Background: Last year, New York started requiring certain out-of-state online vendors to collect and pay New York sales tax on purchases made by New York residents. This has become known as the “Amazon tax,” because Amazon was one of the high profile sites affected and embroiled in the ensuing controversy.

In order to impose sales tax collection requirements on out-of-state vendors, New York had to get around the 1992 U.S. Supreme Court ruling in Quill v. North Dakota (504 U.S. 298 (1992)), which held that out-of-state retailers cannot be required to collect sales tax on sales to persons in states where the retailer does not have a physical presence, because requiring merchants to adhere to the complexities of the state and local tax codes would place an unreasonable burden on interstate commerce.

The New York law gets around Quill by claiming that a physical presence can be established for an out-of-state online retailer (like Amazon) if sales are derived from affiliate sites located in New York that link to Amazon products from their sites with the objective of receiving commissions on the sales. The New York law only applies to online retailers that collect at least $10,000 in annual revenue from affiliates located in New York (unless there is some other physical presence found). It is important to note that prior to this new law, New York consumers were required to report these out-of-state purchases on their tax returns, but this was a law observed in the breach – nobody really did it. The new law is expected to raise $50 million a year – important money in these times of shrinking tax revenue for local municipalities.

Fallout: There were two predictable backlashes from the Amazon tax –

(1) A lawsuit seeking summary judgment against New York, which was filed by Amazon and Overstock. However, on January 12, 2009, a New York State judge dismissed those lawsuits, potentially throwing the case into the Court of Appeals.

(2) Cancellation of relationships with New York affiliates, which was done by Overstock in an effort demonstrate that the Amazon tax will actually result in a decrease in tax revenue due to loss of income by New York affiliate sites.

Current Developments: In the next week few weeks, legislators are expected to introduce bills drafted by the National Conference of State Legislatures in the House and Senate doing away with the “physical presence” requirement. The result is that states would be able to require out-of-state vendors to collect sales tax from in-state purchases.  If such a bill passes, all online retailers, except for the smallest, would very quickly be required to collect sales taxes in the 23 states that are part of the Streamlined Sales Tax Project. Other states would soon follow suit.

The question is not whether such a bill will pass, but only when it will pass. However, the jury is out as to whether such a bill will pass in 2009. The argument that imposing sales tax would hamper the growth of the Internet no longer holds much water now that the Internet has become a powerful and entrenched economic environment. Amazon actually supports the federal legislation, but is concerned about the difficulty of complying with a myriad of state and local sales tax regimes. eBay, on the other hand, is very against the measure, because such a law would impose a burden on its sellers to collect and pay the taxes (and not on eBay).

Practical suggestions/pointers:

Expect more states to try to emulate New York and not wait around for federal legislation. For instance, a proposal to tax certain online sales in Maryland modeled after the New York law was initiated this year, but remained in committee a few days before the end of the Maryland General Assembly’s regular session. Maryland estimates it could raise $7 million annually from such a tax.

Expect affiliate marketing programs that have served to speed the growth of the Internet and e-commerce to become more restrictive in order to avoid these new laws.

Start planning and budgeting for resources necessary to comply with sales tax collection laws from numerous states – because it’s only a matter of time.