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How to Make Yourself Obscenely Wealthy by Destroying the Economy of Your Choice and Still be Home in Time for Dinner: South Korea

Mark D. Diehl

mark-diehl@uiowa.edu

Professor's Explanatory Note: Although there is neither evidence that the author intended the economic collapse of South Korea, nor that this paper provided others with the prescription for what subsequently happened, it is the case that the scenario that follows was conceived and researched by the author in the spring of 1997, long before the events of that fall and winter transpired. -- Nicholas Johnson

Author's Note: The following paper is the result of a unique assignment from Professor Nicholas Johnson’s “Cyberspace Law Seminar" at the University of Iowa College of Law. The participants of the seminar were asked to investigate an Asian country and propose a profitable undertaking for a fictitious corporation interested in telecommunication-related business within the country. The corporation, called Global Telecom, Media and Electronics (GTME), was supposed to be a large multinational enterprise involved in the telecommunications industry. The rest of the assignment was to list foreseeable legal issues which would arise upon implementation of this proposal, and then investigate one of these legal issues in detail. Because the class was not one specifically dealing with international law, the legal analysis was to be done under the laws of the United States. For this reason, the paper begins with a focus on international finance, and ends up concentrating on taxation and interstate commerce under the U.S. Constitution.

The Asian country I researched was South Korea. I noticed that certain economic and fiscal circumstances which had existed there may be vulnerable to exploitation through the use of new technologies. Similar conditions still exist in some other economies of the world, and something like the proposal I develop below could still possibly be carried out in one of those countries.

This paper should not be taken as a threat to those economies, but rather as a warning of how powerful these new technologies can and will be. Although this paper uses credit cards as an example of the technology currently available for the transfer of money, it should not be interpreted as saying that this is the only way this plan could be implemented. Credit cards are used as an example here only because they are the technology with which it can be assumed that the reader will be most familiar. While this technology is relatively easy for target economies to regulate, expected developments in this area, such as “electronic cash” will not be. It is this new type of threat, the detailed functioning of which is beyond the scope of this paper, which is addressed here. Representatives of those countries which may be vulnerable to this kind of attack are encouraged to contact me at the e-mail address above. We can probably work out ways to prevent this.

Assertions about life and conditions in South Korea which are not credited to any other source are based on my own observations, made while I was living and working in the country for nearly two years. -- Mark Diehl

Introduction

Over the past two decades or so, many Asian countries have become well known for their phenomenal rates of economic growth. Much of this growth has been due to the fact that the countries were following the example set by Japan. The so-called “Japan model” involves a national economic policy calling for the establishment of an export-driven economy with stringent market regulation designed to encourage exports while slowing imports. These policies are supposed to ensure that more money flows into the country than flows out of it.

Obvious politically-established barriers to imports, such as tariffs and quotas, make it easy for other nations to criticize and retaliate, so other, less obvious means of protecting local markets developed. Two of the least obvious and most effective of these were the establishment of a nearly-impossible-to-penetrate distribution system for products, and the intentional devaluation of local currency. Although these techniques continue to be vulnerable to attack by trading partners, they can still be effective means of protecting fragile, developing economies, especially when the trading partners do not see the country as a major economic threat.

However, recent advancements in computer and telecommunications technologies may provide opportunities for fiscal marauders to overrun these fortifications. Such new developments include the Internet, encryption technology, electronic cash, and various others which enable the development of World-Wide-Web-based commerce. The purpose of this paper is to explore the possibility of using this type of technology to subvert these mercantilist policies in the interest of profit. Although the level of technology in use today is already sufficient for this purpose, expected future developments, such as “electronic cash” as a replacement for credit cards, will make it even more difficult for governments to prevent the implementation of this plan. Therefore, the probability that it will be used to exploit the weaknesses of certain countries in the future may actually be quite high.

The Republic of Korea (South Korea) (1) was chosen for this analysis not only because it provides an example of a country which achieved rapid economic growth by implementing the aforementioned developmental policies, but also because it gives insight as to the damage that may be caused when they are halted too quickly.

Korea’s economy grew rapidly during the last 20 years, and the policy of keeping the Korean currency (the won) undervalued played a big part in that growth. The value of the won was kept at an artificially low value for many years, finally prompting the United States Treasury Department to issue a report in October of 1988, which accused the Korean government of unfair trade practices. (2)

When the value of a country’s currency is kept artificially low, it becomes relatively cheap for other countries to buy things from there, since the other country’s money buys a lot of local money. In addition, people inside the country have to pay a lot of their money to buy, say, dollars, which they would then have to spend to import goods. As one author stated about the Japanese economy of the late 1970s and early 1980s, “[t]he Japanese currency was clearly undervalued, probably on the order of at least 30%. In other words, every car being exported to the U.S. was being subsidized 30%.” (3) This kind of subsidization was what led to the Treasury Department’s finding of unfair trade practice by Korea.

Before the Treasury’s official report, there were other rumblings about the foreign exchange policy of Korea. (4) These were not without merit. Korea’s gross national product (GNP) showed growth of more than 12% in each of the years 1986, 1987, and 1988, (5) and its trade surplus with the United States had reached 9.6 billion dollars by 1987. (6) That is, Korea sold goods in the U.S. market which totaled 9.6 billion dollars more than the value of the U.S. goods sold in Korea. The foreign exchange policy of South Korea strongly contributed to this situation.

Faced with serious trade sanctions from the U.S., Korea allowed the won to appreciate in value. (7) Although any nation must take U.S. trade sanctions seriously, Korea is more vulnerable to such threats than many other Asian nations. The Korean peninsula has the world’s most heavily armed border, and about 30,000 U.S. troops guard the South Korean side. Thus, its military dependence, along with the very real threat of being effectively shut out of the U.S. market, made Korea more willing to accommodate the U.S. demands than other nations at similar stages of development might have been. This revaluation actually began well before the Treasury Department report, and by the end of 1988 the trade surplus with the U.S. had dropped to 8.5 billion dollars. (8) Although the won had gained in value against the dollar by 15.8% in 1988, (9) the Korean government, by signaling its willingness to make concessions in this area in 1989 (10), was still admitting that the won was undervalued.

The following table shows the amount of won it took to buy one U.S. dollar on the dates shown. Remember that the lower the number in the left column, the more valuable is the won. As the table indicates, the release of the downward pressure on the won resulted in rapid expansion of its value--for a few years. The value of the won dropped again after a little while, but this was not due to more intentional devaluation by the Korean government. The value of the won, no longer artificially fixed, now truly does reflect economic reality. The fact is that the Korean economy is now in rather bad shape, and its currency shows this. Korea’s multi-billion-dollar trade surplus with the U.S. quickly turned into a trade deficit after the tight controls on the won were relaxed, and Korea has a multi-billion-dollar trade deficit with the U.S. today. (11)

If it were possible to predict such changes in the value of a world currency (that is, that its value would rise dramatically, and then fall as money leaves its home country and its economy worsens) the potential for arbitrage would be practically limitless. The proposal of this paper, however, deals not with predicting such an occurrence, but rather with causing it to occur.

Although Korea has already been forced to open its currency market, there are numerous other Asian countries which are still following the Japan model of development, and it should be possible to find one which is still keeping its currency artificially devalued. Preliminary research in this area shows that possible targets include Taiwan, which has very stringent restrictions on its currency exchange, (18) and Malaysia, where the local currency is described by commentators as "hugely undervalued.” (19) Much like corporate raiders, we are looking for a target where the "paper value" is much less than the "breakup value.” In this case, the "paper" simply happens to be the country's money.

The Country

GOVERNMENT

South Korea has a democratic form of government, and its Constitution is strikingly similar to that of the United States, except that the Korean version has an additional provision for the reunification of North and South. The legislature is unicameral, and its members are elected by proportional representation.(20) Although it seems to function in much the same way as the U.S. Congress when described by the official Korean Embassy Web page, (21) this is largely the result of careful wording and the omission of such details as fistfights on the floor of the legislative chamber and midnight sessions of which the minority parties are not notified.

The President likewise functions in a capacity not unlike that of his American counterpart. He is elected by popular vote and is limited to one five-year term. (22) As indicated by the same official Web page, the current Korean president, Kim Young Sam, is indeed the first civilian president since the very long rule of military dictatorship in the country. It is also true that he is a former leader of opposition to those regimes. (23) However, he became president only after switching to the Min Jeong party—the same party that produced all of Korea’s military dictators. Recent crackdowns on labor protesters leave questions about the true nature of Kim’s own regime.

LIFESTYLE AND ECONOMY

Korean culture is strongly rooted in Confucianism, and the ideals of obedience and deference are highly prized. Korean companies are run in much the same way as the American military, and non-conformers are treated quite severely. (24) Even in urban areas, it is still not uncommon to meet young, college-aged women who talk of how they hope their fathers come home early so that they can eat soon, since the mother and daughters eat after the father and sons have finished eating. The personal characteristics that tend to be most meaningful to Koreans are (in decreasing order of importance) gender, age, education, social and family status, and other similar characteristics which allow assignment in the hierarchy. (25) Advanced age is most respected, but mostly only males can derive any advantage out of it. A commonly-repeated phrase in the country is translated as: “Before a woman is married, she obeys her father; after a woman is married, she obeys her husband; and after a woman’s husband dies, she obeys her grown sons.”

In apparent contrast to this traditional lifestyle, the Korean economy has been performing amazingly well since the end of the Korean War. At times, the Korean economic growth rate has been the fastest in the world (26) This is mainly attributable to the militaristic corporate culture (27) and the Japan-style export-driven economy. (28) Markets are largely closed to foreign products, and trade, like everything else in the economy, is tightly controlled by the government. (29) In fact, one of President Kim’s campaign promises was to not allow a single foreign grain of rice to enter South Korea. This later led to riots when he signed the Uruguay round agreement on trade liberalization. (30) Foreign persons on the street in Korea, weeks later, were harassed by mobs of Koreans, angry that the U.S. government had “forced” Korea to agree to open its markets.

Much of the talk of Korean market opening, however, turns out to be little more than just talk, at least in the short term. Eventually, the Korean markets must open , so that Korea can be accepted by the world community into organizations such as the OECD, but the country is stalling as best it can, and for good reason. (31) Some of the more interesting examples of this include the capital and gold markets.

THE CAPITAL MARKET

Few of Korea’s corporations are allowed to borrow outside of the country, and most of those who do are required to spend that money outside the country. (32) The idea is that by keeping out foreign investment, Korea will be able to fend off the internal inflation which usually accompanies a strict exchange rate policy of domestic currency depreciation as a means of supporting exports. (33) (Essentially, the inflation occurs because increased wealth of the country as a whole, combined with the lack of mechanisms for purchasing goods on the world market, means that more wealth ends up chasing each available product within the country. Also, as the country itself becomes more wealthy, more overseas investors see it as a good place to put their money. This means that more investors are trying to buy the local currency in order to make such investments, thus driving up the price of the currency on the world market, and making the country’s exports less competitive.) To prevent this, the country tries to keep out such investment, especially “portfolio” investment, which is reflected only by bonds or stock certificates, and is thus much more liquid than “direct” investment like the building of a factory. (34) In 1992, only ten South Korean firms were permitted to get funds from foreign capital markets.

As a result of these policies, the large corporations for which Korea is becoming well-known--the so-called “chaebol” companies such as Samsung, Daewoo, Hyundai, and Lucky Goldstar--have had to do most of their borrowing from banks inside Korea. Because the government is trying to control inflation inside the country, it is keeping interest rates extremely high, in an effort to dry up the supply of cash. But the problem is that the chaebol, who collectively accounted for 57% of the country’s exports in 1994, are already indebted and are in danger of defaulting on their loans, thus potentially destroying the economy of the country. Thus, a dual-rate lending system has been enacted in order to support them, in which they can borrow at much less than the general rate in Korea. (35)

The Korean stock exchange is not much help for firms attempting to raise capital, because of extensive government controls designed to control speculation—controls which limit both the rise in share prices and the number of shares traded. As a result, almost all of the money raised by the firms comes from either direct borrowing or the issuance of bonds. (36)

The heavily-indebted chaebol are a serious threat to the continued viability of the country’s economy, especially since most of the debt comes from low-interest loans from within Korea. As The Economist has observed, “...a slump in sales could rapidly render them incapable of keeping to their repayment schedules. The bankruptcy of a large group could bury the banking system in bad debts, dulling economic growth and triggering yet more bankruptcies.” (37)

It is apparent, then, that if the buying power of the won had shot up all at once, instead of the controlled three-year rise implemented by the Korean government in the late 1980's, the result could possibly have crippled the Korean economy rather than causing its still rather serious trade deficit. The huge companies would have defaulted on debts, all within a very narrow time frame of each other, and the government would have had to use all of its reserves of foreign currency to try to prop up the value of the won on the world market. A bailout would not have been possible. Economic chaos would have followed. As already indicated above, this situation provides tremendous opportunities for unscrupulous arbitrageurs.

THE GOLD MARKET

In order to keep the Won insulated from outside forces, it was necessary to prevent it from becoming too liquid. If Koreans were free to buy and sell gold on the world market, they could conceivably sell the gold back for any world currency they wanted, since gold has an established price in almost every currency which reflects the world value of both the money and the metal. Korean authorities had apparently thought of this, too.

To keep the currency safely tied down, Korea has kept various import tariffs and domestic taxes on gold at extremely high rates. In 1988, these taxes combined to equal a 116% total tax on sales of the metal. (38) The official plan was to lower these taxes to 30% by the end of the year. (39) but this turned out to simply be more rhetoric designed to fend off the criticism of other countries, rather than an actual attempt to free the gold market. By well into November of 1988, the tariffs were 20%, but special excise taxes were an additional 30%. (40) In 1990, the country lowered the tariffs to only 5%, which many writers hailed as a great opportunity for foreign sellers. (41) But in the same year, a 10% value added tax kept gold sales down. (42) This tax was still in place by late April of 1995. (43) Although it appears that the taxes have gone down, the rhetoric seems to lead the action by a wide margin in Korea. (Evidently, the “decision” to let the value of the won rise made the gold taxes unnecessary to the Korean authorities, so such taxes were slowly removed.)

This kind of manipulation always leaves room for illicit forms of arbitrage. Smuggled gold in Korea provided its sellers with a profit margin of 8%, (44) and there were 156 smuggling cases reported during the first five months of 1990, involving 20,981 million won. (45)

The Deal

GOLD BANKING

As explained above, what this plan calls for is the removal of the downward pressure from the undervalued currency in order to let its true value be realized. Since we have found that the gold market was closed in Korea in order to insulate the currency, it stands to reason that this may have been a possible way to gain access to the won in the mid-1980's. It would have worked something like what follows.

Smuggling gold into Korea is not the sort of business in which a major corporation such as Global Telecom should involve itself. It is illegal, and would soil the reputation of the company. However, the fact remains that Koreans, especially those who understood the fragility of the Korean economy, were looking for ways to invest in a medium that would allow them to protect themselves from inflation and the disastrous consequences that would follow a tumbling of the chaebol. There is a perfectly legitimate way to provide this opportunity to those individuals, and to do so without ever having to enter the country.

This opportunity stems from what is known as “gold banking.” This is basically what was done by every national government which issued currency under a gold standard. An entity, presumably with its own reserves of gold, issues certificates valued in ounces or grams of gold, and the gold itself never circulates. The reason that countries used to back their currencies with gold was that people had faith in the value of the metal, and since the government itself had issued the certificates, they could be relatively certain that the certificates would be accepted as a medium of exchange by other individuals. Now, national currencies circulate without any backing by precious metals at all, and the whole system functions on faith in the issuing regimes.

IMPLEMENTATION

This same kind of thing could easily be done by a corporation the size of Global Telecom. Just as the “certificates” of national currencies circulated because people believed in the power of the issuing government to support them, certificates issued by a major corporation (with resources greater than those of most countries) should also be able to circulate in the same way. In fact, when this is done and backed only by the assets generally held by the company, the certificate is called a bond, and is traded daily on exchanges all over the world. In this case, however, Global Telecom would be backing certificates with more than just its good name and corporate assets. It would actually be selling gold, free of encumbrance, and represented by certificate.

The way to go about this is to set up a service on the Internet which provides gold certificates for sale, and accepts, or in this case, would have accepted, Korean won in exchange. The price at which the market is trading gold futures would be provided by a service such as Reuters, (46) which provides not only real-time trading information, but also the equipment and software necessary for that trading. Any commodities market in the world could be used in this case, allowing the gold banking activity to run almost non-stop, 24 hours per day.

Any individual could connect to the Global Telecom Web page, log on with a user ID, and buy or sell gold in whatever quantity was desired. An account would be set up for the individual, which would keep track of the ounces or grams of the metal purchased or sold. The trade would not be done on the actual commodities exchanges from the buyer’s standpoint, but rather would simply be a direct purchase from Global Telecom. GTME would charge the usual commission that retailers of gold bullion and coins typically charge, with an adjustment downward to reflect the fact that no gold was being shipped anywhere, and that there is in fact a premium on the ability to hold the physical product.

It is important to remember that no gold would have to be owned or stored by GTME. Because the company is able to trade in futures and options, GTME, just like the customers in the target country, would also only have certificates for the gold being exchanged. When an order comes in, the company simply buys an option to buy gold at the prevailing price. The buyer is paying full price for the gold certificate purchased, but GTME only pays a small percentage of this to buy the option to purchase at this price. When the customer then wants to cash out, GTME can simply return part or all of the payment when the gold market has remained unchanged or the value of gold has gone down, or exercise the option to buy at the lower price when the value of gold has gone up. The commission should cover the costs of the transaction and the option purchase. Keep in mind that the company does not need to profit from these transactions in any way; it only wants to break even. GTME's profit will come from currency speculation.

Legal Issues

Check Licensing and Other Regulations:

There are a number of issues which would be raised by such an undertaking. Due to time and space constraints, only a few will be addressed in detail here. Some of the more obvious of these are licensing and regulation. Global Telecom would need to check on the requirements that would need to be met before beginning this project. Some kind of commodities trading license may be required, or perhaps various banking regulations would apply. The Securities Exchange Commission may be a good source for this type of information.

Some type of regulation of the gold bank is necessary, so that GTME will have certification that it has, or has access to, the gold which it is selling. By complying with the requirements of an outside administrative agency such as the SEC, Global Telecom will also boost client confidence. The regulation may be similar to that of other commodities transactions, or may be more like that of other instruments, such as travelers’ checks.

Disclosure:

There may also be certain disclosure requirements which should be investigated prior to implementation of “The Deal.” For example, GTME may be required to have some sort of disclaimer in the client contract to inform investors that they may lose money on these sorts of transactions. There will also be issues of this sort with respect to the Internal Revenue Service, such as the reporting of GTME income from the transactions, as well as the income and losses of clients worldwide.

Security, Liability, and Jurisdiction:

With respect to the specific “cyber” nature of these transactions, a number of issues arise which will require creative programming as well as legal solutions. These include security, liability, and jurisdictional issues. Although a thorough investigation of these issues is beyond the scope of this paper, they should be explored in detail before implementation of this plan.

The issue of security is one which plagues many types of Internet transactions. GTME needs to be sure that all trades are secure, and that important financial information transmitted between the company and its clients does not fall into the wrong hands. The company will also need to be sure that the transaction being initiated is actually being done by the client and not by some other party who has accessed the account. Electronic signatures may provide such security in the future, but a more immediate solution may be to file credit card numbers and conduct transactions by telephone.

Liability is closely related to the security issues. If the system is not as secure as predicted, GTME may be held responsible for the losses of investors. Some of these issues are as yet unanswered by law. For example, can a client sue GTME upon coming home from work to discover that his 10-year-old has traded away his life’s savings? Other liability issues may involve allocation of the risk of system “glitches.” An example of this may be where the client completes a confirmed transaction which is then lost by the GTME network.

Taxation

There are many issues which arise with respect to jurisdiction in the context of this deal. Because of the unique nature of cyberspace transactions, many of these types of questions are as yet unanswered by case law. Problems arising out of the contract, or arising perhaps from the absence of a contract, will need to be decided in some court, in some place, but selection of this court presents numerous problems. Possible solutions may be stipulation of a “choice of jurisdiction” clause in the contract, or provision for some sort of arbitration.

Another jurisdictional issue is that of tax. Taxation by the target country is the most likely response to “The Deal”, and this will thus be the focus of the rest of this paper.

Since the main thing that GTME would be doing here is avoiding the (in this example, Korean) sales and other taxes on the sale of gold, it is quite possible that the government issuing the currency under attack will try to require GTME to collect such taxes. The obvious issue here is the question of whether or not the company will be bound by such a demand.

For a very preliminary analysis of this issue, the problem can be analyzed as if the Republic of Korea were simply another state in the U.S.. The question then becomes "does an out-of-state retailer have to collect sales or similar types of taxes for states in which it sells, but where its only contact with the taxing state is through the Internet?"

As may be expected at this early stage of Internet commerce, there is no clearly-established law in this area. However, sales of this kind have been transacted in the United States for quite some time, in the form of orders from catalogs by means of toll-free telephone numbers. These transactions have often been targeted for taxation by various states, and the resulting litigation has led to the development of a body of law which is adequate for this analysis.

As one author has characterized it, "a sales tax is a state tax assessed on the actual purchase of goods or services within the state.”(47) Obviously, this presents a problem when the transaction that the state is trying to tax takes place on the telephone or over the Internet. The question arises “where does the ‘actual purchase’ take place?” This could be answered in many ways, depending on whose side of the debate one was on. Since it was rather ambiguous, states came up with another taxing mechanism to address sales of this kind. Thus was born the "use tax".

A use tax is one which is "imposed on out-of-state goods purchased for in-state consumption.”(48) These taxes are applied by states having sales taxes "...to protect sales tax revenue in an attempt to ensure competitive equality between local and out-of-state merchandisers.”(49) The reason is quite simple; if the local retailer has to collect sales tax on the goods or services it provides, while the out-of-state vendor collects no tax, products sold by the out-of-state vendor will cost less. Thus, the consumer will buy from the mail-order firm, and both the local retailer and the taxing state will not get the revenue they would otherwise have received. As Hoti concludes, “therefore, to protect local businesses and state tax revenue, states that impose a sales tax on purchases made within their borders also impose a compensating use tax on outside purchases consumed within the state. The subject of the use tax is an in-state transaction, the use of the product within the state, rather than an outside sale.”(50)

The states are actually taxing the in-state residents who are buying the goods or services from the out-of state seller.(51) These buyers are clearly within the jurisdiction of the state. (52) However, because of the difficulty in getting every buyer to report and pay the use tax on the products purchased, the states attempt to get the companies to collect and remit the use tax instead. (53) Because there are approximately 6500 taxing jurisdictions in the United States, and it would be possible for any mail-order company to have at least one customer in each of them, the mail-order companies are understandably opposed to doing so.(54) [GTME would also be opposed to the collection of such a tax, but not because of the difficulty posed by the many jurisdictions involved. If the company had to collect a use tax to "compensate" for the unpaid Korean sales tax on gold, there would be little incentive for buyers to invest with GTME rather than simply buying in their home town in Korea.]

And so, the battle began. States attempted to get the out-of-state sellers to collect the use taxes, and the companies resisted. Use taxes were challenged by the vendors under both the Due Process Clause (55) and the Commerce Clause (56) of the United States Constitution, with mixed results.

One of the earlier cases to examine the use tax under the Due Process Clause was Nelson v. Sears, Roebuck and Co.(57) The tax imposed by the state of Iowa was challenged by the retailer, who claimed that the requirement of its collection violated the seller’s right to due process of law. The United States Supreme Court applied a nexus test it had developed in the earlier case of Wisconsin v. J.C. Penney Co.,(58) which asked “[w]hether the taxing power exerted by the state bears fiscal relation to protection, opportunities and benefits given by the state. The simple but controlling question is whether the state has given anything for which it can ask return.”

In Sears, the Court reasoned that the fact that the retailer had retail stores in the state of Iowa meant that Sears was receiving a benefit from the state, and should be held responsible for the collection of the tax. This was true even though the actual processing of orders and shipping of goods took place outside the state.(59) It is important to note, however, that in applying the nexus test, the Court found that the mail-order business itself had received a benefit from the state because the stores were there.(60) Thus, the Court did not hold that the mail-order portion was somehow taking advantage of “protection, opportunities and benefits given by the state” per se, but rather looked at the entire company as a single entity.

Three years after Sears, Iowa was again successful in holding an out-of-state seller responsible for collection of the use tax. In General Trading Co. v. State Tax Commission of Iowa,(61) the Court found that even though the vendor had no retail outlets as Sears had had, nor even an office or warehouse, it could still be required to collect the use tax. The only contact that General Trading had had with the state of Iowa was through the traveling salespeople who passed into the state to take orders and send them back to the company. (62) Still, this sales force was found to be sufficient to entitle the state to require collection of the tax.(63)

However, when the contact was not continuous, the Court has found that the Due Process nexus was not satisfied. This was the case in Miller Brothers v. Maryland, (64) where a retailer with a store in Delaware who made occasional deliveries into Maryland did not have the minimum contacts necessary to be liable for tax collection in Maryland.(65) Under the Due Process analysis, deliveries across the state line from time to time were insufficient presence in the state for the Court to find that Maryland could make the company a tax collector for it. The important factor in finding the requisite nexus here was that the contact must be continuous and ongoing; it need not be permanent.(66)

Another Due Process analysis was conducted in Scripto, Inc. v. Carson.(67) Present in this case was the additional fact that the individuals who were selling wares inside the state were not employees of the company, but rather were independent contractors.(68) The Court found that these people, through their solicitations there, had the kind of continuous contact with the state which would warrant requiring the company to collect the tax.(69) The court brushed aside the issue of independence of the ten wholesalers, finding that they acted like employees of Scripto, and that the distinction was “without constitutional significance.”(70) As one commentator noted, “[b]ecause Scripto involved independent contractors rather than agents, Scripto implies that the physical presence test does not require an agency relationship.”(71) In other words, since the independent contractors were treated the same as the employees of General Trading, it is apparent that a continuous local presence will be found by the Court to be sufficient under the Due Process analysis, with or without actual employment.

These cases show that the Court’s early analyses of use taxes applied to out-of-state sellers essentially relied only on the “minimum contacts” analysis typical of Due Process Clause interpretation. The issue was whether or not the entity being burdened had sufficient nexus with the state for it to be “fair” for the state to impose upon it the duty of tax collection. However, while this type of analysis may still be of some importance to GTME (for reasons to be explained later), it has gradually been augmented, and then replaced, by analysis under the Commerce Clause.

An important case in this progression was National Bellas Hess, Inc. v. Department of Revenue,(72) in which the Court examined the tax under both provisions. The Bellas Hess Court found that a state’s attempt to force the company to collect the use tax was not allowable when its only contacts with the state were by mail or common carrier.(73) The Court explained that physical presence of the company within the state was required before the state could impose such a duty. It reasoned that this was true under both the Due Process Clause and the Commerce Clause, stating that “the same principles have been held applicable in determining the power of a State to impose the burdens of collecting use taxes upon interstate sales.”(74)

The Due Process analysis in Bellas Hess was basically the same as it had been in the cases cited above. That is, the Court still considered the question of whether or not it was “fair” to require the company to collect the tax, along the same lines as the “for which it can ask return” inquiry from the Wisconsin v. J.C. Penney (75) case.

The Commerce Clause analysis in Bellas Hess has been described by commentators as having two different pillars.(76) The first of these is that “[t]he sharp distinction between mail sellers with local outlets and mail sellers which merely communicate with customers by common carrier is a line that the Court refuses to ignore.”(77) This was taken to mean that the contacts required, such as the “local outlets” mentioned above, were needed to show that the state’s authority was indeed being applied to a transaction which was truly “intra-state.” (78) The second “pillar” was the notion that the company could be made to collect and remit the taxes in each of the multiple-thousands of taxing jurisdictions in the United States, could itself be considered a burden on interstate commerce.(79)

A different commentator has argued that this analysis by the Bellas Hess Court is flawed and outdated.(80) Paul J. Hartman argues in his article in the Vanderbilt Law Review that with the new computer technology available, the burden would be manageable for out-of-state companies, and the Commerce Clause analysis may not be valid anymore.(81) The dissent in Bellas Hess stated that those in the majority “vastly underestimate the skill of contemporary man and his machines.”(82) [In that regard, there is also no need to worry about famine, war, soil erosion, or global warming. Or perhaps the dissent was anticipating that there may come a time when a company could collapse an economy with a computer.] However, even Hartman acknowledges that the “constant updates” that would be required could be “prohibitive.”(83)

There are only a few writers who are willing to claim that Bellas Hess is outdated, and that states are missing out on sales tax revenue, but even fewer still are willing to say that sales taxes themselves are outdated. Hartman calls the collective loss of “as much as 1.5 billion dollars each year” a “major fiscal problem.”(84) While this is certainly a lot of money, it may be time for states’ legislatures to admit that they would be better off, as would everybody else, if they simply abandoned the easy-to-apply, regressive sales tax entirely, and took political responsibility for actually raising taxes that people notice. Thus, while it is true that there are rumblings about holding these mail-order companies responsible for use-tax collection in each and every jurisdiction in the U.S., it seems at least possible that the taxes themselves could just fade away. An excellent example of this kind of thinking is found in Nathan Newman’s article “Prop 13 Meets the Internet.” In it, Newman argues that tax collection should be centralized as a result of the changing economy.(85)

An interesting case which followed Bellas Hess was that of National Geographic Society v. California Board of Equalization.(86) The Court found that the Society could be made liable for the tax because of the presence of an office within the state. It is important to note that the office in this case solicited only magazine subscriptions, while the products that the state was seeking to tax were maps and other items for which orders were taken and filled from out of state. The Court was unimpressed by this distinction. It held that even the “slightest presence” by the company within the state was enough to allow the state to require collection of the tax.(87)

At about the same time as National Geographic, another, perhaps more enlightening, case was decided. This was Complete Auto Transit, Inc. v. Brady.(88) In this case, a new, four-part test was developed which examined the “economic realities” involved in a Commerce Clause analysis.(89) As was pointed out by one commentator: “[t]o survive a commerce clause challenge, a tax must, pursuant to Complete Auto: (1) be ‘applied to an activity with a substantial nexus with the taxing State’; (2) be ‘fairly apportioned’; (3) ‘not discriminate against interstate commerce’; and (4) be ‘fairly related to the services provided by the (taxing) State.”(90) Thus, a new test for Commerce Clause analysis was created.

The case which currently controls this area of law, however, is that of Quill Corp. v. North Dakota ex rel. Heitkamp.(91) This case was decided after all of those described above, and is now the leading case in litigation regarding out-of-state vendors’ collection of use taxes. In it, the state of North Dakota attempted to hold Quill Corporation responsible for collection of the State’s use tax. Quill challenged this action on both Due Process and dormant Commerce Clause grounds, stating that Bellas Hess had held that both of these require that the vendor have physical presence within the state before it could be held responsible for collection of the tax.

The Quill Court, in considering the Due Process argument, found that while there was a “minimum contacts” requirement for taxation of this kind to be allowable under the Due Process Clause, the minimum contact was something less than physical presence. Even though Quill had no employees in the state and did all of its business through mail-order and telephone sales, the Court found that the company had “more than sufficient” contacts with North Dakota for the tax to be a valid exercise of state power under the Due Process Clause. (92) This was due to the volume of business and the continuous solicitation of Quill within the state. Thus the physical presence standard of Bellas Hess was overruled.

However, the Court did find that the dormant Commerce Clause prevents the state’s imposition of the use tax. The Court found that the rule that Bellas Hess had developed did still apply to the Commerce Clause analysis, and that “ a vendor whose only contacts with the taxing state are by mail or common carrier lacks the ‘substantial nexus’ required by the Commerce Clause.”(93) It said that no matter how much business or advertising the vendor may do in the state, contacts made only through the mail or a common carrier could not be considered a physical presence, and thus forcing such a vendor to collect the use tax was not allowable.(94) The reasoning was that the Commerce Clause gives only Congress the power to regulate interstate commerce, and that in the absence of congressional action, the states must avoid activity that interferes with it. This discussion simply describes the “dormant” Commerce Clause interpretation which was used in Quill. Because the Commerce Clause analysis relates directly to acts of Congress, this means that states can not require the collection of such a tax unless Congress declares that they may do so.

Another important fact about the Quill decision is that the Court explicitly states that the Scripto decision is the farthest limit of the interpretation of minimum contacts.(95) This means that the Court is willing to consider independent contractors with physical presence in the state, who are conducting ongoing solicitation, as enough of a presence to justify holding the company responsible for collection of the use tax--but nothing less. Presumably, this means that physical presence and ongoing solicitation are still required, and that any contact without physical presence by some representative of the company will be insufficient.

More Supreme Court decisions in this area can be expected. State supreme courts are interpreting Quill in vastly different ways. One of the better analyses of this development was done by Adam L. Schwartz in the Connecticut Law Review.(96) In it, Schwartz looks at two cases which were decided by state supreme courts in 1995: Orvis Co. v. Tax Appeals Tribunal (97) and SFA Foilo Collections, Inc. v. Tracy.(98)

In Orvis, the vendor had salespeople living in Vermont who had made about twelve trips into New York and had not been shown even to have stayed the night there. The New York Court of Appeals found that Quill stood for the idea that the National Geographic “slightest presence” was all that was required to exist in order for the taxation to be acceptable under the Commerce Clause, and allowed the imposition of the tax.(99)

In SFA Folio, the mail-order company was a separately-incorporated branch of the major retail giant Saks Fifth Avenue, which had department stores in the state of Ohio. These stores distributed catalogs for Folio, and accepted returned merchandise from catalog customers.(100) Nonetheless, the Ohio Supreme Court respected the separate corporate status of Folio, and found that the Commerce Clause did not permit the use tax.

According to Schwartz: “On the facts of Orvis and SFA Folio it appears that neither case was decided correctly. Indeed the only conclusion to reach after examining these two decisions is that the Quill case has failed to provide a workable standard for states to follow in the administration of the use tax on foreign corporations. Quill suggests a respect for the bright line rule of Bellas Hess, yet also encourages a state to find other ways to justify nexus, like sporadic visits of employees to the taxing state, or the state’s provision of an economic climate for the company’s goods. The Supreme Court should revisit the area of mail order sales taxation, and make an effort to restate the bright line rule.”(101) Schwartz then suggests that the intent of the company be used to determine whether it will be responsible for the tax.

While an analysis of Schwartz’s suggestion is beyond the scope of this paper, his comment does that the law in this area is not yet entirely settled. This uncertainty is likely to remain until there is new action by either the Court or by Congress. Since the Due Process objection to the use tax imposition has now been thrown out by the Quill Court, it is possible that Congress could pass legislation which would allow states to force out-of-state companies to collect the tax. Under the Bellas Hess decision, mail-order and similar corporations were safe from this threat, since no legislation could take away Due Process rights. Now, however, only the dormant Commerce Clause protects these businesses, and that clause by its terms allows Congress to regulate interstate commerce in any way it sees fit.(102)

For GTME, though, the tax may not be applicable, even if Congress does allow use tax imposition on mail-order firms. While the Due Process argument was laid to rest in the Quill case, it may yet rise again if a case involving facts such as those suggested by this paper were to come up. In Quill, the Court found that Due Process did not require the physical presence of the company within the taxing state. However, the Court indicated that there were still some “minimum contacts” required by the Due Process Clause.(103) In Quill, extensive marketing to the state in question, and the shipment of large quantities of goods into the state, were influential in the decision that the minimum contacts were present.(104)

In the GTME scenario, however, not even the product will be shipped into the state. Advertising would be done online, and the purchase would take place online. There may or may not be a certificate which represents the product, but since trading could happen instantaneously which would change the holdings of the customer, this would be largely meaningless and unnecessary. Credit card receipts and records would easily serve as proof of the transaction, and the customer’s funds might be transferred from a giant international bank which effectively had no single location where money was stored. Thus, it is conceivable that there would be absolutely no contact with the taxing state at all; other than the simple fact of the buyer’s residence there.

This situation is an example of the innovation required in modern life. The Internet stands to change the way that society operates, and the old ideas of jurisdiction, taxation, and even domestic market protection in an international economy are simply becoming outdated. It should be apparent that the requisite nexus for imposition of the use tax will only become more abstract, and the ties to the state will become more remote, until there is no rational basis at all for the decision to apply the tax. The sales/use tax is just one of a number of legal issues raised by the introduction of this new technology. It is also one of the easiest to fix. This system must be replaced by a simpler regime, and that may mean that state legislatures will simply have to take the political punishment that follows raising income taxes. Or it may mean that there should be a move to a value-added tax.

These same technological advances are making the area of international commerce even more dynamic. Never before has so much been available to so many places in the world. This paper envisions a marketplace where not even products will change hands, and nations will have less control over their economies than at any other time in history. It shows that even if the target economy were subject to the same basic law as the arbitrageur (the U.S. Constitution), it would still be difficult or impossible to prevent this “deal” from reducing that economy to chaos. This paper has shown that State governments are losing sales taxes as sources of revenue already, and the Internet is still in its infancy. Developing economies are far less protected than U.S. States, due to the lack of overarching jurisdiction. The effects of these advancements on those economies may be crippling.

Endnotes

1.Republic of Korea: Law of Cyberspace class “Common Information”:

country name: Republic of Korea

capital city: Seoul

population: 45,482,291

land area: 38,375 sq. mi. g

ross domestic product: (1994) $508 million

per capita income: 11,270

basic unit of currency: won

exchange rate (won per U.S. $): (June ‘96) 809

electricity used: 137 billion KWH per year

number of television sets (# of persons per TV): 4.3

number of telephones: 2.6 persons per phone

percent of population that is literate: 98%

infant mortality rate: 8 deaths per 1000 live births.

Source: The World Almanac and Book of Facts. 1997. Published by World Almanac Books. New Jersey.

2. “South Korea: S. Korea Defends Itself Against Us Currency Charges” Reuter News service-Far East (September 21, 1989)

Moon, Ihlwan “South Korea: Seoul Trade Minister Says Won Should Be Revalued Slowly” Reuter News Service-Far East (February 1, 1989)

3. “Japan: Economic Woes Compounded By Inaction-Exchange-Rate Factor Hamstrings Advanced Economics” Nikkei Weekly (January 31 1994)

4. Chen, Chien-Kuo “Taiwan To Let Currency Rise Faster Against U.S. DLR” Reuter News Service-Far East (November 24, 1987)

5. “South Korea: South Korean Officials Say There Are No Plans To Devalue Won” Reuter News Service-Far East (December 15, 1989)

6. Moon, Ihlwan “South Korea: Seoul Trade Minister Says Won Should Be Revalued Slowly” Reuter News Service-Far East (February 1, 1989)

7. Id

8. Id.

9. Id.

10. Id.

11. Business in Korea—Economic Statistics http://korea.emb.washington.dc.us:80/business/Econostat.htm#KIFC

12. “South Korea: Won Hits 728.50 Per Dollar, Lowest Since 1988” Korea Economic Daily (25 June 1991)

13. Clifford, Mark “On A Short Leash” Far Eastern Economic Review (17 October 1991): 70.

14. “South Korea: Won-Dollar Exchange Rate Hits A 3 Year High” Korea Economic Daily (15 May 1995)

15. “South Korea: Won Continues To Gain Strength Against The Dollar, Yen” Korea Economic Daily (9 December 1994)

16. “South Korea: Won-Dollar Exchange Rate Hits A 3 Year High” Korea Economic Daily (15 May 1995)

17. “South Korea: Won-Dollar Rate Moves to the 770 Level” Korea Economic Daily (31 May, 1996)

18. “Taiwan-Overseas Business Report” 1991 National Trade Data Bank Market Reports (June 12, 1991)

19. Khanna, Vikram “Malaysia: KL GOVT Should Allow Currency To Rise” Business Times (Singapore) (November 1, 1995)

20. Constitution and Governments http://korea.emb.washington.dc.us:80/Kois:Explore/Facts/government.html

21. Id.

22. Id.

23. “South Korea: Quick, Quick, Quick” The Economist June 3, 1995.

24. Management Korean Style http://www.kotra.or.kr/k...es/1997/1-2/koreana.html

25. Id.

26. “South Korea: The Land of the Rising Won” Euromoney p.1 September 12, 1988.

27. Management Korean Style http://www.kotra.or.kr/k...es/1997/1-2/koreana.html

28. “South Korea: Quick, Quick, Quick” The Economist p.1 June 3, 1995.

29. Id., p.11.

30. Id., p.10.

31. Id., p.16.

32. “Past the Worst?” The Economist January 30, 1993. “Korean Corporate Finance: Costly” The Economist May 18, 1991.

33. Mobius, J. Mark “Free Those Exchange Rates Far Eastern Economic Review” July 4, 1996 “Korean Corporate Finance: Costly” The Economist May 18, 1991.

34. Miller, Norman C. “Fast Money Far Eastern Economic Review” April 11, 1996.

35. “South Korea: Quick, Quick, Quick” The Economist pp.10-17, June 3, 1995.

36. Id. “Past the Worst?” The Economist January 30, 1993.

37. “South Korea: Quick, Quick, Quick” The Economist p.12, June 3, 1995.

38. “South Korea is to Liberalise Gold Imports in July” Business Times(Singapore) May 16, 1988.

39. Id.

40. “South Korea: Gold Bank System Being Considered” Korea Economic Daily November 30, 1988.

41. “South Korea: Int’l Dealers of Precious Metals Move Into Korea” Korea Economic Daily January 11, 1990.

42. “South Korea: Lucky Metals Not Competitive in Gold Trade” Korea Economic Daily November 22, 1990.

43. Jeong, Yeom Yoon “South Korean Conglomerates Bank on Gold” Reuters Financial Service April 30, 1995, Sunday, BC Cycle

44. “South Korea: Lucky Metals Not Competitive in Gold Trade” Korea Economic Daily November 22, 1990.

45. “South Korea: 5-Month Smuggling Cases Involve 20.98 Billion Won” Korea Economic Daily June 12, 1990.

46. Smith Barney, Dec. 29, 1995 Reuters Holdings Plc - Company Report. Reuters: “Reuters is the world’s leading provider of technology and information-related products to the financial services industry.... ...Reuters is emerging as the leading developer of information technology solutions for the financial services industry. Reuters has estimated 1995 revenue of US $4.1 billion. Information products is its core area, accounting for 71% of revenue. Information products include real-time financial market data, historical databases and related analytical applications” For additional information about the company, see the Reuters web page: <http://www.reuters.com/>

47. Schwartz, Adam L., Note: Nexus or Not: Orvis v. New York, SFA Folio v. Tracy and the Persistent Confusion over Quill, 29 Conn. L. Rev. 485.

48. Harvard Law Review Association, The Supreme Court, 1991 Term; Leading Cases. 106 Harv. L. Rev. 163 (1992).

49. Schwartz, Adam L., Note: Nexus or Not: Orvis v. New York, SFA Folio v. Tracy and the Persistent Confusion over Quill, 29 Conn. L. Rev. 485.

50. Hoti, Anna M., Comment: Finishing What Qvill Started: The Transactional Nexus Test For State Use Tax Collection. 29 Conn. L. Rev. 485.

51. Schwartz, Adam L., Note: Nexus or Not: Orvis v. New York, SFA Folio v. Tracy and the Persistent Confusion over Quill, 29 Conn. L. Rev. 485.

52. Id.

53. Id.

54. Harvard Law Review Association, The Supreme Court, 1991 Term; Leading Cases. 106 Harv. L. Rev. 163 (1992)

55. U.S. Const. Amend. XIV Due Process

56. U.S. Const Art. I sec. 8 Commerce

57. 312 U.S. 359 (1941).

58. 311 U.S. 435 (1940).

59. 312 U.S. 359 (1941).

60. Id.

61. 322 U.S. 335 (1944)

62. Id.

63. Id.

64. 347 U.S. 340 (1954)

65. Id.

66. Hoti, Anna M., Comment: Finishing What Quill Started: The Transactional Nexus Test For State Use Tax Collection. 29 Conn. L. Rev. 485

67. 362 U.S. 207 (1960)

68. Id.

69. Id.

70. Id.

71. Hoti, Anna M., Comment: Finishing What Quill Started: The Transactional Nexus Test For State Use Tax Collection. 29 Conn. L. Rev. 485

72. 386 U.S. 753 (1967)

73. Id.

74. Id.

75. 311 U.S. 435 (1940) 386 U.S. 753 (1967)

76. Schwartz, Adam L., Note: Nexus or Not: Orvis v. New York, SFA Folio v. Tracy and the Persistent Confusion over Quill, 29 Conn. L. Rev. 485

77. Id.

78. Id.

79. Id.

80. Hartman, Paul J., Symposium on State and local taxation: Collection of the Use Tax on Out-of-State Mail-Order Sales, 39 Vand. L. Rev. 993 (1986)

81. Id.

82. 386 U.S. 753 (1967)

83. Hartman, Paul J., Symposium on State and local taxation: Collection of the Use Tax on Out-of-State Mail-Order Sales, 39 Vand. L. Rev. 993 (1986)

84. Id.

85. Prop 13 Meets the Internet: How state and local government finances are becoming road kill on the information superhighway. Newman, Nathan. Center for Community Economic Research. University of California, Berkeley. August, 1995. Http://ei.cs.ut.edu/~es3604/Fall.95/Impact/Impact.Taxes.html

86. 430 U.S. 551 (1977)

87. Id.

88. 430 U.S. 274 (1977)

89. Id.

90. Hoti, Anna M., Comment: Finishing What Quill Started: The Transactional Nexus Test For State Use Tax Collection. 29 Conn. L. Rev. 485 91. 504 U.S. 298 (1992)

92. Id.

93. Id.

94. Id.

95. Id.

96. Schwartz, Adam L., Note: Nexus or Not: Orvis v. New York, SFA Folio v. Tracy and the Persistent Confusion over Quill, 29 Conn. L. Rev. 485

97. 654 N.E. 2d 954 (1995)

98. 652 N.E. 2d 693 (1995)

99. 654 N.E. 2d 954 (1995) Schwartz, Adam L., Note: Nexus or Not: Orvis v. New York, SFA Folio v. Tracy and the Persistent Confusion over Quill, 29 Conn. L. Rev. 485

100. 652 N.E. 2d 693 (1995)

101. Schwartz, Adam L., Note: Nexus or Not: Orvis v. New York, SFA Folio v. Tracy and the Persistent Confusion over Quill, 29 Conn. L. Rev. 485

102. Schwartz, Adam L., Note: Nexus or Not: Orvis v. New York, SFA Folio v. Tracy and the Persistent Confusion over Quill, 29 Conn. L. Rev. 485 Hartman, Paul J., Symposium on State and local taxation: Collection of the Use Tax on Out-of-State Mail-Order Sales, 39 Vand. L. Rev. 993 (1986) Hoti, Anna M., Comment: Finishing What Quill Started: The Transactional Nexus Test For State Use Tax Collection. 29 Conn. L. Rev. 485

103. 504 U.S. 298 (1992)

104. Id.

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