Bottom Line: Don't Get Caught Web of Taxation

Posted: 09/2000

Don’t Get Caught Web of Taxation
By A. Dale Currie Jr. and Bob Geppert

When Scottish poet and novelist Sir Walter Scott wrote, “Oh, what a tangled web we weave,” it was a philosophical thought regarding people’s deceptive practices during the early 1800s.

Of course, that was long before the advent of mass telecommunications and global business pursuits. One can only imagine the tangled webs about which Scott could have written with regard to 21st century tax issues that face telecom companies–especially since these companies are being driven by the same force and technology that created our modern-day, global web.

The deregulation of the telecom industry, an insatiable demand for broadband capacity; the blurring distinction between telecommunications, cable television, and Internet services; and rapidly changing technologies are spurring a record number of “startup” companies into the telecom marketplace.

These new businesses offer high-speed wired and wireless broadband services, which include Internet access, web hosting, DSL, VoIP and cable as well as traditional local, long-distance, and private line voice services.

In today’s environment, it’s easy for startups to spend anywhere from $300 million to more than $1 billion in constructing high-speed networks to satisfy customer needs. However, few of these upstarts consider anything beyond building networks, operating their systems and obtaining new customers. Taxes usually are not part of the early-on equation, and that can result in significant headaches later.

For example, let’s consider a fictional startup. We will call it Last Mile Communications. A group of network engineers with substantial “big” carrier experience form the company. They spend $500 million on fiber, switches and routers during a three-year period and expect to generate annual revenues of $500 million (and growing) after three years. Top management is not concerned about taxes, as it “doesn’t expect taxable income for five years.”

But a closer look reveals significant tax concerns. Assuming that 60 percent of Last Mile’s purchases are subject to sales tax and its average sales tax rate is 6 percent, the company will pay $18 million in sales tax on the network assets in those states where assets are installed.

Last Mile will pay these taxes at the time it buys the assets from its equipment vendors. That could mean it will be paying in cash at a time when it is, for the most part, “cash-starved.”

Furthermore, as Last Mile builds its network, state and local governments will begin eyeing the construction in progress as new property on which they can and will assess property taxes.

Since typical property tax rates are around 1.5 percent, Last Mile will find itself presented with an annual property tax burden of nearly $4.5 million on its initial network buildout. And remember, this is all before the company begins operating.

Once Last Mile finally is open for business, it has to deal with “customer-level” taxes. Before it sends bills to customers for its services (whether bundled or billed separately), Last Mile must make critical decisions about what taxes, fees and surcharges to collect from customers and remit to state and local tax administrators and the federal government. These taxes, fees and surcharges can easily range from 5 percent to 25 percent of the amount billed to customers. They also are incredibly complex to administer.

It seems to be a law of nature that no two state, local and federal communications taxes have the same tax rate, tax base, collection and remittance responsibilities, or exemptions. Uniformity would make life much too easy.

Also, if Last Mile fails to collect the taxes, fees and surcharges from customers, it still has to pay them to the applicable taxing jurisdictions.

Many startups learn the hard way. After three or four years of operations, they learn they may owe significant tax liabilities for
customer-level taxes, which can have a serious effect on a company’s financial condition. Unfortunately for the companies, it’s virtually impossible to go back to customers and bill them for prior years’ taxes.

To make matters worse, our fictional company’s management starts to realize that many of these tax issues seem to be both mutually exclusive and intertwined. If Last Mile is a wireline voice company, it may be subject to one set of rules. But, if it is a data company, a completely different set of rules may apply.

In reality, companies like Last Mile are, in a multitude of telecommunications businesses, subject to a multitude of conflicting state, local and federal tax rules.

So what can they do? The answer is simple: Find someone who has done this before and make a plan.

The Same Mistakes

Cases like the fictional Last Mile can seem like déjà vu to tax lawyers or accountants. They often see telecom startups make the same kinds of tax mistakes. On the positive side, however, this has helped pave the way for tax professionals to develop some ground rules to offer these companies help.

As mentioned earlier, the issue is that startups rightfully focus on operations and marketing, while generally neglecting strategic tax planning. Being so focused mainly on raising capital and executing their business plans, these companies don’t see how tax planning can save them significant amounts of money and, in turn, further their capital and business goals.

Because taxes do not appear to be core to a startup telecom’s business, talking with tax professionals does not have the same urgency as, say, talking with venture capitalists.

Capital Expansion Planning or Easing the Growing Pains

A great starting point for a startup is to focus on the sales and property taxes paid on a network buildout. Capital expansion tax planning can reduce significantly the initial building costs of a network and the recurring costs of maintaining it.

For example, some states provide sales tax exemptions for purchasing certain types of telecommunications equipment. Qualifying under these exemptions saves significant dollars. Furthermore, even if the tax is due, techniques can help you defer or reduce the sales tax burden.

Here’s one tactic. Last Mile can establish a “captive” procurement company–Last Mile Purchasing–which purchases all the buildout equipment from the vendors. Last Mile Purchasing would then sell or lease the assets to Last Mile’s telecom operating company–Last Mile Telecom.

Because Last Mile Purchasing is a reseller and not the “end user” of the equipment, it is not responsible for paying sales tax to the vendors up front.

Instead, it would bill sales tax as it sells the equipment to Last Mile Telecom. This is a huge advantage, since Last Mile can now decide whether the equipment is subject to any exemptions and may otherwise defer payment of the tax.

Moreover, Last Mile can pay the tax only at the “final destination,” a location often unknown to the equipment vendor.

But that’s just the beginning. Last Mile also can lease the equipment to Last Mile Telecom and collect the sales tax over time, essentially creating $18 million of financing through proper tax planning.

During the early years of its existence, Last Mile might prefer to use this money for payroll rather than to pay sales taxes.

Last Mile also should take great pains to separate all the “soft costs,” such as engineering fees, site selection, professional fees and so forth, from the “hard” assets.

In their haste to build networks as fast as possible, startup telecoms often capitalize everything into fixed assets and then pay property tax on these costs every year. Perhaps Last Mile should set up a separate captive engineering company to capture the soft costs, which could remove them from the property tax base.

Incentives Planning or Looking for the Highest Bidder

Anyone who has ever received multiple offers on a home knows it’s a nice feeling to be fawned over.

The taxation equivalent of this is found in business incentives. States, counties and municipalities often try to encourage high-tech growth companies to locate in their jurisdictions through targeted tax incentives.

For example, Last Mile is trying to decide where to locate its headquarters. States and cities might offer sales tax or property tax abatements. They might offer income tax credits for new jobs created, payroll tax reductions, favorable bond financing, or even grants (i.e., cash).

The window to get these benefits usually is short. Once a state or city knows you’re coming, it is less inclined to dig deep. For Last Mile, assuming it plans to spend $10 million on a headquarters and employ 500 people, an incentive package might total in the millions–money that can be used for other things. The moral here is to seek business incentives as early as possible, in the pre-planning stages, and to coordinate them with other tax planning.

But, even if you can’t do that, tax professionals may be able help qualify you for some benefits on a retroactive basis.

Tax Billing Systems
Can Be a Perilous Journey

Customer-level taxes, fees and surcharges become your liability if you fail to collect them. Thus, properly collecting tax on customer billing is critical.

The problem is that many of the rules of what is taxable for telephone and telecom companies are carryovers from the days of Ma Bell and POTS.

The telecom industry is burdened with the most complicated transaction-based taxes of any business. In fact, for years, telecoms have had to do what e-commerce companies now are screaming about:

collect taxes from tens of thousands of state, city and local jurisdictions. It’s a daunting task.

If Last Mile does not bill customers correctly, it will find itself with little recourse. Short of going to the customer and saying, “Excuse me, but we forgot to bill you for some of these taxes,” any negative bottom line impact eventually will be borne by its shareholders–sure to be unhappy shareholders.

If Last Mile errs on even 10 percent of its tax decisions, this could amount to millions of dollars per year. And it could affect the survivability of the company.

Structural Planning or Building a Strong Foundation

If Last Mile had done some tax planning, it might have a separate operating company, procurement company and engineering company.

The final piece of the puzzle is to review whether all these companies are tax efficient from an income and franchise tax review. It would be a shame to raise $500 million in cash only to park it in a state that assesses a franchise tax on this capital. At a typical franchise tax rate of 0.25 cent, this capital could attract $1,250,000 in annual tax.

Perhaps Last Mile might need a holding company to reduce or eliminate this type of tax. As a practical matter, holding companies can insulate the parent corporation from some of the regulatory constraints imposed on regulated telecom companies. Last Mile should evaluate whether each company’s corporate structure should be a corporation, partnership or limited liability company.

These decisions potentially can save taxes, while providing a more nimble structure within which to raise capital.

Plan Early or Don’t Get Caught With Your Coffers Bare

The bottom line? Early planning can provide significant tax benefits to startup telecoms and to existing companies that enter new lines of business.

Tax planning won’t hamper the raising of capital or the operations side of the business; rather, it works in conjunction with these activities.

Don’t make the same mistakes and try to fix them after the fact. Tax planning can be a significant advantage to achieve your overall business plan.

A. Dale Currie Jr. is a partner and the tax industry leader in communications for KPMG LLP
(www.us.kpmg.com). He can be reached at [email protected].
Robert Geppert is a principal and the state and local tax industry leader in telecommunications for KPMG
LLP. He can be reached at [email protected].