February 2005

VoIP: New Technology Versus Legacy Tax Policy

BY Jim Nason, Partner, Deloitte Tax’s Technology, Media & Telecommunications Group

With the advent of Voice over IP (VoIP), the landscape of telephone communications is changing as dramatically as it did upon the advent of automated switching and cost-effective long-distance technologies. Until recently, the basic technology to make a telephone call had remained the same, but VoIP is taking hold and changing the way the world uses telephony.

When VoIP services first became commercially available, initial criticism of VoIP was aimed at its inconsistent, dubious quality, but today, the emergence of high-speed broadband services has significantly diminished these arguments. In fact, now enterprises are embracing VoIP services and on-premise IP telephony equipment, with some estimates saying that VoIP could completely supplant traditional voice services in less than 15 years. The implications of this forecasted revolution are far-reaching. Given that it is happening in an environment that is still dominated by the heavily regulated telephone services industry, these changes are bringing about unprecedented battles on the regulatory and tax fronts.

A New Era In Regulation And Tax
Currently under discussion is how this revolutionary technology should be treated for regulatory and tax purposes. The regulatory classification of these services could affect any or even all of the following:

• Whether or not state and local taxes are collected, and how;
• Applicability of local exchange carrier access fees;
• Universal service fund contributions;
• Availability of 911 emergency services;
• Law enforcement capabilities under the Commission on Accreditation for Law Enforcement Agencies (CALEA);
• Requirements, or lack thereof, for regulatory oversight and reporting.

In general, the U.S. Congress has been reluctant to impose tax burdens on anything remotely associated with the Internet. To date, it has prevented heavy regulation and taxation in an effort to avoid curtailing the robust, technological growth of online business, which might discourage investment in the Internet and related concepts. The tech market “bubble” still haunts recent memory; therefore, any potential slowing of Internet proliferation by raising the costs of use is deemed unacceptable.

So far, telecommunications service buyers, largely commercial enterprises and public users, have shouldered the financial burden of driving continued growth of Internet traffic and striving toward making telephone and Internet access universally available. Consumers, from both business and personal perspectives, pay taxes to support public Internet access and universal telephone availability, generally in the form of telecommunications taxes and surcharges — particularly charges related to the Federal Universal Service Fund. This fund, combined with existing state and local levies on telecommunications, can drive the tax burden to exceed 25 percent of the cost of service.

To date, the Internet Tax Freedom Act and its offspring (collectively ITFA) have been the major tax legislative guide regarding federal intent related to the Internet. Reaffirming its desire to squelch taxation of Internet access, Congress passed a retroactive Internet tax moratorium which was signed into law by President Bush in December 2004.

A significant battle has been raging at the Federal Communications Commission (FCC) where the issue is how, when, how much, and even if VoIP services should be regulated. If the FCC advocates limited regulatory oversight for all VoIP services, or even advocate complete independence from oversight by classifying VoIP as an “information service,” state taxing bodies could struggle to retain the litany of telecommunications taxes, fees, and charges.

Many tax administrators argue that most state and local tax telecommunication laws are written and enforced comfortably outside the relative reach of both Internet immunity considerations and regulatory classification. However, all parties tend to agree that the lack of clear tax guidance magnifies the potential tax issues.

The Impact Of Transaction Tax “Nexus”
Even if taxation of VoIP services could withstand the FCC’s broad-reaching regulatory interpretations, taxing jurisdictions must still operate within the guidelines of long-standing judicial decisions, tax law, and supporting regulations.

Many feel that VoIP taxation will be tested against the beleaguered and aged concepts surrounding “nexus,” which is roughly defined as the level of contact an entity must have with a jurisdiction before it is subject to the tax rules of that jurisdiction. As a result, nexus, rather than regulatory or even ITFA-like requirements, is likely to be the area around which the most significant skirmishes are fought. Nexus rules have, at their most basic level, dictated that companies must collect tax in jurisdictions where it has property or payroll (employees). The technology itself could allow VoIP providers to benefit from these rules. Lacking most of the requirements to operate a bulky, capital-intensive, circuit-switched infrastructure, a VoIP provider could limit its tax “footprint” to a small number of jurisdictions, reducing or altogether avoiding taxation. As a result, taxing jurisdictions, unable to reach VoIP providers due to nexus considerations, could be forced to forfeit this lucrative revenue source.

Ironically, this potentially dramatic shrinking of a traditionally stable tax base may go far beyond creating new pressures on state and local taxing jurisdictions, but also threaten the very mechanisms that fund universal service and expand public access to the Internet. Consumer advocates argue that since high-speed Internet access is usually required to use VoIP services, people unable to afford broadband access could be the only ones to bear the burden associated with universal services funds.

The U.S. government is already inundated by refund requests and litigation relating to the federal excise tax (FET) on communications, because it failed to keep pace with changing technologies. Although not a direct comparison, this tax controversy is indicative of what can be expected when tax law is not clear and up-to-date. Here, the U.S. tax code roughly holds that long-distance communications services are only subject to FET if they are measured by “time and distance.” In today’s world of plans that allow unlimited calling throughout the country, this wording has outlived its viability. The IRS argues that the intent of Congress was to tax long distance communications, but the problem is, that’s not what the law states. The matter is now in the hands of District, Circuit, and Claims Courts throughout the country.

The Cascade Effect
Far more than just a problem suffered by the telecommunications-buying consumer, the lack of clarity by various taxing bodies has a cascade effect on the communications companies. Today, the term, “communications company,” is not limited to the big carriers, but now includes wireless, wireline, telecommunications resellers, VoIP, and Internet access providers throughout the marketplace. This means these entities, too, must literally predict taxation rules that are yet to be written. They must interpret wide-ranging, conflicting laws and regulations across all the states and federal taxing bodies. In addition, potentially conflicting regulatory classification and broad-impact federal legislation could make meaningful compliance untenable, at best, for VoIP service providers.

There’s a good reason for state and federal taxing bodies to be concerned about a loss of revenues with the lack of VoIP taxation. After all, telecommunications is already one of the most comprehensively taxed services in the United States. In fact, aside from “sin” taxes (on products like tobacco and alcohol) and fuel taxes, it is difficult to find an industry levy with a higher burden or more complicated tax regime than the taxes, fees, and surcharges on telecommunications and related services. Taxes on telecommunications bring tens of billions of dollars into federal, state and local coffers, financing not only typical general fund expenditures, but also many programs, including universal service, deaf and disabled services, 911 services, and drug prevention.

VoIP Delivers Technology, Yet Wreaks Havoc On Taxes
Despite all the clear technological advances of VoIP, telecommunications tax departments are challenged with applying complex antiquated tax law to evolving VoIP product offerings and billing requirements. As a result, the telecommunications industry must constantly walk the tightrope between applying aggressive tax policy, which means charging customers less tax on services and thereby suffering the wrath of a government auditor’s alternative interpretation, or applying conservative tax policy (“when in doubt as to taxability, collect tax from customers”) and facing possible customer class-action suits.

While VoIP may rewrite our understanding of technology in the communications industry, it isn’t without a price. Its complexity just may compromise a formidable and somewhat stable tax base. If alternative methodologies are not implemented or existing legal interpretations reinforced, the uncertainties surrounding the questions of whether and how to apply tax could also lead to consumer and provider confusion, resulting in inconsistent billing amongst the players in the communications space and limiting new competition entering the market. With so many undecided factors, one thing is true: VoIP will fundamentally change the telecommunications landscape by altering the network used to complete the call.

Jim Nason is a Partner in Deloitte Tax’s Technology, Media & Telecommunications Group, where he is responsible for providing tax consulting and advisory services to clients in the telecommunications industry. This article does not constitute tax, legal, or other advice from, Deloitte Tax LLP, which assumes no responsibility with respect to assessing or advising the reader as to tax, legal, or other consequences arising from the reader’s particular situation. For more information, visit the company online at www.deloitte.com.

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