Digital Taxation Wildcards: The Internet Tax Freedom Act and Digital Bundling

Sales tax remains a primary mechanism for states to raise money to fund public works and services, now enhanced by the rise of the digital economy. Unless states efficiently adapt existing tax laws and rules to address the growing volume of transactions involving digital products, state funding needs may not be adequately met by sales tax revenues alone. 

While that premise seems uncomplicated, the tiered dynamics involved in drafting sound digital taxation policies are anything but straightforward. Policymakers designing digital taxation rules must consider numerous critical factors (including existing state tax policies, regulations, and business practices) to effectively administer the revenue imposed on the various digital products and services that are continually evolving.

The Internet Tax Freedom Act Creates Compliance Landmines

The Internet Tax Freedom Act (ITFA, 1998) was enacted to prohibit states and localities from taxing internet access services, including sales taxes on “internet access” fees.  It is this broad definition of internet access that creates legal intricacy. This complexity is currently playing out in the state of Washington, which earlier this year passed a law expanding its retail sales tax to numerous business, personal, and professional services. Newly taxable services include some online and digital advertising services, such as search engine marketing. Because some traditional advertising formats (billboards, newspapers, radio, and television) are not subject to sales tax in Washington, the new law (which took effect Oct. 1) may create a form of discriminatory taxation. If this is determined to be the case, the law may violate the Internet Tax Freedom Act’s (ITFA’s) prohibition on taxing e-commerce differently than traditional, analog commerce -- similar, in a legal and constitutional sense, akin to Maryland’s issues with its own Digital Advertising Tax Act, also currently under judicial review.

The ITFA figures prominently in The National Conference of State Legislatures (NCLS) Taxation of Digital Products report that my colleague, Vertex Chief Tax Officer of Transaction Tax Michael Bernard discusses here. 

Although the NCLS policy brief is directed at legislators and their staff, it includes several discussions and insights that can help indirect tax leaders navigate an evolving and, at times, confusing and complex digital taxation policymaking landscape. For example, tax leaders should keep in mind that the ITFA contains two critical constraints regarding digital taxation.

First, the law prohibits state taxes on “Internet access,” which since 2007 includes broadly defined services like email, instant messaging, video clips, and personal electronic storage capacity (regardless of whether these offerings are sold separately or bundled with Internet access). The second constraint looms even larger as it bans “discriminatory” taxes on e-commerce. In other words, any tax imposed on digital products must also apply to similar offline—or, if you prefer, “IRL”—products. Taxing digital advertisements while exempting print advertisements and billboards violates the ITFA in most cases. By the way, ITFA challenges can take years to resolve, resulting in significant court costs and creating uncertainty regarding tax obligations and potential refund liabilities for affected companies. Consequently, the fundamental issue that continually raises the question is whether a 1998 federal law (ITFA) is outdated, given our modern digital economy, digital retail, and other commercial flows - or if it still remains an effective and viable policy as a moratorium on the imposition of state and local taxes that would interfere with the free flow of interstate commerce over the internet.

Bundled Products Add Another Layer of Complexity

A second wildcard that must be addressed in digital taxation policymaking relates to the bundling of digital products and services. This challenge involves mixed taxability within single digital transactions. In some states, consumers often pay a single price for multiple or combined digital products and services, which can make it difficult to determine the correct amount of tax charged, according to the NCSL.

“Manufacturing companies are wisely leveraging advancements in Internet of Things (IoT) sensors, IoT networks, smart devices, and telecommunications technologies (e.g., 5G and 5G Advanced) to improve not only their manufacturing processes but also the customer experience, to enhance existing products and services, and to launch new business lines,” notes Chris Hall, the Senior Tax Officer in the Chief Strategy Office at Vertex. “Traditional manufacturers are also launching direct-to-consumer (DTC) channels. Each of these activities can expose manufacturing companies to new tax compliance requirements and audit risks.”  When companies offer packages combining taxable digital products with non-taxable services, determining the correct tax treatment often requires a sophisticated analysis.

It is essential that state and local tax policymakers conduct comprehensive analyses of the impacts and implications of new laws and rules on digital taxation. The good news is that organizations such as the NCLS, the Streamlined Sales and Use Tax Agreement (SSUTA), and the Multistate Tax Commission (MTC) are working diligently on developing digital taxation frameworks and standards.

As digital taxation frameworks continue to evolve, tax professionals must remain informed about federal constraints, such as the ITFA, and emerging state-level approaches to taxing digital products and services. Doing so will help tax groups develop compliance strategies that account for the complex interplay between traditional tax principles, the realities of modern digital commerce, and the always-evolving fiscal and legal environment.