On May 9, 2012, the Washington State Board of Tax Appeals granted summary judgment to AOL, Inc., holding that AOL's purchases of services permitting its customers to connect with AOL's data center and the Internet were not subject to retail sales tax. AOL Inc. v. Wash. Dep't of Revenue, No. 11-076 (Wash. B.T.A. May 9, 2012). The procedural lessons of this case may be as important in Washington tax practice as the substantive case.
Procedural Lessons Learned
Prior to obtaining relief at the Board of Tax Appeals ("Board"), AOL sought to have the courts address the substantive legal issue in two different lawsuits. Its goal was subverted in both cases because of a strict "pay to play" requirement.
The Washington Department of Revenue ("Department") had issued two assessments of Washington state retail sales tax, interest and penalties against AOL on December 15, 2006, for the periods 1998 through 2001 and 2002 through March 31, 2006 that amounted to nearly $50 million. On the same day AOL filed administrative appeals with the Department's Appeals Division.
In June 2007, AOL recognized that it might need to litigate the legal issue, but still wanted to avoid paying the nearly $50 million to do so. In an attempt to get to court without paying the assessments, AOL filed an amended return for the January 2000 tax period, paid $331,377 in retail sales tax and interest related to the amended return, and initiated a lawsuit in Thurston County Superior Court, seeking an order stating that the retail sales tax was not due as well as a refund of the $331,377. AOL LLC v. Wash. Dep't of Revenue, No. 07-2-02109-1 (Thurston Cnty. Super. Ct.).
On December 13, 2007, the Department successfully moved to dismiss the Superior Court action on the grounds that AOL had failed to satisfy the "pay to play" requirements of Washington law. The court accepted the Department's argument that AOL was required to pay all of the first assessment ($19 million) if the amended return related to a part of that assessment period (but not the second assessment of $27 million). AOL appealed the dismissal to the Court of Appeals, and it affirmed the trial court's decision. AOL LLC v. Wash. Dep't of Revenue, 149 Wn. App. 533, 205 P.3d 159 (2009).
In a second attempt to reach the merits, AOL filed a return and paid retail sales tax of $5,700 for the June 2008 tax period, which was outside the earlier assessment periods. It then filed another refund suit on December 23, 2008. AOL LLC v. Wash. Dep't of Revenue, No. 08-2-02893-1 (Thurston Cnty. Super. Ct.). The Department thwarted AOL's effort by issuing a refund to AOL and successfully moving to dismiss on the basis of mootness (though AOL still had nearly $50 million in outstanding assessments pertaining to the same legal issue) and the fact that the court lacked jurisdiction because there was no longer a refund claim.
On the administrative front, the Department's Appeals Division finally issued Final Executive Level Determination No. 09-0039E on February 19, 2009, affirming the legal basis for the assessments but remanding the matter to the Audit Division so that it could correct the assessments as they related to the measure of tax. On remand, the Department revised its method for measuring the assessments and the amounts were reduced substantially. Following holds related to the resolution of other litigation, AOL paid one of the assessments (approximately $6 million) while the other assessment was still on hold.
The Merits of AOL's Refund Claim
Having paid approximately $6 million in full, AOL filed a Notice of Appeal with the Board, challenging the assessment and seeking a refund of the retail sales tax paid for the period from 2002 through March 31, 2006, that related to AOL's purchases of managed modem service.
The managed modem service had been purchased from third-party network service providers to answer members' calls at access modems, translate the signal, and connect to AOL's data center and the Internet. The Department took the position that the managed modem service was a "network telephone service" and thus subject to retail sales tax.
The Board concluded that the managed modem service was statutorily excluded from the definition of network telephone service as it satisfied the meaning of an "internet service." In reaching its conclusion, the Board held that the Washington Supreme Court's decision in Community Telecable of Seattle, Inc. v. City of Seattle, 164 Wn.2d 35, 186 P.3d 1032 (2008), was controlling, and found that in both cases, an ISP was being taxed for transmission services that were inseparable from the "internet service." In addition to arguing that the managed modem service was not subject to retail sales tax because it was an Internet service, AOL pled four other bases for its refund: 1) even if it was otherwise a "network telephone service," it was not sourced to Washington (i.e., not "billed to a person in this state"); 2) taxation was preempted by the Internet Tax Freedom Act; 3) the tax would violate federal constitutional requirements; and 4) the tax was already paid by its vendor. Having decided the Internet service argument in AOL's favor and ordering a refund of the $6 million, the Board did not have to address any of the other arguments.
The Board of Tax Appeals decision is the first on the merits for AOL in Washington and a significant victory. The Department has 30 days to seek judicial review and we understand that it intends to do so.
The importance of this decision has already been highlighted as it was cited to the Oregon Supreme Court in Comcast Corp. v. Department of Revenue, for the proposition that data transmission cannot be separated from a taxpayer's provision of Internet service and taxed separately. See Brief of Amicus Curiae Associated Or. Indus., No. S059764 (filed May 18, 2012).
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