The Three Witches of Taxing

Death and taxes-these are the major constants in life, and telecom companies are not immune from either. Over the last several years, state and local governments have increasingly turned to the telecom industry as a revenue source alternative to the more noticeable sales, property and income taxes. Similar moves await the Internet, if the federal moratorium is lifted. As a result, telecom companies face a complicated maze that can put dozens of taxes on an individual bill, with serious reporting overhead as part of the bargain.

Taxation brings a three-level curse to a telecom company-jurisdictional determination, calculation and compliance. Just like the three witches in Shakespeare's Macbeth, each brews its own brand of trouble. Taxation errors seem to appear randomly and, worse yet, often start as small mistakes that go unnoticed by normal monitors. When the problem becomes large enough to be found by customers or auditors, it's already a very serious threat to the business. That threat can take the form of government action or consumer lawsuits for over-collection.

Jurisdictional Determination

Over- or under-taxing usually starts with errors in jurisdictional determination. Such errors usually occur during service provisioning. The provisioning process must gather details on the customer's billing address and the physical site of any landline service. Usually the consumer won't know the level of detail needed, so the systems have a gap to fill (see sidebar "Determining Jurisdiction: A Tale of Two Counties"). If they fail, incorrect tax rates are applied and payments are made to the wrong authorities. For example, assigning an incorrect county will cause underpayment to the correct taxing authority and overpayment to the other county.

As with any rule, jurisdictions can create exceptions-or in this case, exemptions. Customers ranging from nonprofit corporations to clergy and diplomats will often claim they are entitled to tax exemptions. Unfortunately, exemptions create a double edge of liability for a telecom company. If a valid exemption is denied, the customer may seek a refund of the taxes and probably change providers. If an exemption is improperly applied, the government may hold the provider liable for the missed taxes.

Thanks to new federal legislation, there is some hope-at least for the wireless industry. The Mobile Telecommunications Sourcing Act, which takes effect in 2001, will require states to provide a simple, uniform database of taxing jurisdictions. These databases, based on ZIP+4 codes, will give telecom companies a more reliable guide to determining home jurisdictions. Better yet, the law gives telecom companies that use the database a level of immunity if the database has any errors. In some cases, states are looking to apply these databases to landline services as well (see "Uniform Sourcing Forces Tax Changes," Billing World, October 2000).

This act doesn't solve the problem, but it's a good first step. Most landline services will still have the current laws to contend with. There are still obstacles to getting accurate address data and maintaining the new databases. For now, jurisdictional determination will remain problematic at best-potentially setting the stage for billing problems.

Billing Calculation

With proper customer data in hand, the billing process will have to accurately assess taxes for each charge on the bill, which is no easy task. Even supplying a valid rate schedule requires a huge effort. Applicable taxes can vary wildly, depending on the type of service and the locations involved with the billable event. Chances are that every charge will have several potential taxes applied to it. Each of these will have to be calculated and then properly recorded for a host of back-end uses.

Rate Schedules

First and foremost the billing system will need a valid tax schedule for every type of service offered and every jurisdiction served, directly or indirectly. Even if a provider's clients are all in one jurisdiction, extended service offerings-such as providing remote services like calling card long distance via resale-can expose the provider to remote jurisdiction liability. Chances are every telecom provider will have to answer to almost every jurisdiction in the United States. (Most international taxes are based on service line usage and collected through a PTT, so they aren't put on a U.S. customer bill). Since there are thousands of U.S. tax jurisdictions, it's highly advisable to subscribe to a well-known research tax vendor. Tax rate research is its own science-probably not something a telecom company wants to deal with.

Determining the Jurisdictions for Charges

Determining which taxes are applicable to a given charge first depends on the type of service. If it's a classic fixed-point telecom service-dial tone, for instance-it's a simple matter of applying the local taxes. Point-to-point services are another matter. With newer technologies the application of taxes is an evolving field. At least classic long distance has an established method.

Years ago court action set a firm method for determining jurisdiction for a long-distance call. It's often called the "two-out-of-three" rule. Three locations have to be determined: 1. The origination point of the call (although the location of the originating switch is acceptable) 2. The call termination point (again, the switch location is usable) 3. The service address (the exact physical location of the customers primary telephone). This address may or may not be the billing address, a distinction that many billing packages fail to make.

Whenever two of these three are the same at the country, state, or local level, that jurisdiction can tax the call. Take, for example, a customer with a primary phone in Houston. If the customer

· uses a calling card at a Dallas payphone to call another Dallas number: the United States, Texas, and Dallas can tax the call.

· uses a calling card to call from Dallas to Austin: only the United States and Texas match.

· uses a calling card to call from Dallas to Los Angeles: the United States and Texas match.

· uses a calling card to call from Florida to California: only the United States can tax the call.

· makes any direct-dial call: the United States, Texas and Houston match, since the origination and termination points match the service location.

Even though this process may seem simple when applied to telephone calls, complications arise with most of today's pricing schemes. Some examples: · Some states require taxation based on gross revenue rather than net revenue. If a pricing plan gives a percentage discount, these states will require taxes based on the charge before the discount.

· Plans that mix usage types can create havoc for tax calculation. If a plan includes a block of usage-say an hour of long distance-the charge for that block has to be taxed. If the usage is all direct-dial, the taxation can all be based on the home service location. If it includes calling card usage, exotic allocations may be required.

· Plans that give threshold discounts add special complexity, since the threshold is determined only when the usage is totaled. To properly apply the post-discount taxes (assuming the state doesn't require gross taxing), the billing process has to re-evaluate each call for taxes. (Note: many billing systems try to apply the discount and resulting tax credit to the home jurisdiction for simplicity, which can create a tax liability).

With Internet service the federal government has granted the industry a temporary reprieve with a tax moratorium. However, some states managed to implement taxes before the moratorium, so Internet service does not necessarily get an automatic tax exemption.

Right now, wireless service is usually following a variation of the two-out-of-three model, using cell towers and billing addresses as substitutes. However, this method is not a court-established rule, so some jurisdictions try to apply taxes if the call crosses the local cell site, regardless of any other factor.

Fortunately, the federal Mobile Telecommunications Sourcing Act will bring a remarkable simplification for mobile services: all taxes would be based on a single primary jurisdiction. The primary location (usually the billing address) would have jurisdiction over all charges, even roaming. This law may very well save the mobile industry from the pain the landline industry has endured for decades.

The trend toward convergent services is adding a new dimension to the tax calculation menace, since it mixes even more service types. So long as the bundled services are separately priced, the taxing and billing issues are the same as before. However, bundled pricing can create situations where an Internet service suddenly becomes subject to telephony taxation, making the net tax cost to the customer higher than if the services had not been bundled.

The principle with bundled services involves a rule sometimes referred to as "shrink-wrapping." Take a fruit basket bundle, for example. A piece of fruit bought individually is usually not subject to sales tax. However, if that fruit is shrink-wrapped with a gift basket and paring knife, which are taxable, the entire package becomes taxable-fruit included.

Exemptions appear during this process as well-not only those the customer has, but those of the transaction as well. If a customer has a valid tax exemption for a jurisdiction, the associated taxes are not applied (although a record should be retained in case of error). However, the charge itself may be exempt. For instance, calls coming out of a designated U.S. combat zone aren't subject to federal tax. Data charges are now under the Internet moratorium. There are even special exemptions that depend on where the bill is sent.

Bill Presentment Issues

Once the billing process successfully calculates the taxes, it still has the responsibility of printing the bill-and as usual the tax problem adds complexity. Under the guise of requirements for "truth in billing" or "simple billing," federal and state governments are imposing mandates on how taxes are printed on the bill. But most often these mandates work toward making the taxes appear as something else. For example: · Fees for the Universal Service Fund (USF), although a government-mandated charge, can't be shown as a tax. At least one state, Texas, is now requiring that taxes be included in the service charge-much like gasoline (see sidebar "Hiding Taxes: 'Bill Simplification' in Texas"). · Even when taxes can be included in a "tax" section, it becomes problematic to explicitly list them. In some cases, the states will require that the taxes be folded together in a 'sales and other taxes' line. In other cases the sheer number of different taxes forces telecom companies to fold them together to save printing costs. · In some cases, the law requires that the tax be included with explicit language on how it's shown on the bill. This forces a biller to use up bill lines-increasing billing cost.

Compliance: The Link to the Back Office

The final tax responsibility, reporting, is probably the most important-and it's the one where many billing systems fail. It is imperative that the billing system save information on every tax applied to every charge on the bill. Many billing systems will attempt to summarize the tax data for the sake of simplicity or faster implementation, or to cut down on the volume of data. But skimping here can leave a telecom provider exposed to a host of problems with compliance. Often overlooked, as most startups focus on provisioning issues, is that telcos are responsible for correctly remitting the tax returns to the tax authorities. More importantly, a few years down the road this archived tax data will serve as a first line of defense, when the eventual audit comes from one or more taxing authorities.

Audit Defense and Prevention

The audit defense has a particular importance, as full-scale audits are very expensive for the provider. At a high level, a taxing authority is going to be monitoring a ratio of revenues and taxes remitted. In the case of a smaller company, if the ratio seems to get out of alignment, an audit maybe triggered. Larger companies may end up subject to audits, anyway, as the taxing authorities squeeze for revenues.

When that audit comes, the provider must prove that the revenue ratios are correct. There are two critical foundations for proving the ratio: the billing detail and a correctly built tax compliance process.

Correctly built tax compliance processes have three primary components:

Information integration-Many billing systems implement their tax processes as a module separate from other systems. On the surface this approach seems logical, since most tax processes are purchased or require special expertise. So, a billing process will call the tax module, which returns the tax amount for the bill and then generates a feed for the tax return.

Unfortunately, this approach creates audit vulnerability and has a bonus of overpayment risk. It's possible, if not probable, that the billing process may subsequently alter the charges, or some charges may become unbillable further along in the process. As a result, the dollars journalized to the books will be out of alignment, and the taxes for any of these reduced charges will create an overpayment. So, although taxes charged to the customer may be correct, the remittance is out of alignment, potentially drawing an audit.

An audit history trail-If an audit continues past the revenue ratios stage, the auditors will probably start asking for charge detail-data that's probably at least two years old. Worse yet, this sort of detail can't be easily derived from printed bills, since taxes are often lumped together. If the audited company doesn't have a well-developed audit archive, it will be at the mercy of the auditors-and of course, they have none.

Exemption tracking-As mentioned earlier, certain customers are going to claim tax-exempt status, which needs to be documented. Unfortunately the onus will fall upon the telecom provider to maintain these records. If a telecom company exempts customers from taxes and can't prove the exemptions valid, the telecom company is responsible. It's vital to track the status of exemption claims and recheck it at the back end.

Accounts Receivable and Customer Service Impact

Although most providers would prefer to get paid for 100 percent of the billed revenue, it doesn't happen, and the resulting gap creates yet another tax consequence. Every time a customer calls in and gets an adjustment, credits are created that have to be dealt with. Further, some customers don't pay their bill, which eventually requires an A/R write-off.

When a customer balance is written off, there's a golden opportunity-being able to reclaim the taxes paid for that customer. This opportunity is created because the government asks for the taxes from the provider at bill time, rather than waiting for the provider to collect from the customer. If the customer doesn't pay, then the provider can reclaim the monies. Unfortunately, like any tax issue, it's not simple. The provider can only reclaim certain taxes, and doing so is contingent upon certain rules if the customer made any partial payments. For instance, a carrier can't reclaim USF, but X tax can be reclaimed. Many billing systems, due to data summarization or weak A/R processes, make this distinction impossible.

Similarly, handling customer requests for adjustment can create a lot of overhead, and many providers are trying to cut this cost by any means necessary. Such cuts often create tax risks. If the tax consequences aren't fully considered, the customer may get more or less than the real credit due, which may result in another costly call. Worse, if the tax credit is over-applied, it may draw government fire.

Summary

"Double, double toil and trouble"-that line that is so descriptive in Macbeth also sums up telecom taxation. A telecom provider must deal with jurisdictional determination, calculation and compliance, both separately and in unison. Failure to do so can create new levels of toil and trouble for a billing group that could probably do without it.

Paul Maddock is a Senior Consultant at Foxfire Consulting-specializing in revenue assurance, tax, and convergent billing. Prior to joining Foxfire, Maddock was a lead architect at AT&T Consumer Services. He can be reached via e-mail at pmaddock@foxfireconsulting.com

Sidebar

Hiding Taxes: 'Bill Simplification' in Texas

Despite efforts to simplify rates and jurisdictions, a new realm of tax complexity is emerging as states have imposed a number of taxes to fund everything from rural phone service to school Internet access. Some of these taxes are actually classified as fees and surcharges, but in the end they all end up raising the cost of service.

The initial regulations, in an attempt to promote the supported programs, usually required phone bills to explicitly present each tax, fee and surcharge. Over time, however, these items have become an unintelligible laundry list of small charges that have confused and irritated consumers. After a few years of consumer and industry complaints, one state is trying a new tactic with phone taxes: hiding them.

The state of Texas, which coincidentally has the highest telecom taxation rate in the country (up to 32.56 percent), is considering regulations that will require phone companies to incorporate a number of taxes into the basic local rate. These taxes would no longer be itemized on the bill.

Now, instead of having to explain the taxes, the industry will probably have to field complaints about the basic rates having gone up or being too high. Moreover, some Texas carriers are estimating it could cost up to $1 million to modify their billing systems to meet the new display requirements while properly accounting for the hidden myriad taxes in the background.

This approach isn't new. Most gasoline taxes are folded into the pump price and in Europe value-added taxes are usually incorporated into prices. The argument: "You can't buy it without the tax, so why bother separating it?" However, merchants in these cases still have to separate the taxes in the background.

In the meantime, telecom billing systems remain squeezed in the middle.

Sidebar

Determining Jurisdiction: A Tale of Two Counties

Determining the Right County:

The city of Dallas crosses multiple counties, including Dallas and Collin. Often the five-digit ZIP codes will cross counties as well. So, when Customer 1 orders service and gives a Dallas address, some tax software will mistakenly place the customer in Dallas County, where most of the city is-leading to incorrect taxing.

Getting the City Information Right:

Say for example that Customer 2 lives outside the city but has a Dallas mailing address. Some systems will interpret the Dallas mailing address to mean that Customer 2 is taxed by Dallas. This is incorrect, since she lives outside the jurisdiction, even though she has a city mailing address.