The Internet Throws Tax Man for a Loop

States are exploring how to tap Net access providers

Benjamin Franklin once said taxes are one of life's certainties. But that was before the Internet. In the past year:

*California and New York have set up commissions to study the impact of cyberspace on taxes.

*Florida tried to tax companies offering Internet access but backed down after a storm of protest. A special Florida Internet commission is studying the issue.

*Tacoma, Wash., made a name for itself by charging Internet access companies its standard 6 percent levy on telephone companies. Five months later, the city council voted to exempt them because it was bad for business.

Cyberspace, it seems, is throwing the tax man for a loop.

"Some people talk about taxing the Internet. But when you break that down what does it mean?" asks Scott Mackey, tax analyst with the National Conference of State Legislatures based in Denver. "The Internet is not just some thing out there you can tax. It's not a corporation. It's just a bunch of computers linked together."

Part of the problem is that tax officials are trying to apply old standards to a new industry, which is always hard, tax experts point out. It's doubly difficult when the old rules are based on physical goods and physical space - concepts that the on-line world barely comprehends.

For example: If a national Internet provider, such as Netcom, offers its service in a state but has no physical presence there beyond some local phone numbers, is it doing business there? Massachusetts thinks so.

"It seems clear that the Internet access falls directly under our regulation," says Jeffrey Busha, spokesman for the Massachusetts Department of Revenue. The state has started charging a 5 percent tax on on-line service fees.

"They're wrong," counters Martin Eisenstein, an expert on the issue and partner at Brann & Isaacson, based in Lewiston, Maine. He points to a landmark 1992 case in which the US Supreme Court ruled that states couldn't force an out-of-state catalog company to collect sales taxes if it didn't have a physical presence there. If that rule applies to catalogue companies, Mr. Eisenstein argues, it ought to hold for on-line companies too.

Once states try to tax actual commerce over the Internet, the questions will get even trickier. Suppose a computer user in Nevada logs on to an Internet site in California to buy a product in Arizona. Which state gets to tax the sale?

"For the moment, no one has a clue how to tax that," says Brian Roherty, executive director of the National Association of State Budget Officers in Washington. The normal rules of who, what, and where don't apply in cyberspace.

At least when John Doe ordered a sofa in the real world, it went to a physical address. When goods are delivered on-line, "you have no idea where your customer is and, frankly, you don't care," says Kent Johnson, national partner in charge of sales and transactions tax services for KPMG, a financial services firm.

Internet anonymity makes it tough to find out who those customers are and what they're buying. In the real world, it's pretty easy to tell that goods are goods (which states generally tax) and services are services (which they usually don't). On the Internet, where everything is digitized in electronic data bits, it's harder. So a state may end up taxing software sold over the counter, because it comes on physical diskettes, but ignoring the software downloaded over the Internet.

None of this might matter very much except that sales taxes are the states' primary source of revenue. In 1994, they collected $123 billion - a third of their revenues - from sales taxes. And given the states' verve for cutting income taxes, sales taxes are likely to become even more important in the future, says H. Thomas Davis Jr., a tax attorney and partner at Carter, Ledyard & Milburn in New York.

Connecticut, for example, cut income taxes $220 million this year, but it aggressively pushed to collect sales taxes from Internet access providers. If the companies didn't comply voluntarily, the state's Department of Revenue Services threatened to go to their customers directly and demand the tax be paid.

Rather than risk aggravating their customers, Internet access providers agreed to comply. Within two months, predicts department spokeswoman Ellen Schneider, virtually all Internet providers operating in Connecticut should be on board. The agreements should bring an extra $2.5 million to state coffers, according to the revenue department's conservative estimates. The state is now trying to figure out how to tax commerce over the Internet.

As Connecticut demonstrates, cyberspace probably won't outfox the tax man in the long run. But, Ms. Schneider says, "it's keeping him on his toes."

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