Federal Court Halts Iowa Attempt to Tax Internet

October 9, 2008

Iowa-Virginia states

States are geographic entities and can tax to the extent of their geography. However, many businesses today are not confined by geography and transactions occur across multiple jurisdictions. The question then becomes who can properly tax such a transaction?

If I in Washington, D.C. buy something on the Internet from a Minnesota vendor, with the Internet signals relayed via California, Colorado, and Virginia, who gets to tax it? If all of them do, interstate commerce is unconstitutionally discouraged. If none of them do, e-commerce gets off with a free ride. If some of them do, concrete rules with teeth need to be laid down to prevent states from trying to tax too much. Otherwise, states have an incentive to shift tax burdens out-of-state, allowing their residents to consume more government services than they are willing to pay for.

The Iowa Court of Appeals should be lauded for not knuckling under to their revenue officials’ overreaching. The officials had demanded that America Online (AOL) cough up sales taxes for services it provided from 1995 to 1999 (conveniently back when everyone had AOL and such taxes meant something). AOL refused, saying that these transactions were interstate and thus beyond Iowa’s taxing power, and demonstrated that to access AOL one must have gone through their Virginia servers. Iowa responded saying that they were local communications services. The court rejected that argument as contrary to the evidence and ruled for AOL. AOL, LLC v. Iowa Dep’t. of Revenue, No. 8-258/07-1792 (Iowa Ct. App. Oct. 1, 2008).

Say Iowa succeeded. AOL would have to collect Iowa sales tax on these transactions that actually occurred in Virginia. No doubt Virginia also says sales tax is due on the transactions, and maybe all the states in between would ask for a cut. And then there’s income taxes. It wouldn’t end.

Iowa’s courts did a good job understanding the geographic limits of their taxing authority, and this opinion should be a model for future cases.

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