DIGITAL GOODS TAX

Anyone who has seen my wardrobe or kitchen cabinets probably knows I’m not the world’s biggest shopper.

But I do buy at least three things regularly: Kindle books, Amazon videos, Netflix.

Are these three things subject to sales tax under newly-proposed Arizona legislation HB 2479 and SB 1392?

Yes (Kindle book), no (Amazon video stream), and maybe (Netflix).

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Backing up a bit.  As you all know, sales tax is imposed on the state and local levels — not the federal level.   That’s why that beautiful $1.00 large diet coke from McDonald’s costs $1.00 in Portland, Oregon, $1.09 in Phoenix, and $1.08 in Mesa (see here for a table of Arizona city and county taxes).  Arizona has traditionally leaned heavily on sales tax — The Tax Foundation ranks Arizona as one of the most burdensome sales tax states — because we prefer to keep our state-based corporate and individual income taxes below average.  Importantly for this email, services (such as legal advice or a spa massage) are not ordinarily subject to sales tax in Arizona.

The internet sent sales tax policies for a spin.  States first had to deal with physical goods purchased online from a company without a physical presence in the purchaser’s state.

But now the confusing topic is how to treat digital goods that aren’t tangible.  Consider a book from Amazon Kindle: since there is no physical book, should it be subject to state sales tax?  Or is this a service provided by Amazon?  As discussed at a recent conference by Arizona Tax Research Association (ATRA) (see slides 46 – 57), Arizona doesn’t currently have a clear answer.  ARS 42-5001(17) defines “tangible personal property,” subject to sales tax, as “personal property which may be seen, weighed, measured, felt or touched or is in any other manner perceptible to the senses.”  Not terribly helpful in today’s world.

The AZ legislature recently formed a state legislative committee to provide clarity on the topic.  That committee, in turn, led to Michelle Ugenti-Rita‘s (R-LD23) introduction of HB 2479 in the AZ House and David Farnsworth‘s (R-LD16) introduction of the identical SB 1392 in the AZ Senate.  The proposed bills build off the “Exclusive Use and Control” test put forward the Arizona Department of Revenue’s Taxpayer Information Ruling LR15-005.

Here’s a simplified version of how the proposed law shakes out:

  1. If the digital good or service downloads to your device such that you have exclusive use and control over it, and you could disconnect from the internet and still have access to it, then the good is subject to Arizona sales tax.  Think of goods like a Kindle book that you download to your reader and could read on the plane without internet, or an iTunes music download purchase, or a copy of a computer game that you download and then can play on your own device.
  2. If the digital good or service remains online, and you stream it or only have access to it while you are logged into their system, then it is not subject to Arizona sales tax.  This would include renting a movie from Amazon that you can stream online, but don’t have exclusive access to on your computer, and it would include services as Westlaw legal research, which you pay a subscription fee for, but for which you have to log on, and can only conduct research online through their portal.
  3. The debate continues for a product like Netflix.  In exchange for a monthly payment to Netflix, you can BOTH stream content, and you can download a movie to your iPad to watch on the airplane without access to the internet.  It accordingly falls in the middle of the proposed definition.

Both bills have had two readings, but they haven’t yet had committee votes.  It’s of course possible that the details change dramatically or don’t pass at all, but this basic framework seems to be popular.

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Who likes the current version? Anyone who wants added clarity on the taxation of digital goods and services in Arizona.

Who doesn’t like the current version?  Any municipal entity that currently imposes a sales tax on items in #2 above.  Those entities will lose tax revenue.

What are other states doing?  There’s little uniformity on this topic.  Some states (like California and Nevada) impose no sales tax on digital goods, even if it’s something like a downloaded Kindle book (category #1 above).  Some states impose sales taxes on all digital goods and services (see this map).  Some states, like Texas, have their own dividing lines between goods and services different from this Arizona proposal.  Some states haven’t made any effort to define or tackle the confusion.

Unintended consequences?  There’s always a good chance of unintended consequences with new legislation — especially when it concerns a new technology.  If the proposed Arizona law were adopted nationally, then I think you’d see a lot of companies push more content to the cloud or out through streaming services.  For example, Kindle might have you buy a book for $10, but instead of downloading the book, you’d just read it through an online access portal or website, almost like you were reading a website or a subscription-required online newspaper.  That would allow Kindle to avoid sales tax.  Another unintended consequence might be that companies like Netflix split their services, such that there is one service for streaming services — not subject to sales tax — and one for downloaded movies — subject to sales tax.   But until there’s a more uniform policy throughout the country, I don’t know how much tinkering we’ll see as a market response.

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