Joseph Lipari

Many people are familiar with the “resale exception” under which, for example, a sale by a clothing manufacturer of shirts to a clothing store is exempt from sales tax because the sales of the shirts by the store are taxable, see N.Y. Tax Law Sections 1101(b)(4)(i), 1105(a). The sales tax contains corollary exemptions for property purchased to produce goods and services for sale to consumers. Thus, for example, the clothing manufacturer does not pay sales tax when it purchases sewing machines used to produce the shirts, see N.Y. Tax Law Section 1115(a)(12).

Although the purpose of these exemptions is the sensible policy of avoiding multiple taxation, the Fourth Department (some six decades ago) articulated the policy’s inherent problem: “If … pursued to its natural and logical limits, all purchases by [producers] would be exempt.”  as in Niagara Mohawk Power v. Wanamaker, 286 App. Div. 446, aff’d 2 N.Y.2d 764 (4th Dep’t 1955).  The recent administrative law judge determination in Cellco Partnership d/b/a Verizon Wireless, DTA No. 827179 (N.Y. Div. Tax App., Apr. 12, 2018), struggles with this inherent tension in the context of an exemption for providers of telecommunications services.

N.Y. Tax Law Section 1105(a) generally imposes sales tax on “every retail sale of tangible personal property.” However, N.Y. Tax Law Section 1115(a)(12-a) provides an exemption from sales tax for “tangible personal property for use or consumption directly and predominantly in the receiving, initiating, amplifying, processing, transmitting, retransmitting, switching or monitoring of switching of telecommunications services for sale.”

In Verizon, petitioner (the wireless telecommunications provider) claimed a refund on sales tax paid on the purchase of (and service related to) certain equipment used at petitioner’s data centers. Petitioner used the equipment largely to run its proprietary software known as “VISION” (and certain ancillary applications). Among other functions, petitioner used VISION to activate new cellphones, “add new customers,” permit “existing customers to change their price plans, add new features, or upgrade their phones,” and to “bill customers for their phone usage.”  Specifically, “VISION software capture[d] a customer’s voice, data, and text usage [and,] based on the customer’s price plan, features, and promotions, … created the customer bill.” However, “if the VISION system were to ‘go down,’ a customer … would still be able to make phone calls.”  In fact, “if VISION were not working for a month, active customers in good standing could continue to make phone calls.”

The case turned on whether (or not) the equipment purchased to run VISION was used “directly and predominantly” in the activities listed in the statute conducted with respect to telecommunications services. The ALJ concluded that the equipment was not used in such a manner, and that the petitioner was not entitled to a sales tax refund, relying largely on Niagara Mohawk, supra, and Peoples Telephone Co., DTA No. 816253 (N.Y. Tax App. Trib., Jan. 16, 2001).

Niagara concerned a sales tax exemption for tangible personal property used “directly and exclusively” in the production of electricity. The taxpayer in Niagara operated a coal-burning power plant. At issue was whether the sales tax exemption applied for certain (x) coal- and ash-handling equipment (e.g., cranes, conveyor belts), (y) structures to support the electricity-producing machinery, and (z) transformers (which converted the electricity into the wattage certain customers required). The Niagara court laid out three factors in considering whether tangible personal property is exempt from sales tax under the above-mentioned rule: whether the property was “necessary” for “production”; the “physical[]” and “ causal[]” “ close[ness]” of the property to the “ finished product”; and whether the property was part of an “integrated and synchronized system” that produced the product. The court found that the coal- and ash-handling equipment was exempt, as its absence would “stop or impair” production (that is, it was “necessary”); and that the structures were exempt, as they were part of an “integrated” system to produce electricity; but that the transformers were not exempt, as they were used for distribution (rather than production) of electricity. (It is worth noting that the court found that even though part of the structures were used for nonelectricity-producing purposes, such portion was sufficiently de minimis to ignore, meaning that the “exclusively” requirement of the exemption was met.)

The subsequent case of Peoples applied the Niagara factors in finding that pay telephone pedestals and enclosures were exempt from sales tax under a predecessor exemption to that at issue in Verizon. In Peoples, the Tribunal found that the purpose of the pedestals and enclosures was the “security and protection” of the pay telephone components, but that, without them there would be “no meaningful reception or initiation of telephone communication at the pay phone locations.” Specifically, the Tribunal found that “[t]he pedestal, enclosure, telephone and mast are a ‘single integral unit,’” and (citing Niagara) should not be further subdivided in a manner such that individual components of an integrated system of telecommunications service would not qualify for the exemption. The Tribunal found that “the pedestal and enclosure ha[d] an active causal relationship in the production of telephone communications,” and, therefore, qualified for the exemption.

The ALJ in Verizon appears to take an extremely narrow view of the rules and principles of Niagara and Peoples in applying the exemption to the facts of Verizon. In large part, the ALJ’s analysis focuses on the functions of VISION (including managing customer accounts, billing, controlling network access, and customer services). By analogy to our example described above, the ALJ views the taxpayer’s argument as equivalent to a clothing manufacturer claiming an exemption for a computer purchased for its accounts receivable department.

The ALJ characterizes the exemption at issue in Niagara as “much broader” than that at issue in Verizon. However, the Niagara exemption lists a single activity that qualifies for exemption (production) whereas the Verizon exemption lists numerous activities (“receiving, initiating,” etc.). Further (as pointed out by the Tribunal in Peoples) the standard for exemption in Niagara was whether property was used “directly and exclusively” rather than “ directly and predominantly” in the exemption-qualifying activity.

Further, in analyzing the facts of Verizon under the first Niagara factor (necessary to production), the ALJ does not take into account that VISION regulated who may (and who may not) access petitioner’s network. In Peoples, the pay telephones admittedly would have worked in the barest sense without the telephone enclosures. However, in a practical sense, without protecting such telephones, they would have become inoperable in short order. Similarly, although petitioner’s customers did not need VISION to make and receive calls, petitioner could not provide telecommunication services without VISION permitting and restricting access.

Additionally, without any meaningful analysis, the ALJ determined that the second and third Niagara factors (physical and causal close[ness]; and integrated and synchronized system) were inapplicable, even though the Tribunal in Peoples considered them relevant. The factors further demonstrate the applicability of the exemption. With respect to the second factor, the causal relationship exists—but for VISION granting network access, customers could not make phone calls. With respect to the third factor, both Niagara and Peoples (quoting Niagara) state that the exemption language “should not be construed to require the division into theoretically distinct stages of what is in fact continuous and indivisible.” While it is true that a billing system that was used without integration to the overall system might not be exempt, that was not the case here.  The management of network access, provision of telecommunications service, and billing for such services are a “continuous and indivisible” process, not acts that occur in isolation.  (This also puts aside the argument that, even if the VISION equipment is viewed in isolation, a plain reading of the statute could lead one to the conclusion that VISION was used in “processing,” an exempted activity.)

Admittedly, as stated by the Tribunal in Peoples, “statutes creating exemptions from tax are to be strictly construed” (internal citations omitted). Further, although exemptions like the one at issue are meant to avoid the “pyramiding of taxes” (Peoples), some balance must be struck between this policy and the concern that no sales tax would be paid by a telecommunications provider. However, the petitioner in Verizon is not seeking exemption on property that is ancillary to its telecommunications service—such as (nonreal property) structural components of buildings, furniture and fixtures, or office supplies. Rather, petitioner is seeking exemption on property that is an integral part of its provision of telecommunication services.

What is frustrating about the Verizon determination is that it muddies which property is exempt from sales tax under the provision at issue, causing planning issues for taxpayers and inviting more litigation on the topic. As an additional matter, it signals an alarming trend of focusing on narrow statutory construction in conflict with the preceding case law on which taxpayers should be able to rely.

Joseph Lipari is a partner and Aaron S. Gaynor is an associate at the law firm of Roberts & Holland.