On Wednesday, June 29, 2011, Amazon sent a letter to all of its affiliates warning that if California Governor Jerry Brown signed a law that would force the retail giant to collect sales tax, it would terminate their relationship with the affiliates. The law targeted online sales being shipped to the state as Amazon, Overstock, and other online merchants have affiliates operating within the California borders. Consequently, the politicians who created the law, believe that the affiliates are a “nexus” for the online retailer.

Later that same afternoon, Governor Brown signed the legislation and that evening, Amazon (and Overstock) followed through with their promise and terminated their relationships with the 25,000+ affiliates located in the state of California who earned commissions via sales made through the retailers.

Some Background

In 1992, the Supreme Court (Quill Corp. v. North Dakota) ruled that states couldn’t levy taxes against retailers and their products sold unless that retailer had a physical presence in the state, be it a warehouse, offices, etc. The term for this is a “nexus.” Consequently, businesses such as Amazon, Overstock, and others could sell their products tax free online, collecting the tax only in the states where they had a physical presence. This practice gave them an advantage over traditional brick and mortar locations that had to collect the tax regardless.

Bear in mind, all the states have what’s called a “use tax” which requires residents who make online purchases to pay the tax. Almost no one does this as there’s no real way to enforce the law, especially without cooperation from the online retailers. Consequently, the states are losing billions of dollars in tax revenue to the online retailers and are looking for ways to make them pay their fair share.

States have tried to get around the “nexus” requirement by creating laws that require the companies who use affiliates – entrepreneurs, small businesses, mom and pop shops, etc. – who are not actually owned by Amazon (or other retailers), who sell their products through referral links and get a commission, to collect the taxes on the sales made. The thinking is that the affiliates in the state are a “nexus” for the company, and therefore the company should have to collect the taxes of any products sold via the affiliate or otherwise. In response, Amazon and Overstock terminated their relationships with their affiliates in the states that passed these laws. Those states include Connecticut, Arkansas, Illinois, and now California.

Repercussions

With California passing the law and Amazon giving the ax to its affiliates, there will be dramatic changes to the state’s finances to be sure. Because Amazon dropped its affiliates, and has no warehouses, offices, etc. in the California, it has no physical presence in California and therefore will still refuse to collect the sales tax on sales made on products delivered within the nation’s most populous state.

Erica Douglass, famed entrepreneur and business woman, tweeted she’s leaving California:

California will also lose money due in large part to the income taxes it used to collect on the affiliates. Yes, Amazon sent 1099s to its affiliates if they made more than $600 in commissions for the year. Amazon reported the earnings to the state and to the federal government and taxes had to be paid. Now that Amazon has terminated its affiliation with the 25,000 or affiliates, that income tax money also goes the way of the Dodo.

Douglass continued:

The fact that California is the most unfriendly business state in the nation, rife with high taxes and overbearing regulations, companies and their employees leaving in droves, the tax revenues as a whole are going to continue to decrease. Not to mention the lost business that these consumers and businesses will be taking with them to their new locations.

One More Thing

California included an additional passage in the bill that says any retailer through a subsidiary that has a place of business in California, must collect sales taxes. This is aimed at A9, a company Amazon uses for search technology and Lab126 out of Cupertino which designed the Kindle. The audacity of the California government to think that Amazon should be required to collect sales taxes based on these business relationships is ludicrous. It’s apparent that the legislation authors were thinking of every conceivable way to force Amazon to pay the taxes.

There’s no doubt this law will be challenged, especially since last year Californians passed Prop 26, which requires fees, taxes, tariffs, etc. be passed by a 2/3 majority of the state legislature. This bill was passed and signed into law with a simple majority. While not a tax increase per se, it does affect tax revenues. Also, as Amazon stated in their message to affiliates, they believe the law to be unconstitutional, most likely on the basis of the 1992 Supreme Court ruling mentioned above. It will be interesting to see if they mount some sort of legal challenge. Unfortunately, it could take years for the challenges to work their way through the courts.

Final Thoughts

Unfortunately, no one wins in this outcome. The small businesses which foster economic growth lose because they can no longer peddle products sold through Amazon; The state loses because they still won’t get the sales tax owed to them and will wind up losing more revenue due to lost income taxes and revenues that would have been spent in state by consumers and businesses who will no doubt leave to friendlier and more accommodating locales. Also, there will be litigation of some sort that will cost the state millions in tax payer funds – either defending itself and the law or trying to retrieve the taxes from the online retailers.

With a sputtering economy, this isn’t the time for California to grasp at straws and enact legislation that will hurt the economy and the budget more than it helps it. Unfortunately, the politicians running (or ruining) the once golden state, can’t seem to help themselves and continually fail to look at the bigger picture at what their actions are doing to the state.