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Tax Foundation Brief: Stopping the IRS's Revival of an Obsolete Tax

Tax Foundation - Tue, 2014-05-27 07:15

In 1898, the United States went to war with Spain and enacted an excise tax on telephone service to help pay for it. Repealed in 1902, re-enacted in 1917, repealed in 1924, and re-enacted in 1932, the tax was “temporarily” extended a further 29 times until it was made permanent in 1990.

In all other respects, the substantive provisions of the federal excise tax on telephone service has not changed since 1966. The tax is imposed on (1) local telephone service, (2) long-distance telephone service where price varies by distance and elapsed time, and (3) teletypewriter exchange service. Technological advances and changes in telephone habits have rendered teletypewriter exchanges obsolete, and long-distance service is now priced on time or in bundled services, rather than the per-call time and distance defined by the statute.

After losing a series of court cases, the IRS conceded in 2006 that the only remaining relevant portion of the tax is the tax on local telephone service. The IRS no longer attempts to collect the tax on other telephonic communications, recognizing that the rest of the statute is a vestige of a bygone era.

However, in 2007, the IRS demanded $16 million in back telephone excise taxes from bankrupt company WorldCom for data stream services related to its provision of dial-up Internet access in the early 2000s. The IRS contends that these services are “local telephone service,” while WorldCom argues that it is a communications service outside the scope of the statute. The Bankruptcy Court ruled for WorldCom, as did a federal judge, noting that the service was an intermediate service (not an end user service) and not telephonic-quality communication.

The federal Second Circuit Court of Appeals reversed, holding (1) that elements of the service could provide telephonic-quality communication, (2) that the IRS decision not to apply the tax to most communications services was not entitled to judicial deference, and (3) that to hold otherwise would produce “a strange result” of some services being taxed but not others.

WorldCom has appealed this decision to the U.S. Supreme Court, and the Tax Foundation filed a brief in support of the petition on May 21, 2014, requesting the Court to take the case.

Our brief makes two main points:

The Court’s guidance is needed to prevent the Internal Revenue Service from reviving a tax that was bad policy to begin with and was never intended to be a permanent tax, acknowledging recent court decisions and IRS rulings limiting the scope of the tax to local telephone service. The courts should decline to expand the definition of “local telephone service” to new services not contemplated at the time of enactment, absent further congressional authorization.

Read the full brief here. See our page on the WorldCom case here.

The case is WorldCom, Inc. v. Internal Revenue Service, No. 13-1269.

Categories: Tax news

Supreme Court to Hear Maryland Double Taxation Case

Tax Foundation - Tue, 2014-05-27 06:00

The U.S. Supreme Court has announced that it will hear the appeal in Comptroller v. Wynne, on whether states must provide a credit against its own taxes for taxes a resident pays to another state. Maryland allows such a credit against its state income tax but not against its local county and city income taxes.

The taxpayers in the case, Mr. and Mrs. Wynne, owned 2.4 percent of a company doing business in 39 states. Maryland residents, they paid $123,434 in income tax to Maryland, after applying a credit of $84,550 for taxes paid to other states on income earned outside Maryland's borders. Maryland disallowed the credit to the extent that it offset the county income tax. The Tax Court upheld the assessment, a Maryland circuit court reversed and sided with the Wynnes, and Maryland's highest court (the Court of Appeals) agreed, ruling the tax unconstitutional without a credit. The state has now appealed to the Supreme Court.

It's hard to think of a more blatant example of impermissible state taxation of interstate commerce than Maryland's tax here. Maryland certainly has the authority to tax the Wynnes -- they are Maryland residents -- but gets into constitutional trouble when it asserts the power to tax income earned outside Maryland. Until this case, it has generally been undisputed by scholars that such a tax is only permissible if the state credits the taxpayer for taxes paid to another state. Otherwise, states would be able to subject the same income to double-, triple-, quadruple-, etc. levels of taxation. The net result of this would be to strongly discourage interstate investment and commerce of the type the Wynnes undertook, since only by investing within Maryland would income not be subject to gargartuan levels of taxation.

Analyzing whether Maryland's tax is constitutional is a two-step process. First, one must ask whether the state has the authority to impose the tax on income. This is fairly well-settled, with the statute authorizing the tax and numerous court precedents allowing states to tax their residents however they wish, with any credits or deductions a matter of legislative grace. Second, though, one must ask whether the tax discriminates against interstate commerce. This has been sometimes described as an "internal consistency test" -- if every state had such a tax, would the result be discrimination against interstate commerce? The answer here is unequivocally yes. The state (and the U.S. Solicitor General, who was asked for his views) performed step one of this analysis but did not do step two. Their arguments would get an F grade in any state taxation class as incomplete.

17 states have local income taxes, and while most provide a credit for taxes paid to another state, they probably do so because they think they have to, constitutionally. An adverse ruling here will quickly result in taxpayers being taxed on the state income over and over by any state with any tax authority over them. Although this case relates to local income taxes, there is no logical reason why the rule should be different for state income taxes.

It would have been best if the Court declined to hear the case and let the Maryland Court of Appeals ruling stand. As they have now agreed to hear it, the Court should take a strong stand against states using their tax systems to discriminate against interstate commerce. We will make such an argument in our amicus brief. (Both the Maryland Attorney General and Wynne cited our 2011 local income tax study in their briefs to the Court.)

The case is No. 13-485, Comptroller of the Treasury of Maryland v. Brian Wynne, et ux.

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