Legal Notice 97 -9exp
Attached is a discussion draft of the regulation dealing with allocation and apportionment of income of the telecommunications, subscription television, internet access, and electronic information industries. If adopted, the regulation would provide a number of exceptions to the normal apportionment rules for members of those industries.
The Information Age has arrived. Data, audio, video, computer programming and graphic image information is being transferred from one point to another at an astounding rate. A number of business enterprises are involved in such services, including the telephone industry, cable television, electronic information service providers, and internet access providers. There is similarity between many of these enterprises, and some overlap, and many are expected to merge in time. For that reason, this discussion draft regulation addresses all of these industries together.
The Uniform Division of Income for Tax Purposes Act (UDITPA) was originally drafted in the middle 1950s, at a time when electronic transfer of information was largely limited to the telephone. Concerns regarding the application of UDITPA to regulated public utilities, like telephone companies, led the original drafters of UDITPA to exclude such industries from the application of UDITPA. Nevertheless, Californias version of UDITPA (Sections 25120-25138, Cal. Rev. and Tax. Code) makes no distinction between public utilities and other businesses, applying UDITPA to all. UDITPAs rules for treatment of receipts from sales other than sales of tangible personal property (UDITPA Section 17, Cal. Rev. and Tax. Code Section 25136), considered barely "adequate" when drafted (Pierce, Uniform Division of Income for Tax Purposes, 35 Taxes 747, 780), are badly out of date with respect to all facets of the communications industry.
The standard UDITPA property factor rules (UDITPA Sections 10-12, Cal. Rev. and Tax Code Sections 25129-25131) do not clearly provide for the treatment of property not physically located in any state (e.g., satellites, undersea cables, etc.). In addition, because the standard property factor is limited to real and tangible personal property, the factors failure to include the taxpayers often tremendous investment in FCC licenses arguably fail to reflect the true income-generating capacity of the industrys critically important intangible assets.
Under UDITPAs Section 18 (Section 25137, Cal. Rev. and Tax Code), if the allocation and apportionment provisions of the UDITPA do not fairly represent the extent of the taxpayers business activity in the state, the taxpayer may petition for or the Board may require, in respect to all or any part of the taxpayers business activity, if reasonable, the employment of any other method to effectuate an equitable apportionment of the taxpayers income. A number of regulations have been drafted under the authority of that section to deal with the unique issues presented by special industries, such as the provisions of 18 Cal. Code of Regs. Section 25137-4.1 which deal with the allocation and apportionment of income of banks and financial corporations.
The only California regulation currently significantly affecting any portion of the communications industry is 18 Cal. Code of Regs. Section 25137-8, which deals with apportionment of income of the broadcast industry. While a number of issues are in need of development with respect to that regulation, some of which may relate to the industries which are the subject of this discussion draft regulation, the broadcast industry would not be affected by this draft regulation, except to the extent that its business activities expanded into the activities described by the regulation.
Concerned about problems with the standard statutory apportionment formula for these industries, the staff of the Franchise Tax Board conducted a symposium in Sacramento on March 22, 1995. About 50 taxpayer representatives and practitioners participated.
The purpose of the symposium was to present an opportunity for members of the industry and other interested parties to inform the staff as to technology, types of services, how services are provided, targeted markets, pricing, and billing procedures that would be useful in drafting a regulation. At the conclusion of the symposium, invitees were asked to submit written proposals for future consideration by the staff. To date, no comments have been received. The staff plans to hold a second symposium to solicit comments on its discussion draft regulation.
A. The Sales Factor.
The standard UDITPA sales factor for sales of other than tangible personal property is contained in Section 25136, Cal. Rev. and Tax. Code, which provides:
Sales, other than sales of tangible personal property, are in this state if:
(a) The income-producing activity is performed in this state; or
(b) The income-producing activity is performed both in and outside this state and a greater proportion of the income-producing activity is performed in this state in than any other state, based on costs of performance.
These provisions, and their associated regulations, present numerous definitional, practical and administrative problems with respect to the taxpayers addressed in the discussion draft regulation.
1. Cost of performance
a. Definition of "Cost." The elements of cost of performance, which, under the regulations include only "direct costs," are not well defined.
b. Common Costs. There are no guiding principles to deal with assignment of costs which are commonly incurred for many customers. This is particularly true for large information data banks, for example. It is not clear the extent to which such costs should be considered "direct" costs, or whether such costs, because associated with a large customer base, should be considered "indirect."
c. Identification of Costs. There are extraordinary pragmatic problems with trying to identify specific costs associated with specific receipts. Under 18 Cal. Code of Regs. Section 25136(b), each separate item of income must be examined to determine its associated income-producing activity and cost of performance. Sellers of telecommunications and information provider services can have literally billions of charges. With modern telephone technologies, telephone calls are instantly and continuously rerouted through a complex system of microwave transmission, fiber optics, satellites, and cable. Requiring telephone companies to identify costs of performance for each call is a monumental, if not impossible, burden on the telephone industry, and an equally great burden on the taxing agencies to audit and verify.
The department and the telephone industry have recognized the difficulties associated with the existing rules of Section 25136, as it relates to the industry. The practice of the department, as reflected in the departments Multistate Audit Technique Manual, is to assign receipts from interstate and international calls to California based on California net plant facilities used in the call to total net plant facilities used in the call. In many respects, however, this method presents many of the same difficulties as the cost of performance rule, because of the difficulty of determining plant facilities used in the call.
2. Purpose for the Sales Factor. The historical justification for the sales factor is that apportionment should recognize the role of the market state in the production of income. Nevertheless, as noted, sales other than sales of tangible personal property are assigned to the state in which the greater proportion of the income-producing activity takes place based on costs of performance. Even if such costs could be determined, the state in which the greater proportion of the income-producing activity takes place will often not be the state in which the market for the service is located. In fact, for many major providers of telecommunications and information services, the major costs of providing the services are those associated with the facilities and personnel used to provide the services, so the standard sales factor merely duplicates the property and payroll factors.
The assignment of receipts based on "net plant facilities" creates special problems for telephone resellers. Telephone resellers, for the most part, utilize the long-lines and equipment of the major telephone carriers, and have little "net plant facilities" of their own. Most of a resellers telephone "net plant facilities" are switching devices, often covering a geographical area of several states. Thus, the use of "net plant facilities" for resellers tends to concentrate receipts from telephone calls from many states into a single state, exaggerating the lack of reflection of the market state. Moreover, if the telephone reseller is economically neutral regarding the location of its switching facilities, the "net plant facilities" rule might provide an incentive to locate such facilities in a low or no-tax state. Long-line providers dont have that opportunity, because of their commitment to providing a physical connection into the receiving state.
B. The Property Factor.
While the sales factor is the most troublesome, the property factor also presents problems. Property such as satellites and undersea cables are not located within the jurisdiction of any state or country. The effect of inclusion of the value of this property in the denominator of the property factor without being in the numerator of any state is that a portion of the income of the taxpayer is not apportioned to any jurisdiction. In Communications Satellite Corporation v. Franchise Tax Board (1984) 156 Cal.App.3d 726, the Court of Appeal upheld the Franchise Tax Boards method of treatment of such property, which generally assigned the value of such property proportionately back to the taxpayers land based property.
For cellular companies and other companies that dont use wires or cables but have a license to use a portion of the electromagnetic spectrum, including only real and tangible personal property in the property factor arguably does not properly reflect the extent of its income-producing activities in a state. The license has a definable value, and an association with a specific geographic region, and it should be included in the property factor.
Modern-day interstate telecommunications networks were described by the Supreme Court in Goldberg v. Sweet, (1989) 488 U.S. 252, 109 S.Ct. 582.
- Today, a computerized network of electronic paths transmits thousands of electronic signals per minute through a complex system of microwave radios, fiber optics, satellites, and cable. [citations omitted] When fully connected, this network offers billions of paths from one point to another. [citations omitted] When a direct path is full or not working efficiently, the computer system instantly activates another path. Signals may even change paths in the middle of a telephone call without perceptible interruption. [citation omitted] Thus, the path taken by the electronic signals is often indirect and typically bears no relation to state boundaries. The number of possible paths, the nature of the electronic signals, and the system of computerized switching make it virtually impossible to trace and record the actual paths taken by the electronic signals which create an individual telephone call. p. 254-5.
There are at least three global satellite networks on the horizon. One such system would consist of hundreds of satellites operating on a very high frequency band width equipped with new asynchronous transfer mode (switching) technology. As planned, the satellites would receive signals from phone-book size receivers and tiny antennas in homes and businesses and feed them to hundreds of ground stations connected to the regular telephone systems around the world. The network will offer a broad array of interactive voice, data, and video services. Users would be able to access the network with hand-held devices and receive data almost anywhere, even inside buildings.
Wireless services - carrying phone calls, two-way data, and video programming - are expected to become an important part of the nations future communications. Today, a variety of mobile radio services is being provided to the public, including cellular phone, paging, dispatch, pocket-phone, and mobile data services. Recently, the Federal Communications Commission (FCC) carved up the country into specific licensing territories for a category of services known as "narrow-band personal communications service".
Companies providing wireless services possess valuable licenses to use a portion of the electromagnetic spectrum. On the other hand, they use relatively few physical transmission facilities. In addition, their customers are likely to use the service at multiple locations rather than at a single location.
Companies that provide teleconferencing, paging, and "900 services" subscribe to services provided by local exchange companies and interstate carriers. A large number of companies purchase bulk services from interstate carriers and resell them in smaller quantities at lower rates than the carriers sell such services. There are many owners of private networks which sell the use of those networks to others. Some companies provide interstate services by subscribing to services provided by interstate carriers or by using facilities owned by those carriers and patching together their own interstate networks.
Telecommunications companies bill their customers on a variety of bases. Private telecommunications services are billed at a flat rate associated with terminals and mileage between locations. Companies that provide switching services, such as teleconferencing, bill based on the cost of providing the service. The long-distance carriers bill based on distance, length of call, and time of day or day of week.
Transmitting messages often is combined with information processing, and it is difficult to separate the two. Services are being developed that link desktop computer networks and business telephone systems, provide interactive video, and use telecommunications networks that can handle enormous quantities of text, images, and video. The vision of the leaders of the industry is a box in every home to manage TV and cable channels, to play games, do shopping, learn about the world, listen to music, watch movies, and edit family videotapes.
The Internet is an international network of computer networks that is not, as a whole, owned or operated by any single entity. It is made up of many networks of various sizes. All of the computers on the Internet communicate with one another through one communications protocol. The Internet began in 1969 as an experimental project linking computers and computer networks owned by the military, defense contractors, and university laboratories conducting defense-related research. In 1986, the National Science Foundation developed a high-speed network to allow researchers access to its new supercomputer sites and to provide a faster medium for data transmission between sites. Having reached far beyond its research origins, that network is now referred to as "the Internet". Today, the Internet connects 50-60 million of the worlds people through a seamless digital network.
Data transfer on the Internet occurs primarily between a customer (a personal computer) and a "server" or "host" computer. The customers computer initiates a request for data and the server computer responds to, or serves, the request. Servers are typically running and connected to the Internet 24 hours a day. The World Wide Web contains a multitude of "Web sites" which are a collection of Web documents usually consisting of a "home page" which may in turn link to other pages. Typically, the World Wide Web is a subset of Internet servers that support the protocol adopted by participating networks to control the transfer of most documents traveling over the Web.
Access services are those services that enable a customer to get onto the Internet. Access is usually accomplished through a modem and a local telephone circuit. Access to the Internet is provided by telecommunications companies and other private enterprises. Several of those Internet access providers also sell information through a Web site. The Internet access provider maintains a "point-of-presence" in every major market typically consisting of a leased room with modems and routing equipment. The customer is charged a fee for the service. Internet access providers also offer, in many situations, electronic mail, a Web site, and access by means of browsers.
Information services are provided by on-line service providers, by some Internet access providers, and by means of Web sites of third-party content providers. Such services include travel, brokerage, sports, and entertainment services plus information traditionally delivered in tangible form such as newspapers, magazines, books, and music. An increasing number of on-line retailers are paying a sales commission as well as an advertising fee to electronic information service providers (e.g., America Online) in exchange for prominent placement on their high-traffic Web sites. In a recent transaction, it was estimated that agreements with two on-line retailers will bring the on-line service provider $44 million in revenues.
Historically, cable television companies picked up broadcast programs off the air and distributed them to their customers. The transmission was one-way only. Today, cable companies are building high capacity, two-way transmission facilities. They are providing their own programming. Cable companies are preparing to offer telecommunications, Internet access, digital, and interactive services. Another recent innovation is direct satellite television.
The Discussion Draft Regulation.
The discussion draft regulation sets forth proposed apportionment rules for providers of telecommunications, subscription television, Internet access, and electronic information services. Authority for the discussion draft regulation would be Section 18 of UDITPA (Section 25137, Rev. and Tax. Code). The format of the discussion draft regulation is similar to Cal. Code of Regs. Section 25137-12, Print Media.
Subsection (b) of the discussion draft regulation defines the terms used in the substantive portions of the discussion draft regulation. "Telecommunications" and "telecommunications service" are defined broadly but expressly exclude Internet access, subscription television, and electronic information services. Separate rules are provided for the latter taxpayers. This distinction also avoids the uncertainty as to whether the latter taxpayers are properly characterized as in "telecommunications." The definitions are patterned after those in the tax laws of other states (e.g., Tennessee) and FCC regulations.
The definition of "electronic information service" is patterned after the definition in the New York Tax Law. The definition of "subscription television service" is patterned after the definition in the Texas Administrative Code. The definition of "private telecommunications service" is derived from the New York Tax Law. The definitions of "communications channel" and "channel termination point" are from the "Glossary of Telecommunications Technologies" in Maybin, Low Voltage Wiring Handbook, McGraw-Hill, Inc. 1995.
Paragraph (c) of the discussion draft regulation contains rules for determining the property factor and sales factor numerators of the apportionment formula to be applied to taxpayers providing the applicable services.
The property factor is broadened to include licenses granted by the FCC. The reason for including licenses is two-fold: (1) the trend to wireless services has increased the importance of the electromagnetic spectrum as a medium of transmission and (2) recent auctions conducted by the FCC have resulted in amounts in excess of $11 billion being committed to investment by telecommunications companies in licenses to use the electromagnetic spectrum. One company, a new-comer to telecommunications, committed to pay $4.2 billion for a number of those licenses. In fact, as these trends continue, a large number of telecommunications companies will have relatively little investment in wires and cables compared to licenses.
At the March 1995 symposium, concerns were expressed regarding inclusion of FCC licenses in the property factor, on the ground that past licenses were obtained for nominal amounts, and the disparity in the costs for licenses could result in distortion. However, the problem of historical cost not representing the current value of property is not unique to FCC licenses--most property held for a substantial length of time will show similar disparity between cost and current fair market value. But, as noted above, failure to represent the costs of licenses results in its own distortion. If substantial distortion exists, the discussion draft regulation will not prevent the taxpayer from making an ad hoc showing under Section 18 of UDITPA (Section 25137, Rev. and Tax. Code).
The discussion draft regulation attributes tangible personal property that is not located in any particular state (such as satellites, undersea cables, etc.) to California based on the proportion within California of all property (other than property not located in any state) used in furnishing the service in question. In view of the impending widespread use of satellites and other such property, a spread based on other property used in furnishing the service is thought to be the most appropriate attribution rule.
The value of a multistate license is attributed to California based on a population ratio for the geographic region of the license. The assumption in this rule is that utilization of the license is roughly proportionate to the number of potential customers in the applicable geographic region of the license.
The attribution to California of gross receipts for purposes of constructing the numerator of the sales factor represents a significant departure from the standard apportionment formula. Separate rules are provided for receipts from (1) telecommunications services, (2) subscription television services, and (3) electronic information and Internet access services. It was felt that the different characteristics of the services require different attribution rules. In each instance, a "throwback rule" is provided when a taxpayer is not taxable in the state to which gross receipts would be assigned under the primary rules of the regulation.
Telecommunications Services. The sales factor in the draft regulation attributes gross receipts from the furnishing of telecommunications services (other than private telecommunications service) to California if the call originates in California and is not a collect call, or is a collect call billed to and received by a customer in California. With respect to originating calls, the place of origin of the call is thought to be the closest representation of the market, because it is at that point that the customer receives the benefit of the telecommunications service. While the party receiving the call also receives a benefit from the call, the originating customer is the party paying for the service.
With respect to collect calls, the user at the receiving location receives the benefit of the call, and the owner of the receiving equipment is the party paying for the service. Using the destination of the collect call as the location of the sale also avoids nexus problems for collect calls, which can be placed from anywhere in the world.
If the service provides for unlimited calling within a specific geographic area and is billed to a customer in California, gross receipts derived from that service are attributed to California.
A "throwback rule" is provided in the event the receipts are not attributable to any other state or the taxpayer is not taxable in the state to which the receipts are otherwise attributable and the taxpayers billing address is in California. In many instances, the billing address may be expected to reflect market more so than commercial domicile. In the case of a multistate business, using a billing address rule could be expected to assign sales to the various states where the business is conducted rather than just to the single state where the commercial domicile is located.
Gross receipts from the furnishing of private telecommunications services present a unique problem. Charges for such services are usually not based on usage but are flat charges based on terminal equipment and length of channels between termination points on the private network. The discussion draft regulation provides that if the segment of an interstate private telecommunications network is separately billed, charges imposed at each termination point in California and for service in California between those points are attributed to California. In addition, 50 percent of the charge imposed for service between a termination point outside California and a termination point inside California measured by the nearest termination point inside California to the first termination point outside California relative to the point inside California is attributed to California. If each segment of the private telecommunications network is not separately billed, interstate and international channel charges are attributed to California based on the ratio of termination points in California to total termination points on the network.
Subscription television. Gross receipts from furnishing subscription television services which are charged by reference to a subscribers location in California are attributed to California. The subscribers location is where the information and entertainment is consumed, and is clearly the market state for such services.
Electronic information and Internet access services. Gross receipts from furnishing electronic information or Internet access services are attributed to California if (1) the taxpayer has a physical presence (as defined) in California and the information is received or the Internet access is provided at a customers connection point in California or (2) the information is simultaneously received or the Internet access is simultaneously provided at connection points in and outside of California and the charges are for delivery to or equipment in California. In the latter situation, if the charges are not for delivery to or for equipment or for Internet access at a specified connection point, only that proportion of the gross receipts equal to the percentage of connection points in California is attributed to California. Connection point is defined as the physical location of a customer at which a transmission of information originates or terminates.
If the exact location of the customers equipment at which information is received or Internet access is provided cannot be determined, it is presumed that the information is received or the Internet access is provided at a customer location in California if the information is received or the Internet access is provided through a local telephone exchange in California. If information is not received or Internet access is not provided through a local telephone exchange, the information is presumed to be received and the Internet access is presumed to be provided at the customers billing address. This reflects the fact that most local exchanges are exclusively in a single state, and the most customers will access the local exchange to avoid long distance charges.
A "throwback rule" is provided for electronic information and internet access receipts in the event the taxpayer does not have a physical presence in the state in which customer connection points are located. In that situation, such gross receipts are attributed to California if the taxpayer is physically present in California and the customers billing address is in California. If the taxpayer is not physically present in any state in which the customers connection points are located or in the state of the customers billing address (or the customers billing address cannot be determined), gross receipts are attributed to California based on a "cost of performance" ratio (as defined).
The reason why a "connection point" rule was adopted for internet access providers and electronic information services is that the connection point is normally the place from which the customer initiates its communication with the taxpayer, and where the benefit of the information sought is received.
There were a number of reasons why a physical presence limitation was added for such receipts.
a. It is uncertain under the case law whether physical presence is a required condition for tax nexus to exist for income tax purposes under the U.S. constitution; economic presence might be a sufficient condition to satisfy constitutional nexus requirements for such taxes. Because of that uncertainty, if throwback applied only if an entity were not "taxable" in this state, massive amounts of sales described by the regulation, particularly internet sales, would be left in uncertain status, either as market state sales or as throwback sales. That uncertain status could be unresolved for many years. Leaving the apportionment standard at physical presence is comfortably within the U.S. jurisdictional limitations, minimizing uncertainty.
b. Even if economic presence were ultimately held to be a sufficient basis for nexus to impose an income tax, in many cases it is difficult, if not impossible, to determine the taxpayers which generate internet sales. The internet, by its nature, is often anonymous.
c. In addition, if the constitutional nexus standard were broadened to economic presence, requiring filing of returns and collection of tax for inbound transactions would probably be quite difficult. On the other hand, under the same standard, most California internet sellers would never throw back their sales to California, putting the state in a revenue whipsaw. By limiting the application of the rule to physical presence, the department would be examining taxpayers most of which are already in the compliance system.
d. If all states adopted a broad market rule under an economic presence standard, such a rule would generate a substantial compliance burden for small internet sellers which may have buyers in all fifty states, but only minor amounts of sales in any particular state. Under the rules of the draft regulation, such sellers are unlikely to have a physical presence in those states, and would not be obligated to apportion their income to those states.
Where, because of lack of physical presence or tax nexus, the primary rules cannot operate, there is a throwback of electronic information and Internet access receipts, which are assigned based on the "cost of performance ratio" for such receipts. Generally this is the location of payroll and property factor components which are directly related to the production of the defined receipt. This rule avoids some of the problems with the standard "cost of performance" rule, because it relies upon components of the standard payroll and property factors, without requiring determination of "costs" and "direct vs. indirect" character of such costs. In addition, the throwback rule applies proportionately (unlike the "all or nothing" rule of existing UDITPA Section 17 (Section 25136, Rev. and Tax Code)), reflecting the income-generating activity in all states.
Gross receipts from advertising are attributed to California based on billing address. Like the destination rule for print media, this rule reflects the fact that the value of advertising lies in the consumer base which is likely to respond to it. Similarly, gross receipts from the sale or other use of customer lists are attributed to California based on the ratio of customers on the list in California determined by billing address. A "throwback rule" attributes gross receipts to California if the taxpayers commercial domicile is in California and the taxpayer is not taxable in the state of the applicable billing address. This rule assures that if the taxpayer is not taxable in the market state, the sale is assigned to some state. Commercial domicile is commonly used as the throwback state in various UDITPA situations, as well as in many regulations adopted under Section 18 of UDITPA.
Examples are included to illustrate how the foregoing rules are implemented in specific situations.