Net Retailers Face A Taxing Question

Who's collecting sales taxes on purchases over the Internet this holiday season? Only Santa knows for sure.

Uncertainty about the law, lax enforcement and a retail environment in which a 5 percent to 8 percent sales tax could make or break a sale have caused Internet retailers to adopt a variety of policies on collecting sales tax for the 46 states that impose taxes.

Two electronics stores illustrate the point. CompUSA (CPU) doesn't collect taxes on online purchases from shoppers who live outside Texas, Massachusetts and Tennessee, where the computer chain's online subsidiary has operations, even though there are more than 217 CompUSA stores in 42 states. At the same time, a customer buying a computer from CircuitCity.com, the online division of the nationwide chain of 600 stores, is charged sales tax but can return the online purchase to one of the stores. CompUSA's online customers have to send in their returns.

The primary difference between the two examples, according to tax experts, is in the interpretations of existing state and federal case law pertaining to mail-order outfits. The U.S. Supreme Court in 1992 ruled that remote companies, a category that includes such catalog retailers as L.L.Bean and Lands' End, are not obligated to collect sales tax from consumers in states in which the stores don't have a physical presence, or "nexus." Most pure-play Net merchants, such as Amazon.com (AMZN) and eToys, have decided they are like catalog sellers and therefore have adopted policies to collect sales tax only in those states in which they are headquartered or have warehouses.

The wrinkle is that long-established retail chains with stores from coast to coast have flocked to open Internet stores. These companies clearly have a nexus in states in which they have retail stores, personnel and operations. But many retail giants have opted to compete with pure-play Internet companies on price and, as a result, they have structured their online operations as separate subsidiaries. This, they say, relieves them of the obligation to collect sales tax on online sales.

"What they've done is create a legal loophole where you can form a separate subsidiary and claim for legal purposes that the two companies have nothing to do with one another," says Austan Goolsbee, an associate professor of economics at the University of Chicago Business School. "It's a controversial area and an area that's undecided legally." He adds the subsidiary structure comes with certain restrictions: "You are not supposed to be allowed to buy an item from the Web site and return it to the store. You are not supposed to actively advertise the Web site in stores."

State and federal courts have ruled that crossing some of those lines - accepting returns and comarketing - constitutes an established state nexus. Richard Pomp, a visiting professor at Harvard Law School, says he believes the separate subsidiary issue as well as questions about acceptance of returns of online purchases to retail stores will be the next big test cases for the courts.

Pomp notes examples in which some companies are crossing what he calls "the Chinese wall." For example, Barnesandnoble.com, a public company in which the bookseller and the German media giant Bertelsmann own large equity stakes, charges sales tax only in states in which it has warehouses or other facilities (Kentucky, New Jersey, New York and Virginia). But the company recently announced that it has started distributing coupons for the Web site to customers of Barnes & Noble bookstores.

Borders.com, a subsidiary of the bookstore chain, collects sales tax only from residents of Michigan and Tennessee, where the dot-com subsidiary has offices, personnel, warehouses or servers. Accepting online returns in the retail stores is "up to the store manager," according to customer service representatives.

The Internet sales tax issue is even murkier than it sounds. When an online store doesn't collect sales tax from a resident of a state that has a sales tax, the consumer is still legally obligated to pay taxes on the goods purchased. But few consumers actually do that.

States estimate that the amount of sales tax they lose due to Internet purchases is increasing every year and will exceed $10 billion to $15 billion by 2003. Bret Hester, an analyst for the National Governor's Association, admits consumer compliance is low and government enforcement is lax. "If there is a company that clearly is engaging in activities that would lead one to believe they had a physical presence in a state, one method the state could pursue is to try to collect back sales taxes," says Hester. "My guess is that people will continue to push the envelope and see what they can get away with."

But a growing number of brick-and-mortar retailers are experiencing "nexus nervousness," and are not yet ready to take the online subsidiary route. "Our upside is that we can integrate the Internet into our overall operations," says David Bullington, VP of tax issues at Wal-Mart, which collects sales tax on online purchases. "We continue to give consideration to setting up a special purpose subsidiary," he adds. "The sole reason for doing it would be to not have to collect sales taxes. But our analysis right now is, even with the care you might take to keep it totally separate, only in about 20 of the 46 states that impose sales tax would we get a level of comfort and certainty that the states would not come in and later attempt to assess taxes and penalties."

Lisa Gilbertson, director of tax and financial issues for the International Mass Retail Association, says many other companies, such as Circuit City and Home Depot, are following suit. She says the association has asked the Congressional Advisory Commission on Electronic Commerce to study the issue in the context of whether exempting Internet retailers from tax collection laws would give them an unfair advantage over traditional retailers. The commission was created to propose a national Internet tax policy from the Internet Tax Freedom Act, which became law last year. The commission meets in San Francisco next week.

But this holiday season may be the make-or-break period for some online retailers in determining which will pull ahead of the pack. Particularly in some of the most competitive arenas, such as toy sales, there's tremendous price pressure. Toysrus.com charges sales tax but offers returns. One upstart site operated by a toy retailer, ZanyBrainy.com, boasts that it doesn't collect sales tax, although the company says it takes responsibility for paying those fees to the states. "Market share is the mantra of the Internet age," says Joseph Crosby, who advises companies on state tax issues for Ernst & Young. "Many tax directors are receiving pressure from corporate executives as to 'How come so-and-so doesn't collect and we do?'"

"We're still studying the issue," says Srikant Srinivasan, founder and CEO of KBkids.com, a joint venture of BrainPlay.com and KBToys, which has 1,333 stores nationwide. KBkids doesn't collect sales tax (except in Colorado, Massachusetts and Virginia, where the online arm has operations), but Srinivasan says customers can return online purchases to KBToys stores. He believes sales tax is a minor issue for online shoppers; more important to consumers is whether they have a satisfying shopping experience.

There's little consensus on Srinivasan's point. Goolsbee conducted a study earlier this year that found online shoppers were highly price-sensitive. The study estimated that 20 percent to 25 percent of online purchases would be lost if existing sales tax was collected. Yet a recent study commissioned by Gomez Advisors report that other factors - convenience, time efficiency, having goods delivered - were more important than price to the 19 percent of Internet users who do 50 percent of the spending. Says Jill Frankle, director of retail research for Gomez: "People are not shopping online just to avoid sales taxes."

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