By Declan McCullagh and Anne Broache
Staff Writers, CNET News.com
April 13, 2006 4:00 AM PDT

Internet shoppers accustomed to tax-free purchases from Apple Computer's iTunes Music Store soon may be in for an unpleasant surprise.

State legislatures and tax officials, eager to find new ways to boost government spending and curb budget shortfalls, are eyeing the burgeoning market for digital downloads as a potentially lucrative source of revenue.

A CNET News.com analysis shows that 15 states and the District of Columbia now tax downloads of music, movies and electronic books. Some high-tax states such as California do not levy the same charge on iTunes downloads, but that could soon change.

"More states are beginning to tax downloaded products," said Steve Krantz of the Council on State Taxation, which represents companies that do business in many states. "Some are doing it through specific legislation. Others are doing it through the interpretation of previous law."

This means that more Americans will be obligated to pay more every April 15 because of a concept known as the use tax. If your home state taxes digital downloads, those levies are generally collected either when purchases are made or on tax day, depending on the location of the Internet retailer.

One reason that music and movie downloads have largely escaped the notice of tax collectors is that, until recently, the market was relatively small. But the dizzying success of iTunes and such rivals as Yahoo Music Unlimited and eMusic.com has exposed a rich vein of untapped revenue. Hollywood studios raised the stakes even higher this month by announcing plans to sell movies over the Internet that buyers can keep.

Digital sales of music tripled from 2004 to 2005, leaping from $400 million to $1.1 billion worldwide, according to the International Federation of the Phonographic Industry, a trade association known as IFPI. The U.S. recording industry estimates that domestic sales totaled $503 million last year, but that figure doesn't include movies, e-books, online video games and other forms of digital media.

That remarkable growth has prompted states like Kentucky to revisit their laws and impose new taxes on media downloads. "Music is included because music downloads fit the definition of personal property," said Jill Midkiff, a spokeswoman for the Kentucky Department of Revenue.

Similar proposals are on the horizon, with Internet companies tracking tax expansion efforts in New Jersey, Vermont and Rhode Island. New Jersey Gov. Jon Corzine, a Democrat, proposed in his budget (click here for PDF) that "downloaded music and videos" be taxed starting Oct. 1. The state tax agency expects legislation to be introduced in June.

Of the 15 most populous states that, together, represent more than half of the U.S. population, three--Texas, Indiana and Washington state--tax media downloads, according to a News.com survey. In addition to the nation's capital, the lesser-populated states that impose such taxes are Alabama, Arizona, Colorado, Hawaii, Idaho, Kentucky, Louisiana, Maine, New Mexico, South Dakota, Utah and West Virginia, according to an industry lawyer.

These states typically say taxing digital-media downloads is a matter of treating physical shopping and online purchases the same. Buying a CD at Tower Records is taxed, the argument goes, so why should a stream of bits from iTunes or Walmart.com be tax-free?

Taxpayer advocates don't accept that premise, saying it represents an unfair addition of tax laws. "It's antiproductive and anticonsumer, and hurts the business," said Llewellyn Rockwell Jr., founder and president of the Ludwig von Mises Institute, a free-market think tank in Auburn, Ala. "This would be a huge blow against iTunes and the studios that are finally realizing they have to sell their movies online."

Music defined as software

Tax collectors in some states where the law does not explicitly permit taxes for downloaded media have invented ways to expand the tax base, anyway.
"Should administrators (interpret tax laws) in the dark? If changes are made in the legislature, we can duke it out as a tax increase."
--Steve DelBianco, executive director
NetChoice

In Kentucky and Washington, state law does allow the taxation of computer software. Washington law defines software as "a set of coded instructions designed to cause a computer...to perform a task," which tax officials have interpreted to include music, movies and e-books.

"We use that same rationale on other types of files, such as music files or video files," said Gary Davis, the state's tax information and education manager. "We view them as similar because they cause some action by a piece of hardware to play them."

Davis recited aloud the definition of computer software from Washington's tax law and said he believed that data files, like an executable program, cause a computer to "perform a task." He said, "I think it's our policy that that's exactly what a music file does in order to hear it."

That definitional elasticity has alarmed online retailers, which say states are interpreting tax laws in ways never envisioned by elected officials or the general public. They would rather see the issue decided openly in state legislatures than behind closed doors by tax agencies.

"Should administrators do it in the dark? If changes are made in the legislature, we can duke it out as a tax increase," said Steve DelBianco, executive director of the NetChoice coalition, which counts eBay, Oracle, Orbitz, VeriSign and Yahoo as members. "The legislatures have to do it in the daylight."

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That, my friend, is some straight up, baby back bullshit.

But what else would you expect from this glorious government of ours?

Ok, this makes me happy i don't live in these states, at least Denmark hasn't got this crazy yet(but with our VAT it almost doesn't matter). How can any product which is free to distribute ever be taxable?