IRS v. WorldCom, Inc. (In re WorldCom, Inc.)

Internal Revenue Service v. WorldCom, Inc. (In re WorldCom, Inc.), Second Circuit Court of Appeals Case No. 12-803
In reversing and remanding District Court's affirmance of Bankruptcy Court's granting of Debtors' objection to IRS's proof of claim and Debtors' motion for refund of previously paid taxes, Second Circuit held that Debtors must pay federal excise taxes on their purchase of a telecommunications service connecting customers using dial-up modems to the Internet.
Procedural context:
Post-confirmation, Debtors objected to IRS's proof of claim asserting approximately $16.3 million in excise taxes and moved for refund of approximately $38.3 million of excise taxes already paid. Bankruptcy Court ruled in favor of Debtors. District Court reversed and remanded for further factual findings. On remand, Bankruptcy Court again ruled in favor of Debtors and District Court affirmed. This appeal followed.
In the late 1990's, WorldCom purchased COBRA, a "central-office-based remote access" service, from local telephone companies that permitted people the ability to use their modems to connect to WorldCom's network (and the Internet) over their regular telephone line. In objecting to the IRS claim and seeking a refund of the excise taxes previously paid, WorldCom took the position that its purchase of COBRA was not subject to the Internal Revenue Code's ("IRC") three percent excise tax on the purchase of a "local telephone service." 26 U.S.C. sec. 4251. Section 4252(a) of the IRC defines a "local telephone service" as any service that provides "(1) access to a local telephone system, and the privilege of telephonic quality communication with substantially all persons having telephone or radio telephone stations constituting a part of such local telephone system and (2) any facility or service provided in connection with a service described in paragraph 1." On remand from the District Court after the Bankruptcy Court ruled in favor of the Debtors, the Bankruptcy Court concluded that WorldCom had only purchased the ability to plug into the high-speed Internet data stream provided by the local telephone companies which could not support "telephonic quality communication" or, in the Bankruptcy Court's view, regular phone calls. Likewise, on the second appeal, the District Court concluded that COBRA (i) was an "intermediate" step in the Internet-connection process and not a local telephone service and (ii) did not provide the ability to communicate with "substantially all persons" who are part of such telephone system in that COBRA was a self-contained service within the telephone company's facility that did not permit people to access the telephonic quality communications that the COBRA-specific high-capacity telephone lines could theoretically support. The Second Circuit solely reviewed the District Court's conclusions of law, as the parties did not dispute the District Court's adoption of the Bankruptcy Court's findings of fact. It viewed the issue of whether COBRA was a local telephone service as a question of statutory interpretation In support of its holding, the Court carefully parsed through the three core elements of the federal tax code's definition of "local telephone service." Due to the newer technology at issue, the Court found ambiguity in the plain text of the statute and drew upon, and distinguished where applicable, case law, statutory canons of interpretation, IRS revenue rulings, legislative history and the Oxford English and Webster's New Collegiate dictionaries. First, the Court found access in the context of the purchase of a local telephone service to be limited to direct connectivity to a specific local telephone system, which was satisfied by WorldCom's separate contracts with each local telephone company. Second, the Court concluded that "telephonic quality communication" referred to the technological capacity of the channel to transmit voice signals, whether or not the channel is used for voice communication, and that such communication included a data communication transmitted by a modem. As such, this element covered any service that makes use of the traditional telephonic network for communication, regardless of the form of the communication or whether the service also used non-telephone technology, as COBRA did, to accomplish that communication. Third, the Court determined that the statute's requirement of communication with "substantially all persons" in a local telephone system is part of the "privilege" definitional element that focuses on the capacity of the purchaser to communicate with 'substantially all persons," not whether the purchaser actually does so. WorldCom satisfied this element as, in a self-imposed limitation, it chose to resell the COBRA data stream to internet service providers like AOL, rather than act as an internet service provider. In its decision, the Second Circuit remarked that "[I]t is somewhat odd to fit Internet technology into a statutory definition that has not been updated since the Mad Men era."
A.Kearse, R. Katzmann and J.Rakoff (District Judge sitting by designation)

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