The Internet Sales Tax Time Bomb

Sales tax may initially seem only tangentially related to PPC (define) search marketing, but it relates to Internet taxation’s continued evolution and the definition of what constitutes a “substantial nexus” within New York State — or any other state, for that matter.

I’m not convinced the Internet will remain a retail channel where millions of people across the U.S. (and internationally) can purchase goods without paying sales tax (or VAT (define), if speaking internationally). The Internet’s growth may have actually killed the golden goose for catalog merchants as well as those who have long relied on the cost advantages afforded them as a result of not having a New York State office.

If New York were to look more carefully at the types of media deals that Google, Yahoo, and Microsoft accept, it might determine that, like affiliate marketers, these major search publishers are being paid some media dollars on a performance basis. While some interpretations of the New York law hold that only commissions as a percentage of sales are sufficient to trigger the law, it remains to be seen if CPA (define) deals are also targeted by the state. If this is the case, the argument could be made that a merchant doing business with the search engines or with any other publisher with an office in New York (and that would include all the majors, including AOL, Hearst, Fox, “The New York Times,” etc.) would be deemed to have a nexus in New York and be required to collect appropriate sales tax.

Regardless of where you purchase a taxable item, technically you’re supposed to pay the appropriate sales tax for the jurisdiction where you receive the product, even if the merchant doesn’t collect it on a state’s behalf. Clearly, this occurs very rarely, and for Internet merchants — particularly those without a significant retail store presence — this has provided them with a very significant pricing advantage. Amazon is a great example, when compared to Barnes and Noble.

The search marketing community has largely ignored the recent news and activity that has significantly altered the affiliate marketing landscape for both merchants and affiliates located in New York State. The response of many Internet pure-play or smaller merchants with affiliate marketing programs has been to temporarily remove any New York State-based affiliate publisher from their network, effectively removing the New York State nexus. However, if these same merchants buy any of the following media, which results in ads being displayed and paid for on a CPA or revenue-share basis, they could equally fall under New York State’s interpretation of a nexus:

• Text-based advertising in which the text ads appear on any publisher based in, or with an office in, New York State
• Direct or network-delivered banner advertising with any CPA or rev-share element in which any of the banners are displayed on any publisher based in New York State or with a New York State office
• CPA or rev-share e-mail newsletter or e-mail advertising in which the newsletter or list owner has an office in New York State

Google, Yahoo, and Microsoft all have programs (either within their search/keyword-targeted media divisions or within display media) that sell media to merchants based in whole or part on CPA or rev share. Some merchants have interpreted the New York State law as allowing text-link advertising but not other forms, but most merchants interpret any affiliate activity as a potential trigger of the law.

When Overstock.com took a look at the New York State legislation, the company filed suit and terminated 3,400 New York-based affiliates, 200 of which were active. It was an easy call to sacrifice 200 affiliates that, while valuable to the business, were apparently not sufficiently valuable to justify the operational expense of collecting the sales tax, plus the chilling effect it would have on New York State sales (overall, not just through affiliates), along with the fact that it might open up the door for other states to follow suit.

Unlike a few small and midsized affiliates, large merchants will unlikely be able to sever ties with the search engines, large publishers, or ad networks, because severing these ties would have a far greater impact on sales than severing ties with affiliates based in New York. Plus, while some affiliates have already started moving operations to other states, the search engines and major media publishers likely won’t abandon their New York offices (although a few high profile abandonments might send a message to Albany).

All this maneuvering disguises the real issue: whether out-of-state catalogers or online merchants should have a cost advantage over local retailers who employ local state residents and create not only immediate sales tax revenue but also the trickle-down economic impact and subsequent tax revenue from employees and their spending? One way or another, state governments need to collect sufficient taxes to cover the cost of the services they provide. Failure to collect sales tax on out-of-state purchases generally means that the shortfall will have to come from an alternate source, be that cigarette taxes, gas taxes, payroll taxes, tolls, hotel taxes, or some other income source.

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