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Should VoIP be taxed?

Voice-over Internet protocol (VoIP) is a technology that allows a user to make a telephone call over a broadband Internet connection, instead of a telephone line. This technological twist on the old-fashioned telephone call has allowed VoIP providers to avoid a plethora of regulations and taxes at both the Federal and state levels. However, the time may have come for the g authorities to ring VoIP's bell.

What Is VoIP?

Generally, VoIP software converts a voice signal at one end of the line into digital data packets (which are carried over a broadband Internet connection) and then converts them back into a voice signal at the other end. Most VoIP providers allow users to place calls to any standard phone number worldwide and offer more features than traditional phone service, at lower cost.

Regulatory Control

States such as Minnesota have tried to assert that VoIP is subject to the same public utility regulations as traditional phone service. However, in a recent ruling, the Federal Communications Commission (FCC) declared that VoIP is not so subject; see In the Matter of Vonage Holdings Corporation Petition for Declaratory Ruling Concerning an Order of the Minnesota Public Utilities Commission (FCC 04-267 (2004)). The FCC reasoned that because the VoIP provider had no means of directly or indirectly identifying the subscriber's geographic location, VoIP could not be separated into interstate and intrastate communications; thus, Minnesota's regulations would likely interfere with interstate communications.

In line with this ruling, legislation proposed in both the House and Senate would have limited the regulatory power over VoIP strictly to the Federal government; see the VOIP Regulatory Freedom Act of 2004, HR 4129 and S 2281, 108th Cong., 2d Sess. (2004). The Senate version, unlike the House version, would also have allowed for state taxation of VoIP. Currently, neither bill has been reintroduced.

Although the FCC's action displays its power to preempt state regulations that thwart or impede Federal authority over interstate communications, it still leaves unanswered the question of state taxation of VoIP.

State Taxation

Historically, the Internet has been off limits to state taxation. The fear has been that the cost of taxation would impede new technological advancements and reduce the number of users who could afford Internet access. In 1998, Congress passed the Internet Tax Freedom Act (ITFA) (P.L. 105-277), which imposed a three-year moratorium on Internet access taxes, and on discriminatory and multiple taxes on electronic commerce. It extended the ITFA, without change, for two years. Although the ITFA was allowed to expire in late 2004 (after much debate), Congress retroactively extended the tax moratorium to Nov. 1, 2007, when it passed the Internet Tax Nondiscrimination Act (ITNA) (P.L. 108-435); for a discussion, see News Notes, "Extended Moratorium on Internet Taxes," TTA, February 2005, p. 64. However, unlike the ITFA, the ITNA clarified that VoIP is not protected from state taxation.

With VoIP no longer cloaked in ITFA's protection, state taxing authorities have already taken steps to tax it. For instance, Pennsylvania recently issued a sales tax bulletin providing that "VoIP is a taxable telecommunication service subject to Pennsylvania state and local sales tax"; see PA Dep't of Rev., Sales Tax Bulletin 2005-02. The bulletin notes that the ITNA specifically excludes Vole and although the FCC has ruled that VoIP is not subject to state public utility regulation, it expressed no opinion on state taxation of the service. Other states are likely to follow suit.

Federal Taxation

Sec. 4251 imposes a 3% excise tax on certain communications services, including local and toll telephone service. Sec. 4252(b) defines toll telephone service as service whose toll varies based on distance and elapsed transmission time. VoIP, like some traditional telephone services, does not fit within this definition and, thus, is not subject to this excise tax, because:

1. Most VoIP providers offer service on a flat-fee basis, without regard to distance or time.

2. Unlike traditional telephone service, a link is not created and maintained between VoIP subscribers during a call.

3. The VoIP subscriber's geographic location is not always known.

These factors make it almost impossible to determine a call's distance and elapsed time.

Tax reform: In an effort to combat the erosion of the Federal excise tax base, the IRS issued an Advanced Notice of Proposed Rulemaking (REG-137076-02 (7/2/04)) requesting comments or suggestions from the public on possible revisions to the communications excise tax rules. It seeks to update these rules, to reign in some of the nascent technologies (such as VoIP) that have developed outside of the statutory language's reach. Naturally, the advanced notice has been met with responses from many communications companies, urging the Service not to subject VoIP to Federal excise tax. The providers cite reasons such as the impracticality of tracking VoIP service and the preservation of technological innovation.

The Joint Committee on Taxation (JCT) also tried to deal with modifying the Federal excise tax on communications. Its report, titled "Options to Improve Tax Compliance and Reform Tax Expenditures" (JCS-02-05 (1/27/05)), tries to reduce the tax gap by curtailing tax shelters, closing unintended loopholes, addressing other areas of noncompliance and reforming certain tax expenditures. One of the report's proposals presented three options for modifying the Federal excise tax on communications. Under the first, it is uncertain whether VoIP would be considered taxable. However, under the second and third options, VoIP would clearly be subject to excise tax.

Lastly, in January 2005, President Bush signed an Executive Order (Exec. Order No. 13,369, 70 Fed. Reg. 2,323 (2005)), establishing the President's Advisory Panel on Federal Tax Reform, and formally announcing the members. The panel has been assigned to reform the Code to make it more simple, fair and pro-growth. VoIP taxation seems very likely to be one of the issues addressed.

Although nothing has been finalized, it appears that the Federal taxation of VoIP is inevitable.

Future Regulation and Taxation

Due to the ever-changing landscape of the Internet and communication services, future regulations and statutes will have to be artfully crafted and continuously updated to keep pace and prevent the Federal and state tax bases from eroding. The evolution of communication services (such as VoIP) should serve as a reminder of how quickly technology can surpass a statutory definition and, thus, escape the reach of both regulators and taxing authorities.

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Title Annotation:voice-over Internet protocol
Author:Janiczek, Randall
Publication:The Tax Adviser
Date:May 1, 2005
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