As digital downloads heat up, states look for an additional revenue stream.

Despite high piracy rates, digital content services are riding high.  Some like Valve have made a lucrative business off distributing video game content such as the Half Life, Doom, and Grand Theft Auto games (the latter two licensed by id and Rockstar respectively).  Others, such as iTunes and Rhapsody have cashed in on the music business as well as TV episode content.

And though the good times may be rolling for online business, those happy times may be nearing an end.  Many states are after the $130B USD untaxed digital market and salivating at the prospective tax revenue.  While internet taxes may have been shot down at the national level, some states aren’t as forgiving.

Just a few months ago Indiana, South Dakota, and Utah all signed digital download taxes into law.  Nebraska enacted such a measure in April.  June put a digital tax law in Tennessee's books.  In all, nine states adopted taxes on digital downloads in 2008 alone.

Part of the online industry's rapid growth has been thanks to a favorable tax climate -- or lack thereof.  Most downloads in the past have not been taxed at all, as most states' tax laws predate the widespread use of the internet.  Thus some states like California have high taxes on physical purchases of music and games, but low taxes on their online counterparts.

The tech industry argues that this differentiation is vital to their business.  NetChoice who is composed of eBay, AOL, and Yahoo and others is among the groups lobbying against the taxes.  It has thus far had relatively little success.

Steve DelBianco, executive director of NetChoice explains his stance, "With global warming and a world that's running out of oil, the last thing governments should do is add taxes on something that uses no oil and produces no carbon.  A digital download is the greenest way to buy music, movies, and software, since it requires no driving to the store, no delivery vans, and no plastics or packaging."

Stephen Kranz, an attorney at Sutherland law firm who helps the net retailers fight against tax measures, says there have been some victories.  Lobbyists in California and Wisconsin held off tax measures -- for now.

Mr. Kranz is fearful, though, that for these small victories there will be many defeats in the days ahead.  Wyoming and Washington are both reviewing their tax policies in upcoming months.  He adds, "Massachusetts has a draft bill circulating around."

The numbers are growing -- 17 states, plus the District of Columbia, tax digital downloads now, or just over a third of the nation's states.  Among these are Alabama, Arizona, Colorado, Hawaii, Idaho, Indiana, Kentucky, Louisiana, Maine, New Jersey, New Mexico, South Dakota, Texas, Utah, and Washington.  Some states like Washington are considering upping taxes as well.

The Tennessee law governs "the retail sale, lease, licensing, or use of specified digital products transferred to or accessed by subscribers or consumers" while the Nebraska law covers "sales of digital audio works (music), digital audiovisual works (movies, music videos, TV shows), and digital books".

The music industry now gets 30 percent of its revenues from the 500 legitimate download services in operation.  The International Digital Publishing Forum says online audiobook sales are up to $10B USD in Q1 2008, up 25 percent from last year.

One small ray of sunshine for E-Tailers is the legal concept of "nexus", which the Supreme Court ruled in 1992 was mandatory for taxation.  "Nexus" means that a company must have a physical presence within a state to be taxed.  So Amazon, which is Seattle based and has no offices in California, could not be taxed in the state.  Some members of Congress are trying to push through bills to block this concept, making taxation mandatory.  Mr. Kranz is at least relieved that these efforts seem unlikely to succeed.  He states, "Most of the proponents of the nexus legislation would concede that given this is an election year, it's unlikely the legislation will pass."

Many states are joining together on the Streamlined Sales Tax Project, which aims to develop a consistent framework for online taxation.  One key point is “what is digital content” and “what is software”.  Some states want digital software taxes, which could hit Valve and other online game distributors.  Others say this is a bad idea.

Dan Noble, the administrator of the excise tax division for the Wyoming Department of Revenue, says that states could tax anyways, that the laws are just a formality, in effect.  He states, "The way our statute is currently we probably could tax them, but we should probably have the legislature have the final say."

Some states like New York, whose statute states "The sale of digital music delivered electronically to customers for download on their computers... constitutes the sale of intangible property and is not subject to sales or use tax...", may find the allure of the rich tax revenues too much to resist in the long run.

Temporarily, some companies like eBay or Amazon may be able to hide behind the concept of nexus, but others like Apple, which has a store in virtually every state, have nowhere to turn.  As the online digital content industry continues to grow the issue is likely to grow as well.  With illegal downloads gnawing at its sales on one end and increasing taxes on legal downloads on the other end, it should be interesting to see if the industry is able to continue to thrive and grow.

"If they're going to pirate somebody, we want it to be us rather than somebody else." -- Microsoft Business Group President Jeff Raikes

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