should be imposed. This is clearly progress. However, it is also ironic that when Congress is seriously looking at the simplification of a tax code, that proposals are being discussed that would lead to a more complicated and expensive system to implement for retailers and states. Legislators need to look beyond the smoke that is being produced during the debate and look for a workable proposal that would instill fairness in the collection of sales tax from online sales. 

Keywords: Competition, Taxes