Friday, March 13, 2009

Taxation of digital downloads

By guest author, Cory Greenwell, Esquire*

“The customer is always right” has long been a mantra of the business world. Over the last ten years, consumers within the entertainment and software industries have begun to demand instant access to products off all types. Products such as the Apple iPod®, Sony PSP® and the Amazon Kindle® among countless similar products have created an ever-increasing demand for instant access to media content. As a result, the increase of digital distribution of media content has grown, with iTunes alone accounting for more than $5 billion dollars in the US and the industry continues to grow. As a direct result of the increase in volume of the digital distribution of media content, the distribution of physical media, such as compact discs that are customarily subject to sales tax fell sharply in 2007. The paradigm shift has resulted in a major sector of the entertainment industry acquiring virtually tax-freConstitution2e status or consumers.

In the 1992 landmark decision in Quill v. North Dakota, 504 U.S. 298 (1992), the court found that states cannot require out-of-state retailers to collect taxes from customers who live in states where the retailer does not have a related physical presence or “substantial nexus”. The basis for the decision was to give a “safe harbor” for businesses wishing to avoid the burdens of complying with the numerous state tax laws by transacting business online.

Seventeen states, including Tennessee, have updated their tax code and now impose a tax on digital downloads. The legality regarding the taxation of digital media appears to have been resolved in favor of taxation. After Quill, the responsibility rests on the individual consumer to report the transaction on their annual tax return and pay the appropriate amount of sales tax. Some reports indicate that nationwide state and local governments will have lost more than $500,000,000 in uncollected taxes by 2011.

The court in Quill recognized the importance of the emerging e-commerce sector and declared that alternative means to require retailers to collect sales tax, namely that 1) Congress may require retailers to collect sales tax or 2) States may require retailers to collect taxes provided that Congress has provided a mechanism by which to reduce the burden of retailers to comply with the tax laws of the several states.

Since the Quill decision, twenty-two states including Tennessee have joined together under the “Streamlined Sales Tax Agreement” to create a uniform tax code to reduce the burden of complying with the law of the several states. Among other things, the SSTA have created uniform rules regarding digital media. The National Conference of State Legislatures has called for Congress in its next session to review the Sales Tax Fairness and Simplification Act (H.R. 3396) which gives those states that have complied with the Streamlined Sales Tax Agreement the authority to require out-of-state retailers to collect sales tax for online purchases.

Rather than waiting on Congressional action, New York has attempted to circumvent the requirement of a physical location within the state by interpreting their law to include any “affiliate”. In the case of Amazon, affiliates include anyone who advertises on the website. This interpretation, if adopted by the several states, would negate the benefit of the safe harbor by exposing the online retailer to liability throughout the nation.

In conclusion, as the law presently stands, states may tax digital media, however it cannot require out of state retailers to collect taxes. If Congress adopts the legislation proposed by the members of the Streamlined Sales Tax Agreement as anticipated, the Quill case no longer prevents states from requiring retailers to collect sales tax.

Cory Greenwell *Jonathan “Cory” Greenwell is an intellectual property lawyer who practices in Louisville, Kentucky at the firm of Greenebaum Doll & McDonald.  Cory is the co-founder of the website Backseat SandBar and was featured on the WFPK 91.9 feature, “Off the Record.”

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