Copyright 1999 by Eric J. Sinrod and Jeffrey W. Reyna



Eric J. Sinrod(1) & Jeffrey W. Reyna(2)

Commerce on the Internet(3) is growing at a breathtaking pace.(4) Not only are most major corporations on the Web, but small business owners have signed on to the Internet in record numbers.(5) Recently released figures show that Internet commerce totaled somewhere between $8 and $9 billion in 1998.(6) And Internet commerce is not limited to the sale of goods. For example, millions of Americans purchase monthly Internet access from Internet Service Providers ("ISPs").(7) The range of commercial transactions that can occur over the Internet is limited only by the imagination of its users and continues to expand.(8)

The nation's 30,000 local, state and federal taxing authorities(9) are quite aware of the revenue potential of the Internet. Each one of these jurisdictions potentially could impose taxes on monthly Internet access fees, the sale of goods and services over the Internet, the number of "bits"(10) or "packets"(11) of digital information transmitted over the Internet, and even a tax on the fees charged to register Internet domain names.(12) Eight states have enacted laws imposing a taxes on Internet access or Internet commerce.(13) The potential for multiple and differential taxation of Internet transactions is obvious.

With this potential taxation quagmire in mind, Congress approved the Internet Tax Freedom Act ("ITFA")(14) as part of the 1998 Omnibus Consolidated Appropriations bill. President Clinton signed the Appropriations bill, including the ITFA, on October 21,1998.


The Act has four main provisions. First, beginning October 1, 1998, the Act imposes a three-year moratorium on "taxes on Internet access"(15) and "multiple or discriminatory taxes on electronic commerce."(16)

Second, the Act establishes an Advisory Commission on Electronic Commerce composed of 19 members drawn from the federal government,(17) local and state governments,(18) and appointed representatives of the electronic commerce industry who are selected by the majority and minority leaders in the House and Senate.(19) The main directive of the Advisory Commission is to undertake a "thorough study of Federal, State and local, and international taxation and tariff treatment of transactions using the Internet and Internet access and other comparable intrastate, interstate or international sales activities."(20) Perhaps the Commission's most important directive is to submit a report outlining its findings-including legislative recommendations on Internet taxation-no later than 18 months after the enactment of the Act, or April 21, 2000.(21)

Third, the Act includes a recommendation by Congress that no federal taxes on Internet Commerce and Internet access should be enacted during the three-year moratorium.(22) In other words, the federal government should not tax the Internet at the same time that it is prohibiting state and local jurisdictions from doing so.

Finally, the Act contains two sections aimed at removing international barriers to electronic commerce. The first provision amends the Trade Act of 1974(23) to require that the U.S. Trade Representative present a yearly report to Congress outlining the Trade Representative's efforts to: (1) remove international barriers to U.S. e-commerce; (2) estimate the value of U.S. e-commerce that is transacted with foreign nations; and (3) estimate the potential value of U.S. e-commerce that would be generated from the removal of foreign barriers.(24) Finally, the Act urges the President to seek to enter into trade agreements that "remove barriers to global electronic commerce."(25)


Passage of the Act was not without controversy. Most vocal among the Act's opponents was the National Governors' Association, which claimed that the Act would pose a serious challenge to state sovereignty.(26) State and local officials had expressed concern that the Act would lead to an erosion of sales tax revenues akin to what they claimed had been occurring with respect to mail-order catalog sales.(27) This concern stems primarily from the Supreme Court decision in Quill Corp. v. North Dakota, 504 U.S. 298 (1992).(28) The Court in Quill struck down as an unconstitutional violation of the Commerce Clause a North Dakota law that imposed sales taxes on mail-order catalog purchases made by North Dakota residents. Relying on a familiar "substantial nexus" analysis, the Court held that such a tax was unconstitutional if the seller of goods did not have a physical presence in the state where the customer placed the order.(29) The Court further ruled that mere use of a common carrier within the state, such as UPS or FedEx, failed to establish a nexus that satisfied the Commerce Clause.(30)

Proponents of the ITFA pointed to taxation schemes analogous to the North Dakota statute, among others, that have attempted to tax Internet commerce or access, as a means of highlighting the potential for burdensome and multiple taxation by thousands of jurisdictions.(31)

In the Internet commerce arena, complicating any possible analogy to the mail-order catalog example, stands the fact that Internet sales are often begun and completed entirely on-line. The purchase of software over the Internet provides an appropriate example.(32) An on-line software retailer often bypasses the traditional reliance on FedEx or UPS for product delivery, instead downloading the product directly to a customer's computer over the Internet. Such transactions seem to pose even more difficult challenges to the achievement of the "substantial nexus" necessary for state or local taxation within the limits of the Commerce Clause.

Internet retailers are well aware of the complications posed by the threat of multiple state taxation. Take competing Internet booksellers and Borders for example. charges sales taxes only to customers who reside in its home state of Washington. Borders has, on the other hand, responded to the multiple taxation problem by creating Borders Online, Inc. as a separate entity to handle Internet sales. As a result, even though Borders has bookstores in 40 states (which would otherwise provide the substantial nexus necessary for the imposition of income taxes on Internet sales to customers in those states), Borders Online only collects sales taxes in two states: one where it has a warehouse, and one where it has its corporate headquarters.(33)

In addition to taxation of Internet sales, state and local taxation of Internet access and ISPs has fueled further support for an Internet tax moratorium. One example of taxation of ISPs involves the City of San Bernardino's attempt to tax large ISPs under the City's Utility User Tax by classifying ISPs as "teletypewriter exchange services."(34) In yet another example, Wisconsin taxed Internet access as a "telecommunications" service.(35) Taxing Internet access is seen by some proponents of the ITFA as "double taxation," with taxes on the phone service individuals use to access their ISPs, and taxes levied again on the actual service of the ISPs.

The ITFA is a substantial first step in addressing, and hopefully resolving, taxation and Commerce Clause issues affecting e-commerce and the Internet.


The two key provisions of the ITFA are the moratorium on local, state, and federal taxation of Internet commerce and Internet access, and the creation of the Advisory Commission on Electronic Commerce. The moratorium will have the most immediate economic impact by allowing Internet businesses to continue their unprecedented growth without the specter of multiple and burdensome taxation schemes.

The moratorium prohibits any state or local political subdivision from imposing "(1) taxes on Internet access, unless such tax was generally imposed and actually enforced prior to October 1, 1998; and (2) multiple or discriminatory taxes on electronic commerce."(36) As with all legislation, the devil is in the details. The Act carefully defines "multiple tax"(37) and "discriminatory tax"(38) and provides several exceptions to the application of the tax moratorium. At the same time, and as part of a legislative compromise, the Act states that any entity that provides any material that is "harmful to minors," without adequately restricting access to minors, will be exempt from the Act's moratorium and will be subject to taxation that would otherwise violate the Act.(39)

The Act defines "multiple taxation" to encompass a tax imposed by a local or state jurisdiction that could be imposed by another local or state jurisdiction for "essentially the same electronic commerce."(40) This definition explicitly excludes the imposition of a sales tax on "electronic commerce or a tax on persons engaged in electronic commerce which also may have been subject to a sales or use tax."(41) Of course, in order to escape under this latter provision, the tax also likely must pass the constitutional test outlined by the Supreme Court in Quill. This difficult burden effectively precludes local and state jurisdictions from imposing a sales tax on Internet transactions where there is an insufficient "nexus" to the taxing jurisdiction. The Internet industry probably would contend that this provision, when combined with the current legal framework regarding state and local taxes on interstate transactions, would protect it from the burdensome myriad of taxation schemes that threaten to stifle e-commerce.

By comparison, the Act defines a "discriminatory tax" as any tax imposed by a state or local jurisdiction that singles out Internet transactions or Internet services for special taxation.(42) This includes taxing an Internet transaction that would not be taxable by established laws. It also precludes taxation on the Internet transaction of a person or entity that would not otherwise be taxed if the transaction were conducted by other means (e.g. catalog sales), or the taxation of ISPs at a rate higher than the tax rate imposed on services that provide "similar information services" through other means.(43) With respect to the taxation of Internet access alone, the Act provides that a tax is "discriminatory" if the ISP is deemed to be the agent of the seller of goods merely because the ISP hosts the seller's Web "content" or processes orders through an out-of-state computer server.(44) This final provision seems to imply that a state would not run afoul of the moratorium if it based its taxing jurisdiction on a server's presence in the state. However, only time will tell whether this apparent exception will provide a window for state taxation.

In any event, the ITFA provisions outlined above provide a far-reaching moratorium on Internet taxation that is likely to prevent state and local jurisdictions from imposing anything but the most narrow and carefully tailored of tax schemes that avoid the pitfalls of multiple or discriminatory taxation.


In the long-run, the Act's impact likely will be measured by the findings and recommendations of the Advisory Commission, whose report will likely play a central role in the development of model state legislation for Internet taxation.(45) The work of the Commission hopefully will lead to a resolution of any potential Internet tax quagmire through the adoption of a sensible, uniform, and non-discriminatory approach to taxing Internet commerce and Internet access. After undertaking a study of the ramifications on electronic commerce created by local, state, federal, and international taxation, the Commission should be able to formulate a sensible approach to Internet commerce that will foster continuing economic growth in this sector.


Since the passage of the ITFA, federal and state officials have continued the policy debate on how to handle Internet taxation. Those who were unsatisfied with the narrow reach of the ITFA have sought to expand it. One proposal currently pending in Congress would impose a permanent moratorium on Internet taxation.(46) State officials dissatisfied with the ITFA's moratorium on Internet taxation have complained that the members of the Advisory Commission have a bias in favor of the Internet industry.(47) Pressure from state interests may prompt Congress to add two State representatives to the Advisory Commission.(48)

But not all States agree with the official position taken by State organizations such as the National Governors' Association. California, for example, is not waiting 18 months for the Advisory Commission's recommendations. Instead, a state-wide committee formed by former governor Pete Wilson recently proposed both a permanent ban on Internet taxation and a scale-back of some existing net taxes.(49) But while California, with its burgeoning Internet industry, is leading the charge against net taxes, other states will undoubtedly continue their efforts to tap into Internet commerce as a source of tax revenue.(50) This persistence of competing state interests highlights the importance of the ITFA and the work of the Advisory Committee in establishing a sensible and uniform approach to Internet taxation.

1. Eric J. Sinrod, a partner in the San Francisco office of Hancock Rothert & Bunshoft LLP, practices commercial litigation and Internet, information and communications law, and can be reached at or

2. Jeffrey W. Reyna, an associate in the San Francisco office of Hancock Rothert & Bunshoft LLP, practices commercial litigation and Internet law, and can be reached at

3. The Internet Tax Freedom Act defines the "Internet" as "collectively the myriad of computer and telecommunications facilities, including equipment and operating software, which comprise the interconnected world-wide network of networks that employ the Transmission Control Protocol/Internet Protocol, or any predecessor or successor to such protocol, to communicate information of all kinds by wire or radio." Internet Tax Freedom Act 1101(e)(3)(C), enacted as part of the 1998 Omnibus Consolidated Appropriations Bill.

4. Commercial transactions over the Internet are expected to reach a volume of anywhere from $37 billion to $350 billion by the year 2002. See A Taxing Situation, WIRED NEWS, Aug. 31, 1998, available at <>; Gov. Michael O. Leavitt, Support the Internet Tax Freedom Act, Computerworld, Apr. 13, 1998, available at <>.

5. This figure accounts for 35% of all small businesses in the United States (excluding home-based businesses). Of these, 900,000 small businesses have launched web sites, and nearly half of these are conducting Internet commerce. See Mel Duvall, Report finds small biz leading e-commerce change, ZDNet, Feb. 11, 1998, available at <<>.

6. See John Simmons, Consumers ignore Web taxes, to the chagrin of governments, MSNBC.COM, Jan. 26, 1999, available at <<>; Ted Bridis, Feds to Track Internet Sales, LATIMES.COM, Feb. 5, 1999, available at>.

7. An Internet Service Provider, or ISP, provides individuals and/or businesses with connection to the Internet over conventional phone lines or cable connections, usually for a monthly fee. Direct, and therefore faster, connection to the Internet is often provided to educational institutions or larger businesses. ISPs range from large national companies with millions of customers such as AOL, to small, local companies with only dozens or hundreds of customers.

8. For example, on-line transactions can involve a simple e-mail exchange, on-line transfers of money, and the traditional example of burgeoning consumer retail purchases. See e.g. Mark L. Silow, The Internet Tax Freedom Act, The Legal Intelligencer, Jan. 26, 1999, at 7.

9. See A Taxing Situation, supra note 4.

10. A "bit" refers to the smallest unit of data stored in a computer. Bits have values of either "0" or "1." These collections of 0's and 1's generally store data or execute instructions, often when grouped into "bytes." Bytes are usually made up of eight bits, while half a byte (four bits) is affectionately called a "nibble." See <<> (containing definitions of common Internet and high-tech terminology).

The ITFA defines a "bit tax" as "any tax on electronic commerce expressly imposed on or measured by the volume of digital information transmitted electronically, or the volume of digital information per unit of time transmitted electronically." ITFA 1104(1).

11. A "packet" is a "unit of data that is routed between an origin and a destination on the Internet or any other packet-switched network. When any file . . . is sent from one place to another on the Internet," the information is divided into manageable "packets" of information for efficient routing and delivery to its ultimate destination. Each of these individual packets contains the address information for its ultimate destination. "The individual packets for a given file may travel different routes through the Internet," and therefore through multiple tax jurisdictions, before the packets are "reassembled into the original file" at their ultimate destination. See <<> (containing definitions of common Internet and high-tech terminology).

12. An Internet domain name, or "URL," is a Web site's address on the internet, with the most common suffixes assigned to commercial (.com), educational (.edu), and governmental (.gov) web sites. In May of 1998, Congress approved a law granting the National Science Foundation the authority to impose a 42.8% tax on the fee charged for Internet domain name registration. Revenue from this tax is slated to support the NSF's Internet-related research. See 1998 Emergency Supplemental Appropriations Act, Public Law No: 105-174.

13. See David Hardesty, House Passes Internet Tax Freedom Act-Senate Next, Electronic Commerce Tax Services, June 27, 1998, available at <http://>.

14. The Internet Tax Freedom Act is codified in Titles XI and XII of the 1998 Omnibus Consolidated Appropriations bill.

15. The Internet Tax Freedom Act, Section 1101(a)(1). All statutory references are to the Internet Tax Freedom Act, unless otherwise indicated.

16. Section 1101(a)(2).

17. Section 1102(b)(1)(A).

18. Section 1102(b)(1)(B).

19. Sections 1102(b)(1)(C)(i) - (iv). The members of the Advisory Commission are: Dean Andal, Chairman, California Board of Equalization; Michael Armstrong, CEO of AT&T; Jim Barksdale, CEO of Netscape; Ambassador Charlene Barshefsky, U.S. Trade Representative; Commerce Secretary William M. Daley; Virginia Governor Jim Gilmore; Rep. Paul C. Harris (R-Va); Ron Kirk, Mayor of Dallas; Utah Governor Michael O. Leavitt; Gene N. LeBrun, President, National Conference of Commissioners on Uniform State Law; Washington Governor Gary Locke; Grover Norquist, President, Americans for Tax Reform; Richard D. Parsons, President, Time Warner, Inc.; Robert Pittman, President and CEO, America Online; David S. Pottruck, CEO, Charles Schwab & Co., Inc.; Treasury Secretary Robert E. Rubin; John W. Sidgmore, CEO UUNet Technologies and Vice Chairman & COO of MCI Worldcom; Stan Sokul, Association for Interactive Media; and Ted Waitt, Chairman and CEO of Gateway, Inc. See "Members of the Advisory Commission," available at <<>; See also, AOL's Pittman joins Net tax panel, ZDNet, Dec. 7, 1998, available at <<,4586,2172738,00.html>.

20. Section 1102(g)(1).

21. Section 1103.

22. Section 1201.

23. 19 U.S.C. 2241.

24. Section 1202.

25. Section 1203(a).

26. See Rebecca Vaseley, Govs, Mayors Issue New Warning on Net Tax Bill, WIRED NEWS, Oct. 17, 1997, available at: <>

27. Id. But while state officials contend that the ITFA will erode their tax base, others challenge this assertion as erroneous given current economic conditions. In fact, some dispute that states could ever lay claim to taxing commercial transactions over the Internet due to the fact that states were already constrained by the Due Process and Commerce Clause limitations imposed by the Supreme Court in National Bellas Hess, infra note 28, and Quill. See e.g., Killing the Electronic Goose, Investor's Business Daily, Jan. 5, 1999, at A20.

28. Even before Quill, the Supreme Court in National Bellas Hess v. Dept. of Revenue of Illinois, 386 U.S. 753 (1967), invalidated an Illinois law that imposed a tax on an out-of-state mail order company based on Fourteenth Amendment Due Process grounds. The Court held that a "seller whose only connection with customers in the state is by common carrier or the United States mail"did not satisfy the minimum contacts sufficient to tax the transaction. Id at 758.

The Quill Court, however, pointed out that a tax on mail-order sales could meet the Due Process standard where a retailer has sufficient "minimum contacts" with the buyer's state. However, the very same tax could run afoul of the more stringent "substantial nexus" standard required by the Commerce Clause. Quill, 504 U.S. at 305-06.

29. The North Dakota statute at issue in Quill required, among other things, that every "retailer maintaining a place of business in" the state had to collect a sales tax on sales of goods and remit them to the state. N.D. Cent. Code. 57-40.2-07 (Supp. 1991). The definition of "retailer" included "every person who engages in regular or systematic solicitation of a consumer market in the state." N.D. Cent. Code. 57-40.2-01(6). As a result, the law reached mail-order retailers who did not own or maintain any property in North Dakota.

Advocates of the ITFA also have relied on examples such as Quill, arguing that a moratorium on taxation of e-commerce by state and local authorities would avoid a burdensome patchwork of multiple taxation that would otherwise stifle the burgeoning commerce on the Internet.

In the end, the Supreme Court left the final resolution of the issue of state taxation of interstate commerce to Congress. In adopting a "bright line" rule requiring a substantial nexus to the taxing state (such as ownership or management of property), the Quill Court ultimately stated that resolution was "made easier by the fact that the underlying issue is not only one that Congress may be better qualified to resolve, but also one that Congress has the ultimate power to resolve." Id. at 318.

30. Id..

31. See e.g. Dean F. Andal, State and Local Taxation of Electronic Commerce: Read My E-mail, No New Taxes, Symposium: Multi-Jurisdictional Taxation of Electronic Commerce, International Tax Program and the Society for Law and Tax Policy, Harvard School of Law, April 5, 1997. Mr. Andal is the Chairman of the California State Board of Equalization. He was one of five people appointed by House Speaker Newt Gingrich to the Advisory Commission on Internet Commerce. Speaker Gingrich also appointed David Pottruck, President and co-CEO of Charles Schwab & Co., Governor James Gilmore of Virginia, Grover Norquist of Americans for Tax Reform, and Richard D. Parsons, President of Time Warner, Inc.

32. See Wendy R. Leibowitz, Taxman Has Interest In Internet Biz: States At Odds With Clinton Over Moratorium Proposal, Law Journal Extra, March 16, 1998, available at <<>.

33. See Consumers ignore Web taxes, supra note 8.

34. Id. at 3.

35. Wisc. Stat. 77.51(21m) & 77.52(2)(a)5.

36. Section 1101(a)(1)-(2).

37. Section 1104(6).

38. Section 1104(2).

39. Section 1101(e) et seq.

40. Section 1104(6)(A). As part of the definition of "multiple tax," the Act provides that taxation schemes that provide a credit for taxes imposed by other jurisdictions, "for example, a resale exemption certificate," would not be considered in violation of the moratorium. Id.

41. Section 1104(6)(B).

42. Section 1104(2) et seq.

43. Section 1103(2)(A)(i)-(iv).

44. Section 1104(2)(B)(i)-(ii).

45. One of the duties of the Commission is to undertake an "examination of model state legislation" on Internet commerce and Internet access taxation. Section 1102(g)(2)(D).

46. See Senate Bill 328, 106th Congress (introduced as a rider to the Omnibus Consolidated and Emergency Supplemental Appropriations Act of 1999).

47. See e.g., More Members Expected on Tax Freedom Panel, Newsbytes, Jan. 18, 1999, available at <>.

48. Id.

49. See California: No Net Taxes, WIRED NEWS, Dec. 14, 1998, available at <<>; see also Killing the Electronic Goose, supra note 27, at A20.

50. See supra note 13 and accompanying text.