Sales Tax Slice: Will the Internet Tax Freedom Act Prohibit States From Taxing the ‘Internet of Things’?

Although the taxability of telematics or the "Internet of Things" is cloudy, early predictions have been made as to how states will classify and tax it. Some of the predictions hinge on a federal law, the future of which is also currently cloudy-the Internet Tax Freedom Act (ITFA). Set to expire Nov. 1, 2014, the ITFA prohibits states from imposing taxes on Internet access charges.  Because many telematic services require Internet access to complete related data transmissions over the Internet, the usage charges could very likely fall within the definition of "Internet access" provided by the ITFA.

In this interview, Mike Dillon, attorney, and the founder and President of  Dillon Tax Consulting, LLC  shares his insights regarding the potential sales tax issues surrounding telematics. A detailed article authored by Dillon on this topic is featured in the Bloomberg BNA Weekly State Tax Report.

Bloomberg BNA: The definition of "Internet access" has evolved since the ITFA was enacted in 1998. In 2004, the definition expanded to telecommunications services used to provide Internet access, and in 2007, VoIP and similar services were expressly removed from the scope of protected services. Would the current definition of "Internet access" need to expand even further to exempt telematics services from tax?

Dillon:  I believe the ITFA already provides for the exemption of such services. Therefore, I don't believe any legislative change is required by Congress or any state in order to exempt the provision of Internet connectivity or transmission services provided by a provider of telematics services over the Internet.  The same is true for the purchase of underlying communications services used to provide telematics connectivity and transmission services over Internet protocol.  Pursuant to Section 1105(5) of the ITFA, the term 'Internet access' is already defined to mean a service that enables users to connect to the Internet to access content, information, or other services offered over the Internet, and includes telecommunications purchased by or provided by a vendor to provide Internet access or to otherwise enable users to access content, information or other services offered over the Internet.  [ITFA, Section 1105(5)(A) and (B)(ii)].  As such, communications services that enable connectivity to the Internet, and charges for access to and transmissions over the Internet, already constitute exempt Internet access charges.  I believe it is incumbent on state tax practitioners and industry representatives to be the guardians of these issues, seeking to shepherd the issues towards tax laws and policies that promote, among other things, equity, certainty, transparency, simplicity, neutrality, efficiency and economic growth for all interested parties. 

Bloomberg BNA: If the ITFA is extended, and there continues to be a ban on taxing Internet access, will providers of telematics services market their services to fall within the definition of "Internet access" so that the services are exempt from tax under the federal law?

Dillon:  Saying yes to this would presume that providers of telematics services are focused on the state tax treatment of their services.  Experience has taught me that sales tax tends to be an afterthought for most companies, particularly for a growing industry.  Furthermore, telematics providers will not be getting any guidance or clarity from state taxing authorities, as these services are not yet in the center of taxing authorities' radar.  This being said, it is imperative that state tax practitioners work with taxing authorities to promote the treatment of these services as exempt under the ITFA. It is important that state tax practitioners lead the charge to educate companies in the telematics service world as to the potential taxes  - and exemptions - available to their purchases and sales.  It is equally important to educate the companies as to the import of invoice literal and contract service descriptions in defining the services they provide.  Lastly, it is equally vital that telematics service providers seek the expertise and guidance of state tax experts, in order to apply their specific facts to the existing and evolving sales tax laws in each state.

Bloomberg BNA: Why is the invoice description of telematics services so important in determining the state sales tax treatment of the services?

Dillon:  Given that sales taxes are transactional taxes, taxability determinations - and state tax auditor determinations - are driven primarily by what the contract and the invoice states.   In one of the only decision related to this issue, when the Texas Comptroller assessed sales tax on purchases of telematics services provided through the GPS devices that a trucking company purchased from a Telematics Service Provider, the Comptroller closely assessed what the TSP invoices stated. Being that the invoices classified the service as a data service, the Comptroller characterized the services as taxable data services or information services.  [ Texas Comptroller's Decision, Hearing No. 108,095  (February 2014)] This decision demonstrates the importance of invoice literal language and the weight that states may give to what the service contract and invoice indicate is being provided.  Also, this decision is quite typical for what I have historically experienced with state taxing authorities - and it is certainly a cornerstone of the multistate sales tax compliance advice I provide my clients.  That is - what do your contracts and invoices say about what it is that you are providing?  The more closely you align the description of your services and the invoice literal language with the description of an exempt service, or Internet access, the better opportunity you have to assert that the services you provide are not subject to sales tax.

Bloomberg BNA:  Which way do you think most states will classify telematics services for sales tax treatment? Will they simply follow how they've taxed similar technological advancements like digital and cloud- computing products? 

Dillon:  Well, in its most simplistic form, this response has two parts:  First, there are the telematics services provided to endusers (e.g., vehicle tracking, GPS, asset monitoring) that cloud-based Application Service Providers (ASP) and Telematics Service Providers can provide directly to endusers, using the underlying communications they purchase from telecom providers, and application platforms they host and bundle together with connectivity and transmission services to enable Machine to Machine communications.  Illinois, Iowa and Texas have already classified one rendition of these telematics services as data processing or an information service.  Interestingly, only Texas imposed sales tax on the service. Illinois sought to impose Telecommunications Excise tax on the provider's purchase of underlying communications services.  While I support treatment of these services as exempt under the ITFA, I believe states will seek to impose sales tax on the provision of these services, much in the same manner that they have sought to tax other cloud-based information or data services.  Second, there are the telematics services that provide the Internet connectivity and transmission services to ASPs or Institutional Users, enabling them to provide Machine to Machine communications to endusers.  While I support the treatment of these services as exempt under the ITFA, states may seek to tax these services as telecommunications services, as Illinois has done in one rendition of a telematics service.

Bloomberg BNA: Which state, if any, has been the closest to addressing the taxability of telematics services?

Dillon:  I don't believe any state has been the closest because I believe that the technology surrounding the provision of telematics, the potential applications and the potential players, is still rapidly evolving.  The Internet of Things is far out in front of state sales tax policy in this regard.  However, this creates an opportunity for tax practitioners to work with Federal and state tax policy makers to educate them, and foster an environment that promotes stable growth in this area before we rush to tax it.  This same approach was employed with respect to the Internet and the ITFA. 

Bloomberg BNA: Have clients approached you regarding the sales and use tax liability for any products that they sell or are using?

Dillon:  Absolutely.  I am currently working with one of the largest and fastest growing international Telematics Service Providers to enhance their multistate sales tax compliance protocol.  This entails (1) identifying the states in which they have nexus and historical exposure, (2) cleaning up the historical exposure through voluntary disclosures and negotiated settlements of historical liabilities, (3) developing automated sales tax compliance and exemption certificate management solutions, and (4) enhancing the contract and invoice descriptions they utilize to optimize their multistate sales tax position and minimize obligations and risk (i.e., take advantage of exemptions such as those in the ITFA).  I am also working with an international Telecom company, and several cloud-based service providers that provide telematics solutions to endusers.  For these companies, I have provided or am providing the same measures to enhance their mulitistate sales tax compliance protocol.  

Bloomberg BNA:  Without much legislative or administrative guidance from states regarding the taxability of telematics, what steps should taxpayers or practitioners take to determine whether the services that they are providing or using are subject to tax?

Dillon:  I recommend that taxpayers seek the guidance from state tax practitioners. Especially when there is little guidance from states, tax practitioners that have the experience in framing the issues understand the important of asking the right questions, seeking guidance by way of analogy, and seeking guidance from their colleagues in state tax departments, with whom they have developed invaluable relationships.  The approach I tend to take involves developing a strong understanding of the facts for the taxpayer, researching the issue to see if there is any clarity or guidance - either on point or by analogy to something similar.  Next, I tend to speak with my contacts in the tax policy, audit and compliance divisions of the relevant state tax authorities.  If I am able to obtain something in writing, this may suffice, or I may pursue a ruling request from the relevant state tax authority. For the TSP that I  mentioned above, we are currently pursing this last approach in one state in which the company generates significant revenue.