Sales and use taxes are key issues for many states that have been hit with dwindling revenue due to the economic downturn. And there’s a case now on appeal in a New York court that is being closely watched by other states suffering a loss of tax revenue from Internet sales.

The case, v New York State Department of Taxation and Finance, stems from a New York law passed in 2008 requiring online retailers to collect sales tax if they have marketing affiliates in the state. The law defines affiliates as including third-party Web sites that run ads that direct users to another e-commerce site, such as Amazon, according to Venable LLP partner John F. Cooney. The law was upheld in a lower court, and is on appeal before the Appellate Division of the New York Supreme Court. (Contrary to other states, New York’s Supreme Court is the trial court of original jurisdiction.)

“Rhode Island and North Carolina have adopted similar laws, while at least six other states – including California, Illinois, Connecticut and Virginia – are considering their own versions of a tax on online sales,” said Cooney. “And Colorado has passed a variant which requires the company that runs the Web site to collect the names of people in Colorado who make purchases.”

“The case was argued last fall, and the expectation is that it will be decided before the court goes on summer vacation in July,” he added. 

Cooney is the author of an amicus brief in the Amazon case for the Performance Marketing Alliance, a trade group representing online affiliate marketers.

“It revisits the late 1980s and early 1990s when brick-and-mortar shops were upset that catalog shops were getting an unfair advantage because they didn’t have to collect sales and use taxes,” he said. “Then in 1992 the Supreme Court decided the Quill case, which held that a state does not have nexus to require out-of-state retailers to collect taxes from residents in states in which the retailers do not have a physical presence.”

For purposes of state taxes, nexus is the minimum threshold of contact that must exist between a taxpayer and a state that would allow the state to impose a tax. The concept is based on two clauses in the Constitution: the Commerce Clause, which prohibits states from unduly burdening interstate commerce, and the Due Process clause, which requires a minimum connection between a state and an entity it wishes to tax.

In the Quill case, the Court held that while solicitation of business “accomplished by a deluge of catalogs” might be sufficient to establish minimum contacts with a state for purposes of the Due Process Clause, it was not sufficient to constitute a “substantial nexus” for Commerce Clause purposes.

New York claims that the affiliates operate like sales agents, thereby creating nexus. Amazon and other retailers argue that the affiliates are more like sales channels, simply displaying electronic advertisements to users of their Web sites.

“If the corporation is organized in New York, or if the server for the Web site is in New York, the state would have nexus,” Cooney said. “There has to be some physical presence in New York.”

He noted that Joseph Wanamaker, the retailer considered by many to be the father of American advertising, once complained that “half the money I spend on advertising is wasted; the trouble is I don’t know which half.”

The advertising model used by Amazon and other Internet retailers has solved Wanamaker’s dilemma, he observed.

“In traditional advertising there’s no way to connect the ad with the sales it generates, but the performance model has solved this,” he said. “Amazon knows where you clicked through from and compensates the publisher of the ad only if a potential customer takes a defined action, such as making a purchase from the advertiser.”

With electronic marketing, the recipient clicks on a banner ad and is directed to the Amazon site. “There is almost no physical contact between the state where the recipient is and the transaction, so it’s really reviving an old dispute in a new and technical framework,” said Cooney.

Thanks to other aspects of the Internet, the retailer can contract with hundreds of thousands because there are no up-front costs to find someone to advertise, Cooney observed. “Links can be sent out in an automated fashion, and very small businesses and individuals can become advertisers,” he said. “The process has allowed a revenue flow that goes out to small content providers and provides them the financial resources to enhance their offerings.”

The approach to online ads is just one part of a bigger battle, in Cooney’s estimate. “Because Congress has not passed a new statute, they have to use existing precedents developed under catalog-shopping technology,” he said.

Whichever way the court decides the case, it will likely be appealed. “It might eventually go before the Supreme Court, since it involves the application of one of the Court’s prior decisions to a new and fast-growing technology,” Cooney predicted. “Other states are watching. If New York is upheld, they will pass their own versions.”

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