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.”
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.
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