February 15, 2023

Florida Circuit Court Rules on Sourcing of Florida Sales for Corporate Income Tax Sales Factor Apportionment

By John Bonk, Partner, National Co-Leader - State & Local Tax & Zakariya Hussain, Supervisor, Tax & Business Services

Florida Circuit Court Rules on Sourcing of Florida Sales for Corporate Income Tax Sales Factor Apportionment State & Local Tax

While Florida may have developed a reputation as a state that does not impose individual income taxes on its residents, certain entities receive no such favor in the sunshine state. Income earned from S-Corporations, C-Corporations, and Partnerships is subject to taxation in Florida.

Calculating the income tax in the state of Florida is generally determined by multiplying an entity’s adjusted federal taxable income by an apportionment percentage and then further multiplying the resulting state taxable income by the appropriate tax rate. For purposes of this calculation, the apportionment percentage is a fraction most commonly based upon factors consisting of a percentage of the taxpayer’s property, payroll, and sales in a particular state over the taxpayer’s total property, payroll, and sales everywhere.

The sales factor component of the apportionment calculation can often be a cause of confusion for certain business entity types as sourcing sales of intangible property typically requires extra analysis. These sales are most commonly determined by either a Market-Based sourcing method, essentially sourcing sales to where the benefit of the intangible or service is received or located, or a Cost of Performance method, sourcing sales to the location where the costs related to the intangible or service are incurred.

The determination of which sourcing method to use can be complicated, and rulings often differ from what you would typically expect from reading the plain language of the tax code.

Florida tax law, specifically Code Ann. § 12C-1.0155(2)(e) delineates the sourcing of services for Florida purposes to be ostensibly based upon a Cost of Performance method, stating that:

[i]f services relating to a single item of income are performed partly within and partly without Florida, the gross receipts for the performance of such services shall be attributable to Florida only if a greater portion of the services were performed in Florida, based on costs of performance.”

However, rulings from the state have historically taken more of a market-based approach, often concluding that the sourcing of sales other than tangible personal property should be sourced to the location where the customer receives the benefit of the transaction. As a result of this incongruency between the plain language of the statute and the actual application of the tax code by the courts, a taxpayer or tax professional who just pulls a chart from research software or who plainly reads the statute would not have a reason to assume that the state would source the receipts any way other than Cost of Performance and could easily apply an incorrect sourcing method when calculating the sales factor component of their apportionment factor.

Unfortunately for taxpayers, sourcing matters. Depending on the taxpayer’s business, utilizing different sourcing methods for receipts from sales can result in drastically different tax consequences. Take the example of transactions involving a Market-based state, such as Maryland, and a Cost of Performance state, such as Virginia. A Virginia company with employees providing services to a Maryland customer and incurring over half of the costs of generating the revenue from the transaction within Maryland would source revenue from such a sale to Maryland from both a Cost of Performance and a Market-based approach. However, in a scenario where all of the work was instead conducted remotely from Virginia for the Maryland customer, then under the Market-based approach all of the revenue from the sale would still be sourced to Maryland. Under the Cost of Performance method all of the revenue from the transaction would instead be sourced to Virginia.

This sourcing issue was recently considered by the Circuit Court of Florida’s Second Judicial Circuit in Target Enterprise, Inc. v. Fla. Dept of Rev. (“Target Enterprises”) on November 28th, 2022. In Target Enterprises, the Court abated an assessment from the Florida Department of Revenue, siding with a Target subsidiary that claimed receipts from its sale of services should be attributable to Minnesota, the state where the majority of its payroll costs were incurred during the relevant tax periods, and not the state of Florida.

The Florida Department of Revenue (“DOR”) had concluded an audit of the subsidiary’s fiscal years ending January 31st of 2017, 2018, and 2019, contending that the subsidiary was required to use an alternative apportionment method attributing its service receipts to Florida based on a fraction, the numerator of which was the retail square footage of Target stores in Florida and the denominator of which was the retail square footage of Target stores across the country. The subsidiary argued that the DOR’s administrative rules required sourcing to be conducted based on a Cost of Performance method whereby sourcing would be determined based on the location of the costs to perform those services. However, the DOR ultimately issued an assessment against the subsidiary for additional corporate income taxes owed as a result of the application of its alternative apportionment framework.

Holding that arguments regarding the insufficiency of documents provided to the auditor were not supported in the record, the Court went on to rule that sufficient documentation existed in the form of the subsidiary’s payroll apportionment worksheets and related documents to support the implementation of the state’s Cost of Performance sourcing rule. Moreover, the Court held that the DOR’s alternative apportionment method, based on retail square footage of Target’s retail stores within and without Florida, conflated the activity of the parent corporation (Target) with the subsidiary’s business activity and found that it must therefore be rejected in favor of the Cost of Performance method prescribed under Florida’s administrative code, as the subsidiary constituted “a distinct legal entity, separate and apart from Target.”

While the Court’s ruling was primarily concerned with the application of the DOR’s alternative apportionment method to the Target subsidiary’s business activities and the documentary support issues raised by the DOR, the Court’s decision in this case nevertheless provides important guidance for Florida taxpayers required to source receipts from the sale of services within the state. Tax conclusions related to how to source receipts could differ dramatically depending on the facts of each particular taxpayer. Maintaining sufficient evidence and support for the sourcing methodologies used appears to be a key factor in this decision and serves as a warning for taxpayers who take sourcing positions that are not property supported by research and the requisite evidentiary documents.