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1940s Mexican Radio Case Stands As Early Test On Digital Tax

By Alex M. Parker · 2018-11-08 19:00:19 -0500

The new and increasingly cloud-based online economy poses challenges for tax authorities around the globe — except they aren't so novel for the IRS, which was flummoxed 80 years ago by a Mexican radio station whose income was out of the agency's reach even as it blasted radio waves across the U.S.

For tax purposes, internet search engines and social media could be seen as comparable to radio waves heard by a listener in another country. A woman walks past a Google logo at the China International Import Expo in Shanghai. (AP)

In 1942, the Fifth Circuit ruled that the Piedras Negras Broadcasting Co.'s income came from its physical broadcasting facility in Mexico and wasn't taxable by the Internal Revenue Service as U.S.-sourced income — even though a vast majority of the company's advertisers and listeners were from the U.S. The case set a precedent that is coming under increasing strain as the U.S. and the world grow skeptical of using physical presence as a proxy for taxation given that more and more business happens on the internet. But experts say that the case shows these issues aren't new, and that the logic behind the ruling shouldn't be tossed out cavalierly.

"From a historical perspective, this issue has been around a long time," said William Seeger, a professor of political economics at the University of Texas at Arlington. "The same concerns over permanent establishment and how to define them existed. Emotionally, somehow, taxpayers and tax authorities have gotten over it."

Nearly a century ago, the world was trying to absorb and understand a new communications technology that circumvented regulators and governments, just as now.

"Broadcasting technology was revolutionary in its day," Seeger noted.

Created in 1932, the XEPN radio station was one of the many "border blasters" in Mexico along the U.S. boundary, outside the purview of the Federal Radio Commission and capable of broadcasting throughout the U.S. and, supposedly, into Canada. The radio waves were said to be so powerful that farmers could hear the broadcasts off their metal fences.

The stations were an infamous outlet for hucksters and snake oil salesmen to hawk dubious products and medical treatments — most prominently John Brinkley, a fraudulent Kansas doctor and gubernatorial candidate who made, and eventually lost, millions of dollars by promoting the transplantation of goat testicles into patients as a cure for male impotence and other ailments.

At first, XEPN broadcast Brinkley's flim-flam — as well as an upbeat new genre of music, country — using its main studio in Piedras Negras, as well as a remote studio set up in a hotel room in Eagle Pass, Texas, just across the Rio Grande. But after the Communications Act of 1934 — known as the Brinkley Act, which enacted new licensing requirements and prohibited U.S. stations from broadcasting programs by telephone from Mexico as a way to avoid U.S. regulation — the company shuttered its Eagle Pass studio, while still using the hotel to collect and process payments from its advertisers.

The IRS eventually issued notices of deficiency for 1936-1937 for $211,851, or $3.8 million in today's dollars. But the tax bill was dismissed, first by the U.S. Board of Tax Appeals, the precursor to today's Tax Court, and eventually by the Fifth Circuit Court of Appeals, which ruled that the station's income was foreign-sourced and untaxable by the IRS.

"If income is produced by the transmission of electromagnetic waves that cover a radius of several thousand miles, free of control or regulation by the sender from the moment of generation, the source of that income is the act of transmission," Judge Edwin Holmes wrote.

To many, this case is a predigital-age example of the situation confounding regulators around the globe — how do you tax companies that can do substantial business in your jurisdiction without ever setting foot there?

Fueled by anger over online retailers, search engines and social networking sites for their perceived tax dodging, both the United Kingdom and the European Union are mulling digital service taxes, which would tax the revenue from online companies for activities that can be connected to users in those countries. The Organization for Economic Cooperation and Development is also weighing the feasibility of a digital permanent establishment, or taxable nexus, as a way for countries to tax companies that sell or are otherwise present in their jurisdictions without physical offices or personnel.

Meanwhile, the U.S. Supreme Court ruled earlier this year in South Dakota v. Wayfair that states were no longer bound by standards requiring a physical presence as they collect sales tax.

"While businesses have responded to the realities of digitalization, the international corporate tax system has not kept pace," said Mel Stride, U.K.'s financial secretary to the treasury, in the solicitation that accompanied the proposed 2 percent digital services tax. "Only by making fundamental changes can we ensure that the tax system is sustainable in the digital age, and that all types of businesses make a fair contribution to support our vital public services."

But tax experts are wrestling with whether the economy has changed so substantially that the Piedras Negras example simply no longer applies — or if the case remains relevant as policymakers debate where value is truly created on the web or in the cloud.

"It establishes that we don't need to create new rules; these are the rules and they've worked well," said Larissa Neumann, a partner at Fenwick & West LLP in Mountain View, California.

The temptation for policymakers is to look to the users or advertisers as the source of income, but Neumann said the principle still holds that the value is truly generated where a platform is created or maintained.

"Nobody's going to advertise on something that's not a valuable platform," Neumann said. "They pay because you have a good platform."

But not everyone agrees — and didn't in 1942, either.

Writing a dissent to the decision, Judge Leon McCord said the presence of radio waves and listeners alone didn't create a taxable U.S. presence. But the prominence of U.S. advertisers in the company's revenue and the fact that the company maintained U.S. bank accounts and a U.S. office to process the payments were enough, McCord claimed, to establish the operation as a U.S. trade or business.

"It was, therefore, receiving income by broadcasting operations coupled with personal contact in this country," he wrote. "I am of the opinion that all the facts taken together establish that Piedras Negras Broadcasting Co. was doing business in the United States, was deriving income from sources within this country, and was taxable."

Even the dissent wouldn't support the reach being sought by proponents of a digital services tax, which aims to include not only monetary transactions online, through sites such as or Netflix, but activity from users that is entirely digital and uncompensated, such as use of a search engine or social media site. That activity could be seen as highly analogous to radio waves heard by a listener — except that it's interactive.

"I just think the world has changed; I think Piedras Negras is very conventional," said Peter Barnes, a professor of tax at Duke University School of Law and senior international tax counsel at General Electric Co. "I think it would have been decided differently under today's view of things."

But Barnes also said he sees dangers as the world shifts to an online, user-focused outlook.

"I have serious doubts about the idea, under the digital tax, of just going to where the consumers are," Barnes said. "Because I think that conflates an income tax and a consumption tax. We already have consumption taxes that deal with the situation with the consumer."

--Editing by Tim Ruel and John Oudens.

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