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On May 16, 2018, the Virginia Department of Taxation upheld a local jurisdiction’s assessment of Business, Professional, and Occupational License (“BPOL”) tax on a taxpayer that underreported gross receipts related to Internet access services.1
While the Department held that the federal Internet Tax Freedom Act (“ITFA”)2
applies to the BPOL tax, the Department nevertheless upheld the locality’s assessment, declining to determine that the BPOL was subject to the ITFA’s “grandfather” clause.
The ITFA was originally enacted in 1998 as a temporary prohibition on state or political subdivisions from imposing: (i) taxes on Internet access, unless the tax was imposed and enforced prior to Oct. 1, 1998 (known as the ITFA’s “grandfather clause”); and (ii) multiple or discriminatory taxes on electronic commerce.3
Thus, the ITFA’s grandfather provisions not only preserved pre-1998 direct taxes on internet access, but also those pre-1998 taxes that may be considered indirect taxes on internet access. Since its enactment, the ITFA was continuously extended, until it was permanently signed into law in 2016.4
One of the primary purposes of the ITFA was to “foster the then fledging Internet in 1998 by temporarily suspending new taxes on internet access.”5
The many temporary extensions were viewed as an opportunity for Congress to “revisit whether the benefit of providing preferential treatment to one particular industry outweighed the cost of preempting state and local government authority.”6
Although the ITFA was permanently extended, its grandfather clause will gradually be phased out and finally eliminated on June 30, 2020. However, this phase-out will not apply to certain “specified taxes,” and those taxes, such as the Texas Franchise Tax, the Ohio Commercial Activity Tax, and the Washington Business and Occupation Tax, will continue to permissibly be imposed on internet access.7
Virginia’s Communications Sales Tax (“CST”) became effective on Jan. 1, 2007, to replace the majority of prior established state and local taxes and fees on communications services.8
The CST is imposed at a rate of 5%, upon the charge for or sale of communications services, and is generally collected on a monthly basis from consumers by service providers.9
There are a number of taxable and nontaxable services under the CST. Internet access service is an enumerated nontaxable service.10
In response to the ITFA permanent moratorium, several states, including Virginia, took a narrow approach in defining “internet access” for purposes of transactional taxes to compensate for the loss in revenue resulting from the ITFA.11
The CST defines an internet access service as “a service that enables users to access content, information, electronic mail, or other services offered over the Internet, and may also include proprietary content, information, and other services as part of a package of services offered to users.”12
However, the definition of internet access services explicitly excludes telecommunications services. Additionally, the same statute broadly outlines the definition of communication services, stating it includes, but is not limited to:
(i) the connection, movement, change, or termination of communications services; (ii) detailed billing of communications services; (iii) sale of directory listings in connection with a communications service; (iv) central office and custom calling features; (v) voice mail and other messaging services; and (vi) directory assistance.13
Further guidance from the Department has emphasized Virginia’s narrow interpretation of the federal enactment with respect to the CST. The Department issued a ruling directly after the passage of the statute that specifically includes certain internet services as part of the term “taxable communications services.”14
Later rulings dealing with the CST also deemed taxpayers liable for collection and remittance on sales associated with internet access services, interpreting the services as contained under the umbrella of communications services.15
Application of ITFA to the BPOL
In Virginia, localities are authorized to impose a BPOL tax generally on the taxpayer’s gross receipts for the privilege of conducting business.16
The tax is imposed and administered by local officials at different rates according to a taxpayer’s classification.17
Generally, taxable gross receipts include only those receipts attributed to a definite place of business within a jurisdiction; for a service provider, this is based on the place where services are performed, or from which they are directed or controlled.18
In computing the BPOL tax liability, a deduction from total gross receipts is permitted for certain qualifying activities, including gross receipts attributable to a business conducted in another state or foreign country in which the taxpayer is liable for an income tax or other tax based on income.19
In its most recent ruling regarding the ITFA, the Department considered an assessment issued under audit by a Virginia city for the 2016 tax period. As a result of the audit, the city determined that the taxpayer had underreported its gross receipts attributable to Internet access services, and issued a corresponding assessment for BPOL tax. The taxpayer subsequently appealed the BPOL tax assessment, insisting that the federal ITFA preempted the city’s BPOL tax because the gross receipts related to the assessment were attributable to internet access services. After the appeal was denied at the local level, the taxpayer appealed to the Department on the same basis.
The city maintained its assertion that the ITFA only applied to transactional taxes on internet access services. Therefore, as the BPOL is a tax of general application, it did not fall under the ITFA’s purview. Specifically, the city claimed that the BPOL tax should actually be considered an income tax for purposes of exemption from the ITFA. Additionally, the city contended that even if the ITFA were to apply to the BPOL tax, the tax itself was subject to the grandfather provision. Although the Department noted in its ruling that the taxpayer presented its own line of reasoning refuting the city’s arguments, the Department did not elaborate on the content of these arguments.
In its analysis, the Department recognized that in a 2017 public document ruling, it concluded that the ITFA applied to the BPOL tax.20
Following the publication of its ruling, the Virginia Supreme Court determined in Dulles Duty Free LLC vs. County of Loudoun21
that the Import-Export Clause of the United States Constitution22
prevented Loudoun County from imposing a BPOL tax on a taxpayer’s export goods that were in transit. In that case, the Court denied the county’s assertion that the BPOL tax was levied on the privilege of doing business and not simply a tax on goods, at least in light of the Import-Export Clause.23
The Court reasoned that rather than look towards the characterization of a tax for state law purposes and whether that characterization violates the Import-Export Clause, it should concentrate on whether the tax “in its ‘operation and effect’” was a direct tax on export goods in transit.”24
Therefore, although the Department may have considered other reasons as to why the ITFA should not apply to transactional taxes on the service itself, the judicial analysis in Dulles Duty Free
suggests that the determining factor of whether federal law preempts a tax is the operation and effect of the tax.
Additionally, the Department found that although the BPOL tax has been considered an income tax in certain contexts, it is still a tax generally on “the whole, entire, total receipts, without deduction,” per Va. Code Ann. Sec. 58.1-3700.1. As the BPOL tax is a broad-based gross receipts tax, it is unlike the state’s net corporate income tax generally applicable to businesses under Va. Code Ann. Sec. 58.1-400.
Lastly, the Department noted that in the past it has declined to issue any orders for correction based on a Virginia locality’s failure to prove it qualified for grandfather protection under the ITFA.25
This burden of proof generally falls on the party asserting an exception to a federal statute, and this rule is well documented through case law.26
In P.D. 18-24, the taxpayer requested that the Department reconsider P.D. 17-94, a prior determination addressing whether a Virginia city met its burden of proving it qualified for grandfather protection.27
The issue originally arose when the Department determined that the ITFA applied to the city's assessments of BPOL tax, inclusive of gross receipts derived from the taxpayer's charges for internet access. The Department determined that the city qualified for grandfather protection, evidenced by the fact that it collected BPOL tax on charges for internet access prior to Oct. 1, 1998. The Department determined that the ITFA generally applied to BPOL tax, and that the burden rests with any Virginia locality assessing BPOL tax on gross receipts derived from charges for internet access to prove it qualified for exemption under the grandfather provisions. However, when a matter makes its way through the Virginia administrative appeals process after a decision by a locality, the burden of proof for showing that the locality’s assessment was erroneous lies with the taxpayer,28
and that the Department must presume that a final local determination is correct.29
While the Department “may” issue an order correcting an erroneous or improper assessment, the Department is not required to do so.30
On this basis, the Department similarly declined to issue an order for correction in this ruling and upheld the city’s assessment.31
This ruling sheds light on the fact that the burden of proof shifting that occurs with respect to the grandfathering provision under ITFA is extreme. That, coupled with the fact that the Department has no explicit obligation to correct an erroneous or improper assessment, only complicates the ability for a taxpayer to overcome a city’s assessment. This perpetuates the state’s bias against claims that ITFA protects against taxation. This aggressive approach is difficult to reconcile with the policy behind the protective measures of the federal government in enacting ITFA. However, this ruling is consistent with the narrow interpretation of internet access services that Virginia has taken with respect to the CST in order to circumvent ITFA protection. Taxpayers should expect similar results in future rulings as Virginia continues to enforce its taxes despite conflicting guidance at both the state and local levels.
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