Sales Tax Dilemma Threatens Amazon

| About:, Inc. (AMZN)

By David Zeiler

If state legislatures across the country get their way, Inc.'s (NASDAQ:AMZN) 16-year holiday from collecting sales tax will come to an end - with unpleasant consequences for the online retailer.

The U.S. Supreme Court in 1992 established that only retailers with a physical presence (called "nexus") in a given state are required to collect a sales tax from their patrons. But with state budgets being squeezed, more and more legislatures are trying to rope in online retailers - especially Amazon, a company that was specifically engineered to profit from the Supreme Court's ruling.

"[Amazon CEO] Jeff Bezos has built a company strategically around avoiding sales tax. But they're going to have to deal with this," retail analyst David Strasser, a managing director at Janney Montgomery Scott, told Forbes.

In states that have sales tax (five have none), adding it to the transaction will increase the cost to Amazon's customers anywhere from 3% to over 10%. Although state sales taxes range from 2.9% (Colorado) to 8.25% (California), local jurisdictions can - and often do - add piggyback taxes.

The average sales tax rate in the U.S. reached a new record of 9.64% in 2010, according to a report released last month from Vertex, Inc.

The missing sales tax (most states require customers to calculate and pay a "use tax" on Internet purchases but almost few, if any, actually do) gives Amazon a significant competitive advantage, particularly in states with the highest sales taxes.

Back in 2006 two economists at Massachusetts Institute of Technology found that the avoidance of sales taxes clearly influenced people shopping for computer memory modules. Their report said that in a hypothetical state with the average 5.7% state sales tax, eliminating the levy would decrease online sales by 30% (pdf).

That explains why Amazon's response to states threatening to change their policies has been so decisive.

The state of Texas, for instance, sent Amazon a bill last fall for $269 million in past-due sales taxes from 2005-2009, reasoning that an Amazon warehouse in the state qualified as nexus. Amazon responded by shutting the warehouse down and dismissing its 110 employees, citing "an unfavorable regulatory climate."

Since then, Amazon has sought pre-emptive sales tax exemptions before building warehouses, even though many politicians and local businesses have protested.

And just last week the company took on California, which is considering legislation that would use the retailer's affiliates to establish nexus - a strategy New York used successfully in 2008. Affiliates are mostly much smaller companies that sell their wares through Amazon Marketplace, but appear in searches on the Website just like products Amazon sells itself.

The retailer promised to terminate its relationship with all 10,000 of its California affiliates if the pending legislation becomes law.

And it isn't bluffing. Amazon has already cut ties with its affiliates in North Carolina, Rhode Island and Colorado to fend off similar legislation.

However, Amazon's aggressive response could backfire. The Amazon Marketplace accounted for 35% of the company's revenue in the fourth quarter of 2010 and 30% of total units sold. And Amazon gets between 5% and 25% of the revenue from each sale, depending on the margin of the product sold.

Just as importantly, the affiliates allow Amazon to offer a far wider range of products than it otherwise could, making it a more attractive first-stop for online shoppers.

Truth be told, Amazon could easily collect state sales taxes if it were forced to. It already collects sales taxes in about half a dozen states where it has irrefutable physical operations (such as call centers and return processing centers).

And it has few allies among other major online retailers. Of the top ten retailers doing business online - a list that includes Wal-Mart Stores Inc. (NYSE:WMT), Staples Inc. (NASDAQ:SPLS), Dell Inc. (NASDAQ:DELL) and Apple Inc. (NASDAQ:AAPL) -- only Amazon does not routinely collect sales taxes.

Still, what's even more troubling is that this is just one issue that could threaten Amazon's already tight profit margins.

Higher oil prices will make the company's free shipping policies more costly.

The big shipping services like United Parcel Service, Inc. (NYSE:UPS) and FedEx Corporation (NYSE:FDX) that Amazon uses to get that merchandise to its customers add fuel surcharges to their bills - charges they revise monthly. And with the price of oil well over $100 a barrel, those surcharges are headed for a steady climb.

Because its generous free shipping policy is popular with customers, the company may have to eat any rate increases. And that problem is being compounded by its expansion into streaming video.

Last week analyst Brian Pitz of UBS AG (NYSE:UBS) downgraded Amazon to neutral after the retailer announced it would add free video streaming to the perks enjoyed by its Amazon Prime members, who pay $79 a year for unlimited free shipping.

"We note margin is already pressured from continued investment in IT and fulfillment centers," Pitz said in a note to clients. "It now looks likely Amazon will need to invest in 1) acquiring content, 2) distribution deals, and 3) technology."

That's bad news for a company that already has slim profit margins.

Amazon's sales for the fourth quarter of 2010 rose 36%, but its profit increased just 8%. And for the current quarter, the company has projected a decline in operating income.

Disclosure: None

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