Here's an interesting conundrum, posed by Representative Dennis Ross (R-FL), at a House Judiciary subcommittee hearing held on Monday:

"Imagine you are sitting in Dulles airport in Virginia, waiting for a flight back to Florida," Ross began in his opening remarks. "You download a music file from Apple, which is headquartered in California. The music is sent to you via a server in Oklahoma."

Which of these states should be allowed to tax the sale?

Without a "clear national rule," he warned at the hearing, "all four states may attempt to tax the transaction."

And so Congress is considering one such national standard: HR 1860, the Digital Goods and Services Tax Fairness Act of 2011. Representative Lamar Smith (R-TX) submitted the bill to the Judiciary committee two weeks ago. A similar law sponsored by Ron Wyden (D-OR) awaits consideration in the Senate.

Multiple or discriminatory

The crux of the legislation centers around this sentence: "No State or local jurisdiction shall impose multiple or discriminatory taxes on or with respect to the sale or use of digital goods or digital services."

The bill defines a "discriminatory tax" as a tax imposed by a State or local jurisdiction at a higher rate than "is generally imposed on or with respect to the sale or use of tangible personal property or of similar services that are not provided electronically."

A "multiple tax" is defined as one in which that State or locality "gives no credit with respect to a tax that was previously paid on or with respect to the sale or use of such digital good or digital service to another State or local jurisdiction."

Then come more specific limits on taxation. Any tax on the sale of digital goods and services can only be imposed on the State and its localities "whose territorial limits encompass the customer's tax address." This is understood as the address that the customer offered and which the seller received in good faith.

This legislation is strongly supported by the Download Fairness Coalition, which, not coincidentally, describes itself as is "a partnership of businesses, associations, and consumers who have joined together to prevent multiple and discriminatory taxation of digital goods."

The Coalition includes Apple, Time Warner Cable, Comcast, Verizon, and, most notably, Amazon. The last mentioned company has been famously at odds with various states over taxes for years.

The Supreme Court's 1992 Quill v. North Dakota decision stipulated that states can't compel retailers to collect sales taxes for buyers unless the company has some kind of brick-and-mortar residence in the state. But this hasn't resolved everything. For example, Amazon pulled the plug on its affiliate program in Colorado after the state passed a law requiring the online company to collect sales taxes on Amazons' Colorado affiliates. These partners are physically based on those states, Colorado's logic went, and post links on their own sites to Amazon products, thus earning a share of the sale.

All of the benefits

A similar drama took place between Amazon and Illinois. And last we checked the company was suing North Carolina for trying to make the web retailer fork over the names of Tar Heel state buyers in a bid to find out who hasn't been paying their sales taxes (perhaps quite a few miscreants).

So no doubt the hearing testimony of Robert D. Atkinson of the Information Technology and Innovation Foundation pleased these Fairness Coalition members. Atkinson supports the law. According to his research, over 20 states tax digital goods. Of these, 13 have enacted laws designed to place specific tithes on digital items and services. These include Indiana, Kentucky, Mississippi, Nebraska, New Jersey, North Carolina, South Dakota, Tennessee, Utah, Vermont, Washington, Wisconsin, and Wyoming.

"Taxing digital goods increases the cost of online commerce and decreases the value of the Internet economy in the United States," Atkinson argued, measuring that portion of the economy at around $300 billion annually, or about two percent of the US gross domestic product.

Multiple taxes will inhibit a market that is delivering products like digital books at much cheaper prices than their hardback equivalents, he warned: "When states tax digital goods, they receive all of the financial benefit of the tax, but, because of network externalities, the nation as a whole suffers the net social cost of more expensive digital content and services."

Equal praise came from the testimony of James R. Eads, Public Affairs Director of the Ryan tax services company, who argued that it would simply taxation questions for cities, counties, and states.

"This legislation sets forth the framework needed to ensure that state & local jurisdictions wishing to tax digital commerce can do so with certainty," Eads argued, "by clearly identifying which jurisdiction is entitled to tax such transactions and precluding any other jurisdictions from claiming the right to tax the same transaction."

Making things worse?

Not everybody at the hearing supported HR 1860. In his favorable testimony, Atkinson observed that the bill doesn't change Quill. If it were passed, out-of-state online providers still wouldn't have to collect sales taxes from their customers.

It is in this context that Russ Brubaker, Tax Policy Adviser to the Washington Department of Revenue, argued that the legislation would continue to give multistate operations a big ongoing advantage over local businesses:

Sellers who have a physical presence in a state (traditional retail sellers) will have to continue to collect or pay tax on sales of digital goods and services to customers in that state, as they do now. Multi-state and Internet sellers who do not maintain a physical presence in a state and who can deliver the digital good or service from a 'remote location' (electronically) can avoid paying or collecting sales taxes already today. This bill further ensures that sales made by these business cannot, in many instances, be taxed in the state where the sale originates, that is, where the seller is located. As a result, traditional "Main Street" could be at a significantly worse competitive disadvantage than they are today compared to Internet and other types or remote sellers if these sellers structure their operations to avoid tax.

The law "will inevitably result in expensive open-ended litigation that will prevent state tax collections for years and prevent authoritative guidance for businesses on their tax obligations," Brubaker warned.

According to the Thomas Congressional site, HR 1860 is in the Judiciary Committee for consideration. Wyden's equivalent is in the Senate Committee for Finance.