Uncertainties About State Taxation of E-Commerce
and Licensing Income

 

Even after more than ten years since the internet boom, state tax laws have not provided certainty around how they tax e-commerce. In addition, due to lack of definitive guidance from the states, diversity exists around the taxation of licensing income and sales of intangible property.

The problem is that most state tax laws are based on systems that tax tangible personal property. These laws are also geared toward situations where it is easily determined where the sale is made, where the seller is located, and where the customer is located. Those factors are not always easily determined when the product is digital (think music or electronic books) or when the customer is in motion. For example, I recently bought a best-selling thriller on my iPhone’s Kindle e-book reader at an airport connection. I live in New Jersey, Amazon is based in Washington, and the download took place in Georgia. So which, if any, of these three states is entitled to tax the income from this sale?

Two key issues to examine are nexus – does the state have the right to tax a company or individual? And if so, how is the income sourced to the state?

States generally tax a company if it is conducting business activities in the state. This is usually indicated by a company having property or people in such state. However, Public Law 86-272 provides that a state cannot levy an income tax on a company that is merely soliciting sales of tangible personal property in a state when the sales are accepted and fulfilled in another state. Thus, you can have a salesman soliciting orders without creating nexus in a state. This protection does extend to sales taxes but does not apply to intangible property and thus leaves open the question whether a state can tax sales of intangible property such as digital music downloads, sales of e-books, or web-based subscriptions.

To create even more diversity, several states have enacted so-called "economic nexus" statutes. These states would consider that companies have nexus, and should therefore file a tax return in that state, if they have intangible property which is being used in that state. Thus, just licensing a trademarked logo to a T-shirt company can cause the licensor to have nexus in the state where the licensee is located. This kind of transaction is not protected by P.L. 86-272.

Once nexus is established, states only tax a portion of a company’s income based on each state's apportionment rules. States typically use a three-factor approach which apportions income to that state based on the percentage of sales, property, and payroll located in that state. But many states have recently moved to a single-factor apportionment that is only based on sales made in the state. This is meant to capture more income from companies that sell into a state but have very little property or payroll in that state. However, single sales-factor apportionment also greatly benefits companies headquartered in such a state.

This leads to the next level of confusion in the e-commerce and intangible property sales areas. How are such sales to be apportioned to a state? Some states apportion intangible sales based on where the activities take place to generate the income (known as "cost of performance"). Other states apportion these types of sales based on where the intangible is used (known as "market-based" approach). Both methods 5 present difficulties in their application to e-commerce and intangible sales.

In a cost-of-performance state, it is sometimes difficult to source e-commerce sales because the online sales or services and related business activities can take place in many different states and at the same time. Market-based states present difficulties in sourcing intangible licensing income because it is sometimes impossible for a licensor to know where exactly its trademarks are being used.

Of all the states, New York seems to be providing more clarity than others. Companies will find some of the guidance to be beneficial and some not so much. The bad news first: New York passed legislation last May, which would require web-based companies to collect New York sales tax if it pays any unrelated New York-based web site a referral payments for sending it business. This is notwithstanding that the web-based company has no physical presence in New York.

For the good news, New York recently issued an advisory opinion in which it would allow a New York licensing company to apportion its licensing sales based on the address of its licensees. New York is a market-based state when it comes to apportioning intangible sales and recognized the difficulty in determining where intangibles are used. New York companies that license to out-of-state licensees will find this methodology to be very beneficial, particularly since New York State is a single-sales factor state and New York City also began phasing in single-sales factor apportionment beginning on January 1, 2009.