Tax Laws Brew Three-part Mix of Trouble

Posted: 12/2000

Tax Laws Brew Three-part Mix of Trouble
By Paul Maddock

Much like the witches in Macbeth, tax law is brewing a three-part mix
of trouble for the telecom industry. State and local governments increasingly
are turning to telecom as a revenue source. As a result, the industry faces a
complex maze of taxes on bills with serious reporting overhead as part of the
bargain.

Once past today’s OSS problems, telecom companies may discover that taxation
really is "Double, double, toil and trouble."

The telecom taxation trend has been growing for some time. It is a byproduct
of government revenue restructuring. With almost certain protest of increases in
traditional property, sales and income taxes, governments have begun looking in
other areas to raise revenues. They found it in telecommunications.

As a result, telecommunication companies have seen the creation of new taxes
to fund everything from hospitals to school Internet access. And with this has
come new administrative challenges: jurisdictional determination, calculation
and compliance.

Each problem can surface in any phase of the OSS and billing process. Worse
yet, the problems often start as small errors that go unnoticed– especially by
startup companies. When they become large enough that customers or auditors
notice them, the resulting tax burden, and/or penalty, can be a serious threat
to the business. That threat can take the form of government action or even
consumer lawsuits.

Jurisdictional Determination at Ordering

Tax problems usually start with errors in determining jurisdiction. The first
place a billing/OSS system can create this problem is at the beginning–service
provisioning.

The provisioning process must gather details on the customer’s billing
address and the physical location of any fixed service. If it fails, the billing
process could face a twin set of errors: incorrect tax rates and payment to the
wrong authorities.

These errors can get a company in trouble with the customer and the
government.

Most jurisdiction errors are going to favor putting the customer in a higher
tax rate area, so the customer will be overcharged. On top of that, the error
can end up underpaying the correct taxing authority, which invites audit trouble
a year or two down the road. In the meantime, the company actually may be
overpaying another taxing authority.

This one simple error can create a potential war on multiple fronts, which
only a fool would want to fight.

Billing Calculation

If provisioning sets up the proper customer information, the billing process
will have to assess accurately taxes for each charge on the bill, which is no
easy task.

Even supplying a valid rate schedule requires a huge effort.

Applicable taxes can vary wildly depending on the service and what locations
are involved with the billable charge. Several different kinds of taxes can
apply to most telecom charges. Each tax has to be calculated and properly
recorded.

Finding the Right Tax Rate

First and foremost, the billing system needs to have a valid tax rate for
every service offered and every jurisdiction served. Given the probability that
a provider will have to serve a customer away from home via calling card or
other remote facilities, the list of jurisdictions and rates may include the
entire country. Since there are thousands of U.S. tax jurisdictions, it’s
advisable to subscribe to a well-known research vendor that offers regular
updates.

Which Authority Taxes a Charge?

Service type often will determine which authority can tax a given charge. If
it’s a fixed-point telecom service like dial tone, it’s a simple matter of
applying the local taxes.

Point-to-point services are more complex. The law still is being formed on
how to tax many of the new telecom services. However, an established method for
landline long-distance calling already exists.

Years ago the court case Goldberg et al. vs. Sweet, Director, Illinois
Department of Revenue, et al. set a method for determining point-to-point
call jurisdiction. It’s often called "the two out of three rule." This
means, two of three locations must be determined:

1. Origination point of the call (the switch location is usually acceptable).

2. Termination point (again the switch location can be used).

3. The service address (the exact physical location of the customer’s primary
phone). This address may or may not be the billing address. (Many billing
systems make the dangerous assumption that the billing and service address are
the same.)

Wherever two of these three are the same for a jurisdiction, that
jurisdiction can tax the call. For example, if a customer has a primary phone in
Denver:

1. Using a calling card to call from Florida to California–only the United
States can tax the call.

2. Using a calling card at a payphone to call across Denver–the United
States, Colorado and Denver can tax the call.

3. Using a calling card to call from Colorado Springs to Boulder–only
Colorado and the United States can tax the call.

4. Using a calling card to call from Denver to Los Angeles–the United
States, Colorado and Denver can tax the call.

With data services, the federal government has granted the industry a
temporary reprieve with a tax moratorium. However, some states implemented taxes
before the moratorium, and those taxes have been grandfathered. (Some groups
assume that Internet service is always tax free. In some areas, it is not.) Most
of these "taxes" take the form of a percentage based on monthly fees.

The situation with wireless service is a work in progress. Potential help is
on the way.

Currently, some carriers use variations of the two out of three rule.
However, the lack of fixed locations creates ambiguity, so some jurisdictions
try to apply taxes if the call crosses a local cell site–regardless of any
other factor.

Fortunately, the industry has a bill pending before Congress that would
simplify the situation. All taxes would be applied based on a single primary
jurisdiction.

Even though this process may seem simple, complications arise with today’s
pricing plans. Examples include:

1. Some states require tax on "gross" revenue. If a pricing plan
involves a percentage discount, these states tax on the charge before the
discount.

2. Plans that mix usage types can create havoc for tax calculation. If the
usage is all direct dialed then the taxation can be based on the home service
location. However, if it includes calling card usage, exotic allocations may be
required.

3. Threshold discounts, which involve giving a credit based on total
spending. This can create a special problem since the discount isn’t known until
the bill is totaled. To properly apply the post- discount taxes (assuming the
state doesn’t require gross taxing), the billing process has to re-evaluate each
charge–applying the credit to the appropriate jurisdictions. (Note: many
billing systems only use the customer’s home jurisdiction for calculating the
discount and tax credit–a fatal error.)

The trend toward convergence adds a new dimension to the tax calculation
menace. It mixes even more service types. So long as the bundled services are
priced separately, new issues are not introduced. However, if the bundle has one
price for disparate services, extreme complications can occur. As a result,
bundled pricing–usually meant to increase the value proposition–actually can
increase the effective tax rate.

Exemptions

Customers from nonprofit corporations, to the clergy, to diplomats will claim
they are entitled to tax exemptions.

Unfortunately, exemptions create a "double edge of liability" for a
telecom company. If a valid exemption is denied, the customer may seek a tax
refund and probably will change providers. If an exemption is applied
improperly, the government may hold the provider liable for the missed taxes.

This is why careful tracking of exemption certifications is required to avoid
a problem.

Exemptions cause further difficulty because they can be difficult to
determine and track since they can be created by different factors.

If a customer has a valid tax exemption certification for a jurisdiction, the
taxes for that jurisdiction are not applied. However, in some cases the charge
itself may be exempt.

For instance, calls coming out of a U.S. combat zone are not subject to
federal tax. Although this rule is meant to exempt military service personnel,
it’s applied at a call level rather than per customer.

Data charges are exempt under the Internet moratorium, except for certain
grandfathered taxes. Special exemptions even are created if the bill is mailed
abroad.

Bill Presentment Issues

Once the billing process successfully calculates the taxes, tax laws create
complications for presenting it.

Under the "truth in billing" or "simple billing"
regulations, the federal and state governments have mandated how taxes are to be
printed on the bill. Most often these mandates work toward making the taxes
appear as something else. Examples include:

1. Universal service fund (USF). Although it is a government-mandated charge,
it cannot be shown in the tax section.

2. At least one state public utility commission requires that taxes be
included in the service charge, which creates the risk of perceived price
inflation.

3. Even in cases where the tax can be included in a "tax" section,
there may be rules preventing them from being separately listed. In some cases,
it’s just the opposite. The law requires that the tax be listed with explicit
language, forcing a biller to use up bill lines.

Financial Support Functions

All the work so far is only as good as the back-office processes–also known
as financial support. This function, which often is overlooked as startups focus
on provisioning issues, has the responsibility of correctly remitting the tax
returns to the tax authorities.

More importantly, a few years into the future, it is the back office that has
to become the first line of defense when the eventual audit from one or more
taxing authority comes.

Unfortunately, many billing systems will attempt to summarize the tax data
for the sake of simplicity, for faster implementation or to cut down on the data
volumes.

Skimping can leave a provider exposed, and it will cripple the support
processes. Without this critical data, a company may not recover from a tax
error found in the billing process or be able to defend itself in a tax audit.

Audit Defense and Prevention

The audit defense has a particular importance. Audits are expensive and
almost inevitably will result in some sort of charge.

Unfortunately, the complexity of the tax system nearly guarantees there
always will be some kind of error found, which will result in a full audit. This
is why it is critical to have the facilities to respond quickly when an audit
begins, so it does not go beyond a high level.

At a high level, a taxing authority often will monitor the ratio of revenues
and taxes remitted. In the case of a smaller company, if the ratio gets out of
alignment, an audit may be triggered. Larger companies may end up subject to
audits as the taxing authorities squeeze revenues. After all, a small problem
with a large company will have a greater value to a tax authority than a small
one.

If an audit comes, the first line of defense is to prove the revenue ratios
are correct. The two critical foundations for proving the ratio are the billing
detail (described previously) and a correctly built tax compliance process.

If the billing detail–including information on applied exemptions–is
complete and matches the compliance, a deep audit may be avoided.

Accounts Receivable and Customer Service Impact

Although most providers would prefer to get paid for 100 percent of the
billed revenue, it doesn’t happen and the resulting gap creates another tax
consequence.

Every time a customer gets an adjustment, credits are created that can change
the tax. Further, some customers don’t pay their bills, which eventually results
in a write-off. When this happens, the taxing authorities only offer a small tax
relief benefit.

When a customer balance is written off, the provider has an opportunity to
reclaim the taxes already paid for that customer, because taxes initially are
collected from the provider at bill time rather than at collection.

However, reclaiming the tax can be complex because of tax types and
regulations relative to partial payments. Many billing systems make recovery
impossible due to data summarization or weak accounts receivable (A/R)
processes.

A similar tax issue exists with customer adjustments. Handling customer
adjustment requests can create a lot of overhead, and many providers are trying
to cut this cost. Some of the shortcuts used in these instances create credits
with incomplete tax information.

If the tax consequences aren’t fully considered, the customer may get more or
less than the real credit due. This may result in another costly call. Worse, it
may contribute to audit risks.

Keeping the Cauldron from Bubbling

Taxation can be a real cauldron of trouble with many confusing turns and
three main elements.

A telecom provider must deal with each issue– jurisdictional determination,
calculation or compliance–separately and in unison.

With today’s shrinking margins, a provider that fails to address these areas
may very well be risking its existence.

Paul Maddock is a consultant with Foxfire Consulting (www.foxfireconsulting.com).
He can be reached at [email protected].