There has been a great deal of excitement regarding the potential, revolutionary impact of Digital Subscriber Line (DSL) services. The promise of using existing copper telephone lines and cost-effective hardware to achieve vastly fasteraccess to the Internet and improved Internet voice services have made DSL a serious contender in the Internet access industry. The question of whether the states can tax DSL services, however, is one of several unresolved legal questions that has the potential to significantly impact the evolution of the nascent DSL market.
With the passage of the Internet Tax Freedom Act of 1998 (Tax Act), Congress enacted a three-year moratorium on state and local taxation of the Internet with special
exemptions for the few states that had Internet-related legislation prior to the Tax Acts passage. Many Internet-related businesses and consumers hailed the Tax Act as a victory for e-commerce and free enterprise, believing that they had dodged a serious regulatory bullet. For the most part, they had. Unfortunately for DSL service providers, the Tax Act appears to leave open a door that might allow DSL services to be taxed on the state and local levels to the extent such services can be classified as
telecommunications services as opposed to Internet access services.
The Tax Act protects from taxation only those services pertaining to Internet access. Internet access means a service that enables users to access content, information, electronic mail, or other services offered over the Internet, and may also include access to proprietary content, information, and other services as part of a package of services offered to consumers. Services that are deemed
telecommunications services are expressly excluded from the exemption and, therefore, may be taxed by state or local regulatory bodies.
Thus, the question becomes: are DSL services to be classified as primarily Internet-related (and, therefore, not taxable) or as another method of providing telecommunications (and thus taxable)?
Concern among DSL providers arises from the fact that in the Tax Act, Congress uses the broad definition of telecommunications services that is found in the
Communications Act of 1934. Under the Tax Act, telecommunications services are those services offering telecommunications for a fee directly to the public, or to such classes of users as to be effectively available directly to the public, regardless of the facilities used.
Clearly, copper telephone lines, the medium by which DSL is to function, are traditional telecommunications facilities. But that fact would appear to be hardly enough, by itself, to make DSL a telecommunications
service. The problem is that DSL can carry both data and voice, and thus offers a potential alternative to the PSTN. Present and would-be providers of DSL services need not procure a crystal ball to predict that opportunistic state and local governments looking to raise revenue might seek to categorize DSL as taxable telecommunications services and not as Internet access services protected from taxation by the Tax Act.
Taxation of DSL services would have a seriously adverse
effect on the infant industry. Due to DSLs much celebrated voice telephony advantages, taxation of DSL as a telecommunications service would inflate prices. At the same time, data only Internet service providers who are using other facilities-based media the competitor that most readily comes to mind is cable, but mobile and fixed radio competition looms as well would continue to reap the benefits of the moratorium. Widespread state and local taxation could translate into
non-competitive, high charges to consumers that might simply make DSL unprofitable.
So what does this mean for the future of DSL?
The tax classification issue is typical of the regulatory dilemma DSL poses. For example, the FCC recently sought public comment on whether DSL service should be classified as a telephone exchange service or as an exchange access in compliance with the market-opening requirements of the Telecommunications Act of 1996. If classified as the former, incumbent
local exchange carriers (ILECs) would be required to offer DSL blocks to competitive local exchange carriers (CLECs) at lower wholesale rates. Conversely, if classified as exchange access, ILECs could sell DSL blocks to CLECs at higher retail rates. How this important regulatory classification issue is decided could, in a literal way, define the financial bottom line of competitive resellers of DSL services.
Service classification is no less important in the arena of taxation. If DSL is
classified as a telecommunications service, it will likely be taxed, prices for DSL will rise, and profits will fall. On the other hand, if DSL is classified as Internet access, it will likely be protected from state and local taxation and DSL service providers will temporarily clear one regulatory hurdle in their race to gain customers.
For the meantime, DSL has not yet attracted the attention of state legislatures, perhaps because it is so new to the Internet scene. Service penetration remains confined to
select metropolitan areas due to DSLs reliance on central telephone offices. DSL service providers, however, should not be misled into thinking that the Tax Act will necessarily protect them from taxation, and should be alert for state taxation initiatives. One Internet service provider, Bell Atlantic, has already established an escrow fund with the expectation that the states will tax DSL as a telecommunication service in the near future.
DSL service providers should also keep in mind that the Tax
Act only provides a brief respite in what may be a much larger battle over taxation of the Internet. Congress has only forbidden state and local taxation of Internet access services for a three-year period. In the meantime, Congress has created, via the Tax Act, the Advisory Commission on Electronic Commerce. The goal of the Commission, during this three-year pause, will be to examine state regulatory models and proposed taxation of the Internet. Ultimately, the Commission will propose federal
legislation based upon its studies, and that legislation may very well include taxation of a whole range of e-commerce, whether it is labeled Internet access or otherwise.
In the end, DSL providers should pay close attention to federal and state initiatives affecting the legal/regulatory status of DSL services. Bell Atlantics anticipatory action of establishing an escrow account may be an indication of the storm to come.
Thomas K. Crowe is a Washington D.C. based attorney
specializing in ISP and communications legal/regulatory matters. He was assisted in preparing this article by C. Jeffrey Tibbels, a May 1999 law school graduate who recently joined the firm and whose admission is currently pending before the Pennsylvania Bar. They can be reached at 202-973-2890 or