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2001
INTERNET TAX FAIRNESS ACT OF 2001

HEARING

BEFORE THE

SUBCOMMITTEE ON
COMMERCIAL AND ADMINISTRATIVE LAW

OF THE
COMMITTEE ON THE JUDICIARY
HOUSE OF REPRESENTATIVES

ONE HUNDRED SEVENTH CONGRESS

FIRST SESSION

ON
H.R. 2526

SEPTEMBER 11, 2001

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Serial No. 41

Printed for the use of the Committee on the Judiciary

Available via the World Wide Web: http://www.house.gov/judiciary

COMMITTEE ON THE JUDICIARY
F. JAMES SENSENBRENNER, JR., WISCONSIN, Chairman
HENRY J. HYDE, Illinois
GEORGE W. GEKAS, Pennsylvania
HOWARD COBLE, North Carolina
LAMAR SMITH, Texas
ELTON GALLEGLY, California
BOB GOODLATTE, Virginia
STEVE CHABOT, Ohio
BOB BARR, Georgia
WILLIAM L. JENKINS, Tennessee
CHRIS CANNON, Utah
LINDSEY O. GRAHAM, South Carolina
SPENCER BACHUS, Alabama
JOHN N. HOSTETTLER, Indiana
MARK GREEN, Wisconsin
RIC KELLER, Florida
DARRELL E. ISSA, California
MELISSA A. HART, Pennsylvania
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JEFF FLAKE, Arizona
[VACANCY]
[VACANCY]

JOHN CONYERS, Jr., Michigan
BARNEY FRANK, Massachusetts
HOWARD L. BERMAN, California
RICK BOUCHER, Virginia
JERROLD NADLER, New York
ROBERT C. SCOTT, Virginia
MELVIN L. WATT, North Carolina
ZOE LOFGREN, California
SHEILA JACKSON LEE, Texas
MAXINE WATERS, California
MARTIN T. MEEHAN, Massachusetts
WILLIAM D. DELAHUNT, Massachusetts
ROBERT WEXLER, Florida
TAMMY BALDWIN, Wisconsin
ANTHONY D. WEINER, New York
ADAM B. SCHIFF, California

PHILIP G. KIKO, Chief of Staff-General Counsel
PERRY H. APELBAUM, Minority Chief Counsel

Subcommittee on Commercial and Administrative Law
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BOB BARR, Georgia, Chairman
JEFF FLAKE, Arizona, Vice Chair
GEORGE W. GEKAS, Pennsylvania
MARK GREEN, Wisconsin
DARRELL E. ISSA, California
STEVE CHABOT, Ohio
MELISSA HART, Pennsylvania

MELVIN L. WATT, North Carolina
JERROLD NADLER, New York
TAMMY BALDWIN, Wisconsin
ANTHONY D. WEINER, New York
MAXINE WATERS, California

RAYMOND V. SMIETANKA, Chief Counsel
SUSAN JENSEN-CONKLIN, Counsel
ROBERT NEIRA TRACCI, Counsel
ANTHONY R. FOXX, Minority Counsel

C O N T E N T S

SEPTEMBER 11, 2001

OPENING STATEMENT

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    The Honorable Bob Barr, a Representative in Congress From the State of Georgia, and Chairman, Subcommittee on Commercial and Administrative Law

    The Honorable Melvin L. Watt, a Representative in Congress From the State of North Carolina, and Ranking Member, Subcommittee on Commercial and Administrative Law

WITNESSES

Mr. Arthur Rosen, Chairman, Coalition for Fair and Rational Taxation, Partner, McDermott, Will and Emery
Oral Testimony
Prepared Statement

Mr. Stanley Sokul, Member, Advisory Commission on Electronic Commerce, Principal, Davidson & Company, on Behalf of the Direct Marketing Association and the Internet Tax Fairness Coalition
Oral Testimony
Prepared Statement

Mr. Fred H. Montgomery, Director, State and Local Tax, Sara Lee Corporation, on Behalf of the Coalition on State Taxation
Oral Testimony
Prepared Statement

Ms. June Summers Haas, Commissioner of Revenue, Michigan Department of Treasury
Prepared Statement
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APPENDIX

Statements Submitted For The Record

    Mr. Dean Andal, Board Member, California Board of Equalization

    Internet Tax Fairness Coalition

    Mr. Michael Mazerov, Center on Budget and Policy Priorities

Material Submitted For The Record

    Response to questions from the Coalition for Fair and Rational Taxation, Mr. Arthur Rosen, Chairman

    Response to questions from Davidson & Company, on Behalf of the Direct Marketing Association and the Internet Tax Fairness Coalition, Mr. Stanley Sokul, Member, Advisory Commission on Electronic Commerce

    Response to questions from the Sara Lee Corporation, on Behalf of the Coalition on State Taxation, Mr. Fred H. Montgomery, Director, State and Local Tax

    Response to questions from the Michigan Department of Treasury, Ms. June Summer Haas, Commissioner of Revenue
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INTERNET TAX FAIRNESS ACT OF 2001

TUESDAY, SEPTEMBER 11, 2001

House of Representatives,
Subcommittee on Commercial
and Administrative Law,
Committee on the Judiciary,
Washington, DC.

    The Subcommittee met, pursuant to call, at 9:16 a.m., in Room 2141, Rayburn House Office Building, Hon. Bob Barr [Chairman of the Subcommittee] presiding.

    Mr. BARR. I would like to welcome everybody and call this hearing of the Subcommittee on Commercial and Administrative Law to order. I apologize for the delay. I know everybody here has probably heard about the tragedy in New York about the two planes, commercial airliners, deliberately crashing into the World Trade Center. We were just watching some of the footage on TV, and I know our hearts go out to everybody up there as part of that tragedy. I would like us to have a moment of silence, please.

    Thank you.

    In 1998, Congress passed the Internet Tax Freedom Act, which prohibits multiple and discriminatory taxes on Internet commerce. This limited protection expires on October 21 of this year, less than 6 weeks from today. Failure to extend this limited protection will give States and localities free rein to impose a range of Internet specific taxes on goods sold on-line.
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    Over the last several months this Subcommittee has conducted a number of hearings into this critical issue. On June 26 we held a hearing on H.R. 1552 and H.R. 1675, two bills that would preserve the taxing stability of the Internet by extending the moratorium. On July 18 the Subcommittee held a hearing on H.R. 1410, the bill that would clarify State taxing standards to permit States to collect sales and use taxes on remote electronic transactions.

    Today we consider legislation that would permanently extend the moratorium on multiple and discriminatory taxes while abolishing Internet access taxes. In addition, H.R. 2526 provides much needed clarity to the jurisdictional predicates necessary for the States to impose business activity taxes on multi-State enterprises. This legislation does not address the more contentious question of sales and use tax standards, an ongoing debate that has long escaped Congressional resolution. Rather, H.R. 2526 clarifies the jurisdictional requirements necessary to collect business activity taxes such as those measured by the gross income of a business as well as franchise, trademark, licensing, and other taxes imposed for the privilege of doing business in a taxing State.

    Since 1959, interstate sellers of tangible goods have been provided a statutory safe harbor that limits the ability of States and localities to impose business activity taxes on nonresident enterprises. Needless to say, the economy has changed considerably since that time. The emergence of service-based financial technology and entertainment enterprises forms an increasingly important component of the overall economy.

    While the Supreme Court has established a bright-line physical presence threshold for the collection of these taxes, it has not fully articulated a coherent basis for determining when a nonresident business enterprise has a sufficient economic presence to justify their imposition. The degree of connection necessary to justify these taxes has been the focus of ongoing litigation between the State taxing authorities and multi-State businesses. As our witnesses will attest, States have used this uncertainty to aggressively assess taxes on multi-State corporations that have virtually no contact with the taxing State.
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    While large corporations are often well prepared to defend themselves against these sometimes spurious claims, small businesses, particularly those which use the Internet to reach out to a national marketplace, are particularly vulnerable. H.R. 2526 would remedy this vulnerability by establishing a bright-line physical presence requirement for States and localities to collect business activity taxes on interstate enterprises.

    The Congress has a continuing duty to protect and facilitate commerce among States. H.R. 2526 upholds this vital responsibility. It also limits State and local authority to tax interstate sellers of intangible goods. In so doing it helps to ensure that Federal law reflects the realities of the modern economy.

    I look forward to our distinguished panel today, and I now yield to the Ranking Member for any opening statement he might care to make. The gentleman from North Carolina is recognized.

    Mr. WATT. Thank you, Mr. Chairman. This is an important issue on an important topic, part of which we have already explored and had a bill and marked it up, but the other part of which, which is the emphasis of this hearing, is equally important for businesses and for clarity of the law and for local and State governments so that they will know how to proceed.

    I am looking forward to hearing the witnesses' testimony. I hope I have the capacity to concentrate. I am trying to track down my son in New York. So I am a little concerned and distracted by what is going on there, but I appreciate the Chairman having the hearing and I am looking forward to testimony, and I will yield back.
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    Mr. BARR. I thank the distinguished Ranking Member. We have with us today also the very distinguished former Chairman of this Subcommittee, the Congressman from Pennsylvania, Mr. Gekas, who is recognized for an opening statement he might care to make.

    Mr. GEKAS. I thank the Chair. Although I have no formal opening statement, I do want to commend the Chairman on continuing to focus on this massive problem and one that is sure to vex us for years to come unless we come to grips with it or the economy and the world of Internet actually become more clear in their visions and their impacts than they now are. So I am ready to hear the witnesses.

    Thank you, Mr. Chairman.

    Mr. BARR. I thank the distinguished former Chairman. Mr. Green, the gentleman from Wisconsin, do you have an opening statement?

    Mr. GREEN. No, Mr. Chairman.

    Mr. BARR. Thank you. I would also like to call on the gentleman from California, distinguished Member of this panel, Mr. Issa, for any opening statement.

    Mr. ISSA. No, thank you, Mr. Chairman.

    Mr. BARR. And we are also happy to recognize that today, as he has participated in earlier panels even though he is not a Member of the Subcommittee, the gentleman from Virginia, Mr. Goodlatte, the author of the bill that brings us here today and would ask him if he has any statement he would like to submit.
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    Mr. GOODLATTE. Mr. Chairman, thank you very much. I appreciate your allowing me to participate, and I especially appreciate your holding this hearing on this important issue. I also commend you for your work on extending the Internet tax moratorium. As you know, the legislation which I have introduced also provides for a permanent moratorium on Internet access taxes and multiple and discriminatory taxes, but it also adds as an additional component which you have correctly noted is a growing problem. The Supreme Court precedent with regard to nexus has made it clear that a State cannot impose a tax on an out-of-State business unless that business has a substantial nexus with the taxing State. In addition, over 40 years ago Congress passed legislation to ensure that States could not tax the income of out-of-State corporations whose in-State presence was minimal. Public Law 86–272 set uniform national standards for when States could and could not impose such taxes.

    However, like the economy of the time, Public Law 86–272 was limited to tangible personal property. With the growth of the Internet, companies are increasingly able to conduct transactions without the constraint of geopolitical boundaries. The increasing rate of interstate and international business-to-business and business-to-consumer transactions raises questions over States' ability to collect income taxes from companies conducting business within their jurisdiction.

    Over the past several years, a growing number of States have sought to collect business activity taxes from businesses located in other States even though those businesses receive no appreciable benefits from the collecting States and even though the Supreme Court has ruled that the Constitution prohibits a State without the consent of Congress from imposing tax on businesses that lack substantial connections to the State. For example, some taxing jurisdictions have claimed that the mere presence of a Web site accessible to residents of a State creates sufficient nexus or that an ISP by connecting consumers to the Internet acts as an agent of on-line sellers and therefore creates nexus for electronic merchants doing business in the taxing State.
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    States have imposed business activity taxes on out-of-State corporations that merely licensed trademarks to another corporation for use in the State. Other States have imposed business activity taxes on out-of-State banks simply because these banks issued credit cards to State residents. This has led to unfairness and uncertainty, generated contentious widespread litigation and hindered business expansion as businesses shy away from expanding their presence in other States for fear of exposure to unfair tax burdens.

    In this period where the rapid growth of e-commerce will shape the economy of the 21st century, this expansion of a State's power to impose business activity taxes left unchecked will have a chilling effect on e-commerce, interstate commerce generally, and the entire economy as tax burdens, compliance costs, litigation, and uncertainty escalate. Accordingly, the second recommendation of the Advisory Commission on Electronic Commerce majority was that Congress establish national standards for when States can impose business activity taxes.

    That is why I along with my good friend and colleague on the Judiciary, Congressman Rick Boucher, introduced this important legislation. The Internet Tax Fairness Act establishes definite specific standards to govern when businesses should be obliged to pay business activity taxes which will ensure fairness, minimize litigation, and create the kind of legal certainty and stable business climate which encourages businesses to make business investments, expand interstate commerce, and grow the economy and create new jobs. At the same time, this legislation will ensure that States and localities are fairly compensated when they provide services to businesses with a substantial physical presence in the State.

    Again, Mr. Chairman, I thank you for holding this hearing and allowing me to participate.
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    Mr. BARR. I thank the distinguished gentleman from Virginia for his leadership on this issue and thank him for joining us today. At this point I would like to introduce our witnesses, and then we will proceed to allow each of our four very distinguished witnesses today to take 5 minutes to either provide an oral statement or a summary, and then we will turn to questions.

    We are under a little bit of a time constraint today because there are Judiciary Committee bills on the floor. So some of our Members may want to go to that. So if we could make every effort to adhere to the time limits, I would appreciate it, and I know the Chairman of the full Committee would, too.

    Our first witness today will be Mr. Arthur Rosen. Mr. Rosen is testifying today as the Chairman for the Coalition of for Fair and Rational Taxation, an organization composed of more than a dozen major American businesses with multi-State business operations. Mr. Rosen is a partner in the New York City law office of the law firm of McDermott, Will and Emery, where he chairs the firm's nationwide State and local tax practice. A graduate of New York University and St. John's University Law School, Mr. Rosen is a leading expert in the area of State taxation. He is a past chairman of the State and Local Tax Committee of the American Bar Association's Tax Section, a member of the Executive Committee of the New York State Bar Association's Tax Section, and has served as co-chair of its committees on New York State tax matters, New York City tax matters, and State and local tax matters.

    He has served in State government as Deputy Counsel of the New York State Department of Taxation and Finance and Counsel to the Governor's Temporary Sales Tax Commission as well as holding executive tax management positions with the Xerox Corporation and AT&T.
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    Mr. Rosen, we are delighted to have you here today.

    Our second witness will be Mr. Stanley Sokul. Stanley Sokul is a member of the Advisory Committee on Electronic Commerce and testifies today on behalf of the Direct Marketing Association and the Internet Tax Fairness Coalition. Mr. Sokul has extensive experience in State and local tax and regulatory issues. As a member of the Advisory Commission, Mr. Sokul helped develop the Commission's work agenda and participated in drafting its final report to the Congress. He has an extensive public policy background, has served as legislative assistant and then later administrative assistant to Representative and later Senator Judd Gregg. He has also practiced law in the private sector at the Washington, D.C., firm of Beaver, Rich and Diamond. Mr. Sokul is a graduate of the University of Michigan Law School where he graduated in the Order of the Coif and as an honors graduate of Dartmouth College.

    Mr. Sokul, thank you for joining us today.

    Our third witness is Mr. Fred Montgomery, who appears on behalf of the Coalition on State Taxation. He is the Director of State and Local Tax for the Sara Lee Corporation. Prior to joining Sara Lee in 1987, he was manager of State taxes for Coopers and Lybrand. Mr. Montgomery has also served in government as a Special Counsel for the Illinois Department of Revenue and an Illinois Assistant Attorney General. He participated in the U.S. Treasury Department's Worldwide Unitary Taxation Working Group in 1983 and 1984. Mr. Montgomery received his Bachelor's Degree from Swarthmore College, his Master's Degree from Stanford University, and his law degree from DePaul University Law School.

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    An active member of the Committee on State Taxation, he is also Vice Chairman of the State and Local Committee of the Tax Executives Institute and is a member of the Board of Trustees of the Taxpayers Federation of Illinois and the Civic Federation.

    Mr. Montgomery, it is a pleasure having you with us today.

    Our fourth and final witness is Ms. June Summers Haas. Ms. Haas has served as Commissioner of Revenue for the State of Michigan since 1999. Prior to taking her present position, she served as Director of the Legal and Hearings Division for the Bureau of Revenue in the Michigan Department of Treasury. Before joining the Michigan Department of Treasury, Ms. Haas was the Director of the National Nexus Program for the Multi-State Tax Commission where she directed a multi-State voluntary disclosure program, drafted uniform multi-State regulations, and provided litigation support for member States, including writing amicus briefs.

    A graduate of George Mason University with a degree in economics, she received her law degree from the University of Virginia. A frequent speaker on State and local tax issues, she has served with numerous committees of various State and National Bar Associations dealing with tax issues and is co-founder and editor of the American Bar Association's Tax Litigation Subcommittee newsletter.

    Ms. Haas, thank you for joining us today.

    As everybody can see from the distinguished resumes of these four experts today, they indeed are experts, and we will all benefit and our colleagues will benefit tremendously from their input on this very, very important topic. At this time I would like to call on Mr. Rosen to take 5 minutes to present an opening statement, please. Mr. Rosen.
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STATEMENT OF ARTHUR ROSEN, CHAIRMAN, COALITION FOR FAIR AND RATIONAL TAXATION, PARTNER, McDERMOTT, WILL AND EMERY

    Mr. ROSEN. Mr. Chairman, Congressman Watt, Members of the Subcommittee, thank you for this opportunity you have given us today. As was noted by the Chairman, I am here on behalf of the Coalition for Fair and Rational Taxation, or CRAFT, which is composed of a diverse group of American businesses, including such companies as Cisco, Microsoft, Disney/ABC, Viacom/CBS, Sony, American Express, Eastman Kodak, and many others. CRAFT strongly supports the Internet Tax Fairness Act, H.R. 2526, and urges your approval of that legislation. We applaud Representatives Goodlatte and Boucher for their insightful and thoughtful leadership in this area.

    At the outset I think it is important to note that the commerce clause provides Congress with the authority and I think the responsibility to safeguard the principles embodied in that clause, which is the establishment and maintenance of a single robust integrated American economy. It is also important to remember that the sales and use tax issue we have all heard so much about is merely a tip of the iceberg on the State and local tax and Internet relationship.

    Now, States, like governments worldwide, have traditionally imposed their corporate income or franchise taxes, business activity taxes only upon businesses that receive governmental benefits or protections afforded by the jurisdiction. Recently, however, a large number of States and localities have been alarmingly aggressive and creative in attempting to expand the reach of business activity taxes to burden those businesses that are not provided with any measurable Government benefits or protections.
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    The Supreme Court's Quill decision made it clear that substantial nexus is the test under the dormant commerce clause for all taxes. Then the Court went on to say for sales and use taxes substantial nexus means physical presence. In National Geographic, another Supreme Court case, the Court recognized that the imposition of direct tax on a business like a business activity tax is even a greater burden on a business than merely collecting and remitting a sales and use tax. Therefore, the threshold test for imposing a direct tax should clearly be greater or at least equal to the test that is imposed or the criterion that is established for sales and use taxes.

    Most of the State court level decisions on this issue have concluded that there is no principled reason for there to be any lower standard for business activity taxes than there is for sales and use taxes. In other words, the principles incorporated in H.R. 2526 do not roll back current law. The Internet Fax Fairness Act merely codifies what the majority of State courts have been concluding and add to that by providing some specific bright lines which courts of course never do when they are addressing a specific case before them. The Internet Tax Fairness Act will put an end to State and local governments' never-ending attempts at imposing tax on those who are not part of the society that they govern.

    This is the position that the United States and its partners take in the context of international taxation. In such cases the United States and the foreign governments have agreed that direct taxes will be imposed on a foreign business only when those businesses maintain a permanent establishment within their borders. H.R. 2526's threshold is much lower than this permanent establishment criterion. The risk of aggressive State application of business activity taxes has a real chilling effect on interstate commerce and is dampening economic growth.
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    Numerous new business initiatives are abandoned and relationships are not formed because businesses are concerned that they may step over the line and be subject to taxing jurisdiction at some State or locality. I personally witness the chilling effect almost on a daily basis. For example, one client was considering selling optional warranties along with tangible personal property it was selling to direct sales media. However, it was worried that a State where a customer was located might claim that by selling a warranty, my client was no longer selling tangible personal property and accordingly was subject to tax in that State because it was not protected by current Public Law 86–272. As a result, the extended warranty was never offered for sale.

    As another example, a client of mine purchases on a wholesale basis goods from suppliers throughout the country. A common carrier or the supplier's own vehicles deliver those goods to my client's warehouse on the East Coast. To be more efficient, my client was considering using a freight consolidator in California under the following scenario. My client would have each California supplier ship their goods to another California common carrier. That common carrier would consolidate all the goods, put them on one full truck, and the use of one full truck is a lot less expensive and much more efficient than using several trucks. That one truck would then deliver the goods to the East Coast warehouse. My client was then concerned that the activities of this common carrier of consolidating items it had purchased on a warehouse dock might need to be taxed in that State. So my client continued to use the inefficient method of having each supplier ship its own goods in its own trucks all the way to the East Coast.

    If Congress addresses the issue of sales tax in the context of Internet taxation, it must deal comprehensively with all taxes, we suggest. Why? First, the fundamental legal constitutional issue is the same. To what extent should a State or locality tax jurisdiction under the commerce clause reach businesses with no real presence within their boundaries?
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    Second, from the perspective of an interstate business, resolving the sales and use tax issue would not relieve it of the burden of constantly worrying about potential tax effects wherever it has customers.

    Finally, it seems absolutely clear that if State and local governments ultimately succeed in the sales and use tax area, they will merely readjust their sights and redirect their resources to dramatically increase the already current aggressive attempts at imposing direct taxes on remote businesses. Enactment of sales and use taxes without business activity tax legislation would not solve the real issues that are raised in the State and local tax area caused by the Internet.

    Thank you.

    [The prepared statement of Mr. Rosen follows:]

PREPARED STATEMENT OF ARTHUR R. ROSEN

    Thank you for this opportunity to address certain issues of state taxation that have reached critical importance due to the expansion of electronic commerce. I am Arthur Rosen and am a member of the international law firm of McDermott, Will & Emery. I respectfully submit this testimony on behalf of the Coalition for Rational and Fair Taxation (''CRAFT''), a diverse coalition of some of America's major corporations involved in interstate commerce, including Internet companies such as Cisco and Microsoft; broadcasters such as ABC/Disney and CBS/Viacom; electronics manufacturers such as Sony Corporation of America; interstate retailers such as J. Crew Group and Sara Lee Corporation; publishers; financial services businesses such as American Express; traditional manufacturers, such as Eastman Kodak; and other major businesses engaged in interstate commerce. Many of my partners and I at McDermott, Will & Emery have been deeply involved in many of the relevant state tax issues, having successfully represented the taxpayer in such landmark Supreme Court cases as Quill, ASARCO, and Woolworth.
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    CRAFT strongly supports the Internet Tax Fairness Act, H.R. 2526, and respectfully urges your approval of this legislation. We believe that this is absolutely necessary as Congress attempts to address Internet-related taxation issues, as the issue addressed in H.R. 2526, while transcending electronic commerce, clearly becomes more of a crucial concern as electronic commerce and the use of the Internet to effect transactions become a more critical component of the American economy.

    At the outset, it should be noted that one of the principal recommendations of the Advisory Commission on Electronic Commerce majority report was that business activity tax nexus issues be addressed in a manner similar to the approach taken in the Internet Tax Fairness Act. We applaud Representatives Goodlatte, Boucher, and Cox for their insightful and thoughtful leadership in this area.

CONSTITUTIONAL FRAMEWORK

    The principal motivation for our adoption of the Constitution to replace the Articles of Confederation was a desire to establish and ensure the maintenance of a single, integrated, robust American economy. This is reflected in the Commerce Clause, which, as you know, provides Congress with the authority—and the responsibility—to safeguard this principle. Perhaps the hallmark of American federalism is this assignment to the federal government (along with responsibility for foreign affairs and the national monetary/fiscal system). Accordingly, legislation regarding states and localities imposing, regulating, or removing tax burdens placed on transactions in interstate commerce is not only within Congress' realm of authority, it is also Congress' responsibility. As a second point in the context of the fundamental principles to be considered, it is important to remember that while Congress has Constitutional authority and responsibility under the Commerce Clause, it may be constrained by the confines of the Fourteenth Amendment's Due Process Clause. While it is far from clear, most commentators believe that Congress cannot permit states to violate the protections afforded by that clause. In the context of state taxation, the Supreme Court has determined that Due Process means that ''the simple but controlling question is whether the state has given anything for which it can ask return.'' Wisconsin v. J.C. Penney Co., 311 U.S. 435 (1940).
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    H.R. 2526, in addition to addressing the moratorium on Internet access taxes and multiple and discriminatory taxes on e-commerce, focuses on business activity taxes. While there has been a greater amount of publicity regarding sales and use tax nexus issues, those are merely ''the tip of the iceberg.''

    State Business Activity Taxes

    States, like governments worldwide, have traditionally imposed their corporate income and/or franchise taxes (''business activity taxes'') only upon businesses that receive governmental benefits and protections afforded by the jurisdiction. This has meant that businesses maintaining offices, inventory, employees or agents in a state would be subject to business activity taxes in return for the benefits and protections afforded by the taxing state to the businesses' people and their property. Corporations could develop and carry on interstate business knowing that only their activities and presence in a state would incur a business activity tax liability, fostering a business environment without artificial market barriers that would retard economic growth.

    Over forty years ago, Congress passed legislation to ensure that states could not tax the income of out-of-state corporations whose in-state presence was minimal. Public Law 86–272 set uniform, national standards for when states could and could not impose such taxes. Like the economy of the time, Public Law 86–272 was directed at sales of tangible personal property.

    Recently, however, a large number of states have been alarmingly aggressive and ''creative'' in attempting to expand the reach of their business activity taxes to burden those businesses that are not provided with any measurable governmental protections or benefits by the taxing state. These states are seeking to tax the income of out-of-state corporations carrying on virtually no income-producing activity in those jurisdictions, for activities involving services and intangible property.
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    For example, these efforts have resulted in the imposition of business activity taxes by several states on out-of-state corporations that merely licensed trademarks to another corporation for use in the state, but itself carried on no activity and had no tangible property or personnel there. Another state attempted to impose business activity taxes on an out-of-state bank issuing credit cards to residents based largely upon the possession of the plastic credit cards by the state's residents. In yet another instance, a state Comptroller attempted to impose the state franchise tax upon a company whose only contact with the state was its possession of a certificate of authority to do business within the state. In other instances, states have attempted to impose business activity taxes when corporations merely have held passive investments in operating businesses, owned accounts receivable payable by residents, and performed services for residents even though the services were performed in another jurisdiction.

    Confronted with these aggressive—and often unconstitutional (as set forth below)—out-of-State efforts to tax their income, American businesses are faced with a difficult choice. They can oppose the tax—but then must bear substantial litigation costs to do so. They can knuckle under to the state and pay the asserted tax—but then they risk being subject to double and multiple taxation. Moreover, the compliance burdens can be immense. Think of an interstate business, with customers in all 50 states. That business can be faced with having to file an income tax return with every state, and with countless localities.

    In this period where the rapid growth of e-commerce will shape the economy of the 21st century, these efforts by states to expand their taxing jurisdiction to cover activities conducted in other jurisdictions will constitute an even greater burden on the business community's ability to carry on business. Left unchecked, this attempted expansion of the states' power to impose business activity taxes will have a chilling effect on the entire economy as tax burdens, compliance costs, litigation, and uncertainty escalate.
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    Consequently, the time has come for Congress to consider when state and local governments should and should not be permitted to require out-of-state businesses to pay business activity taxes. It appears eminently fair and reasonable for Congress to provide relief from unfair and unreasonable imposition of income and franchise taxes on out-of-state businesses that have little or no physical connection with the state or locality.

    The time has come to update Public Law 86–272 for the digital age, as set forth in the Internet Tax Fairness Act. Ours has become a more service-oriented economy, and intangible property such as intellectual property now plays a much greater role in our economic output. Public Law 86–272 must be modernized to include coverage of services and intangible property, and other refinements.

    The report of the majority of the Advisory Commission on Electronic Commerce agreed with the importance of accomplishing this goal. Passage of the Internet Tax Fairness Act would implement this recommendation and establish a clear, understandable, administerable demarcation of taxation.

CURRENT LAW

    The Supreme Court's Quill decision made it clear that substantial nexus is the dormant commerce clause requirement for all state tax obligations. Further, the Court stated that non de minimis physical presence was the appropriate measure of substantial nexus for sales and use taxes; the Court refrained from articulating the measures for business activity taxes. In National Geographic, the Court recognized that imposing a direct tax is even more burdensome than imposing a mere duty of collecting or remitting a tax. Therefore, the threshold test for allowing states to impose direct taxes such as business activity taxes on out-of-state companies should, if any different, be higher than the test for imposing indirect taxes such as sales and use taxes.
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    So what constitutes substantial nexus for business activity taxes? Since the Supreme Court has not yet ruled on this issue, we must use logic and review what state courts and tribunals have recently decided. The logical answer is clear: if non de minimis physical presence is the test for a mere collection and remission situation, substantial physical presence is the appropriate test for the more burdensome actual tax imposition. Most of the state-level decisions on this issue (including J.C. Penney National Bank, A.O.L., Cerro Copper, K-Mart Properties) have concluded that there is no principled reason for there to be any lower standard for business activity taxes than for sales and use taxes.

    In other words, the principles incorporated in the Internet Tax Fairness Act do not roll back current law. H.R. 2526 merely codifies what the majority of state courts have been concluding and adds to that by providing specific ''bright line'' tests (which courts, by the very nature of resolving only the case before them, can never do).

TAXATION WITHOUT REPRESENTATION

    The Internet Tax Fairness Act would put an end to state and local governments' never-ending attempts at imposing tax on those who are not part of the society that that government governs. A business with no personnel and no property in a jurisdiction has no say, formally or informally, in the operations of that jurisdiction's government. Such businesses simply have no representation where attempts are being made to impose tax on them.

    It is well-recognized that a state should only be able to impose tax on a business if such tax corresponds to the benefits provided to the business by the state. It is interesting to note that this is the position that the United States and its partners have taken in the context of international taxation. In such cases, the United States and the foreign governments have agreed that direct taxes will be imposed on a foreign business only when that business maintains a ''permanent establishment'' in the country. H.R. 2526's threshold for taxation is substantially lower that standard.
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    As the Supreme Court has held,

[a] state is free to pursue its own fiscal policies, unembarrassed by the Constitution, if by the practical operation of a tax the state has exerted its power in relation to opportunities which it has given, to protection which it has afforded, to benefits which it has conferred by the fact of being an orderly, civilized society. . . . The test is whether property was taken without due process of law, or, if paraphrase we must, whether the taxing power exerted by the state bears fiscal relation to protection, opportunities and benefits given by the state. The simple but controlling question is whether the state has given anything for which it can ask return.

    Wisconsin v. J.C. Penney Co., 311 U.S. 435, 444 (1940). Moreover, in another opinion, the Supreme Court, in determining that a tax imposition was valid under the Commerce Clause, noted that ''no claim [ had been] made that . . . the tax is not fairly related to benefits provided the taxpayer.'' Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 287 (1977).

CHILLING EFFECT ON INTERSTATE BUSINESSES

    The risk of aggressive state application of business activity taxes has a real chilling effect on interstate commerce, and is dampening economic growth. As every state and local tax practitioner can confirm from experiences he or she confronts on a daily basis, numerous new business initiatives are abandoned and relationships are not formed (or are formed in contorted fashions) because businesses are concerned that they may ''step over the line'' and be found subject to the taxing jurisdiction of some state or locality; taking this risk is often not warranted by the potential business benefits.
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    It is not difficult to see this chilling effect that a tax burden can have on the American economy or, conversely, the nurturing effect that a tax climate can have on business. As noted by the Supreme Court, the encouragement of settled expectations in the tax area ''fosters investment by businesses and individuals. Indeed, it is not unlikely that the mail-order industry's dramatic growth over the last quarter century is due in part to the bright-line exemption from state taxation created in Bellas Hess.'' Quill Corp. v. North Dakota, 504 U.S. 298, 316 (1992).

    I, personally, witness the chilling effect on almost a daily basis. For example, one client was considering selling optional warranties along with the items of tangible personal property it was marketing through direct sales media. However, it was worried that a state where a customer was located might claim that, by selling a warranty, my client was no longer just selling tangible personal property and, accordingly, was subject to that state's corporate income tax because P.L. 86–272 did not apply. As a result, the extended warranty-an intangible-was not offered for sale.

    In another situation, a client wanted to sell goods, on a wholesale business, to a small retailer located in another state. That small retailer was not very financially secure, so my client wanted to establish a lien on the receivables that the retailer would generate by its sales to its ultimate customers. However, due to my client's concerns that having a security interest in accounts receivable-an intangible-owned by an in-state company might give that state the basis to claim that my client was subject to that state's corporate income tax, the deal was considered too risky to undertake, and the interstate commerce never occurred.

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    As a third example, a client purchases, on a wholesale basis, goods from suppliers throughout the country; a common carrier or the supplier's own vehicles usually deliver the goods to my client, which is located on the East Coast. To be more efficient, my client was considering using a freight consolidator in California under the following scenario. My client would have each California supplier ship the goods to a California common carrier which would then consolidate all the items onto a single full truck (using a single full truck is much less expensive than using part of the capacity on each of several trucks) destined to the East Coast. My client was concerned that the activities of the common carrier freight consolidator might be seen by the California tax authorities as my client exercising dominion and control over property located in California, thereby making my client subject to tax there. The arrangement for freight consolidation was never made, and my client's business instead just bore the higher costs of the more inefficient method of separate shipping.

RELATIONSHIP TO THE SALES AND USE TAX ISSUE

    If Congress is going to address the issue of nexus for requiring sales tax collection, as state and local governments have been seeking for decades, it must deal comprehensively with ALL state and local tax nexus issues, and address business activity tax nexus at the same time.

    While collecting tax from customers and remitting it to governmental units (the sales and use tax situation) pursuant to numerous inconsistent laws is quite a burden, it pales in comparison to the immense burden that is faced by a remote seller or service provider that may have to compute and pay income, franchise and license taxes to every jurisdiction where it has a customer. Such a situation not only causes huge administrative burdens as with the sales tax, but also imposes true, substantial economic hardship for interstate businesses. While the sales tax taxes the transaction, business activity taxes are direct taxes, which impose costs on the business itself.
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    Moreover, the sales tax issue and the business activity tax issue are intertwined for several reasons. First, the fundamental legal/constitutional issue is identical: to what extent should a state's (or locality's) tax jurisdiction, under the Commerce Clause, reach businesses with no real presence within its boundaries? Second, from the perspective of an interstate business, resolving the sales and use tax issue will not relieve it of the burden of constantly being concerned about the potential tax effects of each and every transaction it undertakes with a party in another state. Finally, it seems absolutely clear that if the state and local governments ultimately succeed in the sales and use tax area (i.e., convince Congress that the U.S. Supreme Court's rulings in National Bellas Hess and Quill should be overridden), then they will be able to ''readjust the sights,'' and redirect their resources to dramatically increase their already currently aggressive actions to impose business activity taxes on remote businesses. These efforts will be made far easier by the sales tax data that they would have at their fingertips; the out-of-State business' sales tax report often would simply be turned over from the sales tax desk to the business activity tax desks, with dunning letters for income tax returns sent out automatically. Indeed, enactment of sales tax collection legislation without business activity tax protections would create a Taxation Superhighway.

RESPONSE TO STATES' ARGUMENTS

''Federalism''

    Some state and local tax officials assert that establishing bright-line nexus rules would violate principles of federalism. However, they fundamentally misunderstand the nature of our federal system. As described earlier, the entire basis for our nation's rejection of the Articles of Confederation and establishment of our federal Constitution was to eliminate state-erected barriers to interstate commerce and activity. The federal Commerce Clause is a fundamental part of our federal system, and it is Congress' vital role to protect interstate commerce against state efforts to essentially erect tariffs against it.
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''Market Maintenance''

    In the case of a business with no material property or personnel in a taxing jurisdiction, it is clear that there are no benefits provided by the taxing jurisdiction. Nevertheless, state and local government spokespeople have been claiming that a remote seller has an obligation to pay tax to such governments because those governments are ''maintaining a civilized society'' and/or are ''maintaining a market'' which the remote seller is exploiting. There are some major problems with this argument. As is obvious to the most casual observers, governments provide their protections and services for the benefit of those individuals and businesses physically present in the jurisdiction. Whether it is fire and police protection, education services, social services, or transportation facilities, those WHO ARE THERE, get the benefits. Government spokespeople often say that remote businesses earn a profit because government services allow residents to have the wherewithal to purchase goods and services from remote sellers, and provide remote sellers with means of delivering their products to customers. Consequently, they say, remote businesses ''owe'' such governments for their assistance in generating profits.

    This argument has two fatal flaws. First, the remote seller's delivery media, whether it be a telecommunications company or a trucking company, is paying taxes to the customer's jurisdiction, and such taxes are obviously embedded in the prices such companies charge the remote seller. Second, the residents of the jurisdiction who patronize remote sellers are benefiting from such purchases to the same extent as the sellers are benefiting (as must obviously be the case in any free market society, where a buyer and seller each believe that he or she is ''getting a good deal'' when each gives up something he or she already has for something else). Should such resident customers thus be required to pay tax to the remote jurisdiction where the seller is located because the seller's jurisdiction is providing the protections and services that allow the good or service to be produced for the benefit of the customer?
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    Another incredible argument made by state and local government officials is that a student who benefits from his or her state's education funding may someday work for an out-of-state company. It then asserts that, as a result, that out-of-state company would be receiving benefits that had been provided by that employee's former state. The absurdity of this position should be clear. Should American high-tech companies that have hired people educated in Pakistan have to pay Pakistan taxes? Should every business automatically be obligated to pay taxes to all 50 states, in anticipation of the possibility, however remote, that they may at some undefined future point hire a person who was educated in the taxing state?

    The state and local governments' confusion seems to be related to their misunderstanding of federalism. In our system, states are responsible for state-level issues while those issues that affect the American economy as a whole are the responsibility of the federal government. If a party receives benefits from the American economy as a whole, then any related obligations are owed to the American government. That's why we pay federal taxes.

Revenue Effect

    Spokespeople for some state and local taxing authorities have been saying that proposals such as H.R. 2526 would cost $9 billion in state revenues and thus have a severe detrimental effect on those governments' ability to furnish adequate education for the children of this country. Putting aside the obvious attempt at eliciting emotional responses by their emphasis on ''school children,'' the spokespeople's estimate of the revenues at issue is obviously ludicrous; it is clear that there is no detailed basis for their assertion that enactment of these proposals would cost the states $9 billion.
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    First, as noted by an economist with ties to the Multistate Tax Commission, no reliable revenue figures relevant to this discussion are maintained by the states. Rather, this figure was concocted through an ad hoc survey of the MTC's member tax collectors, conducted for the purpose of opposing this legislation. As a matter of fact, we understand that the figure being used by the state and local tax officials is based on two glaring fallacies: 1) including numerous taxes that are not covered by H.R. 2526, such as insurance gross premiums taxes; and 2) by simply assuming that all businesses that have much greater receipts from sales into a state than they have property or payroll in that state would pay no taxes if the proposal were adopted. This is obviously absurd.

    Objective, pre-existing statistics, not developed for the slanted purpose of opposing or supporting any particular legislation, are maintained by the U.S. Census Bureau, and are available on their website. According to these figures, business activity taxes—as defined by this legislation—account for approximately eight percent of state tax revenues. In contrast, sales and use taxes account for over one-third of state revenues.

    Second, it strains credulity for states to assert that they are currently receiving about one-fifth of their total business activity tax revenues from businesses that have no physical presence, as is being asserted. While the threat of future collections is chilling interstate commerce, states currently are collecting little from out-of-State businesses without physical presence. The issues of ''economic nexus'' (nexus through merely having customers in the state) and ''Geoffrey nexus'' (nexus through having a license of intangible property in the state) are being vigorously challenged in courts throughout the country, with states almost-universally losing the argument, as discussed above. Moreover, if the spokespeople's comments were true, that would mean that in-state businesses are being dramatically undertaxed.
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    Furthermore, there would be no revenue effect from H.R. 2526 in many—perhaps the majority of—states due to the manner by which they compute tax liabilities (such as unitary combination).

    Putting the tax revenues into proper perspective, any reasoned, objective analysis would surely show that any speculative revenue loss that would result from enactment of these business activity tax proposals (keeping in mind that there may be no loss whatsoever—the states where businesses have physical presence will be able to tax fully), must pale in comparison to the over $10 billion in annual revenues the state and local governments claim they will lose in sales and use taxes due to their inability to require remote sellers to collect and remit such taxes. By coupling business activity tax nexus protections with sales tax collection legislation, the states would be receiving, on the sales tax side, guaranteed access to a much larger pool of sales tax revenue, in return for a speculative loss from a smaller pool of business activity tax revenue, which they have been found to be constitutionally barred from collecting by almost every court that has looked at the question anyway.

Tax Planning

    The state and local government spokespeople are claiming that the proposals about which they are concerned would open the floodgates so as to allow almost unlimited ''tax planning'' that would dramatically decrease state tax revenues. Even if there were something wrong with taxpayers minimizing their tax liabilities, which of course there isn't (does any of us in this room voluntarily decide not to take any deductions from our own income taxes?), the state and local governments' assertion is untrue. States have, under current law that nobody is suggesting warrants changing, more than adequate remedies to prevent any ''tax planning'' that could possibly result from enactment of the proposals. We challenge the state and local government staffs to present a fact scenario where enactment of the proposals would leave the states defenseless in combating such tax planning.
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CONCLUSION

    H.R. 2526 warrants the full and enthusiastic support of this subcommittee. Its enactment will ensure that all major tax aspects of ''Internet taxation'' are fully addressed and will guarantee that the American business community, and thus the American economy, are not unduly burdened by unfair attempts at taxation without representation.

    Mr. BARR. Thank you very much, Mr. Rosen. And I neglected to state in the opening remarks that of course your entire written statements and any additional material that you would like to submit for the record will be included as part of the official record in this case for all the witnesses.

    Mr. Sokul, you are recognized for 5 minutes.

STATEMENT OF STANLEY SOKUL, MEMBER, ADVISORY COMMISSION ON ELECTRONIC COMMERCE, PRINCIPAL, DAVIDSON & COMPANY, ON BEHALF OF THE DIRECT MARKETING ASSOCIATION AND THE INTERNET TAX FAIRNESS COALITION

    Mr. SOKUL. Thank you, Mr. Chairman, Mr. Watt. I am testifying on behalf of the Direct Marketing Association as well as the Internet Tax Fairness Coalition. We greatly appreciate the opportunity to testify in support of H.R. 2526, sponsored by Congressman Goodlatte.

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    As Mr. Rosen has discussed, great uncertainty currently exists in the interstate market and some States aggressively push to expand their tax reach beyond their borders. H.R. 2526 responds to these actions by saying a State cannot tax a business unless it has a substantial physical presence in the State. A similar proposal was endorsed by a majority of the Advisory Commission on Electric Commerce, on which I served. The DMA and the Internet Tax Fairness Coalition support a bright-line nexus standard for three reasons: Because it constitutes a proper exercise of Congressional power to protect interstate commerce, because a substantial physical presence standard provides the most sensible and certain standard for the new economy, and because a bright-line standard is needed to protect small businesses from overreaching extraterritorial taxation.

    Some argue that H.R. 2526 would improperly infringe upon States' rights or undermine federalism. This is not true, however, because the bill does not affect how a State may tax its own citizens. It only ensures that States do not gain unwarranted tax power over out-of-State businesses. That does not undermine States' rights or federalism. In fact, the competitive aspects of federalism are seriously undermined when States gain and exercise national tax powers.

    Congress and the courts have traditionally and properly given the States great deference on setting tax policies within their borders, but when States attempt to tax people or companies beyond their borders, Congressional deference should give way to Congressional scrutiny. The Nation's experience under the Articles of Confederation led to our current Constitution, which gives Congress the power and the responsibility to protect the interstate market from each State's tendency to export tax burdens beyond its borders. Some State officials seem to believe the commerce clause only provides Congress the power to burden interstate commerce with Federal regulations, yet the Founding Fathers clearly envisioned Congress taking action to guard the interstate market from burdensome State actions, which Congress has done many times.
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    Many State tax officials are advancing an economic nexus standard under which States can tax a company conducting any business in the State. The lack of tangible presence and thus political reputation is irrelevant under this position. The Internet makes an economic nexus standard particularly untenable because the Internet allows more and more companies to easily participate in the national marketplace. Take, for instance, a small farm selling Georgia peaches by mail order and now on-line such as Pearson Farms in Fort Valley, Georgia. The Pearson family would certainly be surprised to know that they owe income taxes and must file returns and confront potential audits in virtually every State to which they ship peach baskets each year. A strong physical presence standard is needed because accessing the national market on-line should not result in a welcome wagon full of State tax forms.

    The DMA is particularly concerned about the practical implications of economic nexus theories taking root. A tax system that allows for easy extraterritorial taxation requires a compliance regime to track and enforce it. Ever increasing tax compliance costs for businesses engaged in interstate commerce operate as an unwarranted barrier to entry to the interstate market for small firms.

    This is a real issue with real world consequences. A company that receives a tax assessment letter from another State's tax department must decide whether to pay the tax or undertake the expensive proposition of fighting the tax assessment in another State's courts. Large companies have the resources to fight improper and overreaching tax assessments, but scores of smaller firms do not. Accordingly, unless Congress acts smaller firms trying to participate in the interstate market can be increasingly intimidated into paying a bevy of highly questionable State income taxes. In this circumstance the danger of being taxed more than once on the same income also exists.
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    Thank you again for the opportunity to testify, and I will be pleased to answer any questions.

    [The prepared statement of Mr. Sokul follows:]

Sokul1.eps

Sokul2.eps

Sokul3.eps

Sokul4.eps

Sokul5.eps

    Mr. BARR. Thank you very much, Mr. Sokul.

    Mr. Montgomery, you are recognized for 5 minutes, please, sir.

STATEMENT OF FRED H. MONTGOMERY, DIRECTOR, STATE AND LOCAL TAX, SARA LEE CORPORATION, ON BEHALF OF THE COALITION ON STATE TAXATION

    Mr. MONTGOMERY. Thank you.
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    Mr. BARR. You might want to pull the microphone a little closer, please.

    Mr. MONTGOMERY. Thank you. I appreciate the opportunity to appear here on behalf of the Sara Lee Corporation and the Committee on State Taxation, and I would like to thank Congressmen Goodlatte and Boucher for their leadership in support of business growth.

    Sara Lee operates a number of different businesses, and I will mention a couple. Hillshire Farms, we make a lot of good sausage in Wisconsin, and Chock Full'O Nuts is headquartered in New York, Kiwi Shoe Polish is in Pennsylvania, and in North Carolina we operate a number of businesses. I would like to mention we have an Internet and mail order catalogue business there which sells Hanes underwear, L'eggs Pantyhose, Playtex and Bali intimate apparel. Sara Lee is one of 550 members of the Committee on State Taxation whose objective is to preserve and promote fair and nondiscriminatory State taxation.

    What I would like to do hopefully is to be able to answer three questions: What is business activity tax nexus? Why is this issue important for Congress? And why is the physical presence the appropriate standard? Business activity taxes are on income and activity. What they are not are sales tax, property tax, utility tax, or any others like that. If we look at the 1998 census data of all State and local revenue, business activity taxes account for less than 3 percent of the total. This is much less, for instance, than sales tax, which is 16 percent of total State and local revenue.

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    Now, why is this important for Congress? Companies need to know what connection they have with the State before they are obligated to pay tax. This is an important question regardless of what industry a company is in.

    [The prepared statement of Mr. Montgomery follows:]

PREPARED STATEMENT OF FRED H. MONTGOMERY

    Mr. Chairman and Members of the Committee, I am Fred Montgomery, Director, State and Local Tax for the Sara Lee Corporation. Sara Lee is a member of the Committee on State Taxation (COST), on whose behalf I also appear today. I appreciate the opportunity to share with you my views on the important issue that you have before you—the appropriate extent of state tax jurisdiction.

    Sara Lee Corporation operates a number of different businesses, and I would like to mention a few. Hillshire Farm & Kahn's is headquartered in Ohio, and we make a lot of good sausage in New London, Wisconsin. Chock Full O' Nuts is headquartered in New York, and Kiwi shoe polish is headquartered in Pennsylvania. And in North Carolina we operate an Internet and mail order catalog business which sells Hanes underwear, L'eggs pantyhose, and Playtex and Bali intimate apparel.

    COST is a nonprofit trade association based in Washington, DC. COST was formed in 1969 as an advisory committee to the Council of State Chambers of Commerce and today has an independent membership of 550 major corporations engaged in interstate and international business. COST's objective is to preserve and promote the equitable and nondiscriminatory state and local taxation of multijurisdictional business entities.
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    In my testimony today, I hope to answer three questions:

 What is business activity tax (BAT) nexus?

 Why is this issue relevant for Congress?

 Why is physical presence the appropriate standard for BAT nexus?

BUSINESS ACTIVITY TAX NEXUS

    ''Business activity taxes'' are those taxes imposed by the state on income or on the right to do business. This does not include property taxes, sales taxes, utility taxes, insurance premium taxes or any other taxes imposed by the state which do not specifically fall on business activity. ''Taxable nexus'' simply refers to the minimum connection necessary between a jurisdiction and an entity before the jurisdiction can impose a tax on that entity.

    In considering the issue of BAT nexus, Congress should be aware of the importance of business activity taxes themselves to state and local governments. According to the U.S. Census Bureau, corporate income taxes accounted for $34.4 billion in state and local tax revenue in 1998 (the most recent data for state and local revenue). States collected an additional $6.1 billion from corporate license taxes, and $6.2 billion was raised from business and occupation taxes. In total, states and localities collected $46.7 billion from business activity taxes in 1998.

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    This is not a small sum, but it must be compared to total revenues. State and local governments collected $774 billion in taxes during 1998. Taxes, however, account for only 45% of total state and local revenues—transfers from the federal government, user fees and lottery proceeds boost total state and local revenues to $1.721 trillion in 1998. Thus, business activity taxes account for approximately 2.7% of total state and local revenues.

    My purpose is not to minimize the importance of business activity taxes to state and local governments, but to help the Committee define the universe that BAT nexus legislation could possibly affect. It is also important to note that the legislation currently before the Committee—H.R. 2526—and any similar legislation is not intended to meaningfully impact the total amount of state and local BAT revenues.

    Assertions made by some in state government that BAT nexus legislation will result in large revenue losses are misleading. The Multistate Tax Commission (MTC) has stated that state governments will lose $9 billion dollars if BAT nexus legislation is enacted. This is simply not true. The MTC's own staff admitted at the MTC's recent annual meeting that there are no reliable revenue figures on which such an estimate could be based. Moreover, the number includes ''lost'' revenue from companies that currently pay taxes to a state based on the fact that they have property and employees in that state. If BAT nexus legislation is enacted, these companies will continue to pay taxes to these states. BAT nexus legislation is about fundamental fairness, certainty for businesses and states, and minimizing unnecessary litigation. It is not about state and local tax revenue.

CONGRESSIONAL INVOLVEMENT

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    In its 1992 Quill decision, the Supreme Court differentiated between nexus for the Due Process Clause and the Commerce Clause of the Constitution. Few—if any—constitutional scholars believe that the Congress may legislatively alter the Due Process rights found in the Constitution, but none would challenge the Congress' authority over Interstate Commerce. Indeed, the Supreme Court invited Congress to address the issues raised by Quill. Although Quill was limited to sales and use taxation, Congress' Commerce Clause powers are surely not.

    Congress must be concerned with BAT nexus for two reasons. First, states have become increasingly aggressive since the Quill decision in attempting to assert jurisdiction for tax purposes over out-of-state companies. Although the states won an early court victory in South Carolina, since then at least six other states, including Alabama (Cerro Copper), Maryland (SYL, Inc.), Minnesota (MeritCare Hospital), New Mexico (K-Mart Properties), Tennessee (J.C. Penney National Bank), and Texas (Bandag Licensing), have specifically rejected an economic or intangible presence nexus rule. One might conclude from this that Congressional action is not necessary. Taxpayers, after all, are winning much more often than they are losing. Nothing, however, could be further from the truth. Litigation resulting from aggressive state audits continues unabated despite taxpayer victories, resulting in tremendous uncertainty and expense to taxpayers. This is a critical concern of multistate businesses; in a recent survey of COST's membership on tax policy issues, nearly 70% ranked nexus legislation as their company's #1 issue, and 93% ranked it among their top three priorities.

    The second reason that Congress must be involved with BAT nexus is the related ongoing discussion in Congress regarding sales tax simplification and collection. I am surprised by the suggestion by some in the state government community that nexus for sales taxes is unrelated to nexus for business activity taxes. Even a cursory review of the relevant case law will demonstrate that taxpayer victories on the BAT nexus issue rely significantly on the Quill decision. If Congress chooses to remove existing federal limitations on the authority of states to compel remote vendors to collect sales and use tax, Congress should also: (1) require the states to radically simplify and reform the sales and use tax system for all vendors; and (2) formally recognize that a state has no right to impose a business activity tax on any business that does not have a physical presence in that jurisdiction.
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PHYSICAL PRESENCE STANDARD

    Determinations of jurisdiction to tax should be guided by one fundamental principle: a government has the right to impose burdens—economic as well as administrative—only on businesses that receive meaningful benefits or protections from that government. In the context of business activity taxes, this guiding principle means if a business is not physically present in a jurisdiction, it is therefore not receiving any benefits or protections from the jurisdiction, and it should not be required to pay tax to that jurisdiction.

    In testimony earlier this year before the Senate Committee on Commerce, Science, and Transportation, Elizabeth Harchenko, Chair of the Multistate Tax Commission, argued that ''sound economic policy requires the adoption of—economic nexus as the standard for the application of state and local taxes.'' Nothing could be further from the truth. No tax treaty to which the United States is a party recognizes such a low threshold for tax jurisdiction. What is economic nexus? Is it where you have a customer? A website? An account receivable? Under an ''economic nexus'' theory, every company of any measurable size would be taxable in every state. Taken to an international level, every company would be taxable everywhere. Under an ''economic nexus'' theory, companies would lose any ability they currently have to support states that provide a favorable business tax climate, and states would lose any incentive to provide such an environment.

    It is important to note that under the existing physical presence nexus standard, companies do pay—and will continue to pay under HR 2526—a substantial amount of taxes to states and localities. In addition to business activity taxes, business purchases result in approximately 40% of all sales taxes collected, and businesses pay substantial real and personal property taxes to states and localities as well as payroll taxes. The states have more than sufficient power to make sure that the companies that are physically present in their states pay their fair share of taxes to those states. Finally, businesses also pay taxes to the federal government, significant sums of which are transferred to state and local governments to deliver services to their citizenry.
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CONCLUSION

    A properly constructed bright-line physical presence nexus standard will neither increase nor decrease state or local revenues. What it will do is promote fairness, eliminate uncertainty for both businesses and states, and significantly reduce the frequency and costs of litigation. We are very interested in working with this Committee and other interested parties to articulate a bright-line physical presence nexus standard that is fair to both business and government. Mr. Chairman, I again thank you for the opportunity to speak before this Committee today. I welcome any questions that you or the Committee members may wish to pose.

    Mr. BARR. Excuse me. I apologize for interrupting. We are going to have to close the hearing. There apparently are some serious problems. We will have all of your statements in the record. I sincerely apologize for not being able to get to everybody, but apparently there is a fairly serious situation, and this hearing is adjourned.

    [The prepared statement of Ms. Haas follows:]

PREPARED STATEMENT OF JUNE SUMMERS HAAS

    Chairman Barr and Members of the Committee, I am June Summers Haas, Commissioner of Revenue, Michigan Department of Treasury. Thank you for the opportunity to address issues of great importance to Michigan and all other states.

    I have dedicated my entire professional career to the area of state and local taxation, over half of it working as an attorney advising businesses in the private sector as a tax planner and a litigator. I have also served as an advisor to the states as the Director of the National Nexus Program for the Multistate Tax Commission, as a law professor and now as a civil servant in the State of Michigan. I have been asked to speak to you today because I am an expert on state jurisdiction to tax who has dealt with this issue from all sides, as an advocate for business, an advisor to states, as a civil servant seeking to administer the laws and as a law professor who has taught a course on state jurisdiction to over 1200 attorneys, accountants and state tax administrators.
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    I will be giving brief oral comments of my testimony today but a more extensive version of my comments will be submitted for the record.

    Let's put this issue in context. When we talk of jurisdiction to tax, also known as nexus, we are only asking the question of when a corporation is present enough in the state that the state may tax it. Business entities are legal fictions created on paper that have no physical being. These businesses are present in a state through representatives such as buildings, property, or inventory they own or persons they hire, such as employees and independent contractors, to do the corporation's work. They are present in the state through the activities they undertake such as leasing, contracting, licensing, selling, and the like. So for a business entity the nexus question is: When is an entity that has no single physical embodiment, present enough in the state to bring it within the state's taxing jurisdiction?

    House Resolution 2526 would impose new untested limitations on states' taxing jurisdiction over business entities ostensibly to promote e-commerce. This proposal is fundamentally flawed for four reasons.

    First, it violates basic principles of equity and uniform application of tax law by favoring businesses with limited in-state presence over businesses that are based in the state that create jobs to employ state citizens.

    Second, it overturns U.S. Supreme Court rulings on nexus and replaces it with a new, poorly defined standard that will plunge businesses and tax administrators into years of litigation over its vagaries.
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    Third, it is fiscally imprudent, as this proposal will reduce state revenues needed to provide vital state services by an estimated $9 billion per year.

    Fourth, it contravenes the basic principles of federalism and state sovereignty upon which this country was founded. Let me elaborate briefly on each of these points.

    Flaw One—Unfair Treatment of Businesses Based in Your States. The first flaw in this proposal is that it discriminates against businesses that set up plants and create jobs in your states. It favors businesses with limited physical presence but often with major business activity in the state. In other words, H.R. 2526 shifts state corporate income tax burdens to small businesses, manufacturing, and natural resource and service industries; businesses that create jobs, pay local property taxes, sponsor our little league teams. Their competitors receive a tax shelter for their income from these same business activities because H.R. 2526 elevates form—limitation of physical presence—over substance—doing business in the state.

    H.R. 2526 creates tax shelters for businesses but is not limited to e-commerce. For example businesses such as trademark licensing companies, leasing companies, repair service companies, financial service companies, sales solicitation companies, and seminar companies could receive favored treatment. Companies currently doing business in the states and paying business taxes there would be exempted under this proposal if they restructure their businesses to limit the physical presence of property or representatives to meet the artificial limitations of this proposal. There is no rational basis for favoring any business, e-commerce or not, with tax-sheltered income as a reward for limiting the presence of its in-state representatives to 30 days or less.
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    You have heard that only businesses physically present receive state services and thus businesses that limit their physical presence in the state should not have to pay tax to support these services. This is false. States will provide a court system for tax sheltered industries to enforce contracts, to protect trademarks and trade names. States will provide the police, fire and emergency services to tax-sheltered independent contractors and employees and will provide protections for tax sheltered offices or leased property. States provide roads and bridges for deliveries into and out of the state, a public utility infrastructure for all forms of commerce, and an education system that has produced the most sophisticated Internet consumers in the world. Yet, for those favored businesses, this bill would shelter them from paying their fair share of the cost. This is fundamentally unfair.

    Flaw Two—Overturn Supreme Court Decisions. The proposed ''substantial physical presence'' standard is a new, untested standard that will erase years of Supreme Court precedent on nexus. The U.S. Supreme Court has unequivocally stated that nexus is not based on physical presence. For example, the Court has stated: ''The fact that the stockholder-taxpayers never enter Wisconsin and are not represented in the Wisconsin legislature cannot deprive it of its jurisdiction to tax. It has never been thought that residence within a State or country is a sine qua non of the power to tax.'' International Harvester v. Wisconsin Dept. of Taxation, 322 U.S. 435 (1944). Only in the narrow case of use taxes has the Supreme Court upheld a bright-line physical presence nexus standard. Even for use taxes, the Supreme Court specifically rejected the standard that H.R. 2526 seeks to impose.

    H.R. 2526 imposes an amorphous nexus standard that does not define what it is—only what it is not. A substantial physical presence will not create a uniform national standard. What is substantial is subjective geographically—10 sales solicitors may be considered substantial presence in a smaller state such as Massachusetts or Wisconsin but not in larger states such as Texas or California. What is substantial changes depending upon the industry you are measuring—10 sales solicitors is very substantial presence to cover the auto industry in Michigan but not for the fishing industry in Michigan. The uncertainty inherent in the proposed nexus standard will impede business planning, state fiscal forecasting and create chaos in the nexus field that will only be sorted out through years of time-consuming, costly litigation.
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    Third Flaw—Fiscal Imprudence. Based on a survey of state revenue estimators conducted by the Multistate Tax Commission, H.R. 2526 will reduce state revenues by $9 billion per year. These are revenues that are already counted in state budgets. The genius of our federalist system of government is that our nation relies on state and local governments to provide vital services tailored to fit local needs. This resolution puts the provision of some of these services in jeopardy.

    Fourth Flaw—Contravenes Federalism. Finally, this resolution is flawed because it is contrary to the basic principles of federalism. One of the most important features of state sovereignty is the power to tax. Under this resolution, that fundamental sovereign power would be limited.

    I urge this subcommittee to reject the H.R. 2526's vision of federally mandated state tax shelters. Do not discard years of Supreme Court decisions on nexus principles in favor of a legislated nexus standard that will discriminate against our local merchants and businesses in our states and trigger an explosion of nexus litigation.

    Mr. Chairman and members of the committee, thank you for the opportunity to speak to you today. I welcome the opportunity to answer any questions you or the Committee members might have.

    [Whereupon, at 9:49 a.m., the Subcommittee was adjourned.]

A P P E N D I X
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Statements Submitted for the Hearing Record

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Material Submitted for the Hearing Record

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Rosen4.eps

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SokulA.eps

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