Document Number
13-136
Tax Type
Consumer Use Tax
Retail Sales and Use Tax
Description
Provider of cable television, high-speed Internet and digital phone services, untaxed/underreported assets and expensed purchases
Topic
Assessment
Penalties and Interest
Records/Returns/Payments
Date Issued
07-18-2013


July 18, 2013




Re: § 58.1-1821 Application: Retail Sales and Use Tax

Dear *****:

This is in response to your correspondence in which you request correction of the retail
sales and use tax assessment issued to ***** (the "Taxpayer") as a result of an audit for the-period December 2002 through November 2007. I apologize for the delay in responding to your letter.

FACTS

The Taxpayer is a provider of cable television, high-speed Internet, and Voice over Internet Protocol (VolP) digital phone services to residential and commercial subscribers. The Department's audit resulted in the assessment of consumer use tax on various untaxed assets and expensed purchases as well as on items in which the consumer use tax was underreported.

A substantial revision has already been made to the audit. The Taxpayer has paid the revised tax amount but has not paid the revised penalty and interest amounts. The Taxpayer takes issue with the inclusion of several items held in the revised audit and maintains that such contested items are not taxable.

DETERMINATION

Mixed Use

Virginia Code § 58.1-609.6 2 provides an exemption for:
    • Broadcasting equipment and parts and accessories thereto and towers used or to be used by commercial radio and television companies, wired or land based wireless cable television systems, common carriers or video programmers using an open video system or other video platform provided by telephone common carriers, or concerns which are under the regulation and supervision of the Federal Communications Commission and amplification, transmission and distribution equipment used or to be used by wired or land based wireless cable television systems, or open video systems or other video systems provided by telephone common carriers.

With respect to exemptions from the retail sales and use tax, the Virginia Supreme Court has established the doctrine of strict construction. Under this doctrine, exemption from taxation is the exception, and where there is any doubt, the doubt is resolved against the one claiming exemption. Golden Skillet Corporation v. Commonwealth, 214 Va. 276, 199 S.E.2d 511 (1973).

This exemption does not exempt all purchases of tangible personal property purchased by the Taxpayer. Rather, the exemption is based on a certain type of usage and thus limits the scope of the exemption to equipment used to broadcast, amplify, transmit or distribute cable television signals to subscribers. The exemption also applies to equipment used in the provision of Internet services as defined in Va. Code § 58.1-602. The Internet service portion of the exemption is not applicable to broadcast or transmission equipment used for non-Internet services, such as equipment used to transmit cable television programming. When the Internet service equipment exemption was incorporated into subdivision 2 of Va. Code § 58.1-609.6, such enactment did not expand the original broadcasting, amplification, transmission or distribution exemption for cable television systems. Rather, the Internet service equipment exemption constituted a new exemption specifically applicable to equipment used in the provision of certain Internet services, including "production, distribution, and other equipment used to provide Internet-access services, such as computer and communications equipment and software used for storing, processing and retrieving end-user subscribers’ requests.” There is no exemption available if the equipment is put to non-exempt uses.

The exemption does not require predominant use in an exempt manner in order for the exemption to apply. Lacking a predominant use requirement, the exemption is of limited application when the equipment is used for purposes beyond the scope of the exempting language. In other words, the tax must be prorated when the equipment is used in both exempt and taxable activities.1 Generally, the tax is prorated based on the amount of time used in taxable activities versus the amount of time used in exempt activities. The proration methodology is generally based on "the percentage of time" the property is used in a taxable activity and the percentage of time the property is used in an exempt activity. When it is not possible to prorate the tax in this manner, another approach may be considered for prorating the tax.

At issue is the auditor's methodology used to prorate the tax on mixed use equipment used in the provision of telephone, television and Internet services. The auditor calculated a percentage based on the average of 3 factors: telephone subscribers to total subscribers (7.209%), telephone service revenue to total revenue (27.02%), and telephone bandwidth to total bandwidth used (0.02%). These percentages were totaled to 34.249% and divided by 3 to result in an averaged percentage of 11.42%. This averaged percentage was used to prorate the tax on mixed use equipment.

The Tax Commissioner has previously determined that the percentage of time may be calculated by using revenue derived in exempt activities versus the revenue derived in taxable activities. See P.D. 92-28 (4/20/92), 93-229 (12/15/93), and 96-238 (9/20/96).

In this case, a revenue-based proration method provides a direct correlation to purchases of tangible personal property (cable, modems, etc.) used in the provision of services. For instance, money spent by subscribers on cable television, Internet access and telephone services corresponds directly to equipment purchased by the Taxpayer to furnish such services. For instance, as the number of telephone subscribers increase, equipment costs are likely to increase because more equipment must be purchased for the new connections and older equipment must be updated, repaired or replaced. Conversely, a decrease in revenue may occur with a declining number of subscribers. For these reasons, a revenue-based proration method that takes into consideration peaks and lows in revenue caused by promotions and other market fluctuations in revenue would be a suitable measure for determining the taxable portion of mixed use equipment.

While the Tax Commissioner has ruled that using a revenue ratio is an acceptable procedure, in this instance, the telephone service revenue ratio of 27.02% (telephone service revenue to total revenue) was suspected by the auditor of being too high and not a fair representation of usage of the mixed use equipment. Therefore, the auditor included other related factors (the number of telephone subscribers and the telephone bandwidth used) to produce a more representative ratio for prorating the tax.

In regard to a factor using the number of telephone subscribers, the Taxpayer contends that such factor does not affect the cost of providing digital phone services. While the addition of central office equipment may be insignificant or not needed, it seems reasonable that the addition of new telephone subscribers requires the addition of telephone equipment for those subscribers. Notwithstanding, I find that the subscriber-based ratio used in this case does not provide the best correlation. As new subscribers are added for phone services, as well as for Internet and other services, the ratio becomes less dynamic. For example, a subscriber-based factor or ratio would appear to be more affected by the addition of new phone subscribers to the pool of existing subscribers, whereas the subscriber-based ratio would appear to be less affected by the addition of new phone subscribers who also subscribe to Internet access services and other subscriber services.

The Taxpayer disagrees with the auditor’s proration methodology and asserts that revenue and subscribers are not a reasonable measurement for the equipment used to render phone services. Alternatively, the Taxpayer proposes a proration method that is based solely on bandwidth usage. The Taxpayer contends that a more accurate measurement of phone usage is to use a percentage based solely on phone bandwidth used to total bandwidth used, which in this instance results in a ratio of 0.02%. In order to resolve this issue, the Taxpayer has requested that the Department accept 3% as the taxable ratio because that is the maximum amount of bandwidth available to the Taxpayer for digital phone services.

A bandwidth proration method is based on a measurement of traffic over a particular bandwidth. While the Taxpayer contends that such method would present a more accurate measurement to apply tax to mixed use equipment, insufficient evidence has been furnished to establish such a contention. Moreover, it would appear that the bandwidth proration method would lack a direct correlation to purchases of tangible personal property needed in the provision of services to customers.

Furthermore, it is questionable whether a fair comparison can be made between digital phone bandwidth and the analog bandwidth used to provide television programming. In its 2007 annual report (Form 10-K) to the Security and Exchange Commission, the Taxpayer made the following statement:
    • In order to continue to take advantage of growing video offerings, as well as future cross-platform features that will integrate all of our services, we will need to be more efficient in our use of bandwidth available in our network. We believe this can be achieved by delivering our current video services using less bandwidth. To that end, we are moving certain of our video programming from the analog tier to the digital tier, which allows us to deliver the same programming using less bandwidth, and we are using advanced encoding to deliver HDTV content in a more bandwidth efficient manner without a loss in picture quality. In certain areas, we have begun the deployment of a technology called switched digital video, which enables us to stream a channel to a subscriber's home only when they request it. All of these measures will free up bandwidth capacity that can be made available for other uses.

The foregoing establishes that analog equipment requires a much greater consumption of bandwidth than digital equipment. Accordingly, a reduction in bandwidth usage is achievable by merely switching from analog to digital equipment. Thus, the bandwidth methodology proposed in this case is flawed because the methodology compares equipment using dissimilar technologies, i.e., analog versus digital technologies. This comparison does not produce a fair representation of phone bandwidth usage.

As such, I am not convinced that the Taxpayer's methodology is the most accurate measurement for prorating the tax on mixed use equipment. Rather, the auditor's methodology uses a revenue-based methodology that has longstanding acceptance. Furthermore, the auditor modified that methodology by totaling and averaging three factors. I will accept the auditor's modified methodology and will consider it as a compromise for this audit. The Taxpayer has not provided convincing evidence that establishes its bandwidth methodology as being the most accurate methodology. Unless the Taxpayer has convincing evidence to the contrary, I find no basis for accepting such methodology.

Notwithstanding the foregoing, I propose a methodology that is different from the methodology proposed by the Taxpayer or the auditor. Because of the nature of the Taxpayer's business, it appears likely that it tracks usage of its services. Accordingly, I propose the use of a percentage of time methodology to determine the actual amount of time that subscribers used the Taxpayer's services of phone, television and Internet services over a one month period occurring in each of the last three years of the audit period or preferably in each full year of the audit period since phone services do not appear to have been offered in the oldest periods. This sampled monthly usage will be averaged and the averaged ratio applied to compute the exempt versus taxable usage of mixed use equipment. If the Taxpayer can furnish this information to develop the percentage of time methodology, and such methodology results in a lower percentage than the averaged percentage of 11.42% used in the audit, then the audit will be revised accordingly. If the Taxpayer is unable to furnish the additional information within the time allotted in the Conclusion section of this determination, the auditor's methodology will be upheld.

Digital Video Recording ("DVR") Equipment — Set-Top Boxes

The auditor assessed tax on the additional cost for incorporating the DVR capability into DVR set-top boxes on the basis that the DVR and the associated decryption devices (such as CableCARDs) are used in a taxable manner similar to that performed by a VCR, DVD player or Blu Ray player used to record programs from the cable television service for viewing at a later time. The Taxpayer contends that such assessment is erroneous because cable signals are distributed directly to subscribers via the DVR set-top converter boxes. The Taxpayer further contends that the addition of the DVR function should not preclude this equipment from the broadcasting exemption in Va. Code § 58.1-609.6 2, in total or in part.

In this case, the DVR set-top equipment is multifunctional as it is designed to function as a signal receiver and transmitter of television programming. Such equipment is also designed to be operated by the subscriber to record television programs for viewing at a later time. Other viewing features may be included in the equipment to provide additional viewing services to subscribers.

Virginia Code § 58.1-609.6 2 provides an exemption for "amplification, transmission and distribution equipment used or to be used by wired or land based wireless cable television systems." The DVR set-top equipment at issue is designed to function as a signal receiver and transmitter of television programming. As such, it is used to distribute recorded, paused and live television programming to the television set of a subscriber. Based on these facts and the plain language of the statute, I find that the contested DVR set-top boxes and the associated decryption devices qualify for the exemption. Accordingly, the audit will be revised to remove these items from the audit.

Video on Demand ("VOD") Equipment

The Department assessed use tax on VOD equipment used to transmit or receive programming that was not part of the basic or premium programming provided, such as pay­-for-view programming requiring additional fees for services. The Taxpayer contends that VOD services are directly used in the transmission of cable television signals and the equipment used in the provision of such services qualifies for the exemption for broadcasting equipment set out in subdivision 2 of Va. Code § 58.1-609.6, which exempts:
    • Broadcasting equipment and parts and accessories thereto and towers used or to be used by . . . wired or land based wireless cable television systems . . . and amplification, transmission and distribution equipment used or to be used by wired or land based wireless cable television systems. . . .

There is no exclusion in the exemption statute barring broadcasting equipment or amplification, transmission and distribution equipment used by a cable television system to provide pay-for-view programming or similar programming requiring extra fees that are not part of the basic service fee. Provided the VOD equipment is used to amplify, distribute, or otherwise transmit cable television signals to subscribers, the audit will be revised to remove the tax assessed on VOD equipment. If such equipment was used in both exempt and taxable activities, the tax will be prorated as discussed earlier.

Wireless Transmission Equipment

Purchases of wireless gateway devices (serving as modems, routers and switches) were assessed in the audit. These devices are furnished to the Taxpayer's subscribing customers and enable them to gain a wireless connection to high speed Internet services. The auditor's basis for assessing these devices is: (1) the potential for these devices to be used to receive Internet services from providers other than the Taxpayer; and (2) the convenience of the wireless reception virtually anywhere in a residence. The Taxpayer contends that tax was erroneously assessed on these devices because the equipment is used to transmit the Taxpayer's Internet services.

It seems inconsequential whether the subscriber uses these devices to connect with other Internet service providers (ISPs). In this instance, the Taxpayer provided these gateway devices free of charge to allow its subscribing customers to access its Internet services. Under these conditions, such devices are eligible for exemption.

In regard to USB adaptors, it is my understanding that such equipment is furnished to subscribers to use on their personal computers to receive wireless transmissions from the Taxpayer. It is also my understanding that such portable adaptors may have been potentially used by subscribers to receive wireless transmissions from other Internet service providers at Wi-Fi locations outside of the subscriber's residence, such as at restaurants, libraries or other locations. Such outside usage may not necessarily involve the use of the Taxpayer's services but may involve services provided by other ISPs. Notwithstanding the possibility of such usage, the intent of the Taxpayer's provision of USB adaptors was to provide its subscribers, using a personal computer that lacked a built-in wireless connection, with a means of receiving wireless transmissions from the Taxpayer. The Taxpayer does not offer services from other ISPs and cannot control a subscriber's use of the adaptors outside of the subscriber's home. For these reasons, I find basis to remove the USB adaptors from the audit.

Remote Controls

The Taxpayer contends that tax was erroneously assessed on remote controls. The Taxpayer maintains that remote controls qualify for the broadcasting exemption because they are an extension of exempt set-top boxes and drive the cable signals to be distributed to subscribers through such set-top boxes.

The Department has a long-standing policy with respect to the taxation of remote controls. In P.D. 90-48 (3/20/90), the issue was whether hand-held remote controls qualified for exemption as amplification, transmission or distribution equipment used by cable television systems. The Tax Commissioner's interpretation of the exemption was that any applicable accessory must play a role in amplification, transmission or distribution in order to qualify for the exemption. The Tax Commissioner ruled that such remote control units did not qualify for the exemption because the sole purpose of such units was to permit subscribers to change channels more conveniently than to amplify, transmit or distribute cable signals.

In P.D. 88-230 (7/29/88), the Tax Commissioner determined that hand-held remote control units were not used in the amplification or transmission of cable television signals. Nor were they determined to be used in the distribution of signals from the cable television system to the television sets of subscribers. Further, the taxpayer in such case provided no evidence that those units played an active role in supplying cable signals to subscribers. The Tax Commissioner concluded that these remote control units were not necessary in order for subscribers to receive cable television programming.

The Taxpayer maintains that the Department's argument related to remote controls is similar to the one set forth by the New Jersey Division of Taxation ("NJDoT") in RCN Telecom Services, Inc. v. Director, Div. of Taxation, 23 N.J.Tax 520 (2007). The NJDoT's argument was that set-top boxes were not necessary or essential for, or integral to, the transmission of cable signals because RCN's subscribers could obtain basic cable service without the use of set-top boxes. The court ruled that the set-top boxes were used directly and primarily in the transmission of cable television signals and thus qualified for exemption. While remote controls are used to change channels, no facts have been established that any of the remote controls at issue amplify, transmit, distribute or otherwise broadcast television programming signals. Rather, it is common knowledge that the set-top boxes perform the final step in transmitting the television signals to the television set via a cable connection from the set-top box to the television. Based on this understanding, the remote controls at issue are generally not eligible for the exemption.

Moreover, in an unpublished opinion (copy enclosed) in the matter of Comcast of South Jersey, Inc. v. Dir., Div. of Taxation, 2012 WL 6674368 (Tax 2012), the Tax Court of New Jersey specifically ruled that remote controls were not directly and primarily used in the transmission of television information. The court especially recognized the testimony of a Comcast witness who "testified that remotes, while used for operation of the converter, were not required to receive the television information because customers could operate a converter manually." The court held that "[r]emotes were therefore not part of the transmission process and were completely distinguishable from converters and the cable wires in RCN I, which were found to be a conduit in the transmission process.”2

Furthermore, I would note a higher ruling made by the Court of Appeals of Louisiana in Cox Cable New Orleans, Inc. v. City of New Orleans and Etta Morris, 664 So 2d 742 (1995). In such case, the court opined that "[i]t is common knowledge that . . . a converter box is necessary for any cable subscriber who does not have a cable ready television." The court ruled, however, that "remote controls are . . . another matter." While the court regarded converter boxes as "essential to the reception," it regarded the remote controls as providing "a form of customer convenience" and concluded that they "are nice to have, but it is common knowledge that the cable viewer can receive broadcasts and change the channels with nothing more than the converter box." As such, the court held that "such a convenience is not contemplated by the . . . exemption" and thus upheld the tax on the remote controls.

Of additional importance, the Taxpayer contends that remote control units are essential for the operation of certain set-top boxes. In this regard, the Taxpayer has indicated that set-top boxes, *****, ***** and ***** (the "three set-top boxes"), require the use of remote control units because there is no channel changer incorporated in these particular set-top boxes. Accordingly, I would conclude that remote controls for these three set-top boxes are essential for the operation of such set-top boxes and would thus be eligible for the exemption. Notwithstanding, I understand that the audit does not include any of the three set-top boxes. I also understand that the auditor has no documentary evidence indicating whether any of the remote control units assessed in the audit were specifically used in connection with any of the three set-top boxes. Absent such documentary evidence, I must conclude that none of the remote controls assessed in the audit are essential for the operation of set-top boxes and are taxable. I will revise the audit to the extent that it can be established that essential remote control units were included in the audit (e.g., sufficient evidence indicating that a ***** remote control was used only to operate a ***** set-top box). Sufficient evidence should establish that the remote control was used only in connection with one of the three set-top boxes noted above and that such use occurred during the audit period. Appropriate technical and internal evidence is needed to establish such dedicated use of the remote control. For example, some form of technical data may establish the type and use of such remote controls. In addition, internal records may help establish that a remote control unit was only provided in connection with one of the above three set-top boxes. Such appropriate evidence and any other appropriate evidence deemed necessary by the auditor should be submitted to the auditor within the time allotted as set out in the Conclusion section of this determination.

Penalties

Compliance penalty of 6%-30% is imposed on the tax due as set out in Va. Code § 58.1-635. A post-amnesty penalty of 20% may also be imposed on any tax liability that was eligible for amnesty benefits but remained unpaid after the conclusion of the amnesty program.

On third or subsequent audits, penalty will generally be applied unless the taxpayers compliance ratios meet or exceed 85% for sales tax and 85% for use tax, as computed by the auditor or under the alternative method. See subsection B 5 of Title 23 VAC 10-210-2032. In this third audit, the Taxpayer's level of use tax compliance is 31%. As such, the penalty applies unless an acceptable level of compliance is achieved under the alternative method for determining compliance.

In regard to the post-amnesty penalty, subsection F.1 of Va. Code § 58.1-1840.1 provides that this penalty is in addition to all other penalties that may apply to a taxpayer. Subsection C of the same statute authorizes the Tax Commissioner to establish guidelines and rules for the procedures for participation and any other rules that are deemed necessary by the Tax Commissioner. The Virginia Tax Amnesty Guidelines are set out in P.D. 09-140 (9/28/09). Subsection VI of P.D. 09-140 sets out the post-amnesty rules as to how the post-amnesty penalty applies. It also sets out the rules for when the post-amnesty penalty does not apply. For instance, the seventh rule in such subsection provides that the post-amnesty penalty would not apply to a second or subsequent audit assessment, provided the compliance ratio is greater than 85% for sales tax and greater than 60% for use tax, and further provided that no penalty has been applied to the tax deficiency, any uncontested liability is paid within 30 days from the date of assessment, and payment for any contested liability remaining after the resolution of an appeal is paid within 30 days from the date of the final determination. While the Taxpayer's audit is a third generation audit, the revised compliance ratio is 31%, which is well below the threshold for waiver based on the compliance level. Furthermore, penalty was applied in this case and payment of the uncontested tax liability was made over 180 days after the date of assessment. No payment was made towards the uncontested interest.

The Taxpayer indicates that it acted in good faith, without negligence and with no intent to defraud the Commonwealth. The penalties applied in this case are applied for late payment. The Taxpayer also indicates that the tax deficiencies involve new issues to this audit. However, no penalties were applied to the new issues in this audit. A review of the audit report indicates that no penalty was applied to the following categories: T1 law change CDV, T2 DVR, T3 VOD, T4 cable cards, T5 USB adapters, T10 cable in conduit, and purchases T3 VOD. However, penalty was applied to the following purchase categories: underreported consumer use, assets, and purchases. None of the penalized categories appears to contain new issues. For all of these reasons, I find insufficient justification to waive the penalties applied in this case.

Constitutional Argument

The Taxpayer contends that the assessment in question violates the Due Process, Commerce and Equal Protection clauses of the U. S. Constitution. The Taxpayer provides no specific grounds or facts for this contention; therefore, it does not merit consideration as an issue in this case.

CONCLUSION

The audit will be revised in accordance with this determination. The audit may be further revised if the Taxpayer provides the requested documentation for the mixed use and remote control issues within 45 days of the date of this determination. After expiration of this 45 day period, the audit will be revised, and a revised bill, with interest accrued to date, will be sent to the Taxpayer. The outstanding balance should be paid within 30 days of the bill date to avoid additional interest charges. The Taxpayer should remit its payment to: Virginia Department of Taxation, 600 East Main Street, 23rd Floor, Richmond, Virginia 23219, Attn: *****. If you have any questions concerning payment of the assessment, you may contact ***** at *****.

The Code of Virginia sections, regulations and public documents cited are available on­line at www.tax.virginia.gov in the Laws, Rules and Decisions section of the Department's web site. If you have any questions about this ruling, please contact ***** in the Department’s Office of Tax Policy, Appeals and Rulings, at *****.
                • Sincerely,



Craig M. Burns
Tax Commissioner




AR/1-5108136560.R
1.In P.D. 90-184 (10/12/90), an operator of a cable television system claimed that computer equipment that was used both in taxable and exempt functions should be totally exempt as the preponderance of the equipment's use is in exempt activities. The computer equipment was used both to control the distribution of cable signals (an exempt activity) and invoice customers for cable services (a taxable administrative activity). The Tax Commissioner ruled that the computer equipment was not totally exempt of the tax. Rather, it was exempt only to the extent used in exempt activities (i.e., about 58% of the time) and thus the tax was prorated. In P.D. 91-266 (10/23/91), the Tax Commissioner held that "the Taxpayer may be allowed to prorate the tax on any purchases of equipment based upon the extent to which it is used in exempt broadcasting activities...
2. RCN I is the court's abbreviation for "RCN of New Jersey, Inc. v. Div. of Taxation, 23 N.J. Tax 22 (Tax 2006). In that case, the Tax Court ruled that a cable provider's purchase of cable wiring was exempt from sales and use taxation because it served as the means by which television information travels from the provider to its subscriber base and was therefore integral and essential to, and used directly and primarily in, the transmission of television information by cable service providers.

Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46