California Class Action Lawsuit Questions Cell Phone State Sales Tax

In 2010, a consumer columnist for the Los Angeles Times answered a question posed by hundreds of readers:

Why must I pay state sales tax on the full price of a heavily discounted cell phone?

The answer, David Lazarus wrote, lies in the way the California State Board of Equalization (BOE) views the service plans that accompany those reduced-price phones. He explained:

The BOE distinguishes between "bundled" and "unbundled" sales prices. Bundled means a phone comes with a service plan, usually lasting a year or two. Unbundled means the phone has been sold au naturel, without an accompanying plan.

The retailer likely has obtained the cellphone at a wholesale price and is making it available to customers at a discount, but it's required to ensure that the state is cut in for sales tax based on the full retail price—an amount that no one in the sales equation has had to pay...In other words, even if you buy a discounted cellphone as part of a bundled package, you still have to pay the unbundled tax rate. Thus, you're not paying tax on the price of the phone, whatever that may be. You're paying tax on the value of the phone.

Now a class action lawsuit is calling this longstanding state communications tax rule, known as Regulation 1585, into question. Consumers are challenging the mandate, arguing that the state has been unlawfully requiring carriers to collect state sales tax on the full ("unbundled") retail price of phones even when consumers pay discounted prices as part of long-term service agreements.

Coincidentally, the case comes as many carriers are moving away from contract-based subsidized phones. T-Mobile moved to "no contract" plans years ago, Verizon followed suit in 2015 and AT&T abandoned contracts and subsidies in early 2016.

Still, the case puts into question taxes collected on hundreds of thousands of phones since 1999, when Regulation 1585 was introduced, and could have a significant impact on the future of cell phone state sales tax.

Who is being sued?
Technically, plaintiffs are going after the BOE—by way of several major cell phone retailers. Although wireless provider practices are not being contested, California law only allows entities that remit state sales tax to seek recovery of overpayments. The state can't be sued, so suing service providers is a necessary step: If successful, cell phone carriers will be compelled to seek the refunds from the state board on behalf of customers. A ruling in favor of the plaintiffs would also require the BOE to abandon Regulation 1585 and limit future sales tax collections to the actual amount paid at the point of sale without regard to "unbundled" prices.

What is the state's argument?
In general, the California sales tax statute (Section 6012) requires that sales tax must be collected from the purchaser based on the retailer's gross receipts from sales of tangible personal property. From the perspective of the California courts and the BOE, a retailer's gross receipts include all transactions involving tangible personal property—not solely the amounts received directly from consumers. The state points out that in these bundled cell phone transactions, the retail seller of the phone receives a reimbursement from the service carrier in an amount equal to the difference between the lower discounted price paid at the time of the sale, and the unbundled, full retail sales price of the phone.

This reimbursement, according to the BOE, serves as the retailer's compensation for making the sale of the phone. The retailer has actually received payment in the amount of the full, unbundled, retail price of the phone in two waves: First, there is the gross receipt at the time the phone is purchased. Then comes the consumer's payments as part of the cellular service contract, which the BOE says is remitted back to the retailer as a "commission" on the sale of the phone. (Cell phone service is not subject to sales tax in California.)

In addition, the state contends that retailers may collect sales tax reimbursement from customers on the full amount of gross receipts from the sale of tangible personal property, including amounts received from third parties, if their contracts of sale so provide. The state therefore claims that it's proper for the retailer to collect sales tax on the full retail price of a cell phone without regard to the discounted, bundled price actually paid at the point of sale.

What is the consumers' argument?
The plaintiffs contend that Section 6012 is plain in its meaning that sales taxes are to be calculated only on retail point-of-sale gross receipts. They allege that Regulation 1585 unlawfully redefines "gross receipts" to include an arbitrary dollar amount based on imaginary rebates that retailers don't actually receive to make up for the difference in price.

The plaintiffs also argue that the BOE ignored the critical fact that most mobile phones bundled with contracts were sold in carrier-owned or controlled stores—and that carriers do not pay commissions to themselves in those transactions.

Their argument is that the board is effectively taxing non-existent carrier commission revenue in direct violation of the law and now owes millions of dollars worth of refunds.

In conclusion:
The outcome of this case will likely hinge on which definition of "gross receipts" the court chooses to apply to bundled transactions involving discounted cell phones. A point of sale-only interpretation will be a big win for consumers in California. An interpretation that includes any revenue received, from whatever source, will result in a win for the state—not to mention a huge revenue gain.

While California cell phone sellers will not feel a financial impact from the decision either way—they serve only as a collection intermediary of the tax—they will need to be prepared for the tax implications should Regulation 1585 be overturned.

It's just the kind of thing Lazarus' column foreshadowed. "Many laws were written years ago, prior to new technologies coming on the market," one of his sources said. "At the time the tax code was written, cellphones weren't even sold."

As states struggle to keep up with the rapid pace of communications innovations and reinterpret old tax laws for new technologies, this is another example of how dramatically things can change. It is critically important for communications service providers and the tax engines they use to stay current in order to avoid legal and financial trouble, which is why Avalara is committed to bringing you all the latest communications tax news.

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