State Tax Return. Opportunity Calling? Texas Court Rules Certain Telephone Access and Operator Charges are Sourced to Texas.

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1 December 2008 State Tax Return Volume 15 Number 5 Opportunity Calling? Texas Court Rules Certain Telephone Access and Operator Charges are Sourced to Texas. Paul Broman David J. Schenck Houston Dallas (832) (214) Editor s Note: The State Tax Team is grateful to David Schenck for his assistance with this article and our telecom projects. David is a partner in our Issues & Appeals Practice in Dallas. He has successfully represented telecom companies in various appellate cases including: AT&T v. City of Dallas, 243 F.3d 928 (5th Cir. 2001) (set aside adverse order concerning competitive neutrality among competing local telephone service providers); Northrup v. Southwestern Bell, 72 S.W.3d 16 (Tex. App. Corpus Christi 2002, pet. denied) (successful defense of first ever cy-pres class action settlement in Texas); CoServ v. Southwestern Bell, 2003 WL (5th Cir. 2003) (successful representation regarding jurisdictional questions under the Federal Telecommunications Act and arbitration of interconnection arrangements); Southwestern Bell v. City of El Paso, 346 F.3d 541 (5th Cir. 2003) (successfully opposed local governmental agency s imposition of a fee on utilities crossing the agency s property); and Grande Communications v. Verizon, No (211th Tex. Dis. Ct. 2007) (set aside order and defeated action to bar Verizon's access in purportedly exclusive development). David has also worked with the State Tax Team on several other cases. We are proud to include him on the State Tax Team! In Southwestern Bell Telephone Co. v. Combs, 1 the Texas Court of Appeals denied Taxpayer s appeal for summary judgment that receipts from certain telephone access and operator assistance charges should be excluded from the numerator of the receipts factor as services not performed in Texas or as exempted receipts from interstate calls. The decision affirmed the trial court s decisions that: 1) Taxpayer s access and operator assistance charges are sourced to Texas; 2) the apportionment statute and regulations as applied to the Taxpayer did not violate equal protection; and 3) that certain testimony was properly excluded. 1 Southwestern Bell Telephone Co. v. Combs, No CV, 2008 WL (Tex.App.- Amarillo, Oct 28, 2008, no pet. h.). 1

2 Industry Background American Telephone and Telegraph Company dominated the telecommunication industry in the United States until 1982 when an antitrust consent decree, known as the Modification of Final Judgment, was entered. AT&T was required to divest its local exchange subsidiaries, known as Bell Operating Companies ( BOC ). Taxpayer was one such BOC with customers in Kansas, Arkansas, Oklahoma, Missouri and Texas. The United States was divided into 161 Local Access Transport Areas, known as LATAs. Within the LATAs, the BOCs provided local telephone service. Within the LATAs, Local Exchange Carriers ( LECs ) connected the individual telephone customer with the telephone network and provided local telephone service. Taxpayer acted as an LEC within Texas LATAs. The LECs continued to operate as monopolies in their local service areas, and the states acted as the regulators. LECs were restricted from offering any long distance telephone service between LATAs. Instead, long distance service was provided by interexchange carriers ( IXCs ). In the case of long distance calls, the LEC connected the originating customer to the IXC s network, and the IXC transmitted the signal across state lines where another LEC would connect that signal to the receiving customer. In order to open a two way telephone communication, the process was simultaneously reversed to carry a signal from the receiving customer back to the originating customer. The IXCs paid Taxpayer for use and maintenance of its LEC network as part of long distance telephone calls. The payment by the IXC was based upon a uniform access charge rule. Taxpayer s Revenues at Issue Three types of revenue collected by the Taxpayer were at issue for the years 1995 through Firstly, End User Common Line Charges were a flat rate charged regardless of whether long distance calls were made. These charges compensated Taxpayer for providing use of its local network to customers making long distance calls. Secondly, Special Access Charges were a fixed monthly fee charged to customers for dedicated telephone lines between the customers and the IXC s long distance network. Lastly, Operator Assistance Charges were charged on a pay per use basis for directory or dialing assistance. Since Taxpayer operated as an LEC in several states, it was required to apportion its taxable capital and taxable earned surplus components of the Texas franchise tax. Texas employed a single sales factor apportionment methodology for both the taxable capital and taxable earned surplus components. The same apportionment rule continues under the new margin tax. In general, the numerator of the sales factor includes sales of tangible personal property delivered or shipped to a buyer in Texas and each service performed in Texas. However, the Comptroller adopted a regulation providing that receipts from interstate calls are exempted from being included as Texas receipts. 2

3 Taxpayer asserted that: 1) the revenues at issue were not services performed in Texas ; 2) the revenues at issue were from interstate calls and therefore not Texas receipts; and 3) characterizing the revenues at issue as Texas receipts violated the equal protection guarantees. Sourcing of Access and Operator Assisted Charges The statutes and regulations do not clearly define the phrase services performed in Texas. When interpreting a vague or ambiguous statute, the courts look to the appropriate agency s interpretation unless it is plainly erroneous or inconsistent with the statute. Numerous Comptroller Hearing Decisions/Letters classified access charges for use of local telephone networks as services. In light of these administrative rulings, the court found that the Comptroller s interpretation of access and operator assistance charges as a service was reasonable. As to whether the access and operator assistance services were performed in Texas, the court considered that the customers requesting service were located in Texas and the Taxpayer s network, facilities and/or personnel were also in Texas. Therefore, the court found that the Comptroller s determination that the services were performed in Texas and are classified as Texas receipts was reasonable. However, before concluding that the access and operator assistance charges are included in the apportionment formula as Texas receipts, a second inquiry was required to determine whether such receipts were exempted from apportionment as interstate calls as provided in the regulations. Since exemptions from taxation are narrowly construed, uncertainties are weighed in favor of the taxing authority. 2 Taxpayer asserted that the interstate long distance calls are a single transmission across state lines and that customers could not make interstate calls without use of Taxpayer s local telephone network. Accordingly, the Taxpayer asserted that the access charges for use of the local network for the interstate call were a portion of the charges for interstate calls. The court concluded that Taxpayer s access services were independently contracted for and wholly performed in Texas, and that its customers were charged the flat or fixed access fees regardless of whether any interstate calls were actually placed. Therefore, the court found that Taxpayer s services were performed entirely in Texas. Although the services facilitated long distance calls, customers and IXCs paid Taxpayer for its facilities so that they could engage in interstate commerce. The court also considered the Federal Communication Commission s ( FCC ) characterization of the services provided by Taxpayer. The FCC interprets such services as interconnection of a customer to an IXC and that there is no transmission 2 Bullock v. National Bancshares Corp., 584 S.W.2d 268, 272 (Tex. 1979). 3

4 or routing of telephone calls. It was found that Taxpayer s access service was completed when the local customer was connected to the IXC. Regarding the operator assistance charges, the Taxpayer stated that such services are associated with a customer trying to make or place an interstate call, but the court found that such charges were for the use of facilities and personnel located in Texas and were not revenue from calls. Equal Protection Comparison of LECs and IXCs Taxpayer asserted that as an LEC, it was similar to an IXC since it also participated in the transmission of interstate communications via similar equipment in Texas. Taxpayer noted that the portion of receipts reflecting intrastate service for IXCs and certain transportation companies are not sourced to Texas, and Taxpayer was therefore treated differently from IXCs and other transportation companies. States have broad powers to impose taxes, but classifications among taxpayers may not be arbitrary, unreasonable or capricious. 3 Although IXCs and LECs have similarities such as equipment and facilities, the court noted there are differences in that LECs serve a local area while IXCs transmit across state lines. The difference in service areas was found to be a rational basis upon which the state may classify IXC s revenue differently from an LEC such as Taxpayer. Exclusion of Evidence The trial court had sustained Comptroller s objections to certain testimony in the form of affidavits. The appellate court ruled that Taxpayer was prevented from raising the issue. As a result, the Taxpayer had the burden of bringing forth a record to show that the trial court abused its discretion in sustaining the Comptroller s objections to the evidence. The appellate court concluded that such burden was not met in this case. Unfortunately, a procedural hurdle may have prevented influential testimony from being considered. Opportunity Calling? Although the appellate court s decision was not favorable to the Taxpayer, the decision may provide, or at least leave open, apportionment opportunities for taxpayers in other industries. Fully interstate transactions may qualify for the exemption. The court s holding does not require a taxpayer to bifurcate an interstate transaction into instate and out-of-state portions. If a taxpayer contracts to provide a full interstate service (e.g. communication or transportation), the interstate exemption may still be available and present savings opportunities. 3 Hurt v. Cooper, 130 Tex. 433, 110 S.W.2d 896, 901 (Tex. 1937). 4

5 Use of personnel outside the state might also trigger the exemption. The court s holding was based on the finding that Taxpayer s customers in Texas were serviced by network, facilities and/or personnel also located in Texas, thus the service transactions were determined to begin and end in Texas. This precise wording may provide an opportunity for certain taxpayers earning revenue from interstate facilities to favorably characterize such revenue as inter-state if nontexas employees are involved in providing such service. One thing is certain, sourcing and proper tax treatment of interstate services continue to provide many challenges for taxpayers and taxing authorities. This article is reprinted from the State Tax Return, a Jones Day monthly newsletter reporting on recent developments in state and local tax. Requests for a subscription to the State Tax Return or permission to reproduce this publication, in whole or in part, or comments and suggestions should be sent to Teresa M. Barrett-Tipton ( ) in Jones Day s Dallas Office, 2727 N. Harwood, Dallas, Texas or StateTaxReturn@jonesday.com.. All Rights Reserved. No portion of the article may be reproduced or used without express permission. Because of its generality, the information contained herein should not be construed as legal advice on any specific facts and circumstances. The contents are intended for general information purposes only. 5