Netflix, Hulu, and other streaming entertainment providers could be on the hook for millions of dollars in unpaid local utility franchise fees, offering cities and counties a revenue lifeline as consumers cut the cord on cable services and the fees they generate.
Over the last two weeks, municipalities across Texas and Indiana filed suits against Netflix Inc. and Hulu LLC asserting the companies should be paying franchise fees for their use of existing public infrastructure for the delivery of entertainment services. The Indiana lawsuit, filed in state court by Indianapolis and three smaller cities, also included Disney Direct To Consumer LLC, DIRECTV LLC and DISH Network LLC as defendants.
Texas and Indiana argue the streaming entertainment providers should be treated like cable television companies, which have been paying franchise taxes and fees for decades.
“There is a good amount of money lost,” said Scott Houston, general counsel of the Texas Municipal League. “The larger issue is a group of large corporations using public assets, and using them for free.”
Netflix and Hulu couldn’t immediately be reached for comment, but at least one telecommunications tax expert expressed doubts about the municipalities’ legal theory.
“When you think of a Netflix or a Hulu, they obviously aren’t actually in control of any sort of physical infrastructure,” said Toby Bargar, senior tax consultant for communications at the tax software company Avalara. “They aren’t in the public rights of way in a literal sense. They don’t have any control over any activities that would trigger the regulatory concern. That’s presumably going to be part of the defense these companies will raise.”
The suits specify Netflix and Hulu rely on broadband Internet connections located in part in the public rights-of-way to deliver streaming entertainment services to subscribers. In the case of Texas, businesses using this infrastructure are required to obtain a state-issued certificate of franchise authority (SICFA) from the Public Utility Commission and then pay a franchise fee of 5% of gross revenues in each municipality where services are offered.
“Defendants failed to apply for and obtain a SICFA, and are, therefore, providing video service throughout Texas without authorization, and in contravention of the Texas Utility Code,” the lawsuit states.
The class actions mirror a legal theory that first surfaced in 2018 in a suit brought by the City of Creve Coeur, Mo. on behalf of hundreds of Missouri municipalities against Netflix, Hulu, DIRECTV, and DISH Network. A state court judge is currently considering a motion to dismiss filed by the entertainment companies.
Cutting the Cord
The dollars at stake could be substantial in many communities, particularly as consumers continue to cut the cord on their cable television contracts and migrate to streaming services to watch movies, sports, and subscription-based television.
The market research company eMarketer issued a report in March predicting the number of U.S. households using cable and satellite television services would drop from 80.5 million in 2020 to 69.6 million by 2023. Meanwhile, the number of “cord-cutter and cord-never households” will jump from 48.9 million this year to 61.5 million in 2023.
Netflix is picking up a lot of those viewers, particularly during the Covid-19 pandemic. In April the company reported global paid memberships jumped 22.8% to 182.8 million at the end of first quarter of 2020. The company predicted continued growth in subscriptions to 190.3 million during the second quarter of the year.
Across Missouri, local collections from franchise fees paid by the cable companies have declined at least 25% over the last five years, said Richard Sheets, deputy director of the Missouri Municipal League.
“There’s real harm to our municipal revenue sources,” Sheets said. “The streaming companies are providing services in our cities, just like cable. They are using the right of way. But our local revenues are being shipped out of state.”
Stretching Legal Boundaries
Joyce Beebe, a fellow in public finance and tax policy at Rice University’s Baker Institute for Public Policy, said the three lawsuits reflect a broader theme of states and municipalities stretching antiquated tax structures to new technologies in a bid to recapture lost revenue.
Streaming entertainment has been a particularly tough nut to crack, leading to “creative” tax strategies, Beebe said. Recent examples include Florida’s communications services tax, a 7.44% tax on cable, streaming video and music, and Voice-Over-Internet Protocol calling services. Similarly, Chicago has expanded its 9% amusement tax to online video, music and gaming, and California adapted its public utility user tax to streaming entertainment.
“The root cause of the issue, I believe, is the existing tax system is outdated whereas the digital economy is new. Many state and local governments are trying to fit the new products/services into an old tax system,” Beebe said.