Guide to Computer Law—Number 280
Practitioner’s Perspective
by Holly K. Towle, J.D.
Internet Taxation
Holly K. Towle and Scott L. David*
There must be something about this time of year that triggers thoughts of
taxation (could it be that April 15th looms?). In March 2004, my partner
Scott L. David, summarized some of the e-commerce tax issues concerning
high technology companies. I asked him to help out again and this is his
report on what has happened in a year—lots.
Holly K. Towle is a
partner with Kirpatrick &
Lockhart Preston Gates
Ellis LLP (K&L Gates), an international law firm,
and chair of the firm’s E-merging Commerce
group. Holly is located in the firm’s Seattle
office and is the coauthor of The Law of
Electronic Commercial Transactions (2003,
A.S. Pratt & Sons). Holly.Towle@KLgates.com,
206-623-7580.
*Scott L. David is a partner in K&L Gates
Seattle office. Scott practices in both the tax
group and in the electronic commerce group.
Scott.David@klgates.com
I am confused, what is the status of Internet and
telecommunications tax?
Telecommunications and information technologies are evolving at a
blistering pace. New products and services (such as SMS messaging, VOIP,
Wi-Fi, content downloads, etc.) are offered each week. The state and federal
regulatory and tax authorities are struggling to keep up.
A prior column reported that the Internet Tax Freedom Act (ITFA) had
expired as of November 2003. The situation has now changed.
What did the original ITFA do?
Originally passed in 1995, the ITFA prevented states from imposing taxes on:
(i) Internet access (such as the monthly service charge you pay at home for
Internet access) and (ii) multiple and discriminatory taxes on e-commerce
(i.e., those paid when conducting business on the Internet). The ITFA expired
on November 1, 2003. It was not renewed until December 2004, under the
new name “The Internet Tax Non-Discrimination Act” ( ITNDA).
Does the new law permanently extend the ban on Internet taxes?
No. The ITNDA extends through November 1, 2007 the moratorium on
State taxation on: (i) Internet access and (ii) certain elements of electronic
commerce. It also makes changes to the ITFA that are summarized below.
What is at stake here?
The ITNDA, which continues and refines the ban on taxation of certain
technologies, is one manifestation of a struggle that is taking place on the
larger stage of taxation of technology and innovation.
On one side are opponents of the ban, including the states that are already
squeezed for revenue and are seeking to find new revenue sources, including
taxing new technology products and services (and preventing an erosion of
existing tax revenues brought on by such technologies).
Practitioner’s Perspective appears periodically
in the monthly Report Letter of the CCH Guide to
Computer Law. Various practitioners provideindepth analyses of significant issues and trends.
On the other side are proponents of the ban, who want to limit tax on new
technologies to support Internet innovation and permit the expansion of
Internet-related services to underserved areas.
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With the passage of the ITNDA, both sides achieved partial
victories. The ITNDA continues the ITFA ban, but does not
expand it as some supporters had hoped.
The original ITFA permitted state tax on
telecommunication services. Does the ITNDA
also permit state telecommunications taxes?
This is where the issue gets interesting (complicated). Under
the original ITFA, the term “Internet access” did not include
“telecommunication services.” As a result, the original ITFA
permitted the states to continue to impose their taxes on
telecommunications services. Many states impose a sales
tax on telecommunications services and continued to do
so after passage of the ITFA in 1998. This “carve out” for
telecommunication service led to much confusion regarding
whether telecommunications services that were used to
provide Internet services were taxable.
Under the ITNDA, telecommunications services continue
to be carved out of the definition of “Internet access,” but
the carve-out is not applied to telecommunications services
“purchased, used, or sold” by an Internet access provider. In
other words, the states are now prohibited from taxing those
telecommunications services that are related to Internet
access. This will, for example, exempt telecommunication
services that are used to provide the “Internet backbone” and
other similar telecommunications services.
Does the ITNDA permit states to tax VOIP?
Yes. For those of you struggling with the alphabet soup of
the new economy, “VOIP” is Voice
Over Internet Protocol (which we explain below). As a result
of a compromise that was necessary to achieve passage of
the ITNDA, Congress has clarified that states may tax VOIP
services. In the debate leading up to passage of the ITNDA,
the states had been concerned that they would lose sales tax
revenue as VOIP replaced traditional telephone services.
What is VOIP?
VOIP has been the subject of significant news coverage as the
technology has developed into a viable alternative to traditional
telephone service. Briefly, VOIP is intended to permit real time,
telephone quality, voice communication using the Internet.
Traditional telephone service is provided through a dedicated,
switched line and connections (a so-called “circuit switched
network”). By contrast, VOIP service is achieved through
a “packet switched network.” In VOIP, the voice signal is
digitized, broken into packets (each of which is tagged with an
address, size information and error checking information in
the Internet protocol (IP) format), and the packets are then sent
over routers to their destination where they are reassembled
as a file that is then “played” in its original form.
What does the ITNDA provide regarding VOIP?
The ITNDA provides that it will not prevent the imposition of
tax on a charge for “voice or similar service utilizing Internet
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Protocol or any successor protocol.” Thus, the states can tax
VOIP services.
Does the ITNDA permit a state to tax other
Internet services?
The ITNDA permits states to tax “voice or similar service.”
The meaning of “similar service” is not clear. The legislation
does, however, clarify, that states may not tax “voicecapable e-mail or instant messaging.” Beyond these specific
exemptions, it is not clear how far the states can go in taxing
Internet services that involve voice. The permission to tax
“voice or similar service” might be interpreted to cover only
real time, two way, voice communications, but it is not clear
how far the definition will be applied.
How does the ITNDA provision affect other
governmental charges for telecommunications?
There are numerous federal and state charges imposed with
respect to telecommunications services. These include the
federal universal service fee (USF) and state fees supporting
911 services. The ITNDA specifically permits these fees to
continue to be imposed.
What about “bundled” charges?
Companies that offer telecommunications, information and
related products and services, continually seek to increase
market share and customer service by combining various
products and services into myriad combinations of offers.
For example, companies may offer phone service, high speed
Internet access (broadband), instant messaging, various types
of content (such as ring tones, programming, self created
and third party web content), information services, cable
service, and other services. These products and services are
combined (“bundled”) by different companies in a broad
array of service offerings. Where there are separate charges
for the different services, it is relatively easy to identify which
services are taxed and which are not.
Sometimes, however, a single charge applies for multiple
services in a bundled service offering. Some of the services in a
bundle, such as telecommunications services, may be taxable
under the ITNDA, while others, such as Internet access, are
not taxable. The ITNDA establishes how tax is applied to
such a bundled offering. Under the ITNDA, where Internet
access charges are combined with taxable services (such as
telecommunications or other services), then the charges for
Internet access may be taxed, unless the service provider can
reasonably identify the charges for Internet access from its
books and records.
Does the ITNDA “grandfather” certain state
laws?
Yes. Under the ITFA, certain state taxes on Internet access
that were both imposed and enforced prior to 1998 were
“grandfathered” (i.e., the pre-1998 taxes imposed by Texas,
Tennessee, Ohio, North Dakota, Hawaii, Montana, New
Hampshire, New Mexico, South Dakota, Washington, and
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Wisconsin were permitted to continue to be imposed). The
ITNDA extends the original grandfather provision of the
ITFA through November 1, 2007, and adds new grandfather
provisions.
Under one new grandfather provision,
Wisconsin’s telecommunication tax is grandfathered
through November 1, 2006.
A second new grandfather clause allows states to tax other
Internet access taxes that have been enforced since November
1, 2003, if the Internet provider had a reasonable opportunity
to know of the tax because of a rule or announcement
by a state and the state generally collected such tax. This
additional grandfather clause may permit states to continue
to tax certain services that were not as prevalent in 1998, such
as DSL service.
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How does the ITNDA affect other federal
and state laws affecting the Internet and
telecommunications?
The ITNDA provides that it does not affect any federal or state
regulatory proceeding that is not related to taxation. As a result,
the upcoming FCC examination of telecommunications and the
Internet will not be directly affected by the ITNDA. There are
currently several proposals in Congress to expand the federal
3% telecommunications excise tax to cover VOIP, including one
proposal that would apply the tax to all broadband services.
It remains to be seen how such proposals will interrelate with
the ITNDA. One thing is clear, the area will continue to be in
flux as technologies continue to change, businesses continue
to expand their service offerings, and governments struggle to
derive revenues through taxes on such technologies.