Trouble in travel land

(Fortune Magazine) -- Class-action lawyers are offering cash-strapped municipalities a new way to fill their dwindling coffers: sue online travel companies like Expedia, Hotels.com, Orbitz, Priceline and Travelocity.

The argument is that online travel companies (OTCs) have not been paying enough local occupancy taxes on the hotel rooms they help sell, so those companies owe back taxes to nearly every state, county, and municipal treasury in the country. The class-action bar is making the offer compelling. If its case fails, the municipality loses nothing. If it prevails, the government gets a few million dollars, and the lawyers take about 30%.

More than 40 municipalities in 18 states have filed suit so far, though the results to date have been mixed. At least four federal courts, including one federal appeals court, have dismissed the cases after concluding that no such taxes were owed. However, a San Antonio federal judge certified a class of 175 Texas municipalities last May in a case scheduled to go to trial in June. Meanwhile, in February, the city of Anaheim leveled a $21 million assessment for back taxes against seven OTCs that have all filed suits challenging it.

Here's what all the fuss is about. Say a customer walks into a hotel and rents a $100 room for the night. On the bill, of course, the hotel will add a charge representing whatever the local town's occupancy tax is - let's say 6%. In this example, the customer pays $106, and the municipality gets $6. Now suppose the same customer rents the same room using an online travel company. The OTC and hotel typically have a deal under which the OTC agrees to list the room at a minimum retail price fixed by the hotel - say, again, $100 - though the hotel will only actually charge the OTC a discounted rate, say $80. The difference between the tax on $100 and $80 is the crux of the dispute.

The actual room rental paid by the OTC to the hotel is $80, so the OTCs treat that discounted price as the one subject to the local occupancy tax. The other $20, they argue, is compensating the OTC for its online services, not the hotel for its room. Accordingly, the OTC remits only $4.80 in taxes (6% of $80) to the hotel, which, in turn, forwards that sum to the municipality. So this time the customer still pays $106, but the municipality gets only $4.80 instead of $6.

It's never been a secret that OTCs operate this way. In fact, Steven D. Wolens, the attorney who brought the first of these cases, acknowledges that he first came across the issue while poring over an OTC's SEC filings. Wolens, a partner at the Texas law firm of McKool Smith, represents San Antonio, San Diego, Anaheim, and Broward County, Fla. (Earlier this year Broward County and Anaheim were sued by OTCs seeking to overturn assessments.)

The strength of any one municipality's claim will depend on how its local ordinance is worded. If the law imposes a tax only upon "hotel operators," for instance, then the OTCs have a strong case that they're not covered. If, on the other hand, the tax is applied to "managing agents," "vendors," or "anyone who receives consideration for renting a room," then the municipalities have stronger arguments.

The assessment cases have an additional wrinkle to them - one that has some short-sellers excited. Many municipalities have so-called pay-to-play rules, under which a tax assessment must first be paid before it can be challenged in court. The shorts are hoping that if a critical mass of cities started hitting the OTCs with assessments protected by pay-to-play rules, the companies could go bankrupt before they ever got their day in court.

Meanwhile, the OTCs have been challenging what they see as the encroachment of contingent-fee lawyers into the realm of public tax-law enforcement. "We don't think someone should be involved who has a direct financial interest in the outcome," says Darrel Hieber of Skadden Arps Slate Meagher & Flom, an outside lawyer for Priceline. "If a traffic cop was getting 30% of the ticket, how many tickets would he write?"