Government ends long-distance phone excise tax dispute.

On May 26, 2006, Treasury announced its concession in the legal dispute over the Federal excise tax on long-distance telephone service. The IRS also announced its decision to stop collecting the tax and to issue refunds of tax paid on long-distance service over the past three years. These announcements came after the U.S. recently lost, in rapid succession, three more appeals in cases involving the validity of the tax. On March 30, 2006, the Sixth Circuit denied the government's motion for an en banc rehearing in OfficeMax, Inc., 428 F3d 583 (6th Cir. 2005). The government filed its motion after the Sixth Circuit affirmed a district court decision and held that the taxpayer's long-distance telephone service charges must vary by both time and distance to be taxable under Sec. 4252(b)(1).

On April 27, 2006, the government suffered defeat in the Second Circuit; the judges devoted only two paragraphs to their opinion in Fortis, Inc., No. 05-2518 (2d Cir. 2006). Less than two weeks later, on May 9, 2006, the Third Circuit handed down its decision in Reese Brothers Inc., No. 05-2135 (3d Cir. 2006), discussing fully, and rejecting, all of the government's arguments. In total, the government lost five appellate decisions on this issue, which fueled speculation, for some time, that it would abandon further litigation.

Statutory Overview

Sec. 4251 imposes a 3% excise tax on certain communications services. The tax is paid by the person paying for the services (Sec. 425 1(a)(2)) and is collected by the person receiving payment for them (Sec. 4291). Communications services subject to the tax are local telephone service, toll telephone service or teletypewriter exchange service; see Sec. 4251.

Local telephone service is defined as access to a local telephone system and the privilege of telephonic-quality communication with substantially all persons having telephone or radio telephone stations in that system, as well as any service or facility provided in connection with local telephone service; see Sec. 4252(a). However, local telephone service does not include a service that can be categorized as toll telephone service or private communications service; see Sec. 4252(a).

There are two types of services that fall within the definition of toll telephone service. The first is a telephonic-quality communication for which there is a toll charge, which varies in amount with the distance and elapsed transmission time of each individual communication, and the charge is paid within the U.S.; see Sec. 4252(b)(1). The second type of toll telephone service is a wide area telephone service ("WATS"-type service) that entitles the subscriber, on payment of a periodic charge (determined as a flat amount or on the basis of total elapsed transmission time), to the privilege of an unlimited number of telephonic communications to or from all (or a substantial portion of) the persons with telephone or radio telephone stations in a specified area outside the local telephone system area in which the station provided with this service is located; see Sec. 4252(b)(2).

Teletypewriter exchange service is defined as access from a teletypewriter or such data station and the privilege of intercommunication with substantially all persons having teletypewriter or other such data stations; see Sec. 4252(c).

The Dispute

Under Sec. 4251, the 3% telephone excise tax is imposed on amounts paid for toll telephone service and local telephone service. Sec. 4252(b)(1) defines taxable "toll telephone service" (long distance) to include service for which there is a toll charge that varies in amount with the distance and elapsed transmission time of each individual communication.

Historically, the charge for long-distance telephone service was based on both time and distance. Under that system, a call from New Jersey to Pennsylvania was cheaper than a call from New Jersey to California, assuming the calls were of equal duration. As the telecommunications industry and supporting infrastructure became more sophisticated, billing practices evolved. Today, the common industry billing practice for long-distance communication does not charge based on distance. A call from New Jersey to California now costs the same as a call from New Jersey to Pennsylvania, if the calls are of equal duration.

The dispute was whether excise tax applies to modern long-distance telephone services, most of which no longer charge based on each call's distance.

Position of the Parties

The government had argued that "and" meant "or" in the phrase "distance and elapsed transmission time" in Sec. 4252(b)(1), and that the excise tax applied to long-distance telephone services even when the charges were not based on both the distance and duration of the call. It also had contended that the statute was ambiguous and should have been set aside in favor of an interpretation that Congress intended to tax all communication services, whether or not within the statute's scope.

Taxpayers argued that the statute is clear in its meaning and the distance element in Sec. 4252(b)(1) is not optional, but required, to be subject to the excise tax.

Five Strikes

The Second, Third, Sixth, Eleventh and DC Circuits all issued opinions rejecting the government's position that the word "and" means "or" in the phrase "distance and elapsed transmission time"; see Fortis, Inc.; Reese Brothers Inc.; officeMax, Inc.; American Bankers Ins. Group, 408 F3d 1328 (11th Cir. 2005); and National Railroad Passenger Corp., 431 F3d 374 (DC Cir. 2005).

All but the DC Circuit also rejected the government's arguments that long-distance telephone service falls under either (1) Sec. 4252(b)(2), as a periodic-charge service if the toll charge varies by elapsed transmission time alone or (2) Sec. 4252(a), as local telephone service. The government supported the latter argument by reasoning that all long-distance services require access to local telephone systems to originate or terminate the transmissions.

Government to Issue Refunds

In Notice 2006-50, the IRS said that long-distance telephone service and certain bundled services are nontaxable. The notice outlines the procedures for taxpayers to request refunds of Federal excise tax paid on such service. Interest will be paid on refunds.

According to a Treasury press release (IR-2006-82), refunds will not include tax paid on local telephone service; such service was not involved in the litigation.

Taxpayers may request a refund on nontaxable service billed after Feb. 28, 2003, and before Aug. 1, 2006, only on their 2006 Federal income tax returns. Individual taxpayers will be permitted to request either a refund of (1) a safe-harbor amount or (2) the actual amount of tax paid. Taxpayers requesting the actual amount paid will be required to maintain documentation (such as bills for each month during the refund period), and receipts, cancelled checks or other evidence that the amount requested was actually paid. Taxpayers other than individuals may only request the actual amount of tax paid; no safe harbor will be provided.

Notice 2005-79, in which the IRS stated it would continue to collect the tax under Sec. 4251 on all taxable communications services, has been revoked.

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.

FROM JOHN R. KEENAN, J.D., DIRECTOR, ELIZABETH MAGIN, J.D., LL.M., MANAGER, AND SHARLENE M. SYLVIA, CPA, MANAGER, DELOITTE TAX LLP, WASHINGTON, DC