Robert Kugel's Analyst Perspectives

Taxes on Internet Sales Would Drive Software Adoption

Posted by Robert Kugel on Jul 1, 2011 12:32:42 PM

Many companies have automated their sales and use tax processes to cut the effort required to execute them and to reduce the number of errors and their cost in dealing with a fiendishly complex set of rules and rates. This is one step in bringing tax into the mainstream of finance, which we advocate. Most people are familiar with sales tax; a “use tax” is a form of excise tax assessed on otherwise tax-free goods purchased by a resident of the assessing state regardless of where it was purchased. The use-tax rate is usually the same as the sales tax rate that would have been applied to an in-state purchase and is designed to serve the same purpose of generating revenue.

I have noted before that corporations can benefit by managing taxes and tax processes more intelligently. Years ago, automation of sales and use tax (SUT) was available only to the largest companies that could afford the expensive software. Today, though, the all-in cost has declined enough so that it is practical for many more companies, and the market for such software has grown accordingly. The need to automate tax accounting also applies to other transaction-related tax regimes such as value-added tax (VAT) and goods and services tax (GST). It’s likely, in my opinion, that companies will continue to increase their use of automation in alleviating all the onerous aspects of managing tax.

However, one of the wild cards that will affect future demand for sales and use tax software in the United States is the extent to which states are able to collect taxes on sales through the Internet. Because of the peculiarities of its laws and customs, this is an issue unique to the United States. While the individual states have done their best to tax out-of-state electronic commerce, they’ve had only modest success so far. If states can expand the scope of their tax collection (more on that to follow), tax software vendors are likely to benefit since more companies that do business across state lines will find they need automation to meet their SUT calculation and reporting requirements.

But that’s still a big if. Recently, I came across a piece of research from a well-known IT research firm that was published in 2000 on the topic of applying sales tax to Internet purchases. It was amusing that the report forecast that by 2005, the streamlined sales (and use) tax agreement (SSTA) would be in force and states would be raking in taxes from out-of-state purchases. More than a decade after this prediction was made, it still hasn’t happened.

The question remains whether it ever will. As we consider it, here’s a bit of background. In the early days of the World Wide Web, the U.S. Congress exempted Internet commerce from taxation (in the 1998 Internet Tax Freedom Act) as a way of spurring its adoption. This law bars federal, state and local governments from imposing Internet-only taxes (such as on bits, bandwidth or email) or taxing Internet access and prohibits the imposition of multiple taxes on e-commerce.

The act did not exempt purchases from state sales taxes. Companies that have a substantial presence in a state (“nexus” is the term of art) are required to charge and collect sales tax for that state whether the item is purchased from a bricks-and-mortar facility or on the Web. Those that do not have nexus are not required to do so, but in most jurisdictions buyers who purchase goods from out-of-state vendors are required to pay a use tax on that item. In practice, though, unless the item is very expensive (say, that Monet water lily painting you picked up at auction in London), the state authorities do not have the resources to track you down.

The reason why Internet vendors are not required to collect and remit use tax to the purchaser’s state goes back to Quill v. North Dakota (1992), where the U.S. Supreme Court ruled that mail-order retailers are not required to collect the tax because of the complexity of each state’s rules and the burden that complying with them would impose. 

As time passed, in response to the growth in consumer Internet commerce, states started to look for ways to avoid losing an important source of revenue. (Sales and gross receipts taxes account for about one-third of all state revenues and are the second-most important source after income taxes.) Signatories to the SSTA include 44 states and the District of Columbia. Their stated mission is to simplify sales and use tax collection and administration by retailers and states and to provide a rationale for overturning Quill. The goal of SSTA is to eliminate the argument that forcing out-of-state merchants to collect taxes would be too onerous. So far this hasn’t happened. If Quill is overturned, I expect demand for sales and use tax software and services to increase and shares of and the like to decline.



Robert Kugel – SVP Research

Topics: Sales, Office of Finance, Tax, Business Performance Management (BPM), Financial Performance Management (FPM)

Robert Kugel

Written by Robert Kugel

Rob heads up the CFO and business research focusing on the intersection of information technology with the finance organization and business. The financial performance management (FPM) research agenda includes the application of IT to financial process optimization and collaborative systems; control systems and analytics; and advanced budgeting and planning. Prior to joining Ventana Research he was an equity research analyst at several firms including First Albany Corporation, Morgan Stanley, and Drexel Burnham, and a consultant with McKinsey and Company. Rob was an Institutional Investor All-American Team member and on the Wall Street Journal All-Star list. Rob has experience in aerospace and defense, banking, manufacturing and retail and consumer services. Rob earned his BA in Economics/Finance at Hampshire College, an MBA in Finance/Accounting at Columbia University, and is a CFA charter holder.