In a Jekyll-and-Hyde approach to small-business development, the state of California is on one hand actively courting high-tech startups; on the other, it's doing what it can to run them out of the state, if not into the ground. And if you don't think so, ask Ruth Koolis.
Koolis runs Information Sources, a small, Berkeley-based, information-retrieval business that collects descriptive and evaluative information about software tools and applications, then distributes this database to Dialog, an online information provider. Abstracts of the data are accessible through Knowledge Index, CompuServe, Easylink, and other services via gateways to the Dialog system. In return, Information Sources receives royalties commensurate to how many people access the database.
Clearly, how much Koolis receives in royalties depends on the quality of the information she delivers. The quality of Koolis's information must be high, or else she wouldn't have been able to keep the doors open for the past decade.
All of this means little to the California Board of Equalization--aka the tax board--which sees Information Sources (IS) less as an up-and-coming roadstop on the information highway, and more as a cash cow ready for milking. At least, that's what Koolis discovered when state auditors came knocking at her office door, calculators in hand. By the time the bean counters left, Koolis was facing the prospect of coughing up sales taxes, retroactive to January 1991, on royalty income from California-based Dialog. With the logic we've come to expect from out-of-touch bureaucracies, one auditor told me that if IS had delivered the data to Dialog over the phone lines via modem, no sales tax would be required. But since Koolis handed over computer tapes, sales taxes are applicable--as if the delivery vehicle, not the data, is what has value.
With their myriad of overlapping, redundant, and sometimes contradictory regulations, state sales-tax laws are akin to a briar patch--and a tangled one at that. In wandering through the thicket, you learn that the auditors have a number of shoes available and they're looking for one that fits. For instance, one auditor told me that there's no property transfer when data is exchanged online--it's the physical handing over of the tape that generates the assessment. Another auditor contradicted this, saying that the distinction is really between services performed and the sale of tangible personal property--services aren't taxed, property sales are. In short, the transfer medium really doesn't have much to do with taxability.
To explain the difference between services and property transfer, California tax auditors use the analogy of custom versus off-the-shelf software. If someone writes a custom spreadsheet specifically for you (and only you), you're not obligated to pay sales taxes. If you buy an off-the-shelf spreadsheet package that's also available to other users, sales tax is in order. In other words, said the auditor, if Information Sources had given the data to only one provider, IS would have been providing a service. However, in the tax board's view, since IS data is available over multiple providers via electronic gateways, a sale occurred and IS has to pay up--even though IS turned over one, and only one, customized version of the database to a single client, Dialog.
But wait. Information Services really didn't "sell" anything in the sense that one company (Dialog) paid another (IS) when the data was actually transferred. No problem, says the state, there's a regulation for that, too. The tax board lumps royalty arrangements such as that between IS and Dialog under a regulation covering the "leasing" of tangible property.
One of the more curious aspects of the Information Sources case is that this isn't the first time the state has tried to put the squeeze on data providers. Back in the early '80s, California tried to pump up tax revenues by placing "data" and "programs" in the same category. The logic then was that since both data and programs could be delivered on the same medium (tape), data and programs must ultimately be one and the same. Information providers such as Dialog balked, devising instead a means of shipping data tapes in and out of state, thereby circumventing the confusing tax situation and eliminating jobs in California. The situation was resolved in 1987, when the tax board waived its right to levy state royalty taxes on federally copyrighted material. Now, however, the state has done an about face, deciding that federally copyrighted royalty income has always been taxable. The state is also trying to revive the old chestnut that data is the same thing as a software application.
Of course, this distinction will likely disappear when (not if) California catches up with states which already levy a sales tax on services. If nothing else, the service sector is a growth industry, tax-wise. Services account for 51 percent of the U.S. gross domestic product, while goods are down to 40 percent. Employment figures reflect this. Nearly one million manufacturing jobs disappeared in the 1978--82 timeframe, and more than 60 percent of the jobs created in 1993 were service oriented, primarily in the temporary-help, food-service, and health-care industries. To revenue-starved states, services are an untapped resource, and, as regular as rumblings on the San Andreas fault, California legislators routinely reintroduce the notion of applying sales tax to services.
With all they've said about services, taxes, and royalties, there are several things the auditors aren't saying. They aren't, for instance, telling Koolis what her tax liability is--just that she'd better be ready to pay up. Nor will the auditors say why Information Sources was chosen to be audited in the first place. Finally, the auditors sidestep questions about whether or not this signals a push by the state to cultivate a new electronic-data tax base.
One thing is apparent, however. The state's bullyboy tactics involve picking on the smallest businesses with the fewest resources to resist the challenge. Although California is loaded with deep-pocket, lawyer-laden data collectors and software companies, the auditors have opted to blindside a small company that can't afford a protracted fight. It's probably not the money that the state wants from Information Sources; there isn't that much at stake. What the state apparently hopes to gain is precedence--ammunition for taking aim at the big boys further on down the road.
Join us in welcoming Bruce Schneier to DDJ as a contributing editor. Bruce will be editing and writing the "Algorithm Alley" column, taking over the helm from Tom Swan who's opted for more time sailing, less time writing. If you'd like to work with Bruce in sharing your algorithms with your fellow programmers, contact him here at the magazine or at schneier@chinet.com.
editor-in-chief
Copyright © 1994, Dr. Dobb's Journal