Copyright 1998 by Eric J. Sinrod and Jeffrey W. Reyna


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

Internet(3) commerce is growing exponentially.(4) Practically 2.5 million small business owners have signed on to the Internet so far.(5) In addition to numerous individual consumer purchases over the Internet, millions of Americans purchase monthly Internet access from Internet Service Providers ("ISPs").(6)

The nation's 30,000 local, state and federal taxing authorities(7) are quite aware of the revenue potential of the Internet. Each one of these jurisdictions potentially could levy taxes on monthly Internet access fees, the sale of goods and services over the Internet, "bits"(8) of digital information, and information "packets"(9) sent over the Internet. Eight states so far have enacted laws imposing a taxes on Internet access or Internet commerce.(10) The potential for multiple and differential taxation of Internet transactions is obvious.

With this potential taxation quagmire in mind, Congress earlier this year approved the Internet Tax Freedom Act ("ITFA")(11) 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"(12) and "multiple or discriminatory taxes on electronic commerce."(13)

Second, the Act establishes an 19-member Advisory Commission on Electronic Commerce (the "Commission"), composed of members from the federal government,(14) local and state governments,(15) and appointed representatives of the electronic commerce industry who are selected by the majority and minority leaders in the House and Senate.(16) The Commission's principal directive 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."(17) 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.(18)

Third, the Act states that it is the "sense" of Congress that no federal taxes on the Internet and Internet access should be enacted during the three-year moratorium.(19) 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 urges the President to seek to enter into trade agreements that "remove barriers to global electronic commerce."(20)


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.(21) 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.(22) This concern stems primarily from the Supreme Court decision in Quill Corp. v. North Dakota, 504 U.S. 298 (1992). 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.(23) 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.(24)

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.(25) 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.(26) 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.

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."(27) In yet another example, Wisconsin taxed Internet access as a "telecommunications" service.(28) 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."(29) As with all legislation, the devil is in the details. The Act carefully defines "multiple tax"(30) and "discriminatory tax"(31) 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.(32)

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."(33) 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."(34) 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 framework of the law 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.(35) This includes taxing an Internet transaction that would not otherwise be taxable, or taxation on the Internet transaction of a person or entity that would not otherwise be taxed if the transaction were conducted by other means, or the taxation of ISPs at a rate higher than the tax rate imposed on services that provide "similar information services" through other means.(36) 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.(37) 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, which probably will play a central role in the development of model state legislation for Internet taxation.(38) 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.


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 commericial litigation and Internet law, and can be reached at

3. For purposes of this Article, the Internet is defined by the Internet Tax Freedom Act 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. Internet-based commerce is 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. 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.

7. See A Taxing Situation, supra note 4.

8. 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).

9. 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).

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

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

12. Section 1101(a)(1).

13. Section 1101(a)(2).

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

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

16. Sections 1102(b)(1)(C)(i) - (iv).

17. Section 1102(g)(1).

18. Section 1103.

19. Section 1201.

20. Section 1203(a).

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

22. Id.

23. 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.

24. Id..

25. 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.

26. 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 <<>.

27. Id. at 3.

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

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

30. Section 1104(6).

31. Section 1104(2).

32. Section 1101(e) et seq.

33. 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.

34. Section 1104(6)(B).

35. Section 1104(2) et seq.

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

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

38. 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).