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In re WorldCom, Inc.

United States Court of Appeals, Second Circuit

July 22, 2013

In Re: WorldCom, Inc., Debtor.
WorldCom, Inc., Debtor-Appellee. Internal Revenue Service, Appellant,

Argued: January 11, 2013

Appeal from a judgment of the United States District Court for the Southern District of New York (Forrest, J.), affirming the decision of the bankruptcy court (Gonzalez, C.J.), which granted the WorldCom Debtors' objection to the IRS's proof of claim and the Debtors' motion for a refund of federal communication excise taxes previously paid by WorldCom. We hold that the dial-up Internet service purchased by WorldCom from local telephone companies, known as COBRA, was a "local telephone service" that provided "access to a local telephone system, and the privilege of telephonic quality communication with substantially all persons . . . constituting a part of such local telephone system." 26 U.S.C. § 4252(a). WorldCom must therefore pay the three-percent excise tax federal law imposes on the purchase of any local telephone service, id. § 4251, and the Debtors are not entitled to a refund from the IRS. For the reasons stated below, the judgment of the district court is REVERSED, and the case is REMANDED for further proceedings consistent with this Opinion.

Benjamin H. Torrance (Sarah S. Normand, on the brief), Assistant United States Attorneys, for Preet Bharara, United States Attorney for the Southern District of New York, New York, NY, for Appellant.

Alfredo R. PÉREZ, Weil, Gotshal & Manges LLP, Houston, TX, for Debtor-Appellee.

Before: Kearse, Katzmann, Circuit Judges, and Rakoff, District Judge. [*]

Katzmann, Circuit Judge:

This case calls on us to decide if the bankrupt telecommunications company WorldCom must pay federal excise taxes on the purchase of a telecommunications service that connected people using dial-up modems to the Internet. Appellant, the Internal Revenue Service ("IRS"), appeals from a judgment of the United States District Court for the Southern District of New York (Forrest, J.), which upheld the decision of the Bankruptcy Court (Gonzalez, C.J.) to grant the objection of the reorganized debtors ("Debtors")[1] to the IRS's proof of claim for taxes owed and the Debtors' refund motion for the taxes WorldCom had already paid.

In the late 1990s, WorldCom purchased a service from local telephone companies called "central-office-based remote access, " or "COBRA, " that gave people the ability to use their modems to connect to WorldCom's network (and the Internet) over their regular telephone line. The tax code adds a three-percent excise tax to the purchase of a "local telephone service." 26 U.S.C. § 4251. A "local telephone service" is any service that provides "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." Id. § 4252(a). On appeal, the IRS contends that the district and bankruptcy courts erred in concluding that COBRA was not taxable as a local telephone service.

For the reasons set forth below, we hold that WorldCom purchased a "local telephone service" when it paid for COBRA services, and that WorldCom must therefore pay federal communication excise taxes on those transactions. Accordingly, we reverse the judgment of the district court and remand the case for further proceedings consistent with this Opinion.


I. Factual Background

The following background is drawn from the bankruptcy court's factual findings, adopted by the district court and unchallenged by either party on appeal:[2]

In the late 1990s, WorldCom, originally a long-distance telephone service provider, began building a massive Internet network to provide data services. As part of building that network, WorldCom purchased a now-obsolete telecommunications service known as "central-office-based remote access, " or "COBRA" from local telephone companies. COBRA allowed local telephone subscribers to connect to the Internet using a dial-up modem.[3]

In order to connect to the Internet through COBRA, a subscriber's modem would call the COBRA access number over the subscriber's normal telephone line (the public switched telephone network or "PSTN" line). After dialing the COBRA number, the modem signal traveled over the PSTN, the same network on which traditional telephone calls travel. The signal then passed through a switch at the local telephone company's central office that routed the signal over the telephone company's COBRA-specific high-capacity telephone lines, known as "primary rate interface" or "PRI" lines. The PRI lines carried the signal to a network access server, which converted the phone signal to an Internet-appropriate format (TCP/IP) using digital signal process ("DSP") cards. The network access server sent this TCP/IP data signal to a router through another PRI line contained within the network access server, and the router then transmitted the signal, along with other aggregated dial-up data signals, to WorldCom's network on a high-speed data line through the egress of the network access server. The system also worked in reverse and could convert a data signal from the Internet to a phone signal that could be carried through the local telephone lines back to the user's modem. COBRA provided local telephone customers with a two-way connection to the Internet.[4]

WorldCom plugged the output Internet data stream from the local telephone company's network access server into its own network, and sold access to the stream to Internet Service Providers ("ISPs"), like AOL, which in turn sold access to the Internet to people with dial-up modems. The PRI lines and all aspects of the network access server up through the egress port where WorldCom plugged in its network were considered COBRA equipment and were used by the local telephone companies as part of providing COBRA service to WorldCom. WorldCom paid the local telephone companies a monthly fee for access to COBRA.

The parties agree that the COBRA system was theoretically capable of transmitting an ordinary telephone call. The PRI lines that carried a modem signal to the network access server could also carry a regular voice communication signal. Instead of connecting to the network access server, those PRI lines could have plugged into a "PBX, " which is a switch that allows for voice communication over PRI lines. The COBRA-specific PRI lines, however, did not include a PBX switch. As purchased by WorldCom, COBRA was not set up for voice communication.

WorldCom also could not reconfigure the PRI lines, which, along with the other COBRA equipment, were controlled by the local telephone companies. It could access COBRA only remotely to disable a modem if it was malfunctioning or make limited software changes. Accordingly, within the system provided by the COBRA service, once the network access server converted a telephone signal from a modem into Internet-friendly TCP/IP packets (the high-speed data stream), it was no longer possible to transmit a traditional voice communication. A WorldCom employee's husband could not use COBRA to call his wife's office and ask her whether she wanted to get lunch.[5]

II. Procedural History

WorldCom filed its Chapter 11 bankruptcy petition on July 21, 2002, and the bankruptcy court confirmed the reorganization plan on October 31, 2003. In re WorldCom, Inc. (WorldCom I), 371 B.R. 19, 24–25 (Bankr. S.D.N.Y. 2007). After the court confirmed the plan, the IRS filed a proof of claim requesting that the Debtors pay $16, 276, 440.81 in excise taxes on WorldCom's purchase of COBRA services. WorldCom I, 371 B.R. at 25. The Debtors objected to the IRS's claim and additionally moved for a refund of the $38, 297, 513 in excise taxes WorldCom had already paid on COBRA.

The bankruptcy court (Gonzalez, J.) held an evidentiary hearing on February 1, 2006. By opinion dated June 1, 2007, the bankruptcy court ruled in favor of the Debtors, granting both the refund motion and their objection to the IRS's proof of claim. WorldCom I, 371 B.R. at 32. The IRS appealed WorldCom I to the district court. On August 7, 2009, the district court (Jones, J.) concluded that the bankruptcy court erred in ruling that section 4252(a) required WorldCom to have the privilege to both initiate and receive telephonic quality communication. In re WorldCom, Inc. (WorldCom II), No. 07 Civ. 7417, 2009 WL 2432370, at *3–4 (S.D.N.Y. Aug. 7, 2009) (holding that as long as two-way communication occurred, it was irrelevant which party initiated the call) (citing USA Choice Internet Servs., LLC v. United States (USA Choice II), 522 F.3d 1332, 1338–39 (Fed. Cir. 2008)). Accordingly, the district court reversed and remanded to the bankruptcy court for further factual findings on whether COBRA was a "local telephone service."

On remand, the parties submitted additional proposed findings of fact and conclusions of law, and on June 15, 2011, the bankruptcy court again ruled in favor of the Debtors. In re WorldCom, Inc. (WorldCom III), 449 B.R. 655 (Bankr. S.D.N.Y. 2011). The bankruptcy court concluded that the only service WorldCom had purchased was the ability to plug into the high-speed Internet data stream provided by the local telephone companies, i.e., the egress from the network access server. Because that data stream could not support "telephonic quality communication, " which, in the bankruptcy court's interpretation, meant regular phone calls, and because WorldCom could not reconfigure COBRA to provide it with telephonic quality communication, the bankruptcy court concluded that WorldCom had not purchased a "local telephone service" as defined by the statute. The court distinguished WorldCom's purchase of COBRA services from other cases finding that similar Internet services were taxable. See USA Choice II, 522 F.3d at 1341; Comcation, Inc. v. United States, 78 Fed.Cl. 61, 65 (2007). In those cases, the taxpayer purchased a service that provided it with the raw telephone signals, which the company itself converted to an Internet signal. According to the bankruptcy court, because the companies in those cases had access to the telephone lines, they were provided with signals capable of "telephonic quality communication."

The IRS again appealed to the district court. On December 22, 2011, the district court (Forrest, J.) affirmed the judgment of the bankruptcy court. In re WorldCom, Inc. (WorldCom IV), No. 11 Civ. 5463, 2011 WL 6434007 (S.D.N.Y. Dec. 22, 2011). The district court emphasized that WorldCom itself did not connect dial-up users to the Internet and characterized COBRA as simply an "intermediate" step in the Internet-connection process. Id. at *5–7. According to the court, this was another reason to distinguish COBRA from the services at issue in Comcation and USA Choice II, where the ISP plaintiffs connected subscribers to the Internet directly. The district court then evaluated whether this "intermediate" step "c[ould] constitute a stand alone 'local telephone service'" for purposes of section 4252(a). Id. at *5. After retracing the process of how the COBRA service operated in practice, the district court concluded that the "nanosecond" of time that the modem signal spent traversing the PRI lines before being converted into an Internet data stream by the network access server was "[s]urely not" "what Congress meant to tax as a 'local telephone service.'" Id. at *7.

The district court further concluded that COBRA did not provide the ability to communicate with "substantially all persons" who are part of "such [asserted] telephone system" as required by statute. Id. at *7 (brackets in original). The court determined that COBRA was distinct from the local telephone system, and because it "[wa]s a self-contained service" within the telephone company's facility, there was no way for any "person" to access the telephonic quality communication that the COBRA PRI lines could theoretically support. Id. Even though COBRA interfaced with the normal local telephone network—which the court delineated as a separate "service"—people who used their modems to connect to the Internet through COBRA could not communicate with the COBRA system, nor could WorldCom communicate with them. The court entered judgment in favor of the Debtors on December 28, 2011. This appeal followed.


Because neither party disputes the bankruptcy court's factual findings or the district court's adoption of those findings, we address only the legal conclusions of the district court. Our review of those conclusions is de novo. In re CBI Holding Co., 529 F.3d 432, 449 (2d Cir. 2008). Federal tax assessments are presumed to be correct and constitute prima facie evidence of liability. See Welch v. Helvering, 290 U.S. 111, 115 (1933); United States v. McCombs, 30 F.3d 310, 318 (2d Cir. 1994). The taxpayer bears the burden to prove that the assessment was ...

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