Download Fairness Coalition

Update: The Senate late today passed the bill, sending it to the House.

The U.S. Senate is planning to vote Monday to levy new taxes on mobile app developers, cloud computing services, music and movie downloads, and even people selling collections of WordPress themes.

Senators who are backing the legislation known as S.743 describe it as a way to force out-of-state retailers to collect taxes on physical shipments. Sen. Mike Enzi, R-Wyo., claims his bill will "put local and Main Street retailers on a level playing field with their out-of-state and online counterparts."

What Enzi and his Democratic allies don't like to mention is how the fine print of the bill -- expected to be approved in a vote scheduled for late Monday afternoon -- also imposes a new tax regime aimed at companies producing downloadable software or Web services.

"If I'm making an app and I'm distributing the app for $3, then I've got to collect 18 to 25 cents in sales tax," says Steve DelBianco, executive director of NetChoice, which counts eBay, Facebook, Yahoo, and LivingSocial as members. "The cost of collecting that exceeds the revenue you're actually sending to the state."

In an unusual twist, companies in the tech centers of California, New York, Maryland, Massachusetts, and Illinois, will be the hardest-hit if S.743, also known as the Marketplace Fairness Act, is enacted.

That's because those states treat digital goods as non-taxable, meaning startups, individuals, or companies with offices only in those states don't need to worry about collecting sales tax. But if S.743 becomes law, any business of a reasonable size selling digital goods to the 24 states that have decided to tax them must collect sales taxes and comply with audits from up to 600 taxing jurisdictions.

The prospect of a federal law imposing new burdens on Silicon Valley startups that aren't currently required to collect taxes under California state law irks taxpayer advocates.

Americans for Tax Reform sent a pointed letter to Enzi's office saying: "In terms of digital goods, like apps and music, who is responsible for remitting the sales tax: the vendor, an app store or sales platform, or the creator of the digital good?"

A spokesman for Enzi, whose home state of Wyoming does tax digital goods, did not respond to queries from CNET on Monday.

Pete Sepp, executive vice president at the National Taxpayers Union, says the decision by S.743's authors to levy digital taxes "only fuels growing suspicion among taxpayers that the legislation has little to do with 'simplification' and lots more to do with grabbing additional cash for governments."

Monday's Senate vote on S.743 caps years of lobbying by the National Retail Federation and the Retail Industry Leaders Association, which represent big box stores including including Walmart, Target, AutoZone, Best Buy, Home Depot, OfficeMax, Macy's, and the Container Store. President Barack Obama also supports the bill, his spokesman said last month.

Opposing them is a coalition called True Simplification of Taxation, which includes the American Catalog Mailers Association, the Direct Marketing Association, NetChoice, and the Electronic Retailing Association. Conservative groups have largely opposed the bill, and eBay CEO John Donahoe has rallied his sellers against S.743, saying: "This legislation treats you and big multi-billion dollar online retailers -- such as Amazon -- exactly the same... Those fighting for this change refuse to acknowledge that the burden on businesses like yours is far greater than for a big national retailer."

"At the end of the day, each state will decide for themselves what is or is not taxable," says Jason Brewer, vice president of communications for the Retail Industry Leaders Association, referring to digital downloads. "This bill doesn't push a state in either direction -- it leaves that decision to governors and state legislators that are accountable to the voters."

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The "iTunes Tax" dates back to 2006

A national push toward taxing digital downloads started in 2006, which CNET documented in a special report.

At that time, only 15 states and the District of Columbia taxed downloads of music, movies, e-books and other digital goods. By 2008, the number had climbed to 17 states. As of last year, that number has grown to 24 states, though not all tax all types of digital goods the same way.

"Six years ago, when the trend started to take shape, it was an effort to impose taxes on movies, music, books," says Stephen Kranz, a partner at McDermott Will & Emery who follows this issue. "Over the last few years, the state legislative proposals have gotten broader and broader. Now some states are looking at taxing the whole digital world."

In some cases, tax collectors have creatively reinterpreted their state law to levy digital download fees without the legislature acting. One example: Washington state law taxed computer software, which tax officials then interpreted to include music, movies and e-books, part of a trend that alarmed (PDF) a committee of the bipartisan National Conference of State Legislatures.

S.743 does include an exception for business that make under $1 million a year in revenue. But many small businesses can exceed that, and companies and individual sellers would be subject to audits by dozens of states. Businesses would also have to figure out how to handle the complexity of integrating as many as 46 state government-supplied software packages into Web ordering systems, as well as complying with rules specified by American Samoa, the U.S. Virgin Islands, the Commonwealth of the Northern Mariana Islands, and nearly 600 U.S. government-recognized Indian tribes.

It's unclear what fate S.743 will face in the House of Representatives. Last year, a House committee approved Texas Republican Rep. Lamar Smith's H.R. 1860, a bill that took the opposite approach by limiting the taxation of digital downloads. But that measure never received a floor vote.

The current legal and political landscape was shaped by a 1992 case called Quill v. North Dakota, in which the U.S. Supreme Court ruled: "Congress is now free to decide whether, when, and to what extent the states may burden interstate mail order concerns with a duty to collect use taxes."

Under the Quill ruling, out-of-state retailers generally don't have to collect taxes. One exception to that rule is a legal concept called "nexus," which means a company can be forced to collect sales taxes if it has a sufficient business presence. That's why Amazon.com wasn't required to collect sales taxes in California until recently, and why Apple -- with physical stores or offices in many states -- has long collected tax on nearly all sales.

NetChoice's DelBianco says that if S.743 becomes law, states that aren't home to many companies offering digital downloads will have a strong incentive to tax them -- an easy way to boost state revenues without encountering local opposition.

"You've made it all but irresistable for states to tax more and more goods and services," he says.