Baer Business Law – Greater Philadelphia Area – Intellectual Property Law – Business Law – E Commerce – Contracts – Trademarks – Copyrights

A friend of mine who works in the affiliate marketing space recently told me that what keeps him and his partners up at night is the Internet sales tax (the so-called Amazon Tax) passed by New York in 2008 and presently being considered by revenue-starved legislatures in California, Maryland, Hawaii, Minnesota, Tennessee, Connecticut and other states. This will be the first of several blog posts about this vital emerging issue.

For the uninitiated, affiliate marketing is a widely used online advertising model that involves the placement of links for an online merchant’s website on third-party sites (called “affiliates”). The affiliates are compensated for Internet traffic directed to the online merchant’s site by payment of a bounty or commission based on the number of completed sales or percentage of sales volume on the merchant’s site generated by users referred via the affiliate links. Affiliate marketing has been an excellent way for small businesses and individuals with a web presence to generate an easy stream of revenues by signing up to place links from online merchants on their sites. Affiliate network providers, such as LinkShare and Commission Junction, offer merchants seeking to expand their web sales a large pool of potential affiliates, as well as sales tracking and commission payment tools and a convenient interface for enrolling affiliates in the merchant’s affiliate program, getting them to agree to the terms of service and monitoring the progress of the program. I’ve provided legal support for affiliate marketing programs for years and can attest to their potency.

In 2008 New York amended its tax law to create a “rebuttable presumption” that out-of-state merchants must collect and pay sales tax on all sales of taxable goods and services to New York customers if the merchant has agreements with affiliate websites resident in New York to refer traffic to the merchant’s site and the gross receipts from sales to New York customers referred in this manner total $10,000 or more during the preceding four quarterly sales tax periods. In plain English, the new law exposes online merchants who have no physical presence in New York, but have New York affiliates, to potential sales tax liability on all New York sales (not just sales generated by affiliate sites). It was immediately labeled the Amazon Tax because Amazon.com and Overstock.com, two large online merchants with no employees or physical operations in New York, found themselves squarely in the cross-hairs. Both challenged the law in court on constitutional grounds, but it was upheld by a New York trial judge in January 2009 (more on this below).

The reason all of this worries my friend is illustrated by Overstock’s response to the new law, which was to cancel 3,400 New York affiliate relationships. If other states pass Internet sales tax laws like New York’s (which now appears likely) and Overstock’s example is widely followed by other online merchants, it could mean the end of the affiliate marketing model, which has delivered high value for merchants as well as channeling affiliate commissions to many thousands of websites operated by individuals and small businesses.

However, don’t write off affiliate marketing quite yet. For one thing, a “rebuttable presumption” is one that can be overcome through certain proof. In this case, the New York State Department of Taxation and Finance issued a June 30, 2008 guidance bulletin (viewable here) in which it indicated that if an out-of-state online merchant is able to establish that the only activity of its New York affiliates on behalf of the merchant is placing a link on the affiliates’ websites to the merchant’s website, the presumption will be rebutted, and the merchant need not register for sales tax purposes or collect and pay tax.

According to the bulletin, online merchants can do this by fulfilling two requirements. First, they must include in their affiliate contracts or terms of service a clause which prohibits the affiliates from soliciting sales from New York customers through means other than placing a link on their sites (e.g., distributing flyers, sending out e-mails, making telephone calls, etc); if an affiliate is an organization such as a club or non-profit group, the contract must also require the affiliate to place information on its website alerting its members to the prohibition on solicitation activities. Secondly. the merchant must collect from the affiliates annual certificates in which the affiliates certify that they have complied with the prohibition on solicitation activities during the preceding year. The merchant must retain the certificates for audit purposes and provide them to the Tax Department upon request.

This scheme creates some administrative hurdles, particularly when an online merchant is working with an affiliate network provider which may not wish to divulge the contact information for affiliates in its network (this information is obviously necessary to determine which affiliates are located in New York, but also to communicate with the affiliates in order to obtain compliance certificates). However, it is clearly in the network providers’ interest to work with merchants to facilitate compliance, since otherwise the network providers’ business may vanish. When negotiating a contract with a network provider, merchants should specifically raise this issue.

There is also an important constitutional question here, which may ultimately be escalated all the way to the U.S. Supreme Court. The states do not have unlimited ability to tax Internet sales. As the courts have interpreted the Commerce Clause in Article I of the Constitution, which grants Congress authority to regulate interstate commerce, a merchant must have some substantial “nexus” with a state in order for the state to require it to collect a sales or use tax. Physical operations, employees, property or an independent sales force in the state are generally sufficient to create the nexus needed for the state to tax sales by the merchant to its residents. However, a link on a website operated by a state resident is an extremely minimal nexus and may not pass constitutional muster. At the heart of the controversy is the issue of what exactly an affiliate link represents: mere advertising (as Amazon and Overstock have argued) or the use of independent sales force to solicit in-state sales (which is the view underpinning the presumption in the New York law). The New York trial court which reviewed this issue did not seem to grasp fully its subtlety and basically concluded that a merchant’s failure to utilize the rebuttal mechanism described above (prohibiting solicitation activities in its affiliate contract, etc.) allowed the tax authorities to treat its affiliates as an in-state sales force. Overstock has announced its intention to appeal this ruling, so stay tuned.