Amazon Mysteriously Postpones Offensive Against California Sales Tax

Insight September 26, 2011

On June 28, 2011, Governor Jerry Brown of California signed an amendment to the California tax code which would impose on large Internet retailers the obligation to collect sales tax (technically “use” tax – but for our purposes, it’s equivalent to sales tax) from California customers. Initially, Amazon took the battle to a new level by attempting to get a referendum on the California ballot to have the sales tax law reversed. In the end, for reasons that remain a bit mysterious, Amazon entered into an agreement with California on September 9, 2011 whereby California would postpone enforcement of the new sales tax law for one year in exchange for Amazon agreeing to drop its bid to bring a referendum to overturn the new law. Internet legal issues can change quickly, but this turnabout seems without precedent.

Background

The U.S. Supreme Court in 1992 (Quill Corp. v. North Dakota) held that states can only impose sales tax where the out of state retailer does business in the state, or has a sufficient “nexus” to the state. This has traditionally been interpreted as requiring the retailer to have a physical retail presence in the state. Therefore, sales tax on purchases from online retailers would usually only be triggered when the purchaser lived in a state where the online retailer had a physical retail presence. Since Amazon has no retail presence in California, California had not previously been able to impose sales tax on purchases of Amazon goods by California residents. Currently, there are five states in which Amazon pays sales tax: Kansas, Kentucky, North Dakota, New York and Washington.

To understand this issue it is important to note that most states including California impose a use tax on purchases by residents from out of state retailers. Such laws require the purchasers to voluntarily pay these taxes to their state. Have you ever met anyone who has voluntarily paid a use tax for an online purchase? Neither have I. See here for a little humor on the subject. The current use tax legislative approach was designed at a time when people would purchase from catalogues or cross state lines to avoid sales tax in their home state. However, such “tax avoidance” did not approach the magnitude of the Internet purchases of today. Once again, law applying to the Internet struggles to catch up with reality. So, in effect, the new California law seeks to require Amazon and similar large online retailers to collect the use taxes that residents are required to pay.

States have been trying to “fix” this problem, and collect much needed tax revenue, by passing laws that redefine in a broad manner when a retailer is considered “doing business in a state” for sales tax purposes. California’s new law allows such presence to be established by (1) a subsidiary in the state where there is at least 80% ownership, or (2) sales referral sources located in the state which refer to the online retailer annually at least $10,000 plus the online retailer has at least $500,000 in annual total sales to in-state residents. Amazon would qualify on the first criteria, because it has engineering and development subsidiaries in California (including for the Kindle product), and would easily qualify under the second criteria, based upon the numerous Amazon affiliates located in California. Amazon, like other similar companies, has tried to avoid qualifying under the first criteria by practicing “entity isolation”, which basically means that the local presence is operated under subsidiaries and not under the parent company directly. However, the California law essentially closes this loop hole.

Amazon’s Response

Amazon did not take long to remove the gloves. Just hours after Governor Jerry Brown signed the legislation, Amazon severed ties with over 10,000 local affiliates. The immediate effect was to send a message that the new tax law would not benefit California, because the tax gain would be more than offset by loss of jobs and revenue to local affiliates. Then Amazon promptly spent over $5 million to obtain the necessary 500,000 signatures to put a referendum on the ballot to revoke the legislation. At the end of the day, Amazon, which is the largest online retailer, in effect sought to rewrite sales tax policy for Internet.

The Rub

To prevail with the referendum, Amazon would need to convince California residents that it is in their best interests not to impose sales tax obligations on Amazon, and that Amazon is not acting in its own selfish interests, at the expense of it largest source of customers – California. This is possibly a difficult argument to make.

Is Amazon fighting for the viability of the Internet, or are its own interests primarily involved? Well, most people would admit that the viability of the Internet, once the argument for no sales tax, is no longer a question. As a matter of fact, the up to 8% price edge that exemption from sales tax provides online retailers is viewed by Amazon as a critical issue when competing against local brick and mortar state retailers. Not surprisingly, Walmart and Target are opposing Amazon’s referendum. The Wall Street Journal reported that Credit Suisse estimated that the amount of business that Amazon would lose to competitors if it were collecting sales taxes would be 1.4% of its $45.5 billion in annual revenue, or $653 million. Not a small issue. Amazon denied this projected result.

So What Happened?

The California legislature was unable to legislatively have the referendum revoked. Amazon made an offer that, in exchange for exemption from the new law until 2014, it would build two facilities in California and create 7,000 jobs. The Governor rejected this offer. So, as a compromise, California agreed to defer enforcement of the law for one year and Amazon agreed to withdraw the referendum.
Why did Amazon seemingly cave in? Allegedly, the rationale for Amazon’s acquiescence was to give Amazon time to get a federal sales tax regime in place for Internet sales, which would pre-empt state sales tax laws on online retailers. Amazon has supported such federal legislation in the past. Presumably, the tax rate would be lower than many state sales tax rates, and the collection process would be greatly simplified. However, such legislation is in all probability years away. Some say Amazon entered into this compromise in order to have time to move its subsidiaries out of California. In the end, an important factor may very well have been that during the campaign for the referendum, Amazon’s image would be heavily attacked by the opposition and heavily damaged, regardless of the ultimate outcome of the referendum. Lastly, it’s important to note that under the compromise with California, Amazon still has the option to challenge the new law on both Constitutional and other grounds. Stay tuned.