United States: Kentucky Court Of Appeals Holds Telecommunications Tax Is Unconstitutional

The Kentucky Court of Appeals has held that the state's telecommunications tax is unconstitutional because it prohibits local governments from collecting telecommunications franchise fees.¹ The Kentucky Constitution authorizes local governments to impose franchise fees on utilities, but the state has been collecting the telecommunications tax in lieu of the local level franchise fee system since January 1, 2006. Significant changes are expected based on this ruling if it is affirmed on appeal, including the possibility that historic local level franchise fees will be re-enacted as part of a final resolution.

Background

In 2005, Kentucky enacted the telecommunications tax to be effective for services billed on or after January 1, 2006.² Previously, local governments collected franchise fees from telecommunications companies and cable providers pursuant to Sections 163 and 164 of the Kentucky Constitution.³ The telecommunications tax expressly prohibits local governments from imposing such franchise fees on this type of service.⁴ The statute imposes the following:

• 3 percent excise tax on retail purchases of multichannel video programming (MVP) services;⁵
• 2.4 percent tax on gross revenues of providers of MVP services;⁶ and
• 1.3 percent tax on gross revenues of providers of communication services.⁷

In this litigation, several Kentucky cities banded together to challenge the telecommunications tax and seek to restore their right to collect franchise fees.⁸ The circuit court entered a judgment on the pleadings and held that the telecommunications tax did not violate Sections 163 and 164 of the Kentucky Constitution. The cities appealed this decision.

Tax Violates Kentucky Constitution

In an unpublished opinion, the Kentucky Court of Appeals held that the telecommunications tax violates Sections 163 and 164 of the Kentucky Constitution. Section 163 of the Kentucky Constitution provides that no utility franchise may be granted without the consent of the appropriate local government. Kentucky courts have consistently interpreted this provision as a delegation to local governments of the right to grant utility franchises within their boundaries.⁹ Section 164 of the Kentucky Constitution provides that no local government may grant a franchise for a term exceeding 20 years.¹⁰ By enacting this provision, the drafters of the Kentucky Constitution envisioned that local governments would receive valuable consideration in exchange for granting utility franchises.

The Court explained that Kentucky cases have recognized the state's authority to enact a statute to regulate a utility franchise granted by a local government,¹¹ but the telecommunications tax is unique because it "seeks to impose state taxes at the expense of franchise fees historically imposed and collected" by local governments. There was no dispute that the telecommunications tax expressly prohibits local governments from collecting franchise fees. The state has retained considerable power to regulate local utility franchises, but Section 163 of the Kentucky Constitution gives local governments the right to collect franchise fees. The Court held that the state cannot enact legislation to eliminate the local governments' constitutionally delegated authority to grant a franchise and collect franchise fees. According to the Court, this change only may be accomplished through a constitutional amendment. Thus, the cities were entitled to summary judgment because the telecommunications tax is unconstitutional.

Commentary

The state or telecommunications companies are expected to appeal this case to the Kentucky Supreme Court.¹² Because no injunction has been issued, the telecommunications tax still exists and is imposed as it has been since January 1, 2006. This raises more questions for companies collecting or paying the telecommunications tax than it solves. For example, companies need to consider whether they should continue to collect and pay the state telecommunications tax. If refund claims are filed, companies must decide which tax periods and components of the state telecommunications tax to include in the refund claims. Also, companies need to consider whether any amounts refunded to the company will need to be refunded to their customers. There is a possibility that the state and local governments will reach an agreement that will validate the prior taxes and preclude any refund claims. Finally, there is a possibility that a new tax regime will be enacted where both the state telecommunications tax and new local-level franchise fees will be imposed on service providers.

At present, it is assumed that the state or telecommunications companies will appeal this ruling. The Court of Appeals has not addressed or even suggested when and how changes will be made. It is unknown if the ruling will be applied retroactively or prospectively and if any prior period franchise fees could be assessed on qualifying service providers. Given the broad reach of the decision and the possibility that a resolution of the taxability of MVP and communications services is unlikely for some period of time, companies impacted by this case and this tax should consider whether to file protective refund claims for the full open statute of limitations for each company (noting that any lookback periods may be limited under the current ruling that the tax is unconstitutional). In addition, companies should determine whether to file any future returns under protest in order to protect any future refund rights.

Footnotes

1 City of Florence v. Flanery, Kentucky Court of Appeals, No. 2013-CA-001112-MR, Nov. 7, 2014 (unpublished opinion).

2 KY. REV. STAT. ANN. §§ 136.600–136.660. This tax is named the Multichannel Video Programming and Communications Services Tax.

3 According to the Kentucky League of Cities, one of the entities that initiated this litigation, the amount of the fees typically was negotiated in the franchise agreements.

4 KY. REV. STAT. ANN. § 136.660(1)(a).

5 KY. REV. STAT. ANN. § 136.604(2).

6 KY. REV. STAT. ANN. § 136.616(2)(a). Accordingly, the tax rate on sales of MVP services is 5.4 percent.

7 KY. REV. STAT. ANN. § 136.616(2)(b). Accordingly, the tax rate on sales of telecommunications services is 4.3 percent.

8 The Kentucky League of Cities has estimated that the state telecommunications tax has resulted in a $7.5 million annual shortfall to local governments.

9 City of Florence v. Owen Electric Cooperative, Inc., 832 S.W.2d 876 (Ky. 1992); Kentucky Utilities Co. v. Board of Commissioners, 71 S.W.2d 1024 (Ky. Ct. App. 1933).

10 This also provides that local governments must use a competitive bidding process before granting a franchise.

11 Southern Bell Tel. & Tel. Co. v. City of Louisville, 96 S.W.2d 695 (Ky. Ct. App. 1936); Kentucky Utilities Co., 71 S.W.2d 1024.

12 The Court of Appeals currently is considering petitions for rehearing.

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