End of Days for Tax-Free Internet Purchases

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     PIERRE, S.D. (CN) — A new law requiring online retailers to pay state sales tax has made South Dakota the newest player in a national legal battle over online sales taxes — and it looks like the taxes are winning.
     South Dakota’s SB 106 took effect May 1. It applies only to online retailers who make more than $100,000 a year from South Dakota customers, or more than 200 transactions a year in the state.
     The state’s Department of Revenue says 206 retailers qualify, and that 40 already have complied.
     Just over a month after Gov. Dennis Daugaard signed the bill into law, the state sued four online retailers — Wayfair, Systemax, Overstock.com, and Newegg — for failing to register to collect the state’s 4 percent sales tax on orders from South Dakota.
     The state’s April 28 lawsuit in Hughes County Circuit Court acknowledges that a declaration in the state’s favor would contradict 1992 Supreme Court precedent in North Dakota v. Quill, which held that online and catalog retailers without a physical presence in a state did not have to remit that state’s sales tax.
     South Dakota enacted the legislation fully intending to challenge the Supreme Court: “The State recognizes that a change in federal constitutional doctrine will be necessary for the state to prevail in this case,” it states in its 20-page lawsuit.
     Opponents of the Quill ruling claim it is no longer relevant due to the explosive success of online retailers. The state cites Justice Anthony Kennedy’s argument for re-examining the issue in Direct Marketing Association v. Brohl, a 2015 Supreme Court ruling on a Colorado tax-reporting law that grappled with similar issues.
     “When the Court decided Quill, mail-order sales in the United States totaled $180 billion. But in 1992, the Internet was still in its infancy. By 2008 e-commerce sales alone totaled $3.16 trillion per year in the United States,” Kennedy wrote, South Dakota says in its lawsuit.
     On April 29 — one day after the state filed suit — the American Catalog Mailers Association and Netchoice, representing the interests of online retailers, sued back, asking the Hughes County Court to declare the new law unconstitutional. The trade associations sued South Dakota Department of Revenue Secretary Andy Gerlach.
     South Dakota is not the first state to enact legislation that flies in the face of Supreme Court precedent. Alabama adopted a similar statute, which took effect on Jan. 1.
     Alabama, too, is ready and willing to tackle a Supreme Court battle.
     “We’ll be in court before long,” Joe Garrett, with Alabama’s Department of Revenue, said in an interview.
     But so far, no one has sued the Alabama.
     Garrett said his state is contacting online retailers that do more than $250,000 worth of business in Alabama and are not compliant, and going through an assessment process to bring them in line.
     “Once we file an assessment, then the taxpayer who receives it would have to pay it, or they get to go to court,” Garrett said. “When that happens, we will then have a public case, so we are working our way through that system. I expect that we will have a public case within six weeks.
     “It won’t be exactly like the litigation in South Dakota, which is more a declaratory judgment action asking the court to approve or disapprove of a law in its entirety. We will have an assessment against the taxpayer, and that taxpayer will be defending the lawsuit saying, ‘You can’t make me collect that tax and remit it to you because of the U.S. Constitution’s protections.’
     “Same issue, different framework,” Garrett said.
     Though Alabama and South Dakota are the first states to enact legislation taxing retailers with no physical presence in the states, they are unlikely to be the last. Utah and Rhode Island are among other states that have recently or are considering similar legislation.
     Congressional passage of the Marketplace Fairness Act would make state sales taxes on Internet purchases the law of the land, but it has been stalled since 2013. States that are tired of waiting are taking action.
     “I believe we’ve hit a tipping point where states have decided largely on their own that they’ve been patient enough for Congress to act, and Congress has not acted,” Garrett said.
     “So they’ve decided to take the issue into their own hands, and to take action on their own that pushes the issues further toward some sort of resolution.”
     Garrett said there is no coordination among the states, but they are in communication and have a “common understanding … that enough is enough.”
     Dozens of states have found ways to tax online sales. Texas and Pennsylvania are among at least 10 states that tax sales from online retailers with a warehouse or distribution center in the state.
     While this satisfies the “physical presence” element of the law, states including New York, Illinois and Georgia have enlarged the definition of “presence” to include affiliate marketers, which direct traffic to online retailers through code placed on their own websites in return for a portion of the revenue from any subsequent sale.
     Amazon’s response has been to terminate its affiliate program in some of the states encumbered by these laws. It bars residents of Arkansas, Louisiana, Maine, Missouri, Rhode Island and Vermont from operating as affiliates, according to its affiliate operating agreement.
     Similarly, online jewelry retailer Blue Nile said it will no longer do business with South Dakota customers, to protest the new law.
     “That’s not a rational response,” Garrett said. He said that so far, retailers have not refused to do business in Alabama, perhaps because its higher monetary threshold means online retailers would lose a bigger chunk of profits.
     But the departments of revenue in South Dakota and Alabama may be correct in assuming the tide is turning in their favor. In February, the 10th Circuit Court upheld a Colorado law requiring online retailers to track all sales made in that state so that it could pursue taxing those purchases.
     “If anything, by asking us to strike down Colorado’s law, out-of-state mail order and Internet retailers don’t seek comparable treatment to their in-state brick-and-mortar rivals, they seek more favorable treatment, a competitive advantage, a sort of judicially sponsored arbitrage opportunity or ‘tax shelter,'” 10th Circuit Judge Scott Matheson Jr. wrote for a unanimous three-judge panel.
     Even before the 10th Circuit ruling, Amazon had started collecting the state’s 2.9 percent sales tax, after resisting for years, according to the Denver Post. The Post article said Amazon is collecting sales tax in 28 states.
     States that impose sales tax on online transactions often cite the inability of in-state companies to compete. That translates into states hemorrhaging tax revenue that could be used to support infrastructure. Because South Dakota has no income tax, it has an added incentive to impose sales tax on out-of-state retailers.
     South Dakota’s lawsuit claims the Supreme Court precedent “distort[s] the local retail market, causing unfairness to brick-and-mortar retailers generally, and to smaller, locally owned businesses in particular. … As a result, local retailers are unable to compete fairly with online retailers, which is likely to cause even further harm to the State by harming the local businesses that employ local residents and make up the bulk of the state’s tax base.”
     In 2014, the Colorado Department or Revenue estimated it was losing more than $127 million annually due to tax-free online purchases, according to the Post.
     Garrett said he has been “pleasantly surprised” with the level of compliance in Alabama, as well as the tax revenue the measure is bringing into the state.
     “A lot of remote sellers have decided that this is going to happen sooner or later, and they are ready to do business,” he said.