By Raymond P. Carpenter (Atlanta) and Eric Fishman (Washington, D.C.)

Originally published January 4, 2006

For over a century, telephone service subscribers have been subject to a federal excise tax (FET) on communications services. Initially designed to curb the federal deficit caused by the Spanish-American War, the FET currently imposes a 3 percent levy on all "toll telephone service," "local telephone service," and "teletypewriter exchange service." A series of recent appellate court decisions, however, has rejected the application of the FET to a wide category of long distance service, and upheld the right of subscribers to obtain a refund for tax payments they have already made.

At issue in these rulings is whether long distance services fall within the definition of "toll telephone service" set forth in the Internal Revenue Code, 26 U.S.C. 4252(b). Enacted by Congress in 1965, this provision defines "toll telephone service" as the following:

(1) a telephonic quality communication for which (A) there is a toll charge which varies in amount with the distance and elapsed transmission time of each individual communication and (B) the charge is paid within the United States, and

(2) a service which entitles the subscriber, upon payment of a periodic charge (determined as a flat amount or upon the basis of total elapsed transmission time), to the privilege of an unlimited number of telephonic communications to or from all or a substantial portion of the persons having telephone or radio telephone stations in a specified area which is outside the local telephone system area in which the station provided with this service is located.

When Congress adopted this definition in 1965, the country had only one provider of long distance service – AT&T. At that time, AT&T offered two long distance service rate structures: a toll service, where charges varied depending on the duration of the call and the distance which the call traveled; and "Wide Area Telephone Service" (WATS), which imposed a periodic charge for unlimited access within a specified area outside of local service. The definition of "toll telephone service" embodied in Section 4252(b) of the Internal Revenue Code was designed to cover each of these rate approaches.

Since 1965, the telecommunications industry, service offerings and the rates carriers charge for service have changed radically; these sweeping transformations are reflected in the courts’ recent decisions. In each case, subscribers challenging the lawfulness of the FET had purchased service pursuant to a "postalized" rate plan, in which pricing did not vary by distance but is only time-sensitive, where the per minute price of a call was uniform for all out-of-state destinations.

Without exception, the courts have ruled that long distance services offered pursuant to such plans are exempt from the FET since they do not fall within the statutory definition of "toll telephone service." In the first of these cases, American Bankers Insurance Group v. US, the 11th Circuit considered the claim of ABIG for a refund from the IRS of $288,496.10, representing federal excise taxes collected on long distance services rendered by AT&T over a three-year period. Reversing the decision of the lower court which had ruled in favor of the government, the 11th Circuit held that the plain meaning of Section 4252(b)(1) of the Code was "unambiguous," and that the statutory definition of "toll telephone service" did not apply to a toll charge varying with elapsed transmission time, but not distance. The Court further ruled that the services purchased from AT&T did not fall within the scope of the statute, since AT&T’s charges did not vary by "distance." In a stinging rejection of the government’s interpretation of the statute, the Court further held that the services ABIG had purchased did not fall within the other categories subject to the FET since they were neither local in nature nor subject to a "periodic charge."

Subsequent rulings by the 6th Circuit and the U.S. Court of Appeals for the District of Columbia Circuit have reached the same conclusion. In OfficeMax, Inc. v. US, the 6th Circuit rejected the IRS’s interpretation of Section 4252 of the Code and held that "a toll charge must vary by both distance and elapsed transmission time in order to be taxed." Affirming the lower Court’s summary judgment in favor of OfficeMax, which had sought a full refund of $380,296.72 in excise taxes it had paid through MCI, the 6th Circuit panel held that "the government has not identified any tenable bases for deferring to its position – save for the facts that it is the government and we depend on its fiscal health, which are not enough."

Last month, in National Railroad Passenger Corporation v. US, the U.S. Court of Appeals for the District of Columbia Circuit likewise found that the government’s imposition of federal excise tax on long distance offerings to be without merit. Affirming a grant of summary judgment to Amtrak, the Court acknowledged that its ruling "limits the effectiveness of the tax on long-distance calls," but because the language of the statute was "unambiguous, the IRS must take its case to Congress, not this court."

In addition to these appellate cases, telecommunications service subscribers have won victories in district courts in other circuits, including a summary judgment of $6,385,671.86 to Hewlett Packard in the Northern District of California, Hewlett-Packard Company v. US, 2005 U.S. Dist. LEXIS 19972. See also Fortis, Inc. v. US, 2005 U.S. Dist. LEXIS 2104 (S.D.N.Y. August 5, 2005), and Reese Brothers, Inc. v. US, 2004 U.S. Dist LEXIS 26564 (W.D. Pa. Nov. 30, 2004).

Remarkably, the Internal Revenue Service has elected effectively to ignore the courts’ recent rulings, and that it will continue to assess federal excise taxes even in jurisdictions where its enforcement of the statute has been overruled. In Notice 2005-79, 2005-46, issued in late October, after the ABIG ruling, the IRS announced that it would "continue to assess and collect the tax … on all taxable communications services, including communications services similar to those at issue in the cases. Collectors should continue to collect the tax, including from taxpayers within the jurisdiction of the United States Court of Appeals for the Eleventh Circuit." The IRS further announced that, although taxpayers could preserve their claims for overpayments by filing administrative claims for refund, they were advised "that these claims, for which appellate venue would lie in the United States Court of Appeals for the Eleventh Circuit will not be processed while there are pending cases in other United States Courts of Appeal." The IRS has maintained this aggressive policy in the wake of the subsequent OfficeMax and Amtrak decisions.

The decision of the IRS to collect federal excise taxes in a circuit where the controlling case law rejects the agency’s interpretation of the law is highly unusual. Last month, a group of 20 telecommunications carriers and interest groups signed a letter asking U.S. Treasury Secretary John W. Snow to stop the IRS from collecting the excise tax, noting the overwhelming consensus among the courts "that the position being advanced by the IRS is simply wrong." It does not appear, however, that the IRS is inclined to change its enforcement policy at any time in the near future.

It is also unlikely that Congress will intervene to protect past claims. Although bills to repeal the telephone excise tax have been proposed in both the Senate and House of Representatives, neither piece of legislation is retroactive in effect, and neither has moved out of committee.

Given the uncompromising stance the IRS has taken, and the unlikelihood of Congressional intervention, consumers of long distance telephone services should seriously consider seeking a refund for taxes they have previously paid for toll telephone service. While it is not likely that the IRS will grant such petitions immediately, pursuing such an initiative will, at a minimum, preserve the subscriber’s rights and would be a condition precedent to obtaining any future relief. In this regard, consumers should be aware that there is a three-year statute of limitations on refund claims with the IRS, and that refund claims must be thoroughly documented. For assistance preparing such claims, please contact your Holland & Knight attorney.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.