Editors’ Note: The following post is by our guest editor, Michael Lurie.  Michael is a member of Reed Smith’s 2012 Summer Associate class, resident in our Philadelphia office.  Michael recently completed his second year at Temple Law School, and is a Research Editor of Temple Law Review. He is an avid reader of tax and legal blogs.

In a recently-issued decision of the Illinois Department of Revenue, the taxpayer, a Voice over Internet Protocol (“VoIP”) provider challenged the Illinois Telecommunications Excise Tax Act on the grounds that the tax was preempted by federal law. The Department of Revenue ALJ determined that the Department was permitted to impose taxes on VoIP services because the taxpayer did not establish that it is impossible to separate interstate and intrastate communications. If the taxpayer had proved impossibility, the state tax would have been preempted by the FCC order.

Current FCC policy is that a state cannot tax VoIP unless the intrastate component (e.g., calls made within the state) can be separated from the interstate component (e.g., calls made outside the state) because otherwise “multiple state regulatory regimes would likely violate the Commerce Clause.” This policy was explained in a 2004 case—Vonage Holdings. In Vonage, the FCC engaged in a fairly intensive analysis of the complexities of VoIP in its analysis of whether it is possible to determine the “geographic location of a [VoIP] subscriber,” and concluded that it is practically impossible.

As the Department acknowledged in ABC Business, the FCC’s policy was unsuccessfully challenged in federal court. However, in ABC Business the Department distinguished the instant case from the FCC’s policy because the taxpayer’s president only testified that his business could not separate intrastate and interstate calls, not that it was impossible to separate them. The Department put great emphasis on the fact that the taxpayer charged extra for international calls as evidence that the taxpayer could separate the intrastate and interstate components of a subscriber’s service.

Even though VoIP technology has undoubtedly progressed over the past decade, it is still arguably impossible to separate interstate phone calls from intrastate phone calls, at least without massive infringement on the call recipient’s privacy. For example, Illinois shares a land border with Wisconsin. Imagine a VoIP subscriber lives in Chicago. He calls his old college roommate, who happens to be a farmer in Northern Illinois, which is right across the border from Sharon, Wisconsin. The farmer picks up his cellphone and has a half-hour chat with the VoIP subscriber down in Chicago. This would, of course, be an intrastate phone call as they both live in Illinois. Cell phone signals don’t stop at state-line boundaries, so the farmer’s cell phone call goes through the closest cell tower, which is up in Wisconsin.

The VoIP provider cannot know that the call is really intrastate rather than interstate without tracking the recipient’s physical location.  A similar situation may occur in terms of international calls—even though the VoIP charges extra for international calls. For example, you might still get cell phone service at Niagara Falls even though you cross to the Canadian side and won’t be charged for an international call.

The foregoing are some examples of the impossibility of separating interstate and intrastate VoIP. Many American cities, including Philadelphia, New York, Kansas City, Detroit, El Paso, and San Diego, are situated on interstate or international borders, making this a real issue that affects commerce.

So, what does this case mean? One key takeaway is that taxpayers may want to think carefully about how to develop the record regarding the divisibility of interstate and intrastate calls. Specifically, testimony on impossibility from a corporate executive could be carefully scrutinized, since it is against the provider’s interest to separate interstate and intrastate calls. Testimony from upstream and downstream carriers and from expert witnesses could support the point of technical impossibility.