Internet Access Tax Moratorium: Revenue Impacts Will Vary by State

Internet Access Tax Moratorium: Revenue Impacts Will Vary by
State (23-JAN-06, GAO-06-273).

According to one report, at the end of 2004, some 70 million U.S.
adults logged on to access the Internet during a typical day. As
public use of the Internet grew from the mid-1990s onward,
Internet access became a potential target for state and local
taxation. In 1998, Congress imposed a moratorium temporarily
preventing state and local governments from imposing new taxes on
Internet access. Existing state and local taxes were
grandfathered. In amending the moratorium in 2004, Congress
required GAO to study its impact on state and local government
revenues. This report's objectives are to determine the scope of
the moratorium and its impact, if any, on state and local
revenues. For this report, GAO reviewed the moratorium's
language, its legislative history, and associated legal issues;
examined studies of revenue impact; interviewed people
knowledgeable about access services; and collected information
about eight case study states not intended to be representative
of other states. GAO chose the states considering such factors as
whether they had taxes grandfathered for different forms of
access services and covered different urban and rural parts of
the country.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-06-273
ACCNO: A45508
TITLE: Internet Access Tax Moratorium: Revenue Impacts Will Vary
by State
DATE: 01/23/2006
SUBJECT: Federal law
Internet
Municipal taxes
Policy evaluation
State taxes
Tax administration
Tax law

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GAO-06-273

* Report to Congressional Committees
* January 2006
* INTERNET ACCESS TAX MORATORIUM
* Revenue Impacts Will Vary by State
* Contents
* Results in Brief
* Background
* Objectives, Scope, and Methodology
* Internet Access Services, Including Bundled Access Services, May
Not Be Taxed, but Acquired Services May Be
* Internet Access Services, Including Bundled Broadband
Services, May Not Be Taxed
* Acquired Services May Be Taxed
* Some States Have Applied the Moratorium to Acquired Services
* While the Revenue Impact of Eliminating Grandfathering Would Be
Small, the Moratorium's Total Revenue Impact Has Been Unclear and
Any Future Impact Would Vary by State
* According to Information in CBO Reports, States Would Lose a
Small Fraction of Their Tax Revenues If Grandfathered Taxes
on Dial-up and DSL Services Were Eliminated
* Timing of Moratorium Might Have Precluded Many States from
Taxing Access Services, with Unclear Revenue Implications
* Any Future Impact of the Moratorium Will Vary by State
* External Comments
* Bundled Access Services May Not Be Taxed, but Acquired Services Are
Taxable
* Bundled Services, Including Broadband Services, May Not Be Taxed
* Acquired Services May Be Taxed
* CBO's Methodology for Estimating Costs Relating to Taxing Internet
Access Services
* Case Study States' Taxation of Services Related to Internet Access
* California
* Kansas
* Mississippi
* North Dakota
* Ohio
* Rhode Island
* Texas
* Virginia
* Comments from Telecommunications Industry Officials
* GAO Contact and Staff Acknowledgments

Report to Congressional Committees

January 2006

INTERNET ACCESS TAX MORATORIUM

Revenue Impacts Will Vary by State

Contents

Tables

Figures

January 23, 2006 Letter

The Honorable Ted Stevens Chairman The Honorable Daniel K. Inouye
Co-Chairman Committee on Commerce, Science and Transportation United
States Senate

The Honorable Joe Barton Chairman The Honorable John D. Dingell Ranking
Minority Member Committee on Energy and Commerce House of Representatives

According to one study, at the end of 2004 some 70 million U.S. adults
logged on to the Internet during a typical day.1 As Internet usage grew
from the mid-1990s onward, state and local governments imposed some taxes
on it and considered more. Concerned about the impact of such taxes,
Congress extensively debated whether state and local governments should be
allowed to tax Internet access. The debate resulted in legislation setting
national policy on state and local taxation of access.

In 1998, Congress enacted the Internet Tax Freedom Act,2 which imposed a
moratorium temporarily preventing state and local governments from
imposing new taxes on Internet access or multiple or discriminatory taxes
on electronic commerce. Existing state and local taxes were
"grandfathered," allowing them to continue to be collected. Since its
enactment, the moratorium has been amended twice, most recently in 2004,
when Congress included language requiring that we study the impact of the
moratorium on state and local government revenues and on the deployment
and adoption of broadband technologies.3 Such technologies permit
communications over high-speed, high-capacity media, such as that

provided by cable modem service or by a telephone technology known as
digital subscriber line (DSL).4

This report focuses on the moratorium's impact on state and local
government revenues. Its objectives are to determine (1) the scope of the
moratorium and (2) the impact of the moratorium, if any, on state and
local revenues. In determining any impact on revenues, the report explores
what would happen if grandfathering of access taxes on dial-up and DSL
services were eliminated, what might have happened in the absence of the
moratorium, and how the impact of the moratorium might differ from state
to state. This report does not focus on taxing the sale of items over the
Internet. A future report will discuss the impact that various factors,
including taxes, have on broadband deployment and adoption.

To prepare this report, we reviewed the language of the moratorium, its
legislative history, and associated legal issues; examined studies of
revenue impact done by the Congressional Budget Office (CBO) and others;
interviewed representatives of companies and associations involved with
Internet access services; and collected information through case studies
of eight states. We chose the states to get a mixture of those that did or
did not have taxes grandfathered for different forms of access services,
did or did not have local jurisdictions that taxed access services, had
high and low state tax revenue dollars per household and business entity
with Internet presence, had high and low percentages of households online,
and covered different urban and rural parts of the country. We did not
intend the eight states to represent any other states. In the course of
our case studies, state officials told us how they made the estimates they
gave us of tax revenues collected related to Internet access and how firm
these estimates were. We could not verify the estimates, and, in doing its
study, CBO supplemented estimates that it received from states with
CBO-generated information. Nevertheless, based on other information we
obtained, the state estimates we received appeared to provide a sense of
the order of magnitude of the dollars involved. We did our work from
February through December 2005 in accordance with generally accepted
government auditing standards. A later section of this report contains a
complete discussion of our objectives, scope, and methodology.

Results in Brief

The Internet tax moratorium bars taxes on Internet access, meaning taxes
on the service of providing Internet access. In this way, it prevents
services that are reasonably bundled as part of an Internet access
package, such as electronic mail and instant messaging, from being subject
to taxes when sold to end users. These tax-exempt services also include
DSL services bundled as part of an Internet access package. Some states
and providers have construed the moratorium as also barring taxation of
what we call acquired services, such as high-speed communications capacity
over fiber, acquired by Internet service providers and used by them to
deliver access to the Internet to their customers. Because they believed
that taxes on acquired services are prohibited by the 2004 amendments,
some state officials told us their states would stop collecting them as
early as November 1, 2005, the date they assumed that taxes on acquired
services would lose their grandfathered protection. However, according to
our reading of the law, the moratorium does not apply to acquired services
since, among other things, a tax on acquired services is not a tax on
"Internet access." Nontaxable "Internet access" is defined in the law as
the service of providing Internet access to an end user; it does not
extend to a provider's acquisition of capacity to provide such service.
Purchases of acquired services are subject to taxation, depending on state
law.

The revenue impact of eliminating grandfathering in states studied by CBO
would be small, but the moratorium's total revenue impact has been unclear
and any future impact would vary by state. In 2003, CBO reported that
states and localities would lose from more than $160 million to more than
$200 million annually by 2008 if all grandfathered taxes on dial-up and
DSL services were eliminated, although part of this loss reflected
acquired services. It also identified other potential revenue losses,
although unquantified, that could have grown in the future but that now
seem to pose less of a threat. CBO's estimated annual losses by 2007 for
states that had grandfathered taxes in 1998 were about 0.1 percent of the
total 2004 tax revenues for those states. Because it is difficult to know
what states would have done to tax Internet access services if no
moratorium had existed, the total revenue implications of the moratorium
are unclear. The 1998 moratorium was considered before connections to the
Internet were as widespread as they later became, limiting the window of
opportunity for states to adopt new taxes on access services. Although
some states had already chosen not to tax access services and others
stopped taxing them, other states might have been inclined to tax access
services if no moratorium were in place. In general, any future impact
related to the moratorium will differ from state to state. The details of
state tax law as well as applicable tax rates varied from one state to
another. For instance, North Dakota taxed access service delivered to
retail consumers. Kansas taxed communications services acquired by
Internet service providers to support their customers. Rhode Island taxed
both access service offerings and the acquisition of communications
services. California officials said their state did not tax these areas at
all.

We are not making any recommendations in this report.

In oral comments on a draft of this report, CBO staff members said we
fairly characterized CBO information and suggested clarifications that we
have made as appropriate. Federation of Tax Administrators (FTA) officials
said that our legal conclusion was clearly stated and, if adopted, would
be helpful in clarifying which Internet access-related services are
taxable and which are not. However, they expressed concern that the
statute could be interpreted differently regarding what might be
reasonably bundled in providing Internet access to consumers. A broader
view of what could be included in Internet access bundles would result in
potential revenue losses much greater than we indicated. However, as
explained in appendix I, we believe that what is bundled must be
reasonably related to accessing and using the Internet. In written
comments, which are reprinted in appendix IV, company representatives
commented that the 2004 amendments make acquired services subject to the
moratorium and therefore not taxable, and that the language of the statute
and the legislative history support this position. While we acknowledge
that there are different views about the scope of the moratorium, our view
is based on the language and structure of the statute.

Background

As shown in figure 1, residential and small business users often connect
to an Internet service provider (ISP) to access the Internet. Well-known
ISPs include America Online (AOL) and Comcast. Typically, ISPs market a
package of services that provide homes and businesses with a pathway, or
"on-ramp," to the Internet along with services such as e-mail and instant
messaging. The ISP sends the user's Internet traffic forward to a backbone
network where the traffic can be connected to other backbone networks and
carried over long distances. By contrast, large businesses often maintain
their own internal networks and may buy capacity from access providers
that connect their networks directly to an Internet backbone network. We
are using the term access providers to include ISPs as well as providers
who sell access to large businesses and other users. Nonlocal traffic from
both large businesses and ISPs connects to a backbone provider's network
at a "point of presence" (POP). Figure 1 depicts two hypothetical and
simplified Internet backbone networks that link at interconnection points
and take traffic to and from residential units through ISPs and directly
from large business users.

Figure 1: Hypothetical Internet Backbone Networks with Connections to End
Users

As public use of the Internet grew from the mid-1990s onward, Internet
access and electronic commerce became potential targets for state and
local taxation. Ideas for taxation ranged from those that merely extended
existing sales or gross receipts taxes to so-called "bit taxes," which
would measure Internet usage and tax in proportion to use. Some state and
local governments raised additional tax revenues and applied existing
taxes to Internet transactions. Owing to the Internet's inherently
interstate nature and to issues related to taxing Internet-related
activities, concern arose in Congress as to what impact state and local
taxation might have on the Internet's growth, and thus, on electronic
commerce. Congress addressed this concern when, in 1998, it adopted the
Internet Tax Freedom Act, which bars state and local taxes on Internet
access, as well as multiple or discriminatory taxes on electronic
commerce.5

Internet usage grew rapidly in the years following 1998, and the
technology to access the Internet changed markedly. Today a significant
portion of users, including home users, access the Internet over broadband
communications services using cable modem, DSL, or wireless technologies.
Fewer and fewer users rely on dial-up connections through which they
connect to their ISP by dialing a telephone number. By 2004, some state
tax authorities were taxing DSL service, which they considered to be a
telecommunications service, creating a distinction between DSL and
services offered through other technologies, such as cable modem, that
were not taxed.

Originally designed to postpone the addition of any new taxes while the
Advisory Commission on Electronic Commerce studied the tax issue and
reported to Congress, the moratorium was extended in 2001 for 2 years6 and
again in 2004, retroactively, to remain in force until November 1, 2007.7
The 2001 extension made no other changes to the original act, but the 2004
act included clarifying amendments. The 2004 act amended language that had
exempted telecommunications services from the moratorium. Recognizing
state and local concerns about their ability to tax voice services
provided over the Internet, it also contained language allowing taxation
of telephone service using Voice over Internet Protocol (VoIP). Although
the 2004 amendments extended grandfathered protection generally to
November 2007, grandfathering extended only to November 2005 for taxes
subject to the new moratorium but not to the original moratorium.

Objectives, Scope, and Methodology

To determine the scope of the Internet tax moratorium, we reviewed the
language of the moratorium, the legislative history of the 1998 act and
the 2004 amendments, and associated legal issues.

To determine the impact of the moratorium on state and local revenues, we
worked in stages. First, we reviewed studies of revenue impact done by
CBO, FTA, and the staff of the Multistate Tax Commission and discussed
relevant issues with federal representatives, state and local government
and industry associations, and companies providing Internet access
services. Then, we used structured interviews to do case studies in eight
states that we chose as described earlier. We did not intend the eight
states to represent any other states.

For each selected state, we focused on specific aspects of its tax system
by using our structured interview and collecting relevant documentation.
For instance, we reviewed the types and structures of Internet access
service taxes, the revenues collected from those taxes, officials' views
of the significance of the moratorium to their government's financial
situation, and their opinions of any implications to their states of the
new definition of Internet access. We also learned whether localities
within the states were taxing access services. When issues arose, we
contacted other states and localities to increase our understanding of
these issues.

We discussed with state officials how they derived the estimates they gave
us of tax dollars collected and how firm these numbers were. We could not
verify the estimates, and CBO supplemented estimates that it received from
states. Nevertheless, based on other information we obtained, the state
estimates appeared to provide a sense of the order of magnitude of the
numbers compared to state tax revenues.

We did our work from February through December 2005 in accordance with
generally accepted government auditing standards.

Internet Access Services, Including Bundled Access Services, May Not Be
Taxed, but Acquired Services May Be

The moratorium bars taxes on the service of providing access, which
includes whatever an access provider reasonably bundles in its access
offering to consumers. On the other hand, the moratorium does not prohibit
taxes on acquired services, referring to goods and services that an access
provider acquires to enable it to bundle and provide its access package to
its customers. However, some providers and state officials have expressed
a different view, believing the moratorium barred taxing acquired services
in addition to bundled access services.

Internet Access Services, Including Bundled Broadband Services, May Not Be
Taxed

Since its 1998 origin, the moratorium has always prohibited taxing the
service of providing Internet access, including component services that an
access provider reasonably bundles in its access offering to consumers.
However, as amended in 2004, the definition of Internet access contains
additional words. With words added in 2004 in italics, it now defines the
scope of nontaxable Internet access as

As shown in the simplified illustration in figure 2, the items reasonably
bundled in a tax-exempt Internet access package may include e-mail,
instant messaging, and Internet access itself. Internet access, in turn,
includes broadband services, such as cable modem and DSL services, which
provide continuous, high-speed access without tying up wireline telephone
service. As figure 2 also illustrates, a tax-exempt bundle does not
include video, traditional wireline telephone service referred to as
"plain old telephone service" (POTS), or VoIP. These services are subject
to tax. For simplicity, the figure shows a number of services transmitted
over one communications line. In reality, a line to a consumer may support
just one service at a time, as is typically the case for POTS, or it may
simultaneously support a variety of services, such as television, Internet
access, and VoIP.

Figure 2: Simplified Illustration of Services Purchased by Consumers

aTraditional wireline telephone service, commonly referred to in the
communications industry as "plain old telephone service" (POTS).

bMay become taxable if not capable of being broken out from other services
on a bill.

Our reading of the 1998 law and the relevant legislative history indicates
that Congress had intended to bar taxes on services bundled with access.
However, there were different interpretations about whether DSL service
could be taxed under existing law, and some states taxed DSL. The 2004
amendment was aimed at making sure that DSL service bundled with access
could not be taxed. See appendix I for further explanation.

Acquired Services May Be Taxed

Figure 3 shows how the nature and tax status of the Internet access
services just described differ from the nature and tax status of services
that an ISP acquires and uses to deliver access to its customers. An ISP
in the middle of figure 3 acquires communications and other services and
incidental supplies (shown on the left side of the figure) in order to
deliver access services to customers (shown on the right side of the
figure). We refer to the acquisitions on the left side as purchases of
"acquired services."9 For example, acquired services include ISP leases of
high-speed communications capacity over wire, cable, or fiber to carry
traffic from customers to the Internet backbone.

Figure 3: Simplified Model of Tax Status of Services Related to Internet
Access

a"Sell acquired services" refers to selling services, either to a separate
firm or to a vertically-integrated affiliate.

bDepends on state law.

Purchases of acquired services are subject to taxation, depending on state
law, because the moratorium does not apply to acquired services. As noted
above, the moratorium applies only to taxes imposed on "Internet access,"
which is defined in the law as "a service that enables users to access
content, information, electronic mail, or other services offered over the
Internet...." In other words, it is the service of providing Internet
access to the end user-not the acquisition of capacity to do so-that
constitutes "Internet access" subject to the moratorium.

Some providers and state officials have construed the moratorium as
barring taxation of acquired services, reading the 2004 amendments as
making acquired services tax exempt. However, as indicated by the language
of the statute, the 2004 amendments did not expand the definition of
"Internet access," but rather amended the exception from the definition to
allow certain "telecommunication services" to qualify for the moratorium
if they are part of the service of providing Internet access. A tax on
acquired services is not a tax directly imposed on the service of
providing Internet access.

Our view that acquired services are not subject to the moratorium on
taxing Internet access is based on the language and structure of the
statute, as described further in appendix I. We acknowledge that others
have different views about the scope of the moratorium. Congress could, of
course, deal with this issue by amending the statute to explicitly address
the tax status of acquired services.

Some States Have Applied the Moratorium to Acquired Services

As noted above, some providers and state officials have construed the
moratorium as barring taxation of acquired services. Some provider
representatives said that acquired services were not taxable at the time
we contacted them and had never been taxable. Others said that acquired
services were taxable when we contacted them but would become tax exempt
in November 2005 under the 2004 amendments, the date they assumed that
taxes on acquired services would no longer be grandfathered.

As shown in table 1, officials from four out of the eight states we
studied-Kansas, Mississippi, Ohio, and Rhode Island-also said their states
would stop collecting taxes on acquired services, as of November 1, 2005,
in the case of Kansas and Ohio whose collections have actually stopped,
and later for the others. These states roughly estimated the cost of this
change to them to be a little more than $40 million in revenues that were
collected in 2004. An Ohio official indicated that two components
comprised most of the dollar amounts of taxes collected from these
services in 2004: $20.5 million from taxes on telecommunications services
and property provided to ISPs and Internet backbone providers, and $9.1
million from taxes for private line services (such as high-capacity T-1
and T-3 lines) and 800/wide-area telecommunications services that the
official said would be exempt due to the moratorium. The rough estimates
in table 1 are subject to the same limitations described in the next
section for the state estimates of all taxes collected related to Internet
access.

Table 1: Summary of Case Study State Rough Estimates of 2004 Tax Revenue
from Acquired Services

State Collected taxes paid 2004 revenue from taxes paid on acquired
on acquired services services (dollars in millions)
California $0
Kansas x 9-10
Mississippi x At most, 1
North Dakota 0
Ohio x 32.3
Rhode Island x Insignificant compared to total
telecommunications tax revenues
Texas 0
Virginia 0

Source: State officials.

Note: The next section contains a discussion of general limitations of the
state estimates of revenue from taxes.

While the Revenue Impact of Eliminating Grandfathering Would Be Small, the
Moratorium's Total Revenue Impact Has Been Unclear and Any Future Impact
Would Vary by State

According to CBO data, grandfathered taxes in the states CBO studied were
a small percentage of those states' tax revenues. However, because it is
difficult to know which states, if any, might have chosen to tax Internet
access services and what taxes they might have chosen to use if no
moratorium had ever existed, the total revenue implications of the
moratorium are unclear. In general, any future impact related to the
moratorium will differ from state to state.

According to Information in CBO Reports, States Would Lose a Small
Fraction of Their Tax Revenues If Grandfathered Taxes on Dial-up and DSL
Services Were Eliminated

In 2003, CBO reported how much state and local governments that had
grandfathered taxes on dial-up and DSL services would lose in revenues if
the grandfathering were eliminated. The fact that these estimates
represented a small fraction of state tax revenues is consistent with
other information we obtained. In addition, the enacted legislation was
narrower than what CBO reviewed, meaning that CBO's stated concerns about
VoIP and taxing providers' income and assets would have dissipated.

CBO provided two estimates in 2003 that, when totaled, showed that no
longer allowing grandfathered dial-up and DSL service taxes would cause
state and local governments to lose from more than $160 million to more
than $200 million annually by 2008. According to a CBO staff member, this
estimate included some amounts for what we are calling acquired services
that, as discussed in the previous section, would not have to be lost. CBO
provided no estimates of revenues involved for governments not already
assessing the taxes and said it could not estimate the size of any
additional impacts on state and local revenues of the change in the
definition of Internet access. Further, according to a CBO staff member,
CBO's estimates did not include any lost revenues from taxes on cable
modem services. In October 2003, around the time of CBO's estimates, the
number of cable home Internet connections was 12.6 million, compared to
9.3 million home DSL connections and 38.6 million home dial-up
connections.

CBO first estimated that as many as 10 states and several local
governments would lose $80 million to $120 million annually, beginning in
2007, if the 1998 grandfather clause were repealed. Its second estimate
showed that, by 2008, state and local governments would likely lose more
than $80 million per year from taxes on DSL service.10

CBO's estimates resulted from systematic, detailed analyses of information
from state and national sources and involved assumptions to deal with
uncertainties. In arriving at these estimates, CBO asked each state with
grandfathered taxes for information on how much it collected in taxes
related to access services. In addition, it estimated each state's access
service-related taxes by using such data as the number of Internet users
in the state, the average fees that users paid to providers, applicable
state tax rates, expected amounts of dial-up versus broadband usage, and
estimates of possible noncompliance with tax assessments. See appendix II
for further information on the CBO methodology and associated limitations.
Rather than again doing what CBO had done and gathering information on all
50 states, we tried to supplement what we learned from CBO by exploring
more in-depth information in case studies of eight states.

The CBO numbers are a small fraction of total state tax revenue amounts.
For example, the $80 million to $120 million estimate for the states with
originally grandfathered taxes for 2007 was about 0.1 percent of tax
revenues in those states for 2004-3 years earlier.

The fact that CBO estimates are a small part of state tax revenues is
consistent with information we obtained from our state case studies and
interviews with providers. For instance, after telling us whether various
access-related services, including cable modem service, were subject to
taxation in their jurisdictions, the states collecting taxes gave us rough
estimates of how much access service-related tax revenues they collected
for 2004 for themselves and their localities, if applicable. (See table
2.) All except two collected $10 million or less. Even the largest state
tax amount reportedly collected in 2004 for Internet access revenues,
excluding collections for localities-$50 million in Texas-was only about
one-sixth of 1 percent of the state's tax revenues for that year; the
largest percentage for any of our case study states was about 0.2 percent.

Table 2: Case Study State Officials' Rough Estimates of Taxes Collected
for 2004 Related to Internet Access

State Estimated taxes collected (dollars in millions)
California N/A
Kansas $9-10
Mississippi At most, 1a
North Dakota 2.4
Ohio 52.1
Rhode Island Less than 4.5b
Texas 50c
Virginia N/A

Source: State officials.

Note: The accompanying text contains a discussion of general limitations
of the state estimates of revenue from taxes.

aAccording to a Mississippi official, although estimating a dollar amount
would be extremely hard, the state believes the amount collected was at
most $1 million.

bRhode Island officials told us that taxes collected on access were taxes
paid on services to retail consumers, and Rhode Island did not have an
estimate for taxes collected on acquired services.

cTexas officials did not provide us with an estimate of taxes collected
for Texas localities.

The states made their estimates by assuming, for instance, that access
service-related tax revenues were a certain percentage of state
telecommunications sales tax revenues, by reviewing providers' returns, or
by making various calculations starting with census data. Most estimates
provided us were more ballpark approximations than precise computations,
and CBO staff expressed a healthy skepticism toward some state estimates
they received. They said that the supplemental state-by-state information
they developed sometimes produced lower estimates than the states
provided. According to others knowledgeable in the area, estimates
provided us were imprecise because when companies filed sales or gross
receipts tax returns with states, they did not have to specifically
identify the amount of taxes they received from providing Internet
access-related services to retail consumers or to other providers. As
discussed earlier, sales to other providers remain subject to taxation,
depending on state law. Some providers told us they did not keep records
in such a way as to be able to readily provide that kind of information.
Also, although states reviewed tax compliance by auditing taxpayers, they
could not audit all providers.

The dollar amounts in table 2 include amounts, where provided, for local
governments within the states. For instance, Kansas's total includes about
$2 million for localities and North Dakota's about $400,000 for
localities. In these states as well as in others we studied, local
jurisdictions were piggybacking on the state taxes, although the local tax
rates could differ from each other. For example, according to a state
official, in Kansas the state tax was 5.3 percent, and the state collected
an average of another 1.3 percent for local jurisdictions. While we did
encounter localities outside our case study states that taxed access
services under their own authority, almost all the collections for local
jurisdictions that we came across were amounts collected by the states
that were sent back to the localities.

State tax officials from our case study states who commented to us on the
impacts of the revenue amounts did not consider them significant.
Similarly, state officials voiced concerns but did not cite nondollar
specifics when describing any possible impact on their state finances
arising from no longer taxing Internet access services. However, one noted
that taking away Internet access as a source of revenue was another step
in the erosion of the state's tax base.11 Other state and local officials
observed that if taxation of Internet access were eliminated, the state or
locality would have to act somehow to continue meeting its requirement for
a balanced budget. At the local level, officials told us that a revenue
decrease would reduce the amount of road maintenance that could be done or
could adversely affect the number of employees available for providing
government services.

Because of the provisions in the enacted 2004 law, some unquantified
revenue losses noted by CBO in its 2003 study that could have grown to be
large no longer seem to pose the threat that some feared. For example, CBO
mentioned the possibility of state and local governments being unable to
tax customers' telephone calls over the Internet. However, as enacted, the
2004 amendments differed from the version reviewed by CBO and contained
language excluding Internet-based telephone service, known as VoIP, from
the moratorium.12

In addition, CBO expressed concern that providers could bundle products
containing content, such as books and movies, call the product Internet
access, and have the whole bundle be exempt from taxes. Although some
people we interviewed still feared bundled content and information might
become tax free, they and others indicated they were aware of no court
cases in which this argument has been asserted.13

The 2004 amendments also included a provision specifically allowing states
to tax Internet providers' net income, capital stock, net worth, or
property value, addressing another concern raised by some parties.

Timing of Moratorium Might Have Precluded Many States from Taxing Access
Services, with Unclear Revenue Implications

Because it is difficult to predict what states would have done to tax
Internet access services had Congress not intervened when it did, it is
hard to estimate the amount of revenue that was not raised because of the
moratorium. For instance, at the time the first moratorium was being
considered in 1998, the Department of Commerce reported Internet
connections for less than a fifth of U.S. households, much less than the
half of U.S. households reported 6 years later. Access was typically
dial-up. As states and localities saw the level of Internet connections
rising and other technologies becoming available, they might have taxed
access services if no moratorium had been in place. Taxes could have taken
different forms. For example, jurisdictions might have even adopted bit
taxes based on the volume of digital information transmitted.

The number of states collecting taxes on access services when the first
moratorium was being considered in early 1998 was relatively small, with
13 states and the District of Columbia collecting these taxes, according
to the Congressional Research Service. Five of those jurisdictions later
eliminated or chose not to enforce their tax. In addition, not all 37
other states would have taxed access services related to the Internet even
if they could have. For example, California had already passed its own
Internet tax moratorium in August 1998.

Still, after the moratorium began, other states showed an interest in
taxing Internet access services. Although the 1998 act precluded those
jurisdictions from taxing Internet access, it included language stating
that access services did not include telecommunications services. States
seeking to take advantage of this provision taxed parts of DSL service
they considered a telecommunications service and not an Internet access
service. If taxing DSL service shows a desire to tax access services in
general, many states not taxing dial-up or cable modem service14 might
have done so but for the moratorium.

Given that some states never taxed access services while relatively few
Internet connections existed, that some stopped taxing access services,
and that others taxed DSL service, it is unclear what jurisdictions would
have done if no moratorium had existed. However, the relatively early
initiation of a moratorium reduced the opportunity for states inclined to
tax access services to do so before Internet connections became more
widespread.

Any Future Impact of the Moratorium Will Vary by State

Although as previously noted the impact of eliminating grandfathering
would be small in states studied by CBO or by us, any future impact
related to the moratorium will vary on a state-by-state basis for many
reasons. State tax laws differed significantly from each other, and states
and providers disagreed on how state laws applied to the providers.
Appendix III summarizes information we gathered about our case study
states.

As shown in table 3, states taxed Internet access using different tax
vehicles imposed on diverse tax bases at various rates. The tax used might
be generally applicable to a variety of goods and services, as in Kansas,
which did not impose a separate tax on communications services. There, the
state's general sales tax applied to the purchase of communications
services by access providers at an average rate of 6.6 percent, combining
state and average local tax rates. As another example, North Dakota
imposed a sales tax on retail consumers' communications services,
including Internet access services, at an average state and local combined
rate of 6 percent. Rhode Island charged a 5 percent tax on companies'
telecommunications gross receipts.

Table 3: Characteristics Showing Variations among Case Study States

State Type of Taxing Taxing State tax Local tax Exemptions
taxa retail acquired rate rate of customer
consumer services (percentage) (percentage) types or
Internet payment
access amounts
services
California N/A N/A N/A
Kansas Sales x 5.3 1.3 on
average
Mississippi Gross x 7.0 N/A
income
North Sales x 5.0 1.0-2.0
Dakota
Ohio Sales x x 5.5 1.0 on Residential
average consumers
Rhode Gross xb x 5.0, N/A
Island receipts
and 6.0
sales
Texas Sales x 6.25 2.0 limit First $25
of services
Virginia N/A N/A N/A

Source: State officials and laws.

aFor purposes of this report, a reference to a sales tax includes any
ancillary use tax. Also for our purposes, the difference between a sales
and a gross receipts tax is largely a distinction without a difference
since the moratorium does not differentiate between them.

bRhode Island retail consumers did not pay this tax directly, but rather
through the gross receipts tax paid by their providers.

Our case study states showed little consistency in the base they taxed in
taxing services related to Internet access. States imposed taxes on
different transactions and populations. North Dakota and Texas taxed only
services delivered to retail consumers. In a type of transaction which, as
discussed earlier, we do not view as subject to the moratorium, Kansas and
Mississippi taxed acquired communications services purchased by access
providers. Ohio and Rhode Island taxed both the provision of access
services and acquired services, and California and Virginia officials told
us their states taxed neither. States also provided various exemptions
from their taxes. Ohio exempted residential consumers, but not businesses,
from its tax on access services, and Texas exempted the first $25 of
monthly Internet access service charges from taxation.

Some state and local officials and company representatives held different
opinions about whether certain taxes were grandfathered and about whether
the moratorium applied in various circumstances. For example, some
providers' officials questioned whether taxes in North Dakota, Wisconsin,
and certain cities in Colorado were grandfathered, and whether those
jurisdictions were permitted to continue taxing. Providers disagreed among
themselves about how to comply with the tax law of states whose taxes may
or may not have been grandfathered. Some providers told us they collected
and remitted taxes to the states even when they were uncertain whether
these actions were necessary; however, they told us of others that did not
make payments to the taxing states in similarly uncertain situations. In
its 2003 work, CBO had said that some companies challenged the
applicability of Internet access taxes to the service they provided and
thus might not have been collecting or remitting them even though the
states believed they should.

Because of all these state-by-state differences and uncertainties, the
impact of future changes related to the moratorium would vary by state.
Whether the moratorium were lifted or made permanent and whether
grandfathering were continued or eliminated, states would be affected
differently from each other.

External Comments

We showed staff members of CBO, officials of FTA, and representatives of
telecommunications companies assembled by the United States Telecom
Association a draft of our report and asked for oral comments. On January
5, 2006, CBO staff members, including the Chief of the State and Local
Government Unit, Cost Estimates Unit, said we fairly characterized CBO
information and suggested clarifications that we have made as appropriate.
In one case, we have noted more clearly that CBO supplemented its dollar
estimates of revenue impact with a statement that other potential revenue
losses could potentially grow by an unquantified amount.

On January 6, 2006, FTA officials, including the Executive Director, said
that our legal conclusion was clearly stated and, if adopted, would be
helpful in clarifying which Internet access-related services are taxable
and which are not. However, they expressed concern that the statute could
be interpreted differently regarding what might be reasonably bundled in
providing Internet access to consumers. A broader view of what could be
included in Internet access bundles would result in potential revenue
losses much greater than we indicated. However, as explained in appendix
I, we believe that what is bundled must be reasonably related to accessing
and using the Internet. FTA officials were also concerned that our reading
of the 1998 law regarding the taxation of DSL services is debatable and
suggests that states overreached by taxing them. We recognize that
Congress acted in 2004 to address different interpretations of the
statute, and we made some changes to clarify our presentation. We
acknowledge there were different views on this matter, and we are not
attributing any improper intent to the states' actions.

When meeting with us, representatives of telecommunications companies said
they would like to submit comments in writing. Appearing in appendix IV,
their comments argue that the 2004 amendments make acquired services
subject to the moratorium and therefore not taxable, and that the language
of the statute and the legislative history support this position. In
response, we made some changes to simplify appendix I. That appendix,
along with the section of the report on bundled access services and
acquired services, contains an explanation of our view that the language
and structure of the statute support our interpretation.

We are sending copies of this report to interested congressional
committees and other interested parties. In addition, the report will be
available at no charge on GAO's Web site at http://www.gao.gov .

If you or your staffs have any questions about this report, please contact
me at (202) 512-9110 or [email protected] . Contact points for our Offices of
Congressional Relations and Public Affairs may be found on the last page
of this report. GAO staff who made major contributions to this report are
listed in appendix V.

James R. White Director, Tax Issues Strategic Issues

Bundled Access Services May Not Be Taxed, but Acquired Services Are
Taxable Appendix I

The moratorium bars taxes on the service of providing access, which
includes whatever an access provider reasonably bundles in its access
offering to consumers.1 On the other hand, the moratorium does not bar
taxes on acquired services.

Bundled Services, Including Broadband Services, May Not Be Taxed

As noted earlier, the 2004 amendments followed a period of significant
growth and technological development related to the Internet. By 2004,
broadband communications technologies were becoming more widely available.
They could provide greatly enhanced access compared to the dial-up access
technologies widely used in 1998. These broadband technologies, which
include cable modem service built upon digital cable television
infrastructure as well as digital subscriber line (DSL) service, provide
continuous, high-speed Internet access without tying up wire-line
telephone service. Indeed, cable and DSL facilities could support multiple
services-television, Internet access, and telephone services-over common
coaxial cable, fiber, and copper wire media.

The Internet Tax Freedom Act bars "taxes on Internet access" and defines
"Internet access" as a service that enables "users to access content,
information, electronic mail, or other services offered over the
Internet." The term Internet access as used in this context includes
"access to proprietary content, information, and other services as part of
a package of services offered to users." The original act expressly
excluded "telecommunications services" from the definition.2 As will be
seen, the act barred jurisdictions from taxing services such as e-mail and
instant messaging bundled by providers as part of their Internet access
package; however, it permitted dial-up telephone service, which was
usually provided separately, to be taxed.

The original definition of Internet access, exempting "telecommunications
services," was changed by the 2004 amendment. Parties seeking to carve out
exceptions that could be taxed had sought to break out and treat DSL
services as telecommunications services, claiming the services were exempt
from the moratorium even though they were bundled as part of an Internet
access package. State and local tax authorities began taxing DSL service,
creating a distinction between DSL and services offered using other
technologies, such as cable modem service, a competing method of providing
Internet access that was not to be taxed. The 2004 amendment was aimed at
making sure that DSL service bundled with access could not be taxed. The
amendment excluded from the telecommunications services exemption
telecommunications services that were "purchased, used, or sold by a
provider of Internet access to provide Internet access."

The fact that the original 1998 act exempted telecommunications services
shows that other reasonably bundled services remained a part of Internet
access service and, therefore, subject to the moratorium. Thus,
communications services such as cable modem services that are not
classified as telecommunications services are included under the
moratorium.

Acquired Services May Be Taxed

As emphasized by numerous judicial decisions, we begin the task of
construing a statute with the language of the statute itself, applying the
canon of statutory construction known as the plain meaning rule. E.g.
Hartford Underwriter Insurance Co. v. Union Planers Bank, N.A., 530 U.S. 1
(2000); Robinson v. Shell Oil Co., 519 U.S. 337 (1997). Singer, 2A
Sutherland Statutory Construction, S:S: 46:1, 48A:11, 15-16. Thus, under
the plain meaning rule, the primary means for Congress to express its
intent is the words it enacts into law and interpretations of the statute
should rely upon and flow from the language of the statute.

As noted above, the moratorium applies to the "taxation of Internet
access." According to the statute, "Internet access" means a service that
enables users to access content, information, or other services over the
Internet. The definition excludes "telecommunications services" and, as
amended in 2004, limits that exclusion by exempting services "purchased,
used, or sold" by a provider of Internet access. As amended in 2004, the
statute now reads as follows:

The language added in 2004--exempting from "telecommunications services"
those services that are "purchased, used, or sold" by a provider in
offering Internet access--has been read by some as expanding the "Internet
access" to which the tax moratorium applies, by barring taxes on "acquired
services." Those who would read the moratorium expansively take the view
that everything acquired by Internet service providers (ISP) (everything
on the left side of figure 3) as well as everything furnished by them
(everything in the middle of figure 3) is exempt from tax.

In our view, the language and structure of the statute do not permit the
expansive reading noted above. "Internet access" was originally defined
and continues to be defined for purposes of the moratorium as the service
of providing Internet access to a user. Section 1105(5). It is this
transaction, between the Internet provider and the end user, which is
nontaxable under the terms of the moratorium.3 The portion of the
definition that was amended in 2004 was the exception: that is,
telecommunication services are excluded from nontaxable "Internet access,"
except to the extent such services are "purchased, used, or sold by a
provider of Internet access to provide Internet access." Thus, we conclude
that the fact that services are "purchased, used, or sold" by an Internet
provider has meaning only in determining whether these services can still
qualify for the moratorium notwithstanding that they are
"telecommunications services;" it does not mean that such services are
independently nontaxable irrespective of whether they are part of the
service an Internet provider offers to an end user. Rather, a service that
is "purchased, used, or sold" to provide Internet access is not taxable
only if it is part of providing the service of Internet access to the end
user. Such services can be part of the provision of Internet access by a
provider who, for example, "purchases" a service for the purpose of
bundling it as part of an Internet access offering; "uses" a service it
owns or has acquired for that purpose; or simply "sells" owned or acquired
services as part of its Internet access bundle.

In addition, we read the amended exception as applying only to services
that are classified as telecommunications services under the 1998 act as
amended. In fact, the moratorium defines the term "telecommunications
services" with reference to its definition in the Communications Act of
1934,4 under which DSL and cable modem service are no longer classified as
telecommunications services.5 Moreover, under the Communications Act, the
term telecommunications services applies to the delivery of services to
the end user who determines the content to be communicated; it does not
apply to communications services delivered to access service providers by
others in the chain of facilities through which Internet traffic may pass.
Thus, since broadband services are not telecommunications services, the
exception in the 1998 act does not apply to them, and they are not
affected by the exception.6

The best evidence of statutory intent is the text of the statute itself.
While legislative history can be useful in shedding light on the intent of
the statute or to resolve ambiguities, it is not to be used to inject
ambiguity into the statutory language or to rewrite the statute. E.g.,
Shannon v. United States 512 U.S. 573, 583 (1994). In our view, the
definition of Internet access is unambiguous, and, therefore, it is
unnecessary to look beyond the statute to discern its meaning from
legislative history. We note, however, that consistent with our
interpretation of the statute, the overarching thrust of changes made by
the 2004 amendments to the definition of Internet access was to take
remedial correction to assure that broadband services such as DSL were not
taxable when bundled with an ISP's offering. While there are some
references in the legislative history to "wholesale" services, backbone,
and broadband, many of these pertained to earlier versions of the bill
containing language different from that which was ultimately enacted.7 The
language that was enacted, using the phrase "purchased, used, or sold by a
provider of Internet access" was added through the adoption of a
substitute offered by Senator McCain, 150 Cong. Rec. S4402, which was
adopted following cloture and agreement to several amendments designed to
narrow differences between proponents and opponents of the bill. Changes
to legislative language during the consideration of a bill may support an
inference that in enacting the final language, Congress intended to reject
or work a compromise with respect to earlier versions of the bill.
Statements made about earlier versions carry little weight. Landgraf v.
USI Film Products, 511 U.S. 244, 255-56 (1994). Singer, 2A Sutherland
Statutory Construction, S: 48:4. In any event, the plain language of the
statute remains controlling where, as we have concluded, the language and
the structure of the statute are clear on their face.

CBO's Methodology for Estimating Costs Relating to Taxing Internet Access
Services Appendix II

According to Congressional Budget Office (CBO) staff, CBO estimated
revenue losses to states and localities from changing how Internet access
was taxed by using two independent methodologies and comparing their
results. First, it collected information directly from the states. Using
data from the Federation of Tax Administrators and the Multistate Tax
Commission to identify states taxing access and their related tax
collections, CBO discussed with state officials what the dollar amounts
included and what they did not. It then reduced the state loss estimates
by various percentages to get a sense of the ranges possible by assuming,
for instance, that providers were not always paying the taxes states
thought they should pay.

To estimate from a second direction, CBO compiled its own state-by-state
information. It multiplied the number of Internet users by state times an
average access fee for each user times the state's applicable tax rate. It
then discounted each state total based on assumptions about noncompliance
with tax assessments.

To arrive at the number of users, according to CBO staff, CBO consulted
the Department of Commerce, the Federal Communications Commission, and
studies of Internet usage. From these sources, it obtained historical
numbers of users and trends that it could project showing the number of
users growing over time, and how usage was changing between dial-up and
high-speed.

Finally, according to the staff members, CBO gathered the other
information for its state-by-state estimate from other sources. It
obtained state tax rates from Council on State Taxation information and
computed a weighted average access fee after calling access providers
about their current rates. It assumed that any change in revenues brought
on by changes in technology and markets would offset each other. It
estimated noncompliance to cover both tax avoidance and nexus1 issues by
using indications it had of certain Internet service providers not paying
an access tax, considering their market share, and assuming various
percentages of tax not being paid.

CBO considered information from both the approaches it was using to get a
range for each state. It used these estimates to produce the part of its
analysis that it could quantify--the nationwide range of $80 million to
$120 million beginning in 2007 for states with originally grandfathered
taxes and more than $80 million per year by 2008 for the states taxing
DSL. CBO did not give point estimates or ranges for specific states, an
appropriate choice given the uncertainties in the methodologies used.
Although the nationwide estimates should be used with caution, they
provide reasonable bases for comparisons with the size of other revenue
sources, such as that for overall receipts from state taxes, and for
informing policy makers about the relative size of revenue losses related
to the moratorium.

Case Study States' Taxation of Services Related to Internet AccessAppendix
III

Table 4 and the following summaries show how our case study states
significantly differed from each other in how they taxed services related
to Internet access. State tax officials gave us much of the following
information in conversations and written communications, and it represents
their opinions of the application of the Internet Tax Freedom Act and the
2004 amendments to their own unique state laws. That said, the officials'
comments are not necessarily binding and reflect their interpretation of
state law.

Table 4: Characteristics of Case Study States

State Taxed Taxed Taxed Taxed Type of State tax Local tax Roughly
retail retail retail acquired taxa rate rate estimated
consumer consumer consumer services (percentage) (percentage) 2004 state
dial-up cable-modem DSL and local
Internet Internet Internet tax
access access access collections
services services services for all
these
services
(dollars in
millions)b
California N/A N/A N/A N/A
Kansas x Sales 5.3 1.3 on $9-10
average
Mississippi x Gross 7.0 N/A At most,
income 1.0
North x x x Sales 5.0 1.0-2.0 2.4
Dakota
Ohio x x x x Sales 5.5 1.0 on 52.1
average
Rhode xc xc x Gross 5.0, N/A Less than
Island receipts 4.5d
and 6.0
sales
Texas x x x Sales 6.25 2.0 limit 50e
Virginia N/A N/A N/A N/A

Source: State officials and laws.

aFor purposes of this report, a reference to a sales tax includes any
ancillary use tax. Also, for our purposes, the difference between a sales
and a gross receipts tax is largely a distinction without a difference
since the moratorium does not differentiate between them.

bSee earlier text for a discussion of the limitations of the state
estimates of revenue from taxes.

cRhode Island retail consumers did not pay this tax directly, but rather
through the gross receipts tax paid by their providers.

dAccording to Rhode Island officials, Rhode Island did not have an
estimate for taxes collected on acquired services.

eTexas officials did not provide us with an estimate of taxes collected
for Texas localities.

California

According to a state official, California had no grandfathered taxes on
Internet access under any provision of the 2004 amendments. In addition,
she said that California had enacted its own Internet Tax Freedom Act that
generally prohibited imposing taxes on access starting January 1, 1999.
Under this act, local governments were prohibited, with specified
exceptions, from imposing any taxes on buying or using Internet access or
other online computer services. Expiring January 1, 2004, the law did,
however, expressly permit imposing sales and use taxes, utility user
taxes, and other taxes of general application on goods and services that
included access services. At the time of our contact in mid-2005,
California officials were not aware of any state law either authorizing or
preventing the taxation of access.

Kansas

According to a state Department of Revenue official, Kansas taxes on
acquired services were grandfathered under the 2004 amendments. The state
imposed a general sales tax of 5.3 percent (with, according to the
official, local governments adding an average of another 1.3 percent) that
applied to telecommunications services bought by an ISP and used to
provide Internet access. ISPs paid sales tax on these acquired services to
other providers that then remitted the funds to the state. According to
the official, the state annually collected an estimated $9 million to $10
million in revenue from this tax, including about $2 million of local tax
revenues. The $9 million to $10 million was an unverified estimate based
on conversations between the Department of Revenue and telecommunications
providers about the providers' volume of sales to ISPs. It was derived by
taking 10 percent of the $98 million total telecommunications sales tax
receipts that the state collected in 2004. The approximately $8 million of
state revenue was about 0.15 percent of Kansas's total tax receipts of
about $5.3 billion in 2004. According to the official, he expected Kansas
to lose this yearly revenue starting on November 1, 2005.

Mississippi

According to Mississippi State Tax Commission officials, although the
state did not tax access that was purchased by retail consumers, its tax
on sales of telecommunications services to ISPs--services we are
categorizing as acquired services--was grandfathered under the 2004
amendments. Since before the 1998 Internet Tax Freedom Act, the state
collected a gross income tax on public utilities, including
telecommunications providers, which operated much as a sales tax would. No
sale-for-resale exemption applied to these services, according to the
officials, because under Mississippi law the ISP was not a reseller of the
same service; the ISP changed the service before selling it to the retail
consumer. The tax rate was 7 percent and, although officials told us the
amount of resulting revenue collections was extremely difficult to
calculate due to a lack of data, they believed the total amount to be less
than $1 million per year. This was about 0.02 percent of Mississippi's
2004 tax revenues of about $5.1 billion. According to the officials,
telecommunications companies remitted sales tax collected from ISPs to the
state on a monthly basis. As there were no local option sales taxes in
Mississippi, the state was the only Mississippi entity that taxed the
telecommunications services.

North Dakota

North Dakota Office of State Tax Commissioner officials maintained that
their state was grandfathered under the 2004 amendments, and as such
continued to tax retail consumer Internet access. The state imposed a
sales tax on communications services, which it applied to Internet access.
The tax rate was 5 percent and, according to the officials, led to state
revenue collections of about $2 million per year, which was about 0.16
percent of North Dakota's approximately $1.2 billion in 2004 tax revenues.
In addition, local rates of generally 1 percent provided about another
$400,000 in yearly collections for local jurisdictions. Retail consumers
were taxed on intrastate Internet access transactions, whether through
dial-up, cable modem, DSL, or wireless technologies. ISPs collected the
taxes and then transferred them to the state. To determine the amount of
tax revenue collected, state officials said they reviewed each registered
ISP and approximated how much income resulted from providing Internet
access. According to the officials, the state's determinations were
confirmed by subsequent state audits.

Ohio

According to Ohio Department of Taxation officials, Ohio was grandfathered
to continue taxing business (but not residential) purchases of Internet
access and provider purchases of other services to provide access. Ohio
imposed a 5.5 percent sales tax on business users of telecommunications
and electronic information services, supplemented, according to the
officials, by an average 1 percent tax for local jurisdictions. The same
taxes also applied to acquired services. Ohio also provided a 25 percent
sales tax credit for electronic information service providers, which meant
that ISPs could get a tax credit for the equipment that they purchased and
used primarily to provide Internet access.

Because Ohio taxed Internet access as part of electronic information
services for business users, it was difficult for state officials to
determine exactly how much tax was paid on Internet access. Officials
estimated that in 2004, the state collected $17 million in taxes paid on
Internet access services (including some research services) sold to end
users, and an additional $2.8 million from local taxes on those same
services. They derived these numbers using economic census data and
vendors' tax returns.

In addition, an Ohio official estimated collecting another $27.3 million
in state taxes and $5 million in local taxes in 2004 from other Internet
access-related services that state officials said Ohio could no longer tax
starting in November 2005. The combined $32.3 million state and local
revenues for services not taxable in November 2005 included several
components. The largest was $20.5 million on telecommunications services
and property provided to ISPs and Internet backbone providers, for
example, high-speed lines leased by an ISP from a telecommunications
provider. In arriving at this estimate, state officials assumed that 10
percent of telephone and wireless services would become tax exempt. The
next largest component was $9.1 million for private line services, such as
T-1 and T-3 lines, and 800/wide-area telecommunications-type services that
an official said would be exempt due to the moratorium. The state derived
this number by assuming that 10 percent of the relevant services were
attributable to Internet customers. These services had become taxable as
of July 1, 2003, when Ohio repealed exemptions for them, but, according to
state officials, these services were becoming tax exempt again at November
1, 2005, under the changed definition of Internet access.

The amount of Internet access-related state taxes that an Ohio official
said the state collected in 2004 was $44.3 million. This was the sum of
the $17 million from retail services and $27.3 million from acquired
services. This total amounts to about 0.2 percent of Ohio's approximately
$22.5 billion in tax collections for 2004. It does not reflect a problem
that Ohio officials expected from taxpayers bundling services as Internet
access services in order to avoid sales tax. Although the officials said
the size of the problem was unknown, they assigned a $24 million sales tax
loss to it for 2007, assuming it to be similar in size to other annual tax
losses that would start in November 2005.

Rhode Island

State officials told us that Rhode Island was grandfathered under the 2004
amendments to tax Internet access through both a gross receipts tax on
ISPs and a sales tax on telecommunications services acquired by ISPs. The
gross receipts tax, in existence since 1942, was imposed on any company
charging a telecommunications access fee, with provisions to prevent the
same charges from being taxed twice. This tax was assessed at a rate of 5
percent, and companies submitted an annual return to the state and made
estimated payments throughout the year. According to state officials,
Rhode Island did not tax companies providing Internet access services via
cable modem but did tax those providing access services through dial-up,
DSL, or wireless technologies. Not knowing what part of reporting
companies' gross receipts came from providing Internet access, the
officials could not determine precisely how much revenue the state
collected from Internet access under the gross receipts tax. They did say
that since Internet access charges probably totaled less than 10 percent
of annual telecommunications gross receipts of $40 million to $45 million,
the amount of state revenue collected from taxing Internet access would be
less than $4.5 million. This would be about 0.19 percent of 2004 state tax
revenues that totaled about $2.4 billion.

The officials also said that Rhode Island would be affected by the new
definition of Internet access under the 2004 amendments as it applies to
the state sales tax, and thus to the taxation of acquired services. The
sales tax was imposed at a 6 percent rate on the purchase of
telecommunications services bought by ISPs to provide Internet access. The
sale/resale exemption did not apply because ISPs are considered to be the
"end users" of the services, as their own products differ from the ones
purchased. The officials did not think revenues from taxing acquired
services were significant compared to overall state telecommunications tax
revenues.

Texas

An official with the Texas Comptroller of Public Accounts maintained that
his state had been permitted to tax retail consumer Internet access for
years, making Texas another one of the relatively few states that
continued to be grandfathered under the 2004 amendments. Because Texas had
no state income tax, a sales tax was its primary source of revenue. In
1985, telecommunications were added to the services covered by the sales
tax, and in 1988, information services were added as well. According to
the official, the 6.25 percent sales tax rate led to state revenue
collections of about $50 million for 2004, which was about 0.16 percent of
Texas's approximately $30.8 billion in tax revenues for 2004. Local
jurisdictions typically imposed an extra one-quarter to 1 percent
additional sales tax on Internet access, but the combined total of state
and local taxes could not exceed 8.25 percent. Texas exempted from
taxation the first $25 of Internet access charges incurred by a customer
when buying Internet access from an ISP. However, according to the
official, a corporate customer qualified for one $25 exemption regardless
of how many accounts it maintained. The sale-for-resale exemption applied
in Texas to services sold by a provider to an ISP for resale purposes, so
those acquired services were not taxable. Retail consumers were taxed on
intrastate Internet access transactions, whether through dial-up, cable
modem, DSL, wireless, or satellite technologies. ISPs collected the taxes
and then transferred them to the state.

Virginia

According to Virginia Department of Taxation officials, Virginia had no
taxes on Internet access grandfathered under the 2004 amendments. In
Virginia, ISPs were subject to taxes of general application, like
corporate income and gross receipts taxes imposed by the state or local
jurisdictions, but Internet access transactions were not taxable
transactions. According to the officials, Virginia's sales tax statutes
exempted ISPs from collecting sales tax, codifying then current state
practices. Virginia had exempted Internet access services from its sales
and use tax in April 1998. Acquired services were similarly not taxable in
Virginia.

Comments from Telecommunications Industry Officials Appendix IV

GAO Contact and Staff Acknowledgments Appendix V

James R. White (202) 512-9110

In addition to the contact named above, Michael Springer, Assistant
Director; Bert Japikse; Shirley A. Jones; Lawrence M. Korb; Walter K.
Vance; and Bethany C. Widick made key contributions to this report.

(450433)

www.gao.gov/cgi-bin/getrpt? GAO-06-273 .

To view the full product, including the scope

and methodology, click on the link above.

For more information, contact James R. White at (202) 512-9110 or
[email protected].

Highlights of GAO-06-273 , a report to congressional committees

January 2006

INTERNET ACCESS TAX MORATORIUM

Revenue Impacts Will Vary by State

In 1998, Congress imposed a moratorium temporarily preventing state and
local governments from imposing new taxes on Internet access. Existing
state and local taxes were grandfathered. In amending the moratorium in
2004, Congress required GAO to study its impact on state and local
government revenues. This report's objectives are to determine the scope
of the moratorium and its impact, if any, on state and local revenues.

For this report, GAO reviewed the moratorium's language, its legislative
history, and associated legal issues; examined studies of revenue impact;
interviewed people knowledgeable about access services; and collected
information about eight case study states not intended to be
representative of other states. GAO chose the states considering such
factors as whether they had taxes grandfathered for different forms of
access services and covered different urban and rural parts of the
country.

What GAO Recommends

GAO is not making any recommendations in this report.

The Internet tax moratorium bars taxes on Internet access services
provided to end users. GAO's interpretation of the law is that the bar on
taxes includes whatever an access provider reasonably bundles to
consumers, including e-mail and digital subscriber line (DSL) services.
The moratorium does not bar taxes on acquired services, such as high-speed
communications capacity over fiber, acquired by Internet service providers
(ISP) and used to deliver Internet access. However, some states and
providers have construed the moratorium as barring taxation of acquired
services. Some officials told us their states would stop collecting such
taxes as early as November 1, 2005, the date they assumed that taxes on
acquired services would lose their grandfathered protection. According to
GAO's reading of the law, these taxes are not barred since a tax on
acquired services is not a tax on Internet access. In comments,
telecommunications industry officials continued to view acquired services
as subject to the moratorium and exempt from taxation. As noted above, GAO
disagrees. In addition, Federation of Tax Administrators officials
expressed concern that some might have a broader view of what could be
included in Internet access bundles. However, GAO's view is that what is
included must be reasonably related to providing Internet access.

The revenue impact of eliminating grandfathering in states studied by the
Congressional Budget Office (CBO) would be small, but the moratorium's
total revenue impact has been unclear and any future impact would vary by
state. In 2003, when CBO reported how much states and localities would
lose annually by 2007 if certain grandfathered taxes were eliminated, its
estimate for states with grandfathered taxes in 1998 was about 0.1 percent
of those states' 2004 tax revenues. Because it is hard to know what states
would have done to tax access services if no moratorium had existed, the
total revenue implications of the moratorium are unclear. In general, any
future moratorium-related impact will differ by state. Tax law details and
tax rates varied among states. For instance, North Dakota taxed access
service delivered to retail consumers, and Kansas taxed communications
services acquired by ISPs to support their customers.

Simplified Model of Tax Status of Services Related to Internet Access

aDepends on state law.
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