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Federal Courts Determine OTCs’ Service Fees not Subject to Hotel Occupancy Taxes

The federal courts just gift-wrapped a decision for taxpayers, right in time for the holidays. In late November, the U.S. Court of Appeals for both the Fifth and Seventh Circuits held that local hotel occupancy taxes do not apply to the service fees online travel companies ("OTCs") charge for facilitating hotel reservations. These decisions signal not only relief for OTCs, but may have wider reaching implications for the applicability of other local taxes to service fees.

Seventh Circuit's Interpretation of the Plain Language of the Ordinances

The Seventh Circuit struck first, finding on November 22, 2017 in Vill. Of Bedford Park v. Expedia Inc.  that OTCs are not required to collect and remit local hotel taxes on the service fees they collect because they are not "owners, operators, or managers of hotels" and are not "engaged in the business of renting, leasing, or letting rooms in a hotel." As background, the OTCs at issue operate their websites under the "merchant model", meaning that customers pay the OTC directly to reserve a room at a hotel with whom the OTC has contracted. Although the rate is set by the hotels, the OTCs charge the customer a price that includes that rate, the estimated tax owed to the municipality, and an additional charge for the OTCs' services (hereafter referred to as "service fee"). Notably, the OTCs do not pre-pay for the rooms or re-rent them to customers. Rather, the hotels agree to make rooms available for the OTCs in exchange for the OTCs display of information about the hotel on their website. Based on this model, thirteen Illinois municipalities asserted that the OTCs had the duty to collect and remit hotel occupancy tax on their service fees.

Although the thirteen Illinois municipalities follow unique ordinances, the ordinances generally impose the tax in two ways: (1) by placing the duty to collect and remit the tax on owners, operators, and managers of hotels or hotel rooms; and (2) by applying the tax to all persons engaged in the business of renting hotel rooms. Accordingly, the U.S. Court of Appeals for the Seventh Circuit was tasked with determining whether: (1) the OTCs are "operators" of hotels or hotel rooms; (2) the OTCs "own" hotel rooms; (3) the OTCs are "managers" of hotel rooms; and (4) "gross rental receipts" refers to the room rate negotiated between the OTC and the hotel or the full amount the customer pays to the OTC.

In its analysis, the Court refused to certify the four aforementioned questions, instead deciding that the case "involves routine questions of statutory interpretation that this Court is well-equipped to handle". The municipalities focused most significantly the lower court's interpretation of the term "operator", suggesting that an operator is "one who operates or runs a business." However, the Court looked to the plain meaning of the ordinances and found for the OTCs, determining that although the OTCs perform one function of a hotel - namely making room reservations - the OTCs do not perform the function of running a hotel or hotel room. For example, if a hotel contracts with a cleaning service that hires, schedules and pays workers, the cleaning service does not become an "operator" of the hotel. Further, the Court determined that the OTCs clearly do not own the hotels or hotel rooms, because they have no right to possess or use the hotels or hotel rooms and have no independent right to convey them to consumers. Rather, reservations are sent to the hotels and customers can only take temporary possession upon checking into the hotel. Therefore, under the plain meaning of the ordinances, the OTCs do not own the hotels or hotel rooms. Similarly, the OTCs do not manage the hotel rooms because they do not supervise the affairs of the hotels.

The real win for the OTCs, however, is the Seventh Circuit's determination of whether the OTCs were engaged in the business of renting hotel rooms. Because the ordinances do not define "engaged in the business of renting", the Court looked to the commonly understood meaning of "rent", which implies ownership of the hotel rooms. Because the OTCs do not own the hotels or hotel rooms, the OTCs cannot independently grant customers access to the hotel rooms or "rent" the hotel rooms to customers. As such, the Seventh Circuit disagreed with the district court and held that the OTCs are not engaged in the business of renting rooms and are not subject to tax on their service fees.

Fifth Circuit's Focus on the OTCs' "Control" of the Hotels

The Fifth Circuit's November 29, 2017 decision in City of San Antonio v. Hotels.com, L.P., reached a very similar conclusion. Texas municipalities impose a hotel occupancy tax upon "[e]very person owning, operating, managing, or controlling any hotel." Here, the Court immediately dismissed the issues of whether OTCs own, operate, or manage a hotel, and instead focused on whether they "control" it. Although the case addresses 173 Texas municipalities, the ordinances only use two methods for defining the tax base, which are analyzed below as the: (1) Dallas-type ordinances; and (3) San Antonio-type ordinances. First, the Dallas-type ordinances tax "the consideration paid by the occupant of the room to the hotel", which is defined as "the cost of a room in a hotel." In contrast, the San Antonio-type ordinances tax "the consideration paid for a sleeping room" or the "total price of a sleeping room or sleeping facility" including "all goods and services provided by the hotel."

At the district court level (and after a jury trial that included 38 witnesses and over 150 exhibits), the jury determined that the OTCs "control" hotels and awarded the Texas cities $84,123,089 in unpaid taxes, interest and penalties. On appeal, the OTCs made two primary arguments: (1) they do not "control" hotels within the meaning of the ordinances; and (2) only the discounted room rate the OTC pays the hotel, rather than the retail rate paid the OTC by the traveler, is the taxable "cost of occupancy." In reaching its holding, the Fifth Circuit determined that the OTCs do not have rooms or occupancy, but instead have websites that provide information. Accordingly, under both the Dallas-type and San Antonio-type ordinances, only the discounted room rate paid to the hotel is the cost of occupancy. For example, the San Antonio-type ordinance taxes the amount "paid for a sleeping room" which includes "all goods and services provided by the hotel." Only the discounted rate paid to the hotel covers "services provided by the hotel" and as such, the Fifth Circuit held that only the discounted room rate the OTC pays the hotel is the taxable "cost of occupancy."

Additional Considerations

The immediate implication of the Fifth and Seventh Circuit decisions is that municipalities in both circuits will be unable to impose hotel occupancy taxes on the service fees that OTCs charge for facilitating hotel reservations. However, the ultimate implications exceed the scope of municipal hotel occupancy taxes.

For example, in an effort to stay competitive, retailers are increasingly turning to the internet and third-party resellers to market the sale of their goods and services. However, despite outdated ordinances that fail to address these contemporary resale structures, various municipalities in Illinois have recently become increasingly aggressive in their imposition of other local taxes upon service fees. Similar to an OTC, a third-party ticket reseller arguably does not own, operate, manage, control, or engage in the business of operating the theater, stadium, or other venue to which they sell tickets.

As a result, the decisions by the U.S. Court of Appeals for both the Fifth and Seventh Circuits signal not only the perspective of the courts on the applicability of municipal hotel occupancy taxes on service fees but could mark the beginning of a wave of decisions in favor of the nontaxability of service fees of third-party resellers. 

© Horwood Marcus & Berk Chartered 2017. All Rights Reserved.

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About this Author

Samantha Breslow, Horwood Marcus Law Firm, Multistate Tax Litigation Attorney
Associate

SAMANTHA K. BRESLOW is an associate with Horwood Marcus and Berk Chartered where she focuses her practice on multistate tax litigation and planning. Samantha resolves state and local tax controversies for a wide array of clients, including Fortune 500 corporations, investment partnerships, and high net worth individuals. She advises clients on a range of state and local tax topics, including sales and use tax, franchise tax, corporate income tax, personal income tax, gross receipts tax, and unclaimed property.

Samantha received her J.D. from the University of...

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Breen Scheller, Tax Attorney, Horwood, Marcus and Berk Law Firm
Partner

Breen M. Schiller is a partner at Horwood Marcus and Berk Chartered where she concentrates her practice in state and local tax planning and the resolution of state and local tax controversies for multi-state and multi-national corporations.  She advises Fortune 500 companies as well as mid-size and closely-held businesses on issues related to all types of state and local tax, including income tax, sales/use tax, franchise tax, public utility and motor fuel taxes, transaction taxes, gross receipts-based taxes and unclaimed property.

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