Economics and Technology, Inc. -- Views and News, January 2012

January 2012

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Tax Revenues Suffer Unintended Collateral Damage from Regulatory/Marketplace Changes

Should five percent appear too small
Be thankful I don't take it all
'Cause I'm the taxman, yeah I'm the taxman

If you drive a car, I'll tax the street,
If you try to sit, I'll tax your seat.
If you get too cold I'll tax the heat,
If you take a walk, I'll tax your feet.
The Beatles, Taxman

Although state and local taxing authorities rarely become involved in telecommunications policy matters, they have often been blindsided by regulatory or legislative initiatives that, whether intentionally or otherwise, have resulted in a net - and sometimes a large - reduction in tax revenues.

This is hardly a new phenomenon. Prior to the FCC's 1980 Computer II decision initiating the process of deregulating customer premises equipment (CPE) and the 1984 break-up of the former Bell System, the full range of ILEC CPE - from consumer handsets to PBXs - were carried as capital assets in an ILEC's rate base, and represented as much as 15% to 20% of a typical ILEC's assets. Local ad valorem property taxes, local and state franchise taxes, and various other taxation systems were often based upon the value of a utility's capital investment. When CPE was deregulated and transferred to a nonregulated affiliate and/or ultimately sold in-place to individual customers, aggregate ILEC asset values decreased substantially, and tax revenues based thereon experienced a commensurate reduction.

Tax revenues may also be unintentionally reduced even when regulatory policy and law are held constant in the face of major marketplace changes. For example, the introduction and development of competition by nonregulated entities across a broad range of telecommunications industry segments had a similar effect upon state and local tax revenues. In many instances, taxes applicable to "telecommunications" services were explicitly or implicitly linked to the service provider's status as a regulated telecommunications utility or "telephone company" under a specific legal definition. Rather than the tax being applied to the product or service irrespective of who produced it, many telecommunications taxes were specifically applied only where the service at issue was furnished by an entity subject to state public utility regulation. When nonregulated competitors captured some portion of the market for such services, the tax payments by the regulated utility would decrease, but would not be replaced by the nonregulated rival that was not itself subject to an equivalent tax.

Sometimes tax collections may be impacted by technological developments rather than through any specific policy initiative. A case in point is the Federal Excise Tax (FET) on long distance telephone calls. Section 4252(b)(1) of the Internet Revenue Code provides that toll telephone service is subject to the Federal Excise Tax where the charge for such calls varies with both the distance and elapsed transmission time of each individual call. This two-element long distance call pricing scheme - based on distance and duration - had been in effect since the introduction of long distance service nearly a century ago, and was certainly operative when the FET was adopted. But with the arrival in the 1990s of ultra high capacity fiber optics and digital switching, distance dropped out as a material cost driver, and long distance prices became "postalized" - i.e., subject to the same price irrespective of distance. The problem, from the perspective of the IRS, was that the FET was explicitly applicable only where both the distance and the duration element were present - take one away, and the legal basis for the FET disappeared. After a series of federal court challenges that the IRS had consistently lost, the IRS caved, and in 2006 issued Notice 2006-50 effectively eliminating the FET on long distance calls.

MAJOR TELECOM MARKETPLACE CHANGES WITH TAX IMPLICATIONS
Category	Taxable Format	Marketplace change resulting in taxation "gray area"
Music	CDs	iTunes Downloads
TV/Videos	Cable TV; DVD rentals	Netflix-type Streaming Videos
Retail Merchandise Purchases	Brick-and- Mortar retail stores	Amazon, other e- Commerce/ Online Stores
Voice telephone access lines	Wireline ILECs, CLECs	"Over-the-top" VoIP via consumer Internet access service
Mobile voice service	As Provided by wireless carriers	"Over-the-top" VoIP via wireless 3G, 4G, LTE broadband data services
Computers, software	In-house PCs, LANs, storage, software	Cloud computing, remote storage accessed via the Internet

And now, another technological development that has emerged over the past year or so portends a further erosion of state and local tax revenue. Cable television services are typically subject to state sales tax as well as other locally-imposed franchise or similar fees. However, under the 1998 federal Internet Tax Freedom Act (ITFA), Internet services are specifically exempt from state and local sales, franchise, gross receipts, and other taxes that would ordinarily apply to most other businesses and services. The ITFA was initially adopted as a temporary measure, slated to expire in 2001, intended to encourage the development of the then-nascent commercial Internet while sidestepping the problem of identifying the appropriate tax jurisdiction ("tax nexus") where services may have had unknown and multiple geographic points of origin. This "temporary" tax exemption has been extended several times, and there is pending legislation that would make it permanent.

The ITFA has been a source of considerable controversy, since it creates a competitive disparity with respect to otherwise comparable services and business activities based upon whether they are furnished over the Internet or via some more traditional means. Although the ITFA does not preclude the imposition of local sales tax on purchases made over the Internet, its existence has been cited as a rationale for continued state-level sales tax exemption for such transactions. Amazon has been particularly aggressive in fending off state sales tax collection requirements even to the point of dropping so-called "affiliates" who offer merchandise via the Amazon website that are based in states that had sought to utilize their physical presence as a basis for establishing a broader tax nexus applicable to all of Amazon's sales in their jurisdiction. This conflict came to a head in 2011 when California attempted to force Amazon to collect state sales tax on sales to California customers.

The growth of streaming video services - from Netflix, Hulu, Roku, Apple, Google, and even from Amazon - creates yet another challenge for state taxing authorities. As more Internet-based sources of video become available, customers are eliminating their cable TV service ("cutting the cord") or downgrading their service to a lower-priced premium tier or all the way to basic cable only. They are also replacing taxable DVD rentals from stores like Blockbuster with non-taxable streaming downloads from Netflix and others. The downgrades and discontinuations of taxable cable services are being replaced by non-taxable Internet-based streaming services. Of course, in many cases the Internet access service is being furnished by the same entity that had been providing the cable TV (or equivalent) video service. From the provider's perspective, the loss of cable revenue is offset, at least to some extent, by increased demand for higher-bandwidth Internet access. But from the perspective of state and municipal governments, the migration from a legacy taxable service to a competing non-taxable service can have serious revenue impact.

ETI has long believed that the ITFA has outlived its original purpose and needs to be repealed (see Views and News, November, 2010). The Internet is no longer a nascent industry that needs to be nurtured by special tax breaks. Moreover, the disparity between the taxation of traditional businesses and services vis-a-vis those sold over the Internet has contributed to a demise of many otherwise sustainable brick-and-mortar firms. The negative impact upon local communities, local economies and jobs cannot be overstated. The challenges confronting state and local governments during the current economic downturn are exacerbated by the continued erosion of the tax base. Expansion of broadband is a central focus of national telecommunications policy, yet if Internet-based services continue to escape state and local taxation, the unintended consequence of more broadband could well be a further erosion of state and local governments' ability to run their schools and to provide other essential public services.

For more information, contact Colin B. Weir at cweir@econtech.com

Read the rest of Views and News, January 2012.

About ETI. Founded in 1972, Economics and Technology, Inc. is a leading research and consulting firm specializing in telecommunications regulation and policy, litigation support, taxation, service procurement, and negotiation. ETI serves a wide range of telecom industry stakeholders in the US and abroad, including telecommunications carriers, attorneys and their clients, consumer advocates, state and local governments, regulatory agencies, and large corporate, institutional and government purchasers of telecom services.