State Tax Update: The Shift from Cost of Performance to Market-Based Sourcing
By Evan Gallagher, Tax & Business Services Staff Accountant
One of the current shifts in state and local income tax has been the adoption of market-based sourcing for assigning service-based revenue and income from the use of intangibles to a particular state. Many states have enacted legislation to adopt market-based sourcing for tax years 2013 or later, creating additional tax revenue for these states from out-of-state service providers servicing in-state customers.
Cost of Performance vs. Market-Based Sourcing
Most states have historically utilized the Cost of Performance method for purposes of apportioning service revenue to a particular state. The cost of performance method is defined in Section 17 under the Uniform Division of Income for Tax Purposes Act (UDITPA). The rule states service revenue is apportioned to the state where the income-producing activity is performed. It is important to note that it must be the taxpayer’s income-producing activity and not someone else, such as an independent contractor, acting on behalf of the taxpayer. If the income-producing activity is performed across multiple states, the revenue is apportioned entirely to the state in which the greatest proportion of the revenue was earned.The greatest proportion is determined by the cost incurred to generate the revenue.Often, cost of performance is looked at as an all or nothing type sourcing rule because the majority state gets assigned all of the revenue whereas the minority state receives no allocation. Generally, the cost of performance method was not difficult to follow as it only focused on the efforts and locations of the taxpayer’s own employees.The location of the recipient client is not a factor in apportioning service revenue.
Market-based sourcing brings about a complete shift in methodology and allocates the service revenue to the state in which the benefit of the service is received and will subsequently be used. Service revenue is defined as any revenue other than sales of tangible personal property and does include revenue from and sales of intangible assets in some states. Under this statute, the destination of the service revenue is relevant rather than the location where the revenue was earned. Thus, market-based sourcing allows states to tax out-of-state service providers with customers within the respective state.
It is important to note the statutory language used in determining assignment of the service revenue for each state. States assign service revenue to in various ways: the state where the “benefit of the service” is received; the state where “the service is received”; the state where the “customer” is located; or the state where the “service is delivered.” The statutory language of each market-based sourcing state can be found at the end of this article.
The income-producing activity of a company can also impact the tax implication that market-based sourcing has.Service companies generally follow the rules outlined above. Holding companies often hold intangible assets, which can be treated differently across various states.For example, royalty receipts are traced to where the IP is used and they are taxed in that state.Software, which qualifies as a particular type of service, does not follow the same cost of performance and market-based sourcing rules at all times either.Furthermore, the newly adopted market-based sourcing rule in Massachusetts offers different sourcing treatments for in-person services vs. professional services and for services delivered to the customer vs. services delivered electronically.
Tax-Free or Double Taxation Possible
Many of the states that have adopted market-based sourcing regulations have also adopted a single factor sales apportionment method.In this situation, states calculate the overall apportionment percentage by taking the sales assigned to the state and dividing that number by total sales. Single factor apportionment can create a loophole in which a taxpayer pays no tax on a portion of their service revenue. This scenario occurs when the company’s home state is a market-based sourcing state with single sales factor and the destination state is a cost of performance state with single sales factor apportionment. The revenue would not be assigned to the home state since the service was delivered to an out-of-state customer. Additionally, the revenue would not be sourced to the destination state since the income-producing activity was performed outside of that state. Effectively, this is a tax-free transaction since both states would be allocated zero revenue from this service. It is important to note that, assuming nexus was established, the destination would still require a tax return to be filed even though there is no tax due.
Taxpayers should not get too excited as there is also a possibility for service revenue to yield double taxation across states. For example, a taxpayer located in a cost of performance state could provide a service for a customer located in a market-based sourcing state.Let’s assume that both states have a single sales factor apportionment methodology.If the majority of the income-producing activity is performed in the home state, the taxpayer would source the entire service revenue from that transaction to the home state on its home state tax return.Additionally, the taxpayer would have to source the entire revenue from that service to the state of the customer location.In this case, the same service revenue from this one transaction is being taxed in two different states. Double taxation is also possible with no cost of performance states involved. This is due to the unique intricacies of each state’s market-based sourcing rule.
These strange and unique results will continue to arise until all states have chosen to adopt some form of market based sourcing.
Performance of Services and Nexus
The market-based sourcing method’s impact can be clearly identified when comparing it with tangible personal property sales. Long-established Public Law 86-272 governs sales of tangible personal property throughout the United States.Generally, P.L. 86-272 says that no state has the power to impose it’s income tax on an out of state seller of tangible personal property, if the only activity that the seller has in the respective state is sales to customers located in that state and that the company’s activities do not exceed “mere solicitation”. If the company has no other activity in the state, it does not have “nexus.”States have battled as to what types of activities may exceed the protection afforded under P.L. 86-272 but that is beyond the scope of this article. Under P.L. 86-272, a merchant located in Illinois, for example, would not be subject to income tax on a sale of tangible property to a customer in Indiana as long as it has no connection to or presence in Indiana other than this sale.
For a company generating service revenue, there would also be no income tax in Indiana as a result of a service performed mostly in Illinois for an Indiana customer.As long as a majority of the income producing activity occurred in Illinois and only a small portion of the activity occurred in Indiana, the service provider would have no Indiana income tax liability as a result of this service revenue, since Indiana follows the cost of performance rules for receipts from services. However, if the merchant located in Illinois had a customer located in Wisconsin, a market-based sourcing state, and performed a small portion of the services in Wisconsin, the merchant would be subject to Wisconsin income tax and all receipts from the Wisconsin customer would be includible in the merchant’s Wisconsin sales factor for apportionment.It must be emphasized that none of these market-based sourcing rules apply for a particular state unless nexus has been established with that state.
Impact of Market-Based Sourcing on States and Companies
The impact of the market-based sourcing is twofold.For states that have adopted market-based sourcing, they are now able to tax out-of-state service providers, as mentioned previously. In essence, states are eliminating the loophole of the all or nothing scenario that occurs with cost of performance and ensuring themselves a portion of any service revenue generated from customers within their state. In addition, since the sales factor within the home state drops as a result of market-based sourcing methods, in-state companies enjoy smaller tax burdens within their home state.States lose out on income tax revenue from in-state companies due to the lower apportionment figures, but the states generate more income tax revenue from out-of-state companies performing services within their boundaries. These states could also become more attractive for companies looking to establish branches or offices within a new state. States also expect their tax revenues to increase since the pool of taxable sales increases with market-based sourcing.
The companies (or individuals) providing the service are also impacted by the change.Companies will have lower taxable income in their home state since service revenue is no longer entirely assigned to their home state. Depending on the tax rate of the home state relative to destination states, this shift could be either an advantage or a disadvantage for the company.On the other hand, the out-of-state tax burdens will likely increase.
When coupled with the continued presence of cost of performance regulations, market-based sourcing’s emergence has made tax treatment of service revenue more complex.It is important to note nexus must be established before market-based sourcing rules may be applied by a particular state. The combination of both sourcing methods has the potential to produce to both tax-free and double-tax transactions. Slight variations in each state’s specific market-based sourcing rule can produce double taxation among market-based sourcing states. In addition, the type of service and how it’s delivered to the customers can impact the treatment of the service revenue.These possibilities have made it paramount to develop a sourcing strategy in order to avoid double taxation.Since market-based sourcing generally lowers home-state tax revenues, states have become more aggressive in sourcing revenue from out-of-state service providers, especially when it yields additional tax revenues.Please contact your Marcum tax advisor should you have any questions or concerns regarding the tax implications of this new and evolving state tax apportionment methodology.
The following states have enacted Market-Based Sourcing for receipts from services as of June 5, 2014:
- Receipts from services are included if the service is delivered to a location within Alabama.
- If the locality where the service was delivered cannot be determined, if it is reasonably approximated to Alabama, then it is includible in Alabama.
- Throw-out rule applies
- Market-based sourcing is being phased in on an elective basis beginning with the 2013 tax year & it will take full effect in 2016 tax year.
- Receipts from services are assigned to Arizona if “sales are received by the purchaser in this state”.
- If the locality where the service was delivered cannot be determined, the service will be deemed to be received at the home of the customer or the office of the customer from which the service was ordered.
- Individual customers: the benefit of the service is presumed to be received at the customer’s billing address.
- Businesses: the benefit of the service is first presumed to be received at the customer’s location indicated in the contract or according to the taxpayer’s books and records.
- There are various ways for businesses and individuals to overcome these assumptions using preponderance of evidence.
- Sales are assigned to Georgia if the receipts are derived from customers within Georgia or if the receipts are attributable to the state’s marketplace.
- A customer within Georgia is defined as one that maintains a regular place of business within or Georgia or has a Georgia billing address.
- If the customer receives only a portion of the benefit of the service in Georgia, the gross receipts are assigned to Georgia proportionately.
- Services are assigned to Illinois if they are received in the state.
- If the state where the corporation, partnership, or trust is not readily determinable, or if the customer does not have a fixed place of business within Illinois, the services are deemed to be received at the office from which the customer ordered the services.
- Throw-out rule applies.
- Gross receipts are assigned to Iowa “in proportion to which the recipient of the service receives benefit of the service in Iowa”.
- Receipts from services are assigned to Maine if they are received in the state.
- If the locality is not readily determined, the services are deemed to be received at the office where the services were ordered or, if that cannot be determined, then the office to which they were billed.
- There are special rules if the purchaser of the service is the Federal Government.
- Gross receipts are assigned to Maryland if the receipts are “derived from customers within Maryland”.
- A customer is considered to be within Maryland if the business is domiciled in Maryland
- A business is domiciled in Maryland if the office or place of business that has the principal impetus for the sale is located in Maryland.
- Special rule: if the service relates to the construction or improvement of real property, then the property’s situs determines whether a customer is “within Maryland”.
- Effective January 1, 2014
- Receipts from services are assigned to Massachusetts to the extent the service is delivered to a location in the state.
- Throwback rule applies.
- Services are assigned to Michigan to the extent that the recipient receives the benefit of services in Michigan.
- If the recipient of services receives only a portion of the benefit in Michigan, the receipts are assigned proportionately.
- Services are assigned to Minnesota if they are received at the customer’s fixed place of business in the state.
- If this is not readily determinable or the customer does not have a fixed place of business, the services are deemed to be received at the office from which the customer ordered from the service.
- Implemented for tax years after 2013
- Receipts from services are assigned to Nebraska if the receipts are derived from a buyer within Nebraska.
- These receipts are derived from a buyer in Nebraska if:
- they relates to real property within Nebraska
- they relates to tangible personal property located in Nebraska
- they are provided to an individual physically present in Nebraska
- they are provided to a buyer engaged in a trade or business in Nebraska and they relate to that part of the trade or business operated in Nebraska
- Effective January 1, 2015
- Receipts from services are assigned to New York if the benefit is received in New York or the delivery destination is within New York
- Commercial Activity Tax
- Gross receipts are assigned proportionately based on the benefit received in Ohio vs. the benefit received everywhere.
- The physical location where the purchases ultimately uses or receives the benefit is crucial in determining the proportion allocated to Ohio.
- Receipts from services are assigned to Oklahoma if the receipts are derived from customers within Oklahoma or if the receipts are attributable to the state’s marketplace.
- “Customers within the state” means maintaining a regular place of business within or Oklahoma or, in the case of individual customers, having an Oklahoma billing address.
- Effective January 1, 2014
- Receipts from services are sourced to Pennsylvania if the service is delivered to location in the state.
- If the service is delivered to both Pennsylvania and other states, the sale is in Pennsylvania to the extent of the proportionate total value of the service.
- If the state to which the service was delivered cannot be determined, the service is deemed to be delivered at the customer’s billing address.
- Receipts from the performance of a service are assigned to Utah if the purchaser of the service receives a greater benefit of the service within Utah than in any other state.
- Receipts from services are assigned to Wisconsin “if the purchaser of the service received the benefit within Wisconsin.”
- If the purchaser of the services receives the benefit across multiple states, it is assigned to Wisconsin proportionately.
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