By Hoang D. Nguyen, Ph.D., [email protected]

930 Cobble Shore Dr, Sacramento, CA. 95831 Tel.:(916)393-9127


Electronic commerce has grown exponentially in recent years. This explosive growth has created new opportunities, as well as challenges for governments at all levels. Governments need to develop proper electronic commerce policy in order to reap its benefits. The U.S. government has adopted a hands-off policy toward electronic commerce. Recent governmental efforts to reexamine and modify existing tax laws generally have not aimed at imposing new taxes or at controlling electronic commerce. Rather, they have been aimed at extending current tax laws to treat electronic and traditional physical commerce equally. As a result of this hands-off policy, the U.S. private sector has taken the lead in the growth and development of electronic commerce in recent years, and is expected to continue this leading role in the future. Developing countries can learn a great deal from the U.S. electronic commerce experience. Governments that fail to develop proper legal and regulatory framework for electronic commerce, or seek to censor and control it, would impede its growth, deprive their citizens and businesses of its many benefits, and lag behind in economic development.

"… electronic commerce has placed us in the midst of a profound social upheaval comparable to the shift from an agricultural to an industrial-based economy."

(Blake Harris, Editor-at-Large, Government Technology Magazine, April 1997) 

1. Introduction 

Electronic commerce has grown exponentially in recent years. This explosive growth has created new opportunities as well as challenges for governments at all levels. Electronic commerce has offered opportunities for larger tax base, higher economic efficiency, economic growth, and technological progress, etc. Electronic commerce has also challenged governments at all levels to reevaluate current tax laws and regulations and to formulate new ones. Thus, governments need to meet the challenges of electronic commerce policy in order to reap its benefits. 

This paper discusses the recent growth of electronic commerce in the U.S., and how the U.S. government has responded to the issues created by this growth. The next section defines electronic commerce, and reviews the governments’ role in its growth and development in recent years. Section 3 discusses the electronic commerce issues with focus on state sales and use tax, state income tax, and federal income tax. The final section discusses the policy implications of the U.S. electronic commerce experience on the developing economies, such as Vietnam. 

2. Electronic Commerce: Growth And Opportunities 

Electronic commerce can be defined as "any use of electronic networks and technology for commerce and other economic activity. This includes the use of electronic communication as the medium in which goods and services of economic values are designed, produced, advertised, catalogued and inventoried, purchased and account settled. Geographic location, abundance of capital or the ownership of retail outlets is irrelevant to this type of transaction." This paper focuses on commerce conducted through the World Wide Web (WWW) of the Internet.  

Both Internet and electronic commerce have been growing quickly in recent years. PC-Meter estimated that 4% of the U.S. households used WWW in 1995. This percentage more than doubled to 11%, about 11 million households, in 1996. A recent Newsweek article estimated that about 10 million U.S. and Canada households had access to the WWW in 1995. The number rose to about 15 million households in 1996, an increase of 50 %. This fast growth is expected to continue. By the Year 2000, the article projected that 38 million U.S. and Canada households will have on-line access to the Web (Table 1).  

Table 1 - Projected Number of Households On-line (in Millions)









U.S. and Canada







World total







Source: Peter McGrath, "The Web: Infotopia or Market Place?," Newsweek, Jan.27, 1997

 Currently, only 19 % of web surfing is for shopping purpose. However, shopping or electric commerce is probably the fastest growing segment of the WWW. Forrester Research estimated that the U.S. on-line commerce, excluding Value-added Network (VAN) EDI carriers, doubled from a half billion in 1995 to $1 billion in 1996, and would grow to $7 billion by the year 2000. The bulk of electronic commerce, 75 %, would be in the areas of computer products, travel, and entertainment (Table 2). The U.S. Department of Commerce estimated that the share of electronic commerce in total U.S. commerce would increase from the current 4% to 16% in 2000 and 20% in 2005 (Reuter Information Service, August 13,1995). 

Table 2 - Projected Growth of On-line Commerce in the U.S. (in $ Millions)








Computer products
















































Source: Forrester Research, Inc as reported in Bulkeley (1996). 

Initially, the Internet’s major activity was E-mail for researches, purchase orders, inquiries, and basic communication. As WWW gained popularity, more web sites were created and electronic commerce expanded into advertising and web services (consulting, browser, searches, etc.). In recent years numerous new commercial activities have taken place on the WWW. Notable activities include:

Government services. Many governmental agencies have developed web sites to offer a wide range of services, such as providing information on rules and regulations, data and reports, employment opportunities, disbursement of benefits, purchases of goods and services, contract and procurement, tax forms and instruction, tax filing, and crime report filing, etc.

On-line banking. Many banks and credit unions currently offer on-line banking, which provides services such as real-time account information, expense report, bill payments, fund transfers, financial planning, investment services, and credit card, etc. Banks also has been using VAN to provide electronic fund transfer, data exchange between banks, and ATM machines, etc. 

Retail. This is probably the fastest growing area of electronic commerce. The goods and services offered include computer software and hardware, music, wines, and pornography, etc. The type of on-line store varies from virtual stores that exist only in cyberspace, such as the virtual bookstores of Amazon or Barnes and Noble, to hybrid stores, such as Virtual Emporium, which is a conventional store filled with rows of computers connected to WWW. 

Education. Numerous educational services are now offered through the WWW. Students and teachers can subscribe to supplemental educational programs, use on-line search engines, such as Yahoo, Lycos, and Infoseek, etc., to search for information, research on nearly any topics, participate in electronic forum, consult with experts, visit virtual libraries and museums, search for college scholarships, and finding information on nearly any college and university in the U.S., etc. Several virtual schools also offer on-line education programs.  

Publication. Major newspapers and magazines, such as Wall Street Journal, New York Times, Los Angeles Times, Washington Post, San Francisco Chronicle, The Economist, and thousands of other electronic magazines (E-zines), have been "published" on the WWW. These on-line publications cover a wide range of subjects from news to scientific researches. 

Computer and telecommunication technology continues to advance at a blinding speed. New processor chips, faster modem speed, Digital Subscriber Line (DSL) for faster WWW downloading, cable modem, wireless modem, new electronic cash standards (Cybercash, Digicash, SET, …), and Internet smart cards are a few examples of new technology that would fuel future growth of electronic commerce.  

The U.S. Department of Defense and National Science Foundation funded the initial development of the Internet in the 1970’s and early 1980’s. Since then the U.S. government’s role in the growth and development of the Internet and electronic commerce in recent years has been minimal. This minimal role is the result of a hands-off policy which has been well articulated in many government documents. A 1994 study entitled "Electronic Enterprises: Looking to the Future" published by the Office of Technology Assessment (OTA) recommended that: 

"In the context of National Information Infrastructure, the private sector clearly has the primary role for developing, deploying, and operating the NII. For the most part, industry will develop the technology, provide bandwidth, offer connectivity, and ensure the availability of services and products in the pursuit of profit." 

A more recent report, "A Framework for Global Electronic Commerce," published in 1996 by a task force of 14 U.S. agencies and commissions, reiterated this hands-off policy: 

"For electronic commerce to flourish, the private sector must continue to lead. Innovation, expansion of services and participants, and lower prices will depend upon the Internet remaining a market-driven arena, not one that operates as a regulated industry." 

Another 1996 report, "Selected Tax Policy Implications of Global Electronic Commerce," published by the Department of Treasury, suggested no "new or additional taxes on electronic transactions and instead simply requires that the tax system treat similar income equally, regardless of whether it is earned through electronic means or through existing channels of commerce." 

The Clinton administration recently reaffirmed this hands-off policy by supporting the Wyden-Cox Internet Tax Freedom Act, which seeks to prevent state and local governments from imposing new taxes on the Internet.  

3. The Taxation Of Electronic Commerce

The problem of applying existing laws and regulation to electronic commerce can be illustrated by a review of state and federal tax laws which were generally adopted in the early part of this century to deal with traditional commerce. Current state and federal tax laws dealing with conventional interstate and international commerce already formed a complicated, overlapping and sometimes contradicting web. This web has grown even more complicated and intimidating under electronic commerce. In a recent survey conducted by KPMG Peat Marwick on 251 large U.S. corporations, 70% of the corporations financial executives said that state and local tax laws are ambiguous, and 50% said that this ambiguity is already inhibiting their involvement in electronic commerce (Trommer, 1996). This taxing headache can be illustrated by the following software sale example. Under traditional commerce, the buyer pays a sale tax upon purchase of a software package. The retailer is required to collect and reimburse the state the sales tax. The situation becomes tangled when the same buyer purchases the software by downloading it from the Internet. First, there is the issue of income classification. The downloaded software is no longer a finished tangible good. The software downloading transaction can be classified either as a transmission service, a software royalty payment, an Internet connection service, or a software storage and retrieval service. Proper income classification is important, since service income, royalty, and sale income are all taxed differently under current tax laws. Some states, such as California, do not impose sales tax on services and downloaded software. Another important tax issue is recordkeeping in the paperless world of electronic commerce. Recordkeeping regulations concerning the type of data, recordkeeping medium, and the retention period for business transactions taking place in cyberspace are not yet adopted. Similarly, audit procedures for electronic commerce are not yet developed. Current tax audit procedures and auditors are geared more toward conventional physical commerce.

Income classification, recordkeeping, and audit are common issues that government needs to deal with under electronic commerce. Many states are beginning to draft revised regulations to address these issues. The rest of this section discusses some other issues associated with interstate and international electronic commerce for three major taxes – state sales and use tax, state corporate income tax, and federal corporate income tax. 

3.1. State Sales and Use Tax Issues 

State sales and use tax was generally adopted in the 1930’s to deal with traditional commerce involving tangible goods. Such tax was based mostly on the destination principle (i.e., the state where the goods are sold has taxing jurisdiction). Complication arises when sellers are located outside the state. In such cases, the legal validity of the state sales and use tax may be challenged on the grounds of the Due Process Clause of the 14th Amendment and/or the Commerce Clause. Central to these legal challenges is the concept of nexus. "One necessary condition to the application of a state sales tax or a state use tax or the imposition of a use tax collection duty, is the satisfaction of the U.S. constitutional requirement of nexus. Nexus means there is sufficient connection with the state to apply its sales or use tax or to impose a use tax collection duty" (Multistate Tax Commission, 1997). Several court cases illustrate the legal evolution of the nexus requirement in state sales and use tax.

National Bella Hess, Inc. v. Dept. of Revenue of Illinois (1967) 386 U.S. 753. Bella Hess had no offices or employees in Illinois. The Supreme Court ruled that Illinois’ imposition of sale tax collection duty on Bella Hess was unconstitutional, since Bella Hess had no physical presence or nexus in Illinois. This decision set physical presence as a standard nexus requirement. 

Complete Auto Transit Inc. v. Brady (1977) 430 U.S. 274. The Supreme Court decision in this case reaffirmed the Bella Hess physical presence requirement of nexus. The court also expanded the state tax validity test to include four parts: (1) substantial nexus within a state, (2) taxable amount is fairly apportioned, (3) does not discriminate against interstate commerce, and (4) fairly related to the services provided by the state. This four-part test was often used in later cases to determine the validity of state sales and use taxes.  

National Geographic Society v. California Board of Equalization (1977) 430 U.S. 551. National Geographic Society had no offices or employees in California except two offices for solicitation of advertisement only. The U.S. Supreme Court affirmed the California Supreme Court’s decision that the ‘slightest presence’ of National Geographic Society in California established sufficient nexus.  

Quill Corp. v North Dakota (1992) 504 U.S. 298. Quill, a mail order company, had no locations or employees in North Dakota. All property sold to North Dakotans was delivered by mail or common carrier. The Supreme Court ruled in favor of Quill. The Quill case reaffirmed the physical presence and substantial nexus requirement of Bella Hess. Specifically, the Court ruled that to establish nexus, the retailer must meet both the minimum presence test of Due Process Clause as well as the substantial presence test of Commerce Clause. More importantly, the Court decision made it clear that it is Congress, not state governments, who has the power to determine whether, when, and to what extent the States may impose tax collection duty on interstate mail-order companies. Quill’s decision weakens the states’ power to impose sales and use tax on traditional interstate commerce and even more on interstate electronic commerce. 

The above legal decisions dealt with traditional commerce of tangible goods. The implication of these decisions on electronic commerce, which often involves service and intangibles, is uncertain. A number of states has challenged the extension of Quill’s decision to electronic commerce. For example, New Jersey proposed that the nexus of a foreign software corporation is sufficiently established if its software is licensed in the state. Wisconsin recently ruled that the licensing of intangible rights for use in Wisconsin is sufficient to establish nexus (Graham, 1996). Many other states and organizations are actively drafting guidelines for application of state sales and use tax to computer software in particular and electronic commerce in general.

3.2 State Corporate Income Tax Issues 

Interstate electronic commerce has created two major issues for state corporate income taxes – taxing jurisdiction (nexus), and apportionment of income. The nexus issue in state income tax is similar to that of sales and use tax. However, since the above legal cases dealt with sales and use tax only, it is uncertain if their decisions can be extended to income tax cases. This uncertainty leaves the states in a quandary. Should the state take an aggressive stand with regard to the income tax nexus issue? Or should the state simply extend the Quill decision to state income tax laws by requiring both minimum presence and substantial nexus presence? Or should the state adopt a wait-and-see attitude until the nexus issues for state income tax are clarified later?  

State income tax laws are complicated further by P.L. 86-272, which prevents the state from imposing an income or franchise tax on sellers of tangible personal property, even if the sellers establish constitutional nexus, if their only activity in the state is solicitation. It is uncertain if P.L. 86-232 can be extended to intangible goods and services cases.  

Electronic commerce has also complicated the income apportionment problem. Most states tax corporations only on the income derived from sources within the states. When income is derived from more than one state, it is divided among the states based on income apportionment formula. For instance, California apportions business income using a formula that takes into account the ratios (factors) of California property, payroll, and sales values over corresponding worldwide values. The sales factor is double-weighted. Under electronic commerce, the buyers, sellers, ISP, web servers, and telephone companies, etc., might be in different states. Determining the proper sales and property location is nearly impossible. In addition, most states determine the property, payroll, and sales factors based on rules contained in the antiquated Uniform Division of Income for Tax Purpose Act (UDITPA). Many provisions of UDITPA become obsolete and inappropriate under electronic commerce. For instance, under UDITPA’s rules, sales of personal tangible property are assigned to the state of destination, while sales of intangible property are assigned to the state with the highest cost of performance. For a California corporation with intangible sales, the cost of performance which, in this case, consists of mostly payroll and property, would be highest for California. Thus, the seller would have all of its worldwide sales assigned to California. The sales factor becomes irrelevant in this case. Recognizing the limitation of UDITPA in dealing with new communication technology and electronic commerce, California has been reexamining its tax laws. In 1996, the Franchise Tax Board, in consultation with the industry, has developed ad hoc practices for the telephone industry. Under these new practices, call originating and terminating in California is assigned to California. Interstate and international call is assigned to California, based on the ratio of California "net plant facilities" over the taxpayer’s total "net plant facilities" used in the call (Brownell, 1997). The Franchise Tax Board is currently working with industry representatives to draft new regulations to deal with telecommunication and information services. Similar works to modify UDITPA are also being initiated by other state tax agencies.

3.3 Federal Corporate Income Tax Issues 

One of the key federal tax issues under global electronic commerce is taxing jurisdiction. The U.S. taxes its citizens and corporations on the basis of residence of the taxpayer. Thus, worldwide income of U.S. citizens and corporations is subject to federal income tax. Foreign income tax credits are allowed to avoid double taxation. Foreign persons and corporations who do business and have "permanent establishment" in the U.S., on the other hand, are taxed on source-based income, i.e., the country where the economic activities creating the income take place has taxing jurisdiction. Under current law, the "permanent establishment" condition generally requires the physical presence of a fixed place of business in the U.S. through which business is conducted. However, national borders, locations of business and customers, and property are irrelevant in the cyberspace of electronic commerce,. Sellers, buyers, ISP’s, and servers can be anywhere in the world. Thus, both the source-based income, and the "permanent establishment" concept are obsolete. Furthermore, the source-based income concept might discriminate against U.S. businesses as foreign persons and corporations located outside of the U.S. can conduct electronic commerce with their U.S. customers without paying any U.S. tax. The taxing jurisdiction issue becomes even more complicated when foreign persons or corporations maintain, lease, or contract with a web server in the U.S. Does the presence of such a server establish sufficient physical presence for taxation purpose? Current tax laws do not have a definite answer yet.  

The U.S. government had conducted a number of studies in recent years to address some of the above electronic commerce issues, including the impact of electronic payment on the current U.S. tax administration and compliance (Treasury, 1996), regulations on the classification of income from transactions involving computer programs (Treasury, 1996), key federal income tax issues created by electronic commerce (Treasury, 1996), and global electronic commerce issues (Interagency Working Group, 1996).  

The federal income tax issues study advocated for a tax system guided by the principle of neutrality between conventional physical and electronic commerce. It identified certain situation when the current tax laws are obsolete, such as the concept of source-based taxation, and noted the increasing importance of the residence-based taxation concept. 

The global electronic commerce report suggested a set of principles and policies for international discussions to facilitate future growth of worldwide electronic commerce. Five guiding principles were suggested: 

    1. The private sector should continue to lead the growth and development of the Internet;
    2. Governments should avoid undue restrictions on electronic commerce;
    3. Where governmental involvement is needed, its aim should be to support and enforce a consistent and simple legal system for electronic commerce;
    4. Governments should recognize the unique qualities of the Internet; and
    5. Electronic commerce should be supported on an international basis. 

The report also recommended three electronic commerce taxing principles – It should neither distort nor hinder commerce, it should be simple and transparent, and it should be able to accommodate the U.S. and its partners’ tax systems. Specific tax policies recommended included keeping cyberspace a duty free zone, imposing no new taxes on electronic commerce, letting electronic payment system evolve without premature government involvement, and allowing competition and consumer choice to shape future electronic commerce. 

In summary, current state sales and use tax, state corporate income tax, and federal income tax laws are generally antiquated and inadequate to deal with electronic commerce. Governmental agencies are currently reexamining and modifying existing tax laws to address these problems. However, it would take probably another decade before the Supreme Court, Congress, and governments at all levels can resolve most of the electronic commerce tax issues.  

4. Summary And Policy Implication For Developing Countries 

This paper examines the recent growth of electronic commerce in the U.S., and some of the U.S. government efforts to respond to its challenges and opportunities, especially the tax policy area. Several observations can be drawn from this examination. 

First, electronic commerce has grown exponentially in the U.S.. This strong growth shows that electronic commerce is more than a computer fad. Electronic commerce is becoming an important part of the global commerce in the 21st Century. It holds the promises of being the next economic revolution similar to the last industrial revolution. Any countries that choose to ignore this reality run the risk of being left behind. 

Second, many provisions of existing U.S. tax laws and regulations are obsolete and inadequate under electronic commerce. Governments at all levels in the U.S. have been reexamining and modifying existing tax laws, regulation, recordkeeping requirements, and audit procedures. However, it would be a long time before the major tax issues of electronic commerce are resolved.  

Third, the growth of electronic commerce in the U.S. has been facilitated by high-income level, advanced national information infrastructure (NII), strong high-technology industry and, more importantly, the government’s hands-off policy. Market competition has been the driving force behind the recent explosive growth of electronic commerce in the U.S. Many developing countries, however, have sought to control and censor the Internet. For instance, until recently, Vietnam prohibited all connection to the global Internet. New Internet policy adopted in March, 1997 still imposes severe restriction. Legislative, judicial, research organizations, and other state agencies are not allowed to connect with the Internet. Foreign diplomatic staff, international organizations, and foreign news agencies are required to seek approval to distribute information via the Internet. Considering the relative poor NII of Vietnam (Annerstedt and Sturgeon, 1994), and the recent success of the U.S. private sector in leading the growth and development of electronic commerce, this policy of Internet control and censorship should be reevaluated. 

Finally, developing countries can learn a great deal from the U.S. electronic commerce experience. Governments that fail to develop proper legal and regulatory frameworks for electronic commerce, or seek to censor and control it, would impede its growth, deprive their citizens and businesses of its benefits, retard the development of NII, and lag behind in economic development.


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