It is not unusual for taxing authorities to apply “creative” interpretations of a business’s tax operations to maximize their tax obligations. What is a little more unusual is for two or more states’ “creative interpretations” to be directly contradictory. Unfortunately, in states’ scramble to get a slice of tax revenue from Netflix, that is exactly what is happening.
The Interstate Income Act of 1959, more commonly known as P.L. 86-272, has long been a thorn in the side of states seeking to apply their corporate income tax to out-of-state businesses. P.L. 86-272 prohibits states from assessing corporate income tax obligations on businesses whose sole activity in that state is the sale of tangible goods to that state’s residents.
I’ve written before about some of the more imaginative schemes that states have come up with to get around this pesky prohibition and tax more traditional businesses, but states don’t have to think as hard when it comes to more modern businesses. Despite the fact that P.L. 86-272 was written when there was no such thing as “digital goods” such as software or entertainment streaming services, these digital goods do not appear to be covered by the phrase “tangible goods.” Consequently, many states have simply defined Netflix’s products as “intangible goods” and therefore not protected by P.L. 86-272.
Colorado, on the other hand, often has its tax ambitions thwarted by its unique Taxpayer Bill of Rights (TABOR), which requires any tax increase to be approved in a referendum by voters. Knowing how little taxpayers like paying taxes, the state often twists itself into knots trying to avoid having to rely on voter approval for plans to raise taxes.
In the case of Netflix, Colorado’s sales tax, which is based on a 1935 law allowing the state to tax “tangible personal property,” works against the state. In 2021, Colorado passed a law adding digital goods to its sales tax. Netflix responded with a lawsuit arguing this constituted a new tax that should have been approved by voters under TABOR.
In oral arguments in this case, Colorado’s lawyers have defended the state’s actions by arguing that Netflix’s products are tangible, as they provide content that is “perceptible” to the senses. Since the 2021 law merely clarified Netflix’s “tangibility,” the Colorado Department of Revenue argues that it had no need to get voter approval.
That leaves Netflix seemingly defying the laws of physics by having its product simultaneously defined as both tangible and intangible by different taxing authorities. While it is profoundly silly, it is also a stark reminder of the fact that taxing authorities can and will perform incredible feats of legal and mental gymnastics in order to ensure maximum tax revenue. After all, when was the last time a taxpayer found themselves caught between two states giving different reasons why the taxpayer didn’t owe taxes?
It’s also not the first time that Netflix has found itself subjected to bizarre arguments why it should owe another government taxes. The Illinois city of East St. Louis recently tried to argue that Netflix was “trespassing” on city property by delivering streaming products to city residents, a claim so absurd it is surprising that the city bothered trying to take the case to court.
Rather than trying to come up with increasingly ingenious justifications to grab at every bit of tax revenue, no matter how frivolous the basis, states and localities should aspire to create and apply tax rules in a consistent and reasonable manner. That may be a naive suggestion, but different tax authorities’ aggressiveness in trying to get a slice of tax revenue from each others’ residents tends to cancel out, while taxpayers are left with the additional compliance burdens.
On the other hand, courts must recognize this growing trend and end their habit of deferring to tax authorities on all but the most absurd claims. Until those taxing authorities begin acting in good faith, courts should stop assuming that they are.
