In general, the U.S. Supreme Court has recognized that the Due Process Clause of the U.S. Constitution limits states from taxing activities (broadly speaking) that lack a sufficient connection with the state. The Court has also recognized that the dormant commerce clause doctrine prohibits states from imposing taxes that would discriminate against or unduly burden interstate commerce. In practical terms, these limitations have recently been raised in the context of:

• Whether a transaction must be conducted in the state in order for the state to impose the sales (but not the use) tax–or whether the presence of the customer in that state is sufficient.
• Whether the use tax may be applied to the total value of items brought into the state on which no sales or use tax has previously been paid.
• Whether sourcing of items to local taxing jurisdictions can vary based on location of the seller’s activities.

The Internet Tax Freedom Act (ITFA) is a federal law codified at 47 U.S.C. § 151 Note.  See HERE (You will have to access the “Notes” tab on this page to see the applicable text). ITFA imposes limits state taxation of “internet access” and also prohibits states from imposing multiple or discriminatory taxes on “electronic commerce.” To the extent digital products may be covered by the Act’s definition of “internet access” or may be sold through “electronic commerce,” as defined, the Act will dtermine whether state taxes imposed on those products are allowed. The white paper will address in more detail the potential effects of ITFA on taxing digital products.   

To the extent they may be relevant, the white paper will draw on work done by state legislatures studying the possible inclusion of digital products in the sales tax base generally. 

– New Jersey Digital Economy Study – 2023

– Report to the Mississippi Legislature on Taxation of Software Products and Services – 2022

A concern often raised is that digital products are changing over time and this raises questions of whether those products fit the tax definitions adopted by states in years past.

Related to the issue of evolving products, practitioners and taxpayers expressed concerns that, especially when it comes to digital products, they are often uncertain of how state revenue agencies will apply existing laws to new or different digital products.

The issue of taxing similar or competing products in the same way came up not only in the context of similar digital products but also where digital products may replace traditional tangible products or services. If digital products that serve a similar purpose to other products are taxed differently, this can affect the market for those products (positively or negatively). 

When it comes to changes in digital products over time, businesses need to respond to their customers and this may mean changing the nature of the product or the manner in which it is provided to the customer. If these changes cause differences in the tax treatment of those products, then this may affect the ability of businesses to be flexible in how the respond to their customers. 

One of the most important topics which came up in discussions with stakeholders was the different ways that states structure their sales and use taxes when addressing digital products and whether the mechanics of their tax system are workable. This goes beyond the question of what to tax to the issue of how to impose the tax and involves the ways in which definitions are structured and whether they address both the nature of the product and the way it is transferred to a customer, the application of common exclusions and exemptions from tax, the sourcing of transactions sold electronically or through subscription or as part of a service, the specific thresholds and rules for handling mixed and bundled transactions, etc.

The topic of tax exemptions generally centers around how common sales tax exemptions might be applied to digital products, including:

• Sale for resale exemptions.
• Other general business-to-business (B2B) exemptions.
• Exemptions that may be based on the nature of the item, the customer, or the use of the item. 
• Typical exemptions related to services, e.g., educational services, medical, etc.

• Treatment of bundled or mixed transactions – where digital products that are or may be taxable are sold in combination with or integrated with other items, including services, which are not taxable
  • Consideration includes ITFA bundling rule
  • Possible solutions
    • SSUTA, Appendix C, Part I – Administrative Definitions provides a lengthy definition of a bundled transaction which also contain substantive rules. Some of these rules apply specifically to traditional services or tangible personal property. The portions of the definition most relevant is excerpted here:

A “bundled transaction” is the retail sale of two or more products, except real property and services to real property, where (1) the products are otherwise distinct and identifiable, and (2) the products are sold for one non-itemized price. A “bundled transaction” does not include the sale of any products in which the “sales price” varies, or is negotiable, based on the selection by the purchaser of the products included in the transaction.

(A) “Distinct and identifiable products” does not include:

. . .

1. 1. 1. 1. 1. 2. A product provided free of charge with the required purchase of another product. A product is “provided free of charge” if the “sales price” of the product purchased does not vary depending on the inclusion of the product “provided free of charge.”
               3. Items included in the member state’s definition of “sales price,” pursuant to Appendix C of the Agreement. [See that definition discussed above.]

(B) The term “one non-itemized price” does not include a price that is separately identified by product on binding sales or other supporting sales-related documentation made available to the customer in paper or electronic form including, but not limited to an invoice, bill of sale, receipt, contract, service agreement, lease agreement, periodic notice of rates and services, rate card, or price list.

(C) A transaction that otherwise meets the definition of a “bundled transaction” as defined above, is not a “bundled transaction” if it is:

. . .

(3) A transaction that includes taxable products and nontaxable products and the “purchase price” or “sales price” of the taxable products is de minimis.

(a) De minimis means the seller’s “purchase price” or “sales price” of the taxable products is ten percent (10%) or less of the total “purchase price” or “sales price” of the bundled products.

(b) Sellers shall use either the “purchase price” or the “sales price” of the products to determine if the taxable products are de minimis. Sellers may not use a combination of the “purchase price” and “sales price” of the products to determine if the taxable products are de minimis.

(c) Sellers shall use the full term of a service contract to determine if the taxable products are de minimis; or

. . .

• Application of special tax treatment of communications, especially when bundled with other digital products – e.g., enterprise software.
• Application of tax to data and information and whether public information can be “sold” or whether the product is the mechanism for transmitting or using that data

The Streamlined Sales and Use Tax governing board has been working on sourcing issues involved in taxing digital products. See the latest information on sourcing those products on the SSUTA website, HERE.

In addition, there have been past federal proposals on the sourcing of digital goods and services, see for exemple – HERE. 

 A number of taxpayers and practitioners commented that they are not simply concerned with the risk of being audited and found not to have properly complied with tax provisions in a state but also with the risk of being sued as part of qui tam or other litigation seeking damages for improperly charging and collecting tax. There have been cases in which the taxpayer was successfully sued and had to refund tax to customers but could not obtain a refund from the state. 

In some cases, a seller may not know enough to easily determine whether a sale or other transaction to a particular customer is subject to a state’s sales tax because the tax ultimately depends on the nature or location of the customer’s use. In these cases, it may be easier for the customer to be allowed to “direct pay” the tax as part of its own filing with the state.

In addition to the issues outlined above, a number of taxpayers and practitioners have expressed concern over certain general administrative issues, including:

• How revenue agencies may interpret and apply existing laws to new products and whether it is proper to effectively “expand the tax base” through this process.
• Whether, in the case of sales of digital products, the state has clear rules for treatment of products sold across marketplaces that may provide different types of services to the seller.
• The extent to which lawmakers and administrators allow sufficien time for taxpayers to implement changes and for agency to issue necessary guidance.

– Comments of the ABA – Issues to Address Regarding the Taxation of Digital Products – Nov. 2, 2021

– Letter from Eversheds Sutherland – Sept. 21, 2022 to the Work Group at its initial meeting.

– Letter from Eversheds Sutherland – Jan. 3, 2023

– Multistate Tax Group Needs Expertise to Form Digital Definitions, by Kelvin M. Lawrence, published by Bloomberg Tax June 13, 2023, and posted with permission

– Comments from Jeff Friedman and Charlie Kearns, Eversheds Sutherland, “The MTC’s Digital Products Work Group Should Adopt Our Three Guiding Principles” Aug. 9, 2023.