Net Taxes: Tug of War Looming?

A federal stalemate may open the way for state online access taxes.

It has been six weeks since a federal ban on taxing Internet access expired, and a political stalemate in Congress leaves a theoretical vacuum for state tax collectors to fill.

Although theres been no new tax proposals from the states, some policy watchers warn that seeds are being sown for new ways to tax online access and that politics could complicate the matter next year.

"In January, were expecting to see an avalanche of legislation being introduced as states try to increase their revenue," said Marie Lee, director of tax policy at the American Electronics Association, in Washington.

Only a handful of state legislatures are in session this time of year, and the absence of any discernible action on their part results largely from a widespread expectation that Congress was going to extend the ban before adjourning. Nobody planned for the 11th-hour stalemate that obstructed congressional action.

"There was never any thought or intention of changing what states do just because the [federal] law expired," said Verenda Smith, government affairs associate at the Federation of Tax Administrators, in Washington. "Why would you go to all the trouble to put a law in place that you know is going to be preempted a few months later?"

While the seeds for new state tax laws may or may not be germinating, there are subtle ways for states and cities to take advantage of the federal policy vacuum and reinterpret existing laws, observers said. Even before the federal moratorium expired, four Southern states decided to tax DSL service. In two of the states, the court overturned the decision, but in two others, it remains in effect.

"States can decide certain things are taxable now," Lee said. "Tax laws are full of gray areas."

South Carolina and Montana already had tax measures in place that would go into effect once the federal moratorium expired. However, activity in Montana since the expiration brings good news for the industry: Montana plans to issue an official proclamation to not enforce the measure.

Perhaps the main reason that states havent rushed to introduce new tax bills is that such action would likely backfire by galvanizing congressional resolve to enact a strong, permanent ban, observers said.

"States have all the incentive in the world not to act right now," said Bartlett Cleland, vice president of the software division at the Industrial Telecommunications Association of America, in Washington. "It would be dumb strategically for the states to start putting a lot of new taxes in place. The [federal] legislation hasnt gone away, and I think they know that."

The House of Representatives passed a permanent ban on Internet access taxes in September, but a similar measure met resistance in the Senate when lawmakers began looking more closely at the definition of access. States claimed that they could end up being pre-empted from taxing almost any digital communications service, and fears rose that online services could also escape taxes. Carrying the mantle for states rights, a small group of senators suggested a two-year extension of the existing ban instead of a permanent ban, and the debate ended in a standoff.

Some industry observers said the delay in Congress may work to the states advantage, giving them time to work on a separate taxing issue that could be used for leverage on the access tax matter.

For several years, the budget-strained states have sought to streamline their tax structures as a prerequi-site to collecting taxes on remote sales, including Internet sales. A U.S. Supreme Court decision prevents them from requiring merchants to collect sales taxes unless the merchant has a physical presence in the state, but once they streamline their tax structures, they can request congressional authorization to collect those taxes.

This year, access tax opponents successfully convinced key members of Congress to address the two tax issues separately and not allow the access tax moratorium to become a pawn in the sales tax debate. But over the year, the states made considerable progress on the streamlined sales tax initiative, making the topic ripe for congressional review next year.