The tax perk that online retailers have enjoyed over their brick-and-mortar rivals is on its last legs.
Already we've seen Texas join California and Pennsylvania on Amazon.com's (NASDAQ:AMZN) growing list of states where it collects sales taxes. And the online megaretailer has more of the same type of deals in the works with other states.
But U.S. consumers might not have to wait for Amazon's patchwork of state-by-state deals to make its way to them. Federal legislators just introduced a law that would force all Internet retailers to collect sales taxes.
For states, if the law passes it could mean progress toward collecting the estimated $23 billion in annual tax revenue that's lost to online purchases. For Amazon, it would mean higher prices for its customers, and the end of a key competitive advantage. But don't mistake this for a big hit against Amazon. The company has seen this coming, and it stands to gain plenty from the trend.
I fought the law
Amazon, along with other e-tailers, can trace its special tax treatment back to a 1992 decision by the Supreme Court. Back then -- way before Internet retailing took off -- the court ruled that sellers who don't have a physical presence in a state don't need to collect sales taxes there. Instead, most states have required that citizens self-report online purchases that they made at tax time. But few people actually do that.
So in practice, e-tailers have been able to avoid charging their customers sales tax, while their local competitors haven't. And the ruling created an incentive for Internet companies to limit their physical footprint, so that they can keep that tax benefit in as many states as possible.
In 2011, for example, Amazon closed its distribution center in Texas in the middle of an argument over taxes, citing the state's "unfavorable regulatory environment." Texas had been seeking close to $300 million in sales taxes from Amazon.
And the law won
But last spring the company mended fences with Texas officials. It relented on the tax fight, announcing that it would begin collecting sales taxes there starting in July. According to The Wall Street Journal, even without any national law taking effect, Amazon is on pace to collect sales taxes in 12 states by 2016. And those areas represent about 40% of the U.S. population.
California joined the taxing ranks just before last year's holiday season. And all indications were that the result was a measurable drop in Amazon's sales relative to non-tax states. Competitors seemed to benefit, too. Best Buy (NYSE:BBY) told Reuters at the time that it saw a 5% rise in online orders in Amazon's new taxing locations. Best Buy reported flat holiday sales, but enjoyed a solid 10% bounce in online orders.
But this is a lose-win situation for Amazon, and what it wins is just as important. Coming to these tax agreements has freed the company to expand its physical footprint across the county. Just last month the company announced that it will open a group of sparkling new distribution facilities in Texas covering over 3 million square feet of space.
That's key at a time when rivals eBay (NASDAQ:EBAY) and Wal-Mart (NYSE:WMT) are both testing their own same-day delivery services. eBay has a strong working relationship with local retailers that it can parlay into instant gratification with online order delivery. And Wal-Mart has thousands of stores that can double as mini distribution centers. Amazon lacks those advantages, so it needs to build out its fulfillment centers to bring speed and efficiencies to its shipping. It has made real progress there. As company CFO Tom Szkutak explained in a conference call, "we have expanded in our fulfillment network pretty extensively to the point where we are closer to customers."
And the results have already started to show up in Amazon's earnings. The company's net shipping costs tanked over the holiday quarter, down to 4.5% of sales from the 5.4% it booked a year ago.
Foolish bottom line
Quirks in the law can become big competitive advantages for companies that aren't shy to apply them. Netflix, for example, made full use of the copyright provision called "first sale doctrine," which allowed it to purchase DVDs and rent them out without owing anything to the original owners of the content. But these protections don't usually last forever, and the challenge is for companies to adjust to life without them. Amazon looks set to lose its tax tailwind when the law finally changes, but its competitive retail advantage is intact.