California Tax Policy and the Internet:

Legislative Analyst's Office
January 2000



Many telecommunications taxes were structured for an industry that has changed significantly in recent years in terms of its technology and competitive characteristics. These taxes have neither evolved sufficiently to mesh with the current industry structure, nor do they possess the flexibility to accommodate future changes in telecommunications technology. A number of the features of telecommunications taxes may no longer be justified in an economic or policy sense. Some of the outmoded features of the tax system relate to (1) an industry typified by monopoly, (2) special rights and privileges that were granted to the industry, and (3) efforts to provide an integrated telecommunications network with universal access. Some of these concerns or industry features are no longer present, while others have changed significantly in composition or magnitude.

The technologies involved in telecommunications--telephone, television, radio, and Internet--while still distinct in some respects, are rapidly beginning to blend and over-lap. This process has made many tax distinctions between the different media difficult to justify in economic terms, and has resulted in inefficiencies and unfairness. Many features of the Internet are similar to those embodied in television, radio, and telephone communications, while others remain distinct. This blending and overlap of technologies--or “convergence”--can result in an inconsistent and uneven application of taxes which benefit or hinder particular industries or sectors. This can result, for example, when one particular activity is treated differently by the tax system simply because it uses a different technology or transmission system.


Telephone-Service Taxation

The telecommunications industry has been treated differently than other businesses with respect to taxes, based on its market structure, economic characteristics, and particular social goals. Telephone service was perceived as a natural monopoly (based on its technology and access to scale economies), and was designated by states--including California--as a “common-carrier” industry. On the basis of the special privileges that were accorded to it (such as local rights-of-way) and its monopoly position, the industry was treated separately and uniquely for tax purposes, resulting in an exemption from local franchise fees, and different treatment with respect to property taxes and certain other business taxes. State regulation allowed telephone charges to be set at levels that

provided for subsidized rates for certain parties and geographic areas, helping to further the goal of universal service and establish a telecommunications network. These subsidization measures were motivated by a belief in the essential nature of telephone service and the economic benefits of universal access. As the industry became more competitive (and direct-rate subsidization became infeasible), the levying of surcharges allowed states to continue to fund universal telephone access as well as certain other programs.

There are currently a number of charges placed on local and long-distance telephone service in California, with most other states having similar charges. In addition to the state surcharges and local taxes on telephone service outlined below, surcharges are also imposed by the Federal Communications Commission (FCC) for network access for interstate calling, regulatory charges are levied by the FCC and Public Utilities Commission (PUC) in order to fund the oversight of the industry, and excise taxes are levied by the federal government. Current levies include:

Universal Lifeline Trust Surcharge--this is imposed by the PUC in order to provide discounted local telephone services to low-income households.

California Relay Service and Communications Devices Surcharge--this is imposed by the PUC in order to provide telecommunications equipment and relay telephone service for deaf or otherwise disabled individuals, and to place similar equipment in buildings and public places.

California High-Cost Fund Surcharge--this is imposed by the PUC for the purpose of subsidizing basic local telephone service to residential customers in high-cost areas.

California Teleconnect Fund Surcharge--this is imposed by the PUC in order to provide discounted telecommunications services to qualified entities.

Emergency Telephone Users’ Surcharge--this is imposed by the PUC for the purpose of funding emergency telephone service (911) in California.

Utility-User Tax--this may be levied by local governments on a gross-proceeds basis on local and long-distance telephone service as well as wireless telephone service.

Cable Service Levies

Cable service in California is subject to direct local taxation based on the rationale of the use of public rights-of-way and being granted a local monopoly. Cable service is regulated by the federal government and the State of California, and is subject to a regulatory fee levied by the FCC. In California, two principal fees and charges are levied on cable television connections.

Franchise Fees--these are paid to local governments by privately-owned cable companies for the privilege of using local government property and rights-ofway. Federal law prohibits franchise fees from exceeding 5 percent of gross receipts, while state law also limits franchise fees to a percentage of gross receipts. State and federal law also prevent companies from providing cable services without acquiring a franchise. California has delegated to cities and counties the franchising authority over cable companies, whose fee payments represent an unrestricted revenue source.

Utility-User Tax--this is a gross proceeds tax levied by some local governments on cable television services, and other utilities such as telephone, gas, and electric services. Tax rates generally range from 5 percent to 7 percent and represent an unrestricted revenue source for local governments.

Internet Service Charges

California does not have any state or local taxes levied directly on Internet access (that is, the monthly fee that subscribers pay to an ISP to provide access to the Internet). Several states and local governments do have such taxes on Internet access, however, and prior to the adoption of California’s Internet Tax Freedom Act, such taxes were apparently contemplated by some local governments.

Despite the lack of direct taxes, Internet access may be subject indirectly to telephone surcharges or other taxes. To the extent that the Internet user connects to an ISP through telephone lines, this telephone connection would be subject to various telephone surcharges and (in some localities) utility user taxes. In addition, the ISP could be subject to taxation on the use of telephone lines to connect the subscriber to the Internet trunk lines. These taxes would be incorporated in its business costs, and to the extent possible, passed along to the Internet subscriber. If, on the other hand, Internet access were achieved through cable connections, franchise fees and utility user taxes could be levied.


The complexity of the existing telecommunications tax structure makes it difficult to apply to even standard technologies in an even handed and consistent fashion. Adding to the existing complexity is the trend towards convergence of telecommunications technologies--the set of technological changes that results in a blurring of the formerly distinct divisions that existed between and among television, telephone, radio, and Internet service. Until relatively recently, television, radio, and telephone service were separate technologies. Even the Internet, prior to its availability to the public, largely existed as a distinct system. As a result of this technological separation, the tax system--while it did suffer from inefficiencies and inconsistencies--generally treated simi-

lar activities in a similar fashion. Taxes were unlikely to alter behavior in choosing one particular medium over another since they served different purposes.

This situation is changing rapidly. Convergence has made these technologies increasingly similar with respect to basic operating principles and use. As a result, similar activities are being conducted over different mediums or systems. Many examples of this currently exist, and they are increasingly likely to occur as the Internet develops. These “cross-technology” activities include electronic Internet telephony (voice communication using the Internet instead of telephone lines), and the use of greater Internet band widths--in conjunction with special software--to yield Internet access to radio and television stations, as well as other technological advances. In addition, company ownership is evolving to include the integration of different types of systems.


Technological convergence has generally outpaced laws, court opinions, and regulatory treatment--all of which tend to treat the telephone companies and cable providers as separate entities and technologies. The tax system in the telecommunications area is equally dated and unable to account for the degree of technological change that has occurred in recent years.

California's two basic alternatives in this area are to (1) study existing telecommunications taxes in order to initiate a basic restructuring of the tax system, or (2) accept the telecommunications tax structure as it now stands and attempt to make its application more fair. We suggest that the state pursue the first of these two options, the details of which are further discussed in the text. In undertaking a study of the telecommunications tax area, the potential effects on local government revenues and specific state programs would need to be taken explicitly into account and addressed.


The principal tax-related issues that arise from Internet activity involving the Bank and Corporation Tax (BCT) are nexus and income apportionment.

Nexus. In order for a corporation to be subject to the California BCT, the corporation must be considered to have “nexus”--or sufficient contact--with the state. Internet activities raise complex issues regarding whether or not certain activities meet the nexus threshold.

Apportionment. California’s BCT law requires that income be apportioned across state jurisdictions to reduce the possibility that the income is either taxed more than once, distributed between states unfairly, or not taxed at all. Internet activity makes it more difficult to calculate the factors included in California’s apportionment formula.

The BCT issues that are raised by Internet activity can be quite technical in nature. For this reason, the basic principles of the tax are provided below prior to addressing the Internet-related tax policy questions.


For a corporation to be taxable in California, it must be considered to have nexus in the state. Corporations that have nexus in the state and earn income derived or attributable to California sources are subject to California’s BCT. Most California corporations are subject to the franchise tax, which is levied for the privilege of conducting business in California, generally at a flat 8.84 percent tax rate. Corporations that derive income from California sources but do not have a substantial enough presence to be classified as “conducting business” in the state are subject to the corporate income tax, which is levied in a manner similar to that of the corporate franchise tax.


Sources of Income

If a corporation derives all of its income from California sources, the entire nonexempt portion of income is used in the state BCT liability calculation described above. However, if the corporation has multistate or multinational operations and has business income attributable to non-California sources, then the corporation must apportion the amount of its business income attributable to its California operations.

Before apportioning income, the corporate taxpayer must first identify and then combine the income from the corporation or group of corporations operating as one integrated business. The taxpayer may elect to combine either (1) its worldwide income or (2) its income within the U.S. The former method is known as the “worldwide” basis and the latter as the “water’s-edge” basis. Once this election is made, formula apportionment (see below) is used to determine the portion of income attributable to California for tax purposes.

Formula Apportionment

California’s apportionment formula is generally based on a multistate agreement called Uniform Division of Income for Tax Purposes Act (UDITPA), which measures a firm’s average ratio of corporate activity in California relative to its total corporate activity (either on a worldwide basis or water’s-edge basis) for three factors: property, payroll, and sales (the sales factor being generally double-weighted in California). The average computed ratio is then multiplied by the total net corporate income to arrive at the amount of income attributable to California. This amount is then used in the calculation described above to arrive at state BCT tax liabilities.


The areas most in question with respect to the application of the BCT to Internetrelated business activity have to do with (1) threshold requirements for establishing nexus in the state, and (2) determining the sales component used in the income apportionment formula.

Current Nexus Status

The issues raised in establishing nexus for BCT purposes are similar to those raised with respect to the SUT in the text and Supplement D--namely, how much taxpayer presence is required before a state can collect the use tax? In contrast to the SUT nexus issue (which requires a physical presence in the state), the nexus requirement with respect to the BCT is less clear. In the Quill decision (described in Supplement D-4 in the SUT discussion), the Supreme Court did not extend the physical presence requirement to taxes other than the SUT, including income taxes. As a consequence of this and other court decisions, the level of activity required before other types of taxes can be collected has been left somewhat undefined.

A number of state court cases have led to decisions which specifically hold that physical presence is not necessary for a corporation to be subject to corporate income taxes. For example, the South Carolina Supreme Court found in Geoffrey vs. State of South Carolina that “purposeful direction” of business activities and the presence of intangibles constituted sufficient nexus for due process clause purposes. In addition, it found that physical presence was not necessary to establish nexus for corporate income

taxes on commerce clause grounds. On the basis of this and other court decisions, some states have taken steps to simply assert nexus for corporate income purposes in the absence of physical presence. California, however, has not taken such an aggressive stance with respect to nexus.

Internet Activity and Nexus

The development of and growth in Internet activity raises important issues regarding what constitutes nexus for BCT purposes. This is particularly true, given that the necessary threshold itself has not been sufficiently refined for even traditional business activities--and Internet activity adds an additional layer of complexity.

Some of the issues involved are similar to those raised by traditional forms of telecommunications. For example, primary information providers such as ISPs may use local telephone companies for access to subscribers as well as own their own equipment (such as modem connection points or “nodes”) in the state. This arrangement could be sufficient for nexus. On the other hand, ISP connections made through satellite or third-party arrangements may not result in sufficient contact for nexus purposes. Similarly, providers of information over the Internet through third parties (like cable television companies or ISPs), may not have any physical presence in the state. In either of these cases, the lack of physical presence would result in the state having to rely on more uncertain, nonphysical presence in order to assert nexus.

Generally, the continued growth of the Internet and the adaptations that businesses will use in order to avail themselves of Internet technology could result in a relative decline in the presence of tangible property in the state, and make it somewhat more questionable for the state to assert nexus in “borderline” situations. This could result in adverse effects on state revenues as companies shift their points of operation out of state, or as more product is delivered through the Internet using third parties.

Apportionment Issues

Even if a company has nexus in California, this makes no difference from a revenue standpoint unless a portion of the businesses income is assigned to the state under BCT apportionment rules. The largest source of concern with respect to the apportionment formula and Internet activity has to do with the attribution of the sales factor, which differs substantially for tangible and intangible property. For tangible products, the sale is sourced (that is, attributed) to the destination point. For intangible products, on the other hand, all of the sale is sourced to the location with the greatest income-producing activity. This means that a state in which a significant amount of income-producing activity occurs can be completely disregarded if another state has slightly more. This could become increasingly the case for e-commerce businesses engaged in the sale of intangible products from outside California.

Under UDITPA--to which California generally adheres--as well as the California Revenue and Taxation Code, income-producing activity must be related to direct costs of performance. With Internet activities--like telecommunications activities--direct costs are quite difficult to determine. Telephone and Internet activities are routed through a complex system of microwave transmissions, fiber optics, satellites, and cables which make the tasks associated with identifying the direct costs associated with a particular transmission financially prohibitive. In addition, there is some difficulty in defining direct costs as distinct from indirect costs.

In addition, under this approach to attributing sales, certain biases exist in the tax treatment of similar types of businesses. For example, resellers of telecommunications or Internet providers might have little or no physical property of their own used in placing a call or connection, and no associated direct costs. In contrast, other companies engaged in similar telecommunications activities would incur such direct costs based on their ownership of property. The use of property without a jurisdictional home (such as satellite and undersea cables) by Internet providers also could present a problem. Finally, information providers may have data banks located in a single state, while the compilation of such information may occur in several jurisdictions. Under current rules, the state with the largest concentration of income production activities would receive the assignment for tax purposes to the exclusion of other states.


Regarding nexus, the uncertainty of the “presence” threshold required for tax purposes suggests either court decisions or national legislation likely will be required in order to establish a firm operational rule for Internet-related activities. Aggressive approaches by the state in nexus issues is likely to run counter to trends in Internet business evolution, and could result in either compensating policies being adopted by other states, and/or negative economic repercussions associated with business decisions. Apportionment questions, in contrast, are best dealt with by continuing efforts to achieve consensus based on state cooperation.

The development of Internet-centered business activity raises distinct challenges for the application of the BCT. As businesses shift their methods of operation toward Internet activity, this could result in an alteration in the number of states where nexus occurs under current definitions. In addition, the growth in the amount of sales of intangible products could result in a shift in the apportionment of income. California should continue to pursue multistate agreements in order to address these issues.

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