[Update: In 2013 the N.C. Supreme Court reversed the Court of Appeals decision discussed below. See this blog post for more details.]
In the first of three decisions we are expecting on internet sweepstakes, the N.C. Court of Appeals ruled in favor of the City of Lumberton and its authority to levy substantial privilege license taxes on these businesses. As predicted in prior blog posts, the Lumberton decision firmly establishes that municipalities have the authority to levy privilege license taxes on internet sweepstakes.
But this fight is far from over. The Lumberton decision leaves the door open for future plaintiffs to attack the amount of city privilege license taxes on internet sweepstakes. And we are still waiting on two more Court of Appeal’s decisions: one involving privilege license taxes levied by Fayetteville and one involving a constitutional challenge to the criminal ban on internet sweepstakes that was intended to take effect in late 2010.
The Fayetteville tax case is unlikely to undermine the conclusion that cities and towns have the right to levy privilege license taxes on internet sweepstakes. But it could provide more guidance as to what evidence is needed to prove that a city’s tax on these businesses are too high. And the criminal case could moot the tax issue by banning the internet sweepstakes entirely.
Here’s an analysis of the Lumberton decision and what it means going forward.
Beginning in fiscal year 2010, Lumberton increased its privilege license taxes on internet sweepstakes from a flat-rate tax of $12.50 per establishment to a tax that varied based on the number of machines used to play the sweepstakes games. Lumberton now taxes internet sweepstakes businesses at $5,000 per establishment plus $2,500 per terminal or computer at that establishment. The city’s internet sweepstakes tax classification applies to:
businesses or enterprises [that] have as a part of [their] operation the running of one or more games or processes with any of the following characteristics: (1) payment, directly or as an intended addition to the purchase of a product, whereby the customer receives one or more electronic sweepstakes tickets, cards, tokens or similar items entitling or empowering the customer to enter a sweepstakes, and without which item the customer would be unable to enter the sweepstakes; or (2) payment, directly or as an intended addition to the purchase of a product, whereby the customer can request a no purchase necessary free entry of one or more sweepstakes tickets or other item entitling the customer to enter a sweepstakes.
Four sweepstakes businesses challenged the legality of the new tax in state court. Because the plaintiffs’ claims were similar, all four cases were consolidated and heard together before a trial judge.
The plaintiffs attacked Lumberton’s tax based on the wording of the local ordinance, on its interference with federal law, on its constitutionality, and on the tax burden it created. The trial judge issued summary judgment in favor of Lumberton on all issues, concluding that the plaintiffs had not produced enough evidence to justify a trial on the matter. The sweepstakes operators appealed, which produced last week’s opinion.
The Court of Appeals quickly rejected the plaintiffs’ arguments that their businesses fell outside of Lumberton’s definition of internet sweepstakes. It also made short work of the plaintiff’s claims based on the federal Internet Tax Freedom Act (“ITFA”), which prohibits local taxes on the sale of internet access and local taxes that discriminate against transactions conducted over the Internet. (Here’s the original ITFA; Congress later extended it until 2014.) The court found that the city’s tax avoided a conflict with ITFA because the tax was applied to all sweepstakes games played on computers, regardless of whether those games were conducted over the internet or were conducted by a business that sold internet access.
The court spent more time analyzing the constitutional challenges to Lumberton’s tax. Plaintiffs first argued that a privilege license tax based on the number of computers used in a business violates the N.C. Constitutional provision (Art. V, Sect. 2) that reserves the right to classify property for taxation to the General Assembly and not to local governments. The court disagreed, concluding that a privilege license tax is truly a tax on the privilege of doing business and is not a property tax even if it is based on the units of particular property used by a business: “Here, the city is not taxing individual computers for the sake of taxing computers. The city is taxing businesses for the privilege of carrying out cyber-gambling through the use of computer terminals, and we hold such a tax is authorized by N.C. Gen. Stat. 160A-211.”
The plaintiffs next alleged that Lumberton’s tax violates the N.C. Constitution’s uniformity provision (also found in Art. V, Sect. 2) because it taxes computers used for “games of chance” but not computers used for other business activities. The court rejected this argument because Lumberton’s tax “operates without distinction or discrimination upon all persons describing the class:” the tax applies equally to all businesses using computers to operate games of chance. Businesses that use computers for other purposes fall outside of the internet sweepstakes category created by the city and therefore can be excluded from the tax without violating the uniformity requirement. For similar reasons, the court concluded it was constitutional for Lumberton to exclude state lottery operations from the privilege license tax.
The plaintiffs’ strongest argument, and the only one that garnered support from one of the three appellate judges who decided the case, was based on the amount of Lumberton’s tax rather than on the authority to levy such a tax. Without question, Lumberton’s tax on internet sweepstakes is one of the highest in the state and is dramatically higher than the privilege license taxes it levies on other businesses. For large operations, the tax could easily rise to six figures. One of the plaintiffs in the case operates 55 sweepstakes computers and was levied a tax of over $135,000 annually.
However, just because a tax is high does not mean it is illegal. The N.C. Constitution requires that all taxes be “just and equitable.” Presumably a tax could be so high as to violate this mandate, but neither state law nor the courts have given us much guidance on that question.
What the courts have told us is that taxes should reasonably relate to the profits of the business being taxed and that a tax may not be so high “as to amount to a prohibition of the particular business.” But the mere fact that a particular tax is thousands of times higher than other similar taxes or than that tax itself was in the previous year does not alone render it unjust or inequitable. In other words, “the mere amount of the tax does not prove its invalidity.”
Citing prior opinions, the Lumberton court concluded that evidence of the effect on the business paying the tax is “typically unhelpful.” The fact that a business shut down because it could not pay a tax bill doesn’t necessarily mean the tax amounted to a prohibition of that business. The owner’s “negligence, incompetence, or other considerations” could have contributed to that result.
Instead, the court found that the most helpful evidence a plaintiff could provide to prove that a tax was unconstitutionally burdensome would be evidence concerning the relationship of the tax to the business’s revenues and to the costs incurred by the city to regulate and police that business. A larger city with a larger market for the taxpayer’s business likely would justify a larger tax on that business. To prove that a tax was too high, the business would need to show that its target territory and market could not generate enough revenue to pay the city’s tax.
Two of the three judges hearing the case concluded that the sweepstakes plaintiffs failed to produce enough evidence to deserve a trial on the question of whether Lumberton’s tax was unconstitutionally high. One judge disagreed and would have ordered the case back to the trial court to resolve that question. However, even the dissenting judge agreed with the majority on the plaintiffs’ other challenges to Lumberton’s tax.
What does it all mean?
For starters the plaintiffs have an automatic right to appeal to the N.C. Supreme Court under GS 7A-30. That statute gives the losing party at the Court of Appeals the right to seek review by the Supreme Court of any issues involving the state or federal constitutions and any issues not resolved unanimously by the Court of Appeals. Because most of the plaintiffs claims against Lumberton involved the N.C. Constitution, the plaintiffs have the automatic right of appeal for the bulk of the issues decided by the Court of Appeals.
I think the only issues that fall outside of the appeal right are the claims based on the wording of Lumberton’s tax ordinance and those based on the federal Internet Tax Freedom Act. The Supreme Court could exercise its discretion to review those issues, but that court (actually, any court) generally does not review anything more than absolutely required.
Were I forced to wager on the outcome of an appeal, my bet would be that the only issue up for serious debate before the Supreme Court would be the question of whether the plaintiffs deserve a trial about the tax being too high. And even if the plaintiffs prevailed on that issue, the case would not be resolved in their favor. Instead, the case would return to the trial court where the plaintiffs would need to produce persuasive evidence that Lumberton’s tax is unconstitutionally high.
In sum, I think the Lumberton decision provides strong support for the authority of North Carolina’s cities and towns to levy privilege license taxes on internet sweepstakes businesses. It seems likely that the only open question is how high those taxes can rise before they violate the N.C. Constitution. We may yet get an answer on that issue from either the Lumberton case or the Fayetteville case still pending before the Court of Appeals. And remember that there remains a good chance that the appellate courts moot the tax issue entirely by upholding the criminal ban on all internet sweepstakes.
In other words, the Lumberton decision is just another round in a long, hard fight.