States New Market-Based Appoach

One of the current shifts in state and local income taxation has been recent adoption of market-based sourcing for assigning service-based revenue and its related income from the use of intangibles to a particular state. Many states have enacted new legislation to adopt market-based sourcing for state franchise and excise (income), creating additional tax revenue from out-of-state service providers servicing in-state customers.
 
Old Cost of Performance vs. the new Market-Based Approach

Frankly, this makes sense. Most states have historically utilized a cost of performance method for purposes of apportioning service revenue to a particular state. The cost of performance method is defined in 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, on the other hand, 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 method, the destination of the service revenue is the driving factor rather than the location where the revenue was actually earned. Market-based sourcing allows states to tax out-of-state service providers. 
 
It is important to note the statutory language used in determining and assignment of the service revenue for each state. States access service revenue in various ways. Samples of the criteria can be 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 income-producing activity of a particular company can also impact the tax implications that market-based sourcing covers.  Service companies generally must look at the criteria cited 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. Software, which often is categorized as a type of service, does not follow the same cost of performance and market-based sourcing rules and are often treated differently. 

Many of the states that have adopted market-based sourcing regulations have also adopted a single factor sales apportionment method now rather than the old two-factor and three-factor appointment methodologies (ie. sales assigned to the state and divided by total sales in all states). Single factor apportionment can create a loophole (or a headache – see later) in which a taxpayer pays no tax on a portion of their service revenue.  This scenario can occur when the home state uses the market-based sourcing approach with single sales factor and the destination state uses the cost of performance approach with single sales factor apportionment.  In this case, 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 company's income-producing activity was performed outside of that state.  Effectively, this is a tax-free transaction.

The aforementioned headache could occur producing double taxation across various 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 where both states happen to use a single sales facto apportionment methodology. If the majority of the income-producing activity is performed in the home state, the taxpayer would be forced to source the entire service revenue from that transaction to its home state, while also being forced to source the same transaction to the state of the customer.

Performance of Services and Nexus

Market-based sourcing obviously has a direct impact on the allocation of tangible personal property sales.  Long-established Public Law 86-272 governs sales of tangible personal property and the assessment of sale taxes throughout the United States. Generally, P.L. 86-272 says that no state has the power to impose its income (excise) 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 is said to 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.

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 by higher overall bills when taxed by other states.  States lose out on income tax revenue from in-state companies due to the lower apportionment factors, but the states generate more income tax revenue from out-of-state companies performing services within their boundaries. 

When coupled with the continued presence of cost of performance regulations, the new market-based approach has made tax treatment of service revenue more much complex. It is important to note nexus must be established first before market-based sourcing rules may be applied.