Sales, Use and International Tax Activity Update - September 2009

Iowa Departmental Battle on Internet Taxability

The Iowa Supreme Court has upheld the ruling of the Iowa Court of Appeals and ruled that state residents are not required to pay sales tax on Internet access service. This case involved a challenge by the Iowa Department of Revenue against Internet service provider AOL. The issue in Iowa came to the forefront in 2001 when the Department of Revenue audited AOL and issued an assessment for unpaid sales tax for internet-related communications services during the period 7/1/95 through 12/31/2000.

The ISP, AOL, provided a variety of services to their members such as: 

• Internet access
• Email
• Instant messaging
• 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. Any information that an AOL subscriber posted on the internet or sent by email was first routed through Virginia before it could be accessed by any other users. Additionally, any information sent to an AOL customer in Iowa had to be routed through Virginia before the information reached Iowa, even if the information originated in Iowa.  AOL argued that the department’s administrative rule required that the communication must originate and terminate in Iowa in order to be subject to sales tax.  Since it was impossible for AOL members to access AOL content without connecting through the servers located in Virginia, the communication service was not provided “in this state” as required by the rule.
 
The Director argued that AOL’s gross receipts from its internet access services was 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.

The parties in this case disagreed whether the definition of communications services provided “in this state” found in Iowa Administrative Code Rule 18.20(1)(b) applied to the taxation of internet services described under subrule 18.20(5).  The department argued that subrule 18.20(5) was a stand-alone provision and that the definitions in section 18.20(1) did not apply to this subsection.

The Supreme Court stated that “the very purpose of putting the definitions at the beginning of a statute, contract or rule is to establish the framework for the proper interpretation of subsequent provisions.  If the Department did not intend for the definitions to apply to subsequent subsections in the same rule regarding internet sales, it should have either removed the internet access provisions from the rule or expressly severed them by stating that the generally applicable definitions did not apply to internet services.”  The Department did neither.  The court found that the agency made an “irrational, illogical and wholly unjustifiable” decision that the definitions found in Rule 18.20(1)(b) did not apply to subrule (5).  The court held that the definition of “in this state” fully applicable in determining whether AOL services were subject to state sales tax.

Finally, the court noted that its conclusion was consistent with case law in other jurisdictions.  It noted a similar case in Wyoming which involved that state’s revenue department and Qwest.  The Wyoming Supreme Court characterized the issue as whether the “complete end-to-end” communication occurred within the taxing state, prior to finding the disputed service an interstate communication service.

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