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418 TAXATIONISSUESincorporate the principles and terms of the OECD model
tax treaty.
The new commentary on PE and e-commerce provides
that a Web site does not create a PE. It also clarifies
that human intervention is not required to have a PE
in a country, thus opening the door to the possibility of
equipment alone (such as servers) creating a PE. However,
the facts and circumstances would have to be such that
the equipment performed functions that were more than
preparatory or auxiliary to the generation of income. If a
server is merely hosting a Web site or displaying a prod-
uct catalog, it is unlikely to be a PE. However, if a server is
enabling the processing of orders and payments and per-
haps delivery of product, it is likely to be a PE. Because
the OECD treaty is a model, rather than a mandate, it re-
mains to be seen whether all countries will adopt the same
perspective as presented in the new commentary. Also, the
OECD continues to explore whether additional guidance
is needed to determine how much income is attributed to
a PE of an online vendor.What to Tax—Tax Base and Characterization
of Income
To calculate any tax liability, one needs to know both the
tax rate and tax base. The well-known, but poorly under-
stood, “Internet tax moratorium” also has some bearing
on a state tax base, as described below. Finally, one of-
ten needs to know the particular type of income involved
(sales of goods, services, or royalties) to determine tax
consequences.Sales Tax Base
One of the most complicating factors about the sales tax
for multistate businesses is that not only do sales tax rates
vary from state to state and even within different cities in
a state, but the tax base varies from state to state (and
perhaps even between a city and state). For example, the
number and types of services taxed by the states vary
tremendously. Hawaii, New Mexico, and South Dakota
tax over 140 types of services, while 7 states tax fewer than
20 types of services (states without a sales tax have been
omitted from this count). Although most states do not tax
custom software, 15 states and the District of Columbia
tax it. Some states tax computer-related services (FTA,
1997).
Many states exempt food, even more exempt prescrip-
tion drugs, and a few also exempt nonprescription drugs.
A few states, such as Illinois, tax these items, but at a lower
rate than for other taxable items. In California, clothing
is subject to tax, although it is exempt in Minnesota,
and in Massachusetts, clothing is only subject to sales
tax to the extent its cost exceeds $175 (information ob-
tained from state tax agency Web sites: California, http://
http://www.boe.ca.gov/pdf/pub61.pdf; Massachusetts, http://
http://www.mass.gov/dor/publ/pdfs/slsuse.pdf; and Minnesota,
http: // http://www.taxes.state.mn.us / salestax / factshts / salestax.
html). In addition, the definition of clothing may vary
from state to state. For example, it may or may not
include recreational clothing, such as sports gloves and
ski boots.The complexity of the rules and cost of compliance can
cause new online vendors to limit the number of states in
which they have a physical presence and, thus, a sales
tax collection obligation. Efforts have been underway to
streamline the sales tax rules, including definitions for the
tax base, but it is uncertain how many states will par-
ticipate in the reforms. Also, even with streamlining, tax
bases will continue to differ although the definitions of
what is and is not taxable would be the same from state to
state.The “Internet Tax Moratorium”
With respect to the Internet, Congress has exercised its
authority under the Commerce Clause to impose a mora-
torium on state and local taxes on Internet access, unless
such tax was generally imposed and actually enforced be-
fore October 1, 1998 (about 10 states had such taxes in
place). The moratorium also applies to multiple or dis-
criminatory taxes on e-commerce. This moratorium was
created by the Internet Tax Freedom Act (Public Law 105-
277) in 1998, and was extended to November 1, 2003, by
the Internet Tax Nondiscrimination Act (Public Law 107-
75).
The moratorium was enacted to ensure fair and ad-
ministrable rules so that growth of the Internet would not
be impeded. Also, proponents of the Act wanted to avoid
multiple taxation of transactions among the states and to
allow time for thoughtful consideration on how the Inter-
net and online transactions should be taxed. Opponents of
the Act noted that it imposes a federal restriction on state
and local governments and could reduce state and local
tax revenues. A report by the Center on Budget and Policy
Priorities (Mazerov & Lav, 1998) noted that the Act allows
for unfair competition by online vendors at the expense
of Main Street vendors, benefits wealthier consumers who
tend to use the Internet, and is not needed as there was
no evidence that state and local taxes were impeding the
growth of the Internet and e-commerce.
The moratorium has created a fair amount of confu-
sion, even leading some consumers and businesses to be-
lieve that the Internet and e-commerce are tax-free. How-
ever, this is not the case. The moratorium primarily pro-
hibits state and local governments (unless they fall within
the grandfather provision) from taxing Internet access ser-
vices. The Act specifically preserves state and local taxing
authority that is otherwise permissible. Thus, purchases
made via the Internet, if otherwise taxable, are still tax-
able when purchased “on the Net.” For example, if a Cal-
ifornia consumer purchases books from a bookseller that
only has a physical presence in New York, no sales tax is
collected (because the vendor has no physical presence in
California). However, the buyer is required by California
law to self-assess a use tax (equivalent to the sales tax). It is
theQuilldecision (discussed earlier), not the moratorium,
that absolves the New York vendor of the responsibility to
collect sales tax from its California customers.
In addition, even with the “Internet tax moratorium,”
Internet access providers and other Internet businesses
are subject to federal and state income taxes, business
license taxes, property taxes, and payroll taxes, just like
other businesses. Purchases of airline tickets via the In-
ternet are included in the tax base for federal excise taxes