Texas On-line Service Providers Fight Taxing Situation

P> The Texas Comptroller has fired the opening salvo of a potentially bloody tax war with the state's Internet service providers.

"This is a tax that limits growth in the name of helping it," said Ronald Yokubaitis, president of Texas NetWorking Inc., an Austin-based Internet service provider.

Service providers believe language inserted by the legislature exempts them from the tax. The comptroller disagrees. If the tax stands, urban schools serviced by the service providers could lose their free or low-cost access because the providers no longer will be able to afford to donate the service.

"Quite frankly, if the comptroller can't honor the deal [made with legislators to exempt service providers], then there will be litigation," said W. Scott McCollough, an attorney who wrote the legislative exemption. However, the service providers are engaged in informal discussions with the comptroller's office and hope an agreement can be reached.

The exemption states that nothing in "this Act [is] intended to regulate or tax Bulletin Board Systems or Internet Service Providers... provided they only provide enhanced or information services and not telecommunications services."

The exemption was written that way because Southwest Bell was concerned about the potential for voice Internet communications to become a cheap substitute for long distance service, said McCollough.

The comptroller has interpreted it to mean that content providers, such as America Online, Vienna, Va., are exempt, said David Somerville, a tax specialist in the Tax Policy Division of the Texas Comptroller's office. But companies that provide on-line access via taxable telecommunications systems are not exempt. Neither are companies that sell fax services, cellular communications or traditional phone service.

Using telecommunications systems is an integral part of an Internet service provider's operations, and the legislature intended to exempt service providers, said Chad Kissinger, president of Onramp Access Inc., a service provider in Austin. Part of the problem is that there is no legal definition for an Internet service provider, he said.

One thing is certain - the legislature did intend to raise $150 million annually through the tax. It directed the creation of two funds, each designed to raise $75 million annually. Cellular communications providers pay into one fund, and telecommunications utilities pay into the other.

The telecommunications tax is tied to a provider's gross receipts. The provider must pay the telecom tax on services for which consumers pay a sales tax. This means that some providers will be exempt. For example, a provider that sells Internet service to the state, which does not have to pay sales tax, would not have to pay the telecommunications tax on that portion of the business.

Because there are fewer cellular providers, their tax was higher - roughly 6 percent compared with 1.36 percent for the utilities. That is, until the group sued. A district court judge decided it was not appropriate that cellular providers had to pay a higher rate. So now, both groups will pay the same rate, resulting in a potential shortfall, although the state has not decided what the flat rate will be.

Providers can pass the tax along to the public in the form of higher prices, but many are loathe to do so. In today's competitive market, consumers drive down the price of access, said McCollough. A higher price could mean less business.

But unless service providers find a way to make up the lost revenue, they could still lose business. The tax will hinder a provider's ability to upgrade equipment or to hire people for technical support, so the public will be less likely to pay for an account with that provider, said Kissinger.

One possible way to save money would be to stop donating access, said Yokubaitis. His company provides free dial-in access to 30 schools in the San Antonio area. He also offers a 60 percent discount on T1 lines to schools.

This is a new market, so access will be unequal for some time until the infrastructure can be built, Yokubaitis said. But the state's actions will "tax away [our] ability to extend service to rural schools," he said.

The debate between the two groups is one that could be played out nationwide as states struggle to find new ways to increase revenue. States must change their tax codes to keep up with changing technologies, or they risk taxing obsolete services and losing revenue, said Don Bucks, executive director of the Washington-based Multistate Tax Commission, which works to coordinate tax laws among states.

On-line taxes are an issue that the commission is only now beginning to study, Bucks said.

The Florida Department of Revenue is considering an on-line tax, but imminent legislation is expected to prohibit that, said Robert Smith, executive director of the Interactive Services Association, a Silver Spring, Md., association of on-line companies. California and Colorado also are investigating the possibility of an on-line services tax.

If states do act, the on-line industry could face a nightmarish tangle of tax laws that differ in each state. A solution would be to ask Congress to legislate a nationwide policy, but it could be hard to generate support for a national tax if only a few states have enacted their own on-line taxes. Under the Texas law, the tax only applies if the service originates in the state.