• by Wendy Davis  @wendyndavis, November 8, 2010

In a partial victory for Amazon and Overstock, an appellate court in New York ruled that a trial judge prematurely dismissed their lawsuit challenging a law requiring some online retailers to pay sales tax on purchases by state residents.

But although the case has been reinstated, it's not clear whether Amazon and Overstock will be able to prevail in their argument that the law unconstitutionally constrains interstate commerce.

The New York law, enacted in 2008, calls for online retailers to collect sales tax from state residents if the sites use New York affiliates. Amazon, Overstock and other opponents of the measure argue that a 1992 U.S. Supreme Court decision prohibits state governments from forcing retailers to collect sales tax unless they have a physical presence in the state, like a brick-and-mortar store. The online retailers argue that affiliate marketers -- including Web publishers that garner referral fees because they have placed links to Amazon on their sites -- don't constitute a sufficient presence in New York to justify the tax.

In a decision issued last week, the New York Appellate Division ruled that whether the companies will be able to defeat the law depends on the nature of the affiliates. If they are "passive" advertisers, the law appears unconstitutional, but if the affiliates are engaged in "direct solicitation," then the sites will have to pay the tax.

The appeals court said that examples of direct solicitation could include sending emails, as well as "distributing flyers, coupons, newsletters and other printed promotional materials, or electronic equivalents."

The problem, say some observers, is that much of the activity described as direct solicitation occurs throughout the Web in all forms of advertising -- for instance, when display ads include coupons.

"It doesn't make any sense to go this route," says Santa Clara University law professor Eric Goldman. He adds that the court's examples of direct solicitation made more sense offline, "when people were making in-person sales or even telephone calls from boiler rooms."

Goldman adds that one result of the court's reasoning could be that Amazon and other companies will eschew cost-per-action ads and instead rely solely on cost-per-click or cost-per-thousand-impression models because publishers who accept those ads are more likely to be considered "passive."

The Performance Marketing Association, which filed a friend-of-the-court brief in the appeal, says it is worried that online retailers might decide to stop using all performance marketing affiliates that offer pay-per-action ads.

Rebecca Madigan, director of the trade organization, says she is hopeful that Amazon will be able to prove that its in-state affiliates should not be considered direct solicitors. If not, however, online retailers could well decide to avoid paying sales tax on New York consumers' purchases by terminating affiliates in the state. "My concern is that the entire industry could be wiped out, or that the compensation model will change," she says.

Since the New York law went into effect, around 200 online retailers, including Overstock and Blue Nile, stopped working with affiliates in the state. Amazon didn't drop New York affiliates, but stopped working with affiliate marketers in North Carolina and Rhode Island, which also recently passed similar laws.