This visit we talked about Colorado, object of the paeans of the late John Denver and also the latest battleground over the Internet sales tax or affiliate tax (also known as the “Amazon tax” because of the online retailer’s starring role in the drama). As everyone knows, the states are parched for revenue in the Great Recession, and the idea of solving fiscal problems by reducing spending is anathema. Moreover, in-state brick-and-mortar retailers have been smarting for years over the competitive advantage enjoyed by many online businesses like Amazon that do not charge sales tax. However, as the Supreme Court has held, states can’t simply require out-of-state retailers with no physical presence (or “nexus”) in the state to charge sales tax on purchases by state residents, since this violates the constitutional prohibition on burdening interstate commerce.

What a few states have done, following New York’s lead in 2008, is pass laws taking the position that the use of in-state affiliates — websites featuring links to refer Internet traffic to the out-of-state retailer’s site — amounts to having an independent sales force in the taxing state and provides the nexus needed for the state to constitutionally exercise its taxing power over interstate commerce. (Indeed, the New York statute used affiliate nexus to require the collection of tax on ALL online sales to New York residents, not just on those sales referred by in-state affiliates.) Online businesses, affiliates and their lobbyists in the Performance Marketing Association (PMA) countered that affiliate marketing should not be likened to engaging a force of door-to-door salesmen, but is actually nothing more than the rental of advertising space.

Great album, but if you order it online in Colorado you may get a tax notice.

Amazon, to shield itself from sales tax nexus, has been terminating its affiliate relationships in the taxing states. While some affiliates are large, sophisticated businesses (sometimes with their own networks of sub-affiliate publishers), many are home businesses operated by bloggers and small website owners who have managed to monetize their site traffic to the tune of a few hundred dollars per month or more. Amazon’s understandable but still draconian response to the affiliate tax laws threatens an important source of income for these creative and enterprising individuals in difficult times.

Aggressive lobbying by the PMA and others has stalled or killed affiliate tax initiatives in other states, with California’s Governor Schwarzenegger vetoing the legislature’s bill last year. As of the date of this post, Rhode Island has reported collecting no revenue from its affiliate tax. With tax-and-spend fatigue growing on both the national and state levels, there is increasing recognition that the affiliate tax is punishing in-state web entrepreneurs while hardly filling state coffers.

Which brings me to Colorado. Colorado represents a twist on the affiliate tax paradigm. The PMA successfully lobbied to remove explicit affiliate provisions from the bill. As approved by the Governor and effective as of March 1, House Bill 10-1193 says nothing about affiliates or collecting taxes on sales referred by affiliates.

What it does is impose stringent tax notice and reporting obligations on retailers doing business in Colorado (a category which is broadly defined to include anyone “soliciting [transactions in tangible property], either by direct representatives, indirect representatives, manufacturers’ agents, or by distribution of catalogues or other advertising, or by use of any communication media, … or by any other means whatsoever”) that do not collect Colorado sales tax. These retailers are required to (1) notify annually by first-class mail all Colorado purchasers that sales or use tax is due for which they are required to file a return with the state, and provide these purchasers with detailed information itemizing taxable and exempt purchases, purchase dates, amount of each purchase, etc., and (2) file an annual statement for each purchaser with the Colorado Department of Revenue showing the total amount paid for Colorado purchases during the preceding calendar year. Failure to provide the required notices and reporting can subject an online retailer to penalties of up to $10 per violation (which could get expensive if a retailer has hundreds of thousands of customers in Colorado).

In response to passage of House Bill 1193, Amazon promptly terminated all of its Colorado affiliates. The reason was not immediately clear, since the bill’s requirements are not targeted to affiliate marketing and on its face applies to Amazon’s direct sales. In addition to punishing Colorado, I suspect Amazon also wanted to preserve its ability to argue that the bill unreasonably burdens interstate commerce and cannot be constitutionally applied to Amazon without an affiliate network to provide a ghost of an in-state footprint. (Recall that the New York Supreme Court didn’t buy the argument that affiliates are advertisers rather than an independent sales force, which is sufficient to create sales tax nexus.)

While Amazon’s actions may strike us as a bit churlish and heavy-handed, the plain fact of the matter is that laws like this are not revenue generators and impose unnecessary costs on businesses — devastating costs, in fact, when you see things from the affiliates’ point of view. While Baer Business Law welcomes the opportunity to assist marketers and publishers in the affiliate space on affiliate tax compliance matters, it is my firm belief that a crazy quiltwork of divergent laws benefits no one but lawyers. Rather, there should be a uniform Internet sales and use tax law, implemented either by act of Congress or by multistate participation in a streamlined sales initiative.

The impetus toward affilliate taxation has slowed somewhat, but as long as state legislatures continue to defer the day when they learn to operate like a business, they must continue to stretch their manicured fingers toward virgin sources of revenue. Of course, a public suffering from tax-and-spend fatigue may send a different message in November.

NOTE: The views expressed in this post are solely those of the author.

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.