Why California's Amazon Law Won't Work—Not Without An Act Of Congress

Attorney Mark D. Rasch is the former head of the U.S. Justice Department's computer crime unit and today serves as Director of Cybersecurity and Privacy Consulting at CSC in Virginia.

California's new "Amazon tax" took effect on July 1 and, as in the other states that have passed similar laws, Amazon and Overstock.com have severed relations with online marketing affiliates to maintain their position that, when it comes to sales tax, "California? Never heard of it. We don't do business in California!" And without those affiliate connections, the new law is not likely to pass Constitutional muster once it reaches the U.S Supreme Court.

But E-tailers' legal dance to avoid paying the sales taxes that brick-and-mortar retailers collect and remit every day may be futile. Although their move might buy them a bit of time, in the end, death and (sales) taxes are inevitable. Allowing states to collect Internet taxes will literally require an act of Congress—and such a law could be introduced this month.

So why is Amazon currently exempt, and why is this happening now? Historically, out-of-state merchants have been exempt from having to collect and remit sales taxes on in-state sales unless they had a store or office in the state seeking to collect the tax. This was true for three legal reasons. First, because the out-of-state retailer had no real contacts with the taxing state, it violated "due process" to make the retailer subject to the laws (and tax laws) of the taxing state.

Second, making an out-of-state retailer (or E-tailer) collect and remit sales taxes from hundreds of possible jurisdictions was unfair when it didn't have an office in the state. And third, having states impose taxes on out-of-state retailers that don't have offices within the state puts an impermissible burden on interstate commerce, which is left for Congress and not the states to regulate.

In 1992, in a case called Quill v. North Dakota, the Supreme Court was asked to reexamine the ban on interstate sales taxes. North Dakota argued that its tax on catalog sales into the state should be subject to either the sales or the comparable use tax (sales taxes are collected by the merchant, use taxes imposed on the consumer). The state argued that the law should reflect changes in technology and business practice.

Companies were increasingly advertising across state lines, promoting goods and services nationally and internationally, and shipping goods anywhere. The idea that you had to have a store, a salesperson or a corporate office in a jurisdiction to be "doing business" there was, in the state's mind, arcane. In particular, North Dakota argued that because office-products vendor Quill let its customers order products using a PC and modem, the custom-ordering software on their computers qualified as "nexus," just like a store or salesperson would.

The Supreme Court mostly disagreed.The Supreme Court mostly disagreed. Although the Court agreed that due process permitted one state to tax sales coming from out of state if the retailer had substantial contacts in the state (routinely made sales there, or what the law calls "purposely availed" themselves of the benefits of doing business in the state), the Constitution gives Congress and not the states the power to regulate interstate commerce. Because interstate sales "affected interstate commerce" and because sales taxes impose a burden on these sales, only Congress could regulate that behavior.

The Court also found that order-placing software running on a customer's own computer didn't qualify as a strong enough contact to trigger collection of out-of-state sales taxes. But if you were a retailer with an office, store, salespeople or other physical presence in a particular state, all bets were off. Any state where you had a store or office could tax all of your sales in that state.

Needless to say, E-tailers have gone to great lengths to avoid having such a presence in most states. E-tailers like Amazon and Overstock actually do have substantial contacts with states like California. They actively market and sell in the state—with print, Internet, radio and TV ads targeting in-state residents. They directly solicit sales in California, and ship physical products into the state. Amazon offers services, including Cloud computing, to California residents and resident companies. It also sells and delivers intellectual property into California—downloads onto a Kindle, for example.

But these aren't the only "contacts" these companies have with California. Amazon and Overstock have hundreds of "affiliates" or "associates"—independent and semi-independent individuals who do have a physical presence in the state, and who use their Web sites to solicit and direct sales to the E-tailers. These associates are paid by Amazon or Overstock for these sales, although the contracts expressly provide that the affiliates are independent contractors.

So what it comes down to is this: If Amazon or Overstock or an E-tailer without a presence in a state hires employees to do sales and marketing in that state, bingo! it has a presence in the state and can be taxed on sales in that state. If they rely on third parties to do these activities on commission, voila! no sales taxes are due.

Needless to say, cash-strapped states sought ways to get at this unpaid sales tax. Brick-and-mortar retailers likewise felt "punished" by the loophole, which encouraged consumers to use their stores as showrooms to look at and test products before buying them cheaper (because of the lack of sales taxes) online.

In 2008, New York passed a law pegging the duty of out-of-state retailers (and E-tailers) to pay New York taxes on the activities of the business associates. Essentially, New York treated the affiliates and associates as "agents" of the E-tailer and the links and leads as contacts with the taxing jurisdiction. When Amazon challenged the Constitutionality of the law, a New York State court found, not surprisingly, that New York could tax these sales.Since then, more than a dozen other states have either passed or are planning to pass laws allowing them to collect sales taxes on Internet sales if there is a substantial presence in the state and there are paid affiliates or associates. California last week just did what New York did four years ago.

Amazon and Overstock's reaction to the California legislature was essentially to say "It's my football, and I am not going to play." They terminated all affiliate relationships with marketers or other third parties in California that could create a legal nexus between them and the state to use for taxing. This approach, of course, punishes these affiliates.

Moreover, the affiliates now are threatening to establish their own virtual presence in, say Oregon or Nevada, or anywhere they can rack up a server. So the tax revenue California is looking for may slip away, and Amazon, Overstock and others may be able to delay collection.

What is worse, the new rules can sweep into their ambit much smaller E-tailers, which do thousands or tens of thousands of dollars in sales through affiliates, rather than millions or tens of millions. By aggregating the actions of marketers and affiliates into the "presence" of the out-of-state merchant, the state may be running afoul of the basic due process concerns that prevented out of state taxation in the first place.

Ultimately, it will be up to Congress to decide how it wants state sales taxes to be collected on out-of-state sales. In fact, in the Quill decision two decades ago, the Supreme Court invited Congress to step in, and assumed that it would. But Congress has not—until now.

Senate Majority Whip Dick Durbin is readying legislation that will allow states to treat Internet retailers that sell substantial amounts within a state the same as brick-and-mortar retailers. That means the E-tailers could be required to collect and remit taxes to the state as if they had a brick-and-mortar store. Durbin hopes to introduce his bill this month. Thus, even if Amazon and Overstock win, they may lose in the long run.

So this battle really isn't about the law, about due process, about the Commerce clause or about federalism. Although Constitutional principles are being bandied about, let's face it—E-tailers don't want to collect taxes that will make their products more expensive, and brick-and-mortar stores don't want to be at a competitive disadvantage.

Whether states can use affiliate marketing as a "hook" to force the payment of sales tax is only a short-term issue. We will wait for Congress to act. Or not.

If you disagree with me, I'll see you in court, buddy. If you agree with me, however, I would love to hear from you.