Amazon's Taxing Dilemma

Amazon.com (Nasdaq: AMZN) humiliated North Carolina when the leading online retailer dodged requests to begin collecting sales tax last year, but the state may get the last laugh.

North Carolina is now asking Amazon.com to hand over sales records of all transactions shipped into the state since 2003. The state believes that many of its constituents are not paying the appropriate "use tax" on purchases, and it's probably right.

This is a tricky situation, though. Amazon is turning to the federal courts to block the state's request, the company's argument being that privacy rights are being trampled. On that count, Amazon is probably right, too. Critics of the state's move argue that it violates free speech as well as a federal law governing the confidentiality of video purchases.

Amazon doesn't peddle hardcore pornography, but it's understandable why someone wouldn't want the state to know that they're reading up on coping with alcoholism or unpopular religious beliefs.

The two parties lunged at one another this past summer, and Amazon came out on top. Under old mail-order laws, a retailer doesn't have to collect sales tax if it lacks a physical presence in the state. Amazon automatically tacks on sales tax in its home state of Washington and the handful of states where it houses a distribution center.

North Carolina argued that the Amazon Associates program -- the affiliate marketing plan that allows bloggers, website operators, and fundraising groups to generate royalties by referring visitors to buy merchandise through Amzon.com -- gave it a physical presence in North Carolina.

Amazon's response was swift and brutal. It booted all of the state residents as affiliates, leaving North Carolina to address the move that tripped up home businesses and cut off the incremental revenue streams.

So is this new move simply a case of sour grapes? It is, if it's only targeting Amazon. However, smaller e-tailers, including Overstock.com (Nasdaq: OSTK) and mail-order specialists such as Lillian Vernon, are also likely to be subject.

If North Carolina is successful, Amazon will be taken down a few pegs. Shoppers who don't pay the use tax, whether intentionally or not, will no longer perceive Amazon's pricing advantage the same way. Privacy concerns may force some Amazon shoppers elsewhere.

The outcome won't be fatal, of course. Wal-Mart (NYSE: WMT) and Target (NYSE: TGT) have busy e-tail sites despite automatically tacking on sales tax during the checkout process. The trend to watch will be whether the move helps the untaxed resale market. If shoppers turn to secondhand goods on eBay (Nasdaq: EBAY), then states, retailers, and the original merchandise manufacturers will all feel the pain.

North Carolina may be doing the right thing, since it's rightfully entitled to collect use tax, but it seems to be going about it the wrong way.

Is it too late to change those "first in flight" license plates to "first in paranoia-mongering"?