Sales Tax State Activity Update - November 2008

Dial-Up Internet Alive, Well and Exempt in Iowa

The Iowa Court of Appeals held that an Internet service provider’s (ISP’s) access charges were not subject to sales tax because the charges were not local communication services, as members could only access the service through the provider’s out-of-state call centers.

The ISP, AOL, provided a variety of services to their members such as: internet access, email, instant messaging and a variety of other original content features. In order to retrieve content over the Internet, members dialed a local telephone number through their modem-equipped computer. One of the clusters at the local exchange answered the call, completing the local connection between the member and the modem. The modem then passed a digital signal which was routed to one of AOL’s call centers located in Virginia. Before the customer could access any content, “authentication” of the customer’s information occurred in Virginia, after which the member’s session began.

The Iowa Department of Revenue issued an assessment for unpaid sales tax for internet-related communications services provided by AOL, during the period from 7/1/95 though 6/30/99. (Interestingly enough, the legislature as since enacted a statute which expressly exempts internet access services from sales tax.) The administrative proceeding in this case started out in favor of the Department. The Director held that AOL’s gross receipts from its internet access services were subject to sales tax because the member dialed a local telephone number to access the service and therefore was considered to be a “local communications service”. The Director held that AOL’s claim that its access service was an interstate service was without merit.

Upon subsequent judicial review, the district court sided with AOL. The district court held that because it was impossible for AOL members to access AOL content without connecting through servers in Virginia, the communication service was not provided “in this state” as required by the statute. The court, siding with AOL, reversed the agency’s ruling and the Department appealed the district court’s ruling.

The Court of Appeals held that AOL’s Internet access charges were not subject to sales tax because they did not take place “in this state” as required under the statute. The court did not exclusively rely upon Iowa Administrative Code Rule 701-18.20(5) and determined that particular subrule’s section should not be read in a vacuum and must be interpreted with reference to the rest of the chapter and the statutory authority for it in the Code. The court concluded that Rule 18.20(1)(b) clarified the phrase “in this state” meaning that the point of origination and the point of termination of the communication service must occur entirely within the borders of Iowa. Communication service between any other points was “interstate” and not subject to sales tax. It was undisputed that the only method for AOL members to access its service was through a connection with AOL’s data centers in Virginia. Simply placing a local call to a local access point in Iowa would not provide any service whatsoever. Furthermore, the court noted that when a member requested termination from an AOL session, the AOL servers in Virginia made the actual disconnection.

The court held that the agency’s final determination that AOL’s services were subject to tax was a wholly unjustifiable application of law to the facts in this case and the decision of the district court was affirmed. The service was an interstate service and not subject to tax.

(AOL, L.L.C., Petitioner-Appellee, v. Iowa Department of Revenue, Respondent-Appellant, Iowa Court of Appeals, 10/01/2008)

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