AOL Llc Vs. Iowa Department Of Revenue ( 2009 )

IN THE SUPREME COURT OF IOWA
No. 07–1792
Filed August 21, 2009
AOL LLC,
Appellee,
vs.
IOWA DEPARTMENT OF REVENUE,
Appellant.
On review from the Iowa Court of Appeals.
Appeal from the Iowa District Court for Polk County, Robert B.
Hanson, Judge.
Department seeks further review of the reversal of its
determination that AOL is subject to state sales tax. DECISION OF
COURT OF APPEALS VACATED; DISTRICT COURT JUDGMENT
AFFIRMED.
Thomas J. Miller, Attorney General, Marcia Mason and James D.
Miller, Assistant Attorneys General, for appellant.
Bruce W. Baker of Nyemaster, Goode, West, Hansell & O’Brien,
P.C., Des Moines, and Peter J. Brann, Martin I. Eisenstein and David
Swetnam-Burland of Brann & Isaacson, Lewiston, Maine, for appellee.
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APPEL, Justice.
This case involves the question of whether the State of Iowa may
impose sales tax on internet services provided by America Online, LLC
(AOL) to its Iowa customers. The parties disagree as to whether the
applicable administrative rule requires the origin and terminus of the
communication to occur in Iowa in order for AOL’s gross receipts to be
taxable and whether AOL’s service met this requirement. While the
department found AOL subject to state sales tax, the district court and
the court of appeals disagreed. For the reasons stated below, the
decision of the court of appeals is vacated and the district court
judgment is affirmed.
I. Background Facts and Proceedings.
AOL is a communication service provider that offered its Iowa
members internet access, e-mail, instant messaging, and a variety of
original content features. The essential operational features of AOL’s
internet service are not materially disputed. In order to obtain content, a
member residing in Iowa must first place a call to a local telephone
number through a modem-equipped computer. One of the cluster of
modems at the local exchange (modem hotel) would answer the call and
then forward a digital signal routed to one of AOL’s data centers in
Virginia through a private system controlled by AOL.
Before the customer in Iowa could receive any content from AOL,
“authentication” of the customer’s information must occur in Virginia.
Once authentication is verified, the service commences through the
connection of the Iowa customer’s personal computer to the data centers
in Virginia. AOL refers to this as the client/server connection. Any
information that an AOL subscriber posted on AOL servers, the internet,
or sent by e-mail would be routed through Virginia before it could be
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accessed by any other user, including AOL members and any non-AOL
members in Iowa. Additionally, any information sent to an AOL
customer in Iowa must first be routed through Virginia before that
information reached Iowa, even if that information originated in Iowa.
Thus, without a connection between the user’s computer in Iowa via
AOL’s local exchange to the AOL data center in Virginia, no services
could be provided even for communications between two AOL members
who both resided within the state.
At the time of this dispute, Iowa Code section 422.43(1) (1999)
imposed a state sales tax on “the gross receipts from the sales,
furnishing, or service of . . . communication service . . . when sold at
retail in the state to consumers or users . . . .” The department
promulgated Iowa Administrative Code rule 701—18.20 to enforce this
statutory provision. The introduction to rule 18.20 and the definitions in
section 18.20(1) provide:
701—18.20 . . . Communications services. The gross
receipts from the sale of all communication services provided
in this state are subject to tax. . . .
18.20(1) Definitions.
a. Communication services shall mean the act of
providing, for a consideration, any medium or method for, or
the act of transmission and receipt of, information between
two or more points. Each point must be capable of both
transmitting and receiving information if “communication” is
to occur. . . .
b. Communication service is provided “in this state”
only if both the points of origination and termination of the
communication are within the borders of Iowa.
Communication service between any other points is
“interstate” in nature and not subject to tax.
The rule goes on to further address the taxation of internet services
specifically:
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18.20(5) Prior to July 1, 1999, charges for access to
or use of what is commonly referred to as the “Internet” or
charges for other contracted on-line services are the gross
receipts from the performance of a taxable service if access is
by way of a local or in-state long distance telephone number
and if the predominant service offered is two-way
transmission and receipt of information from one site to
another as described in paragraph “a” of subrule 18.20(1). If
a user’s billing address is located in Iowa, a service provider
should assume that Internet access or contracted on-line
service is provided to that user in Iowa unless the user
presents suitable evidence that the site or sites at which
these services are furnished are located outside this state.
On June 14, 2001, the department issued an assessment on AOL’s
Iowa sales of communication services during the period from July 1,
1995 to December 31, 2000. In August, AOL filed a protest, but the
matter was held in abeyance pending the outcome of a similar dispute
involving AOL and Tennessee tax authorities. The Tennessee matter was
settled after the Tennessee Court of Appeals ruled in favor of another
company on similar issues. See generally Prodigy Servs. Corp., Inc. v.
Johnson, 125 S.W.3d 413 (Tenn. Ct. App. 2003). The matter eventually
came to an evidentiary hearing before an administrative law judge (ALJ)
of the Iowa Department of Inspections and Appeals in late October 2005.
The ALJ issued a proposed decision concluding that the services
provided by AOL were not subject to state sales tax. The ALJ analyzed
the statutory and administrative framework surrounding the issue and
concluded that under the department’s own rules, AOL services
amounted to an untaxable interstate service. The ALJ noted that while
an Iowa resident might use his Iowa-based computer to initiate service
and that the signal is transferred through the Iowa-based modem hotel
to AOL, one could not conclude that the communication originated and
terminated in Iowa. Simply put, the ALJ concluded that no service or
communication was provided at the modem hotel in Iowa.
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Communication occurred between the data center in Virginia and the
user in Iowa.
The department appealed the ALJ’s decision to its director, who
reversed the ALJ’s proposed decision. The director largely adopted the
findings of fact made by the ALJ. The director concluded, however, that
AOL’s services were the result of a local call, regardless of the manner in
which AOL connected the local call to its network. In addition, the
director noted that the legislature amended the governing statute to
exempt from sales tax “gross receipts from charges paid to a provider for
access to on-line computer services.” The director reasoned that this
legislative change would be unnecessary if such services were not subject
to tax in prior years. Finally, the director concluded that AOL charged
an access fee, which was not dependent on the user actually utilizing the
service, making it subject to state sales tax.
AOL filed a petition for judicial review. The district court
overturned the agency’s decision, finding it an irrational, illogical, and
wholly unjustifiable application of law to fact. The district court
concluded that only one point of communication occurred in Iowa, the
other occurred at the AOL data center in Virginia. Because the
department’s administrative rule required that both points of
communication occur within the state in order for sales tax to be
assessed, the district court concluded that AOL services were not subject
to the tax.
The department appealed. We transferred the case to the court of
appeals. On appeal, the department argued that the definitions provided
in section 18.20(1) did not apply to section 18.20(5) which specifically
dealt with the taxation of internet services. Thus, there was no
requirement that AOL services be provided “in this state” in order for it to
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be subject to state sales tax. In the alternative, the department asserted
that if the definitional section did apply, both points of communication
occurred within the state. The court of appeals affirmed the district
court, concluding that both the origin and the termination of the
communication must occur within the state and that the communication
at issue here “terminates” out of state. As such, AOL’s services were
interstate and not subject to state sales tax. The department sought
further review.
II. Standard of Review.
Our review of the two issues presented in this appeal is governed
by the Iowa Administrative Procedure Act. The first inquiry involves the
proper interpretation of the department’s rule, specifically, what is meant
by communication service provided “in this state” in Iowa Administrative
Code rule 18.20 and whether this term, as properly interpreted, applies
to limit taxation of internet access services described under section
18.20(5). The second inquiry is whether AOL, under the undisputed
facts, provided taxable communication services in this state within the
scope of the department’s administrative rules.
An agency’s interpretation of law is given deference if authority to
interpret the law has “clearly been vested by a provision of law in the
discretion of the agency.” Iowa Code § 17A.19(10)(l) (Supp. 1999). If the
interpretation is so vested in the agency, then the court may reverse an
agency’s interpretation only if it is “irrational, illogical, or wholly
unjustifiable.” Id. If, however, the interpretation of a provision of law is
not vested in the discretion of the agency, our review is for correction of
errors at law and we are free to substitute our interpretation of the
statute de novo. Id. § 17A.19(10)(c); Auen v. Alcoholic Beverages Div.,
679 N.W.2d 586, 589–90 (Iowa 2004).
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The legislature has provided that the Director of the Iowa
Department of Revenue shall have the power to promulgate “rules not
inconsistent with the provisions of this chapter, necessary and advisable
for its detailed administration and to effectuate its purposes.” Iowa Code
§ 422.68(1) (1999). In light of this language, we have concluded that the
agency’s interpretation of the statute as reflected in its administrative
rules is a power that has “clearly been vested” in the agency. Ranniger v.
Iowa Dep’t of Revenue & Fin., 746 N.W.2d 267, 268 (Iowa 2008). As a
result, rules promulgated by the department will be found invalid only if
they are “irrational, illogical or wholly unjustifiable.” Id.AOL does not challenge the general proposition that the director
has broad authority to promulgate rules that the director finds
consistent with the governing statute. Indeed, AOL does not make any
claim that the applicable rules in this case are invalid. Instead, AOL
argues that broad authority to promulgate rules consistent with the
statute is not the same as the issue presented in this case, namely,
whether the director is vested with authority to interpret the rules. As a
result, AOL argues that the director’s interpretation of the rules is not
entitled to deference under Iowa Code section 17A.19(10)(c) (Supp. 1999).
In this case, it is not necessary to decide the question of whether
the director’s interpretation of the department’s rules is entitled to
deference. As will be seen below, we conclude that the director’s
interpretation fails to meet even the most deferential standard of review.
Once we have resolved proper interpretation of the applicable
administrative rules, we must next consider the application of law to the
established facts. Factual determinations of the agency must be affirmed
by a reviewing court if they are supported by substantial evidence. Iowa
Code § 17A.19(10)(f). The application of law to the established facts can
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be reversed only if the application is “irrational, illogical, or wholly
unjustifiable . . . .” Id. § 17A.19(10)(m).
III. Discussion.1
A. Proper Interpretation of Administrative Regulations. The
parties disagree as to whether the definition of a communications service
provided “in this state” in Iowa Administrative Code rule 18.20(1)(b)
applies to the taxation of internet services as described under rule
18.20(5). The department argues that rule 18.20(5) is a stand-alone
provision and that the definitions do not apply to this subsection. Thus,
according to the department, the question of the taxation of AOL’s
services may be made without considering whether AOL provided a
“[c]ommunications service . . . ‘in this state’ ” as defined by rule
18.20(1)(b). AOL urges us to apply the plain meaning of the
administrative rule without engaging in the legal jujitsu employed by the
department to escape it.
We agree with AOL. Definitions are a common part of the legal
landscape. Ranniger, 746 N.W.2d at 270 (noting that the legislature may
be its own lexicographer). The very purpose of putting the definitions at
the beginning of a statute, contract, or rule is to establish the framework
for the proper interpretation of subsequent provisions. When an agency
elects to be its own lexicographer, persons are entitled to rely upon the
established definitions. An agency simply cannot assert a “King’s X”
defense when unambiguous definitions prove too tight or too loose. If the
department did not intend the definitions of rule 18.20(1)(b) to apply to a
subsequent subsection in the same rule regarding internet sales, the
1On appeal AOL raises a number of other arguments, including federal
preemption, in support of its claim to be immune from state sales tax. Due to our
disposition on the proper interpretation of the department’s rule, we do not address
these additional arguments.
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department should have either removed the internet access provision
from the rule to escape its definitional tentacles or expressly severed
them by stating that the generally applicable definitions did not apply to
internet services. The department did neither.
We further note that the phrase “in this state” in rule 18.20(1)(b),
which the department now seeks to escape, is also found in the preface
to rule 18.20, which broadly states, “The gross receipts from the sale of
all communication services provided in this state are subject to tax.” The
use of the phrase “in this state” in the general introduction to rule 18.20
further demonstrates that the concept has general applicability
throughout the subsequent provisions of the rule.
The department suggests that the enactment of Iowa Code section
422.45(56) (2001) by the legislature, which specifically exempted internet
access charges from state sales tax, demonstrates that internet services
were previously subject to tax. Under AOL’s interpretation, therefore,
this legislative action would be meaningless.
We do not agree. The subsequent legislation exempted all receipts
from the sale of access to online services largely after the period relevant
to this dispute. Thus, our holding in this case does not render the
legislative action redundant. Further, to the extent the subsequent
legislation does have a bearing on the issues in this case, it does not offer
much support for the department’s position. It is not unusual for the
legislature to enact clarifying legislation in response to an ongoing
dispute with an agency. 1A Norman J. Singer, Statutes & Statutory
Construction § 22:31, at 379–80 (6th ed. 2002).
In conclusion, we hold it is “illogical, irrational, and wholly
unjustifiable” for the department to determine that the definitions in rule
18.20(1)(b) do not apply to subrule (5). There is simply no “play in the
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joints” of the rule sufficient to allow the department to escape the rule’s
plain meaning and overall structure. Cf. Marovec v. PMX Indus., 693
N.W.2d 779, 785 (Iowa 2005) (discussing a situation where agency rules
and statutory law granted the agency enforcement discretion). Thus, we
hold that the definition of “in this state” found in rule 18.20(1)(b) is fully
applicable in determining whether AOL services are subject to state sales
tax.
B. Application of Administrative Rules to AOL. The parties
adopt fundamentally different approaches to the application of rule 18.20
to the facts of this case. The department stresses that access to AOL is
triggered by a local call to the switch or modem hotel also located within
Iowa. The department then reasons that gaining access to AOL through
its access fee is an intrastate transaction subject to sales tax. AOL
counters that regardless of the point of access, no communication service
is provided as a result of the Iowa access. Without the Virginia computer
system, no communication service is provided at all.
In order for AOL to prevail, it must show that the department’s
application of law to the facts of this case is “an irrational, illogical, or
wholly unjustifiable application of law to fact . . . .” Iowa Code
§ 17A.19(10)(m) (Supp. 1999). We conclude that AOL has met this
demanding burden.
In this case, the access points located in Iowa do not amount to
the provision of an intrastate “communication service” subject to tax. A
“[c]ommunication service . . . ‘in this state,’ ” according to rule
18.20(1)(b), involves both the transmission and receipt of information.
The record in this case demonstrates that for AOL members, the
transmission and receipt of information does not occur wholly within
Iowa. No information is transmitted to Iowa until a member’s account
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has been authenticated in Virginia. It is undisputed that if the plug is
pulled on the Virginia computer, Iowa AOL customers access no
information of any kind. Under these undisputed facts, it cannot be
maintained that AOL’s communication service is intrastate when,
without the Virginia connection, the user gets nothing. As a result, there
is no rational, logical or justifiable basis for imposing state sales tax on
AOL under the applicable rule.
We note that our conclusion is consistent with the case law in
other jurisdictions. For example, in Qwest Corp. v. State ex rel. Wyoming
Department of Revenue, 130 P.3d 507, 515 (Wyo. 2006), the Wyoming
Supreme Court characterized the issue as whether the “complete end-to-
end” communication occurs within the taxing state, prior to finding the
disputed service an interstate communication service. Although the
regulatory framework in Iowa is not identical to that in Wyoming, the
similarities are sufficient to provide support for our conclusion in this
case.
IV. Conclusion.
For the reasons expressed above, the decision of the court of
appeals is vacated and the district court judgment is affirmed.
DECISION OF COURT OF APPEALS VACATED; DISTRICT
COURT JUDGMENT AFFIRMED.