Telecom Taxes Face Upheavals in 2006

With the passage of Congress’ contentious and voluminous tax bill for 2006 come changes in telecom tax rules that will force carriers to change their legacy billing systems. The taxes that continue to cause the most headaches for carriers, however, are the old ones.

The federal excise tax, for instance, continues to be a sore point with carriers that insist that they don’t fall under the Internal Revenue Service definition of taxable services for purposes of the FET, and RBOCs, wireless carriers and Internet providers are trying like heck not to pay those taxes, which industry-wide add up to hundreds of millions of dollars.

Service providers should be careful when setting up their tax modules and billing systems, because new technology is spreading faster than the IRS can rewrite tax code. Carriers can combine their various wireline/wireless/Internet services to their benefit, because tax liability can be reduced depending on how one bundles those services. Digital products delivered over handsets, for instance, can be classified differently for tax reasons; sophisticated carriers can alter digital signatures, making it difficult to determine which downloads are ring tones and which represent song and video clips. The real challenges occur when these bits are sent as IP packets using Session Initiation Protocol. Carriers can add and delete services or digital goods using the protocol at a keystroke, adding to the complexity of rating and billing by inserting taxation rules.

Much as wireline carriers can “hide” call origination to avoid paying higher termination fees to certain other carriers, tax liability with digital transmissions can just as easily be manipulated.

Unfortunately, the new tax rules don’t necessarily translate into less tax liability for carriers. As in years past, telecom taxes are among the most-heavily taxed services, exceeded only by gasoline taxes and levies on tobacco and alcohol. State and local taxes—which change rate and jurisdiction at the drop of a hat—still make up as much as 30 percent of a customer’s phone and Internet bills. Tax rates also depend on how a business defines itself: Is it a cable provider? A telephone company? An Internet provider? Though each of these entities might bundle voice, data and video, they’ll pay different tax rates depending on how they market themselves.

Here are several tax issues to look for in 2006:

The Federal Excise Tax
Carriers continue to argue that they don’t have to pay FET because, under IRS rules, the tax applies only to carriers that bill traffic based on both call duration and the distance between the originating and terminating central offices. More than a handful of lawsuits surrounding FET and call accounting are winding their way through the courts, says Dan Copeland, product manager for communications tax at Vertex Inc.

“Carriers argue that the calls being billed don’t fit what the IRS statute requires,” he says. “They argue that the calls are being billed on time only and not subject to FET.” ISPs such as AOL are refusing to pay FET, because they say they aren’t communications networks, but data networks.

Though the IRS has lost the FET argument in court, Copeland says, the agency is not giving up. In October it issued a notice to carriers that, in spite of court rulings, they are still required to collect FET money until the debate makes its way through the courts. “The IRS says carriers can file protective claims,” Copeland says, “and if the carriers eventually win, they can reclaim that money from the IRS in the form of a refund.”

The United States Telecom Association in mid-December sent a letter, signed by several carriers, to Treasury Secretary John W. Snow requesting that he urge the IRS to stop taking carriers to court or to come up with a more concise policy for FET.

States Could Start Taxing DSL
Disagreements continue over whether DSL is exempt from sales and use taxes continue. Though other telecom services access the Internet under non-discriminatory access rules, DSL is a different matter, Copeland says. “The Internet Tax Freedom Act of 2003—which states that all communication service purchased or consumed via an ISP is not a telecom service—extends the moratorium on taxing the Internet until 2007,” he says. Though most ISPs and service providers insist that DSL service is not subject to sales and use tax, states such as North Carolina and Pennsylvania have issued findings contrary to the Internet tax ban, and other states may not be far behind.

Streamlined Sales Tax
Some states have redesigned tax rules so online vendors’ tax burden is more on a par with bricks-and-mortar stores. The administrative burden on telecom companies is pretty high compared with businesses one finds on city streets, Copeland says. “Telecom carriers have myriad taxes, heavier compliance burden, must deal with more tax jurisdictions and pay more taxes,” he says. “Retail stores only are concerned with sales and use taxes.”

Thirteen states participate in the Streamlined Sales Tax Project, which seeks to even the playing field so ISPs don’t pay 20 percent in taxes while regular stores pay 10 percent. Some 13 states, six of which have passed legislation finalizing their tax simplification rules, adopted uniform definitions of enhanced services and sales and use terminology, and extend those definitions to the telecom arena. Those states signed a somewhat final agreement on Oct. 1 cementing the plan, though they are still hammering out some matters, such as technical details for the certified databases that record transactions, figure the tax and assign jurisdiction.

VoIP Tax Standards Taking Shape
Then there’s the unsettled issue of IP voice services, ensconced in court battles and regulatory debate. Some 13 states have issued opinions, bulletins and directions on whether they’ll tax VoIP. While the FCC and other federal entities debate the status of E-911 rules, many states still differ on whether VoIP is a communications service subject to E-911 taxes.

Hurricane Katrina and USF Charges
The FCC has told the governments of Louisiana, Mississippi and Alabama that it will send $211 million in emergency USF money so school systems and libraries can restring communications networks, buy PCs and other equipment, and restart Internet service. That’s not all, however. RBOCs and other service providers have to track any USF money applied to the recovery work they perform. Under suspended USF rules, FCC will let carriers apply USF funds to reconnect some residences to the E-911 system and restart LifeLine service for poor and elderly residents. Carriers also can apply “high-cost support funds” from USF to pay for reconnecting residents in Alabama, Louisiana and Mississippi. Under the suspended USF rules, outside carriers helping out in the Gulf Coast are designated “Temporary Eligible Telecommunications Carrier,” which also serves as a tax designation. It’s unclear whether Alabama, Louisiana and Mississippi will tax income earned in their states by outside telecom workers but there‘s a good bet they will. And the FCC fully expects the army of telecommunications and service providers using emergency funds to account for their spending. “All eligible communications carriers, service providers requesting support under these temporary rules must make available any documentation or records necessary to verify compliance with these rules,” reads the FCC Katrina order. The emergency USF order is at http://www.universalservice.org/download/pdf/FCC-05-178A1.pdf.

USF Applied to VPNs, Voice Mail
In an unrelated decision, Congress recently expanded USF rules to let schools, libraries and campuses purchase voice mail and VPN equipment, items that carry their own taxes and surcharges. The VPN equipment lets schools and libraries build LANs and WANs that interconnect classrooms, libraries and administrative offices. The burden on carriers will change with the addition of new services, most likely in the amount of money collected for the USF. Carriers that own and service those elements and networks will be taxed accordingly.

How Is Service Classified?
Every state and county classifies digital service and goods differently, and the downlink matters. Ring tones that reach servers and handsets via satellite can be classified as software, content or communications, depending on the jurisdiction. Tax too low or not at all, and you’ll still be responsible for the tax and may be audited. Carriers that have charged taxes improperly, however, end up being targets in class-action suits.