Companies that must assign their income or loss among the states they do business in face a daunting task. This is particularly true for those rendering services, selling software, or licensing intangibles. Such businesses must rely on a formula; the key element of which is the sales factor: the ratio of sales within a state to sales everywhere.
There is a trend in which states are migrating from a cost-based sourcing method toward a market-based sourcing method when determining the sales factor. The resulting apportionment changes have introduced new uncertainties to the multistate tax world—one with significant tax implications for service firms, software companies, franchisors, and other types of businesses.
Such taxpayers are required to apportion their tax base among the states in which they have nexus or taxable presence. The goal of apportionment is to allocate an amount of income or loss to each jurisdiction that is proportional to the taxpayer’s taxable activities in the jurisdiction. This can be measured by economic presence, physical presence, or both. In order to apportion income from the sales of “other than tangible personal property” (e.g., software, services, intangibles), states primarily use two approaches to determine the source of the income:
- Cost-of-performance method; or
- Market-based sourcing method.
Cost-of-performance and market-based sourcing concepts
States that use the cost of performance (COP) method generally source sales of other than tangible personal property to the state or states where work activities are conducted. Typically, states that use the COP method assign more income or loss to those taxpayers that run their business operations within the state because they incur a significant portion of their direct costs (e.g., labor, utilities, supplies) within the state. For example, a taxpayer that reports net income and has its location in a COP state will have a larger sales factor and potentially higher tax liability in that state. Currently, about 30 states use the COP method, including Florida, Indiana, Louisiana, New Jersey, Texas, and Virginia.
Alternatively, states that use the market-based method source sales of other than tangible personal property to the state where the customer receives the benefit. The intended effect of the market-based sourcing method is generally to collect more tax from out-of-state businesses with significant economic activity, but little in the way of payroll or property. The specific market-based sourcing rules employed by different tax jurisdictions vary widely from state to state. Market-based sourcing rules can also differ depending on a taxpayer’s industry. For example, receipts from software, patents, franchises, and trademarks may be assigned using a different standard than services like engineering, legal, and architectural. About 20 states apply market-based sourcing rules, including Illinois, Michigan, Minnesota, New York, Ohio, and Wisconsin.
The effect on taxpayers
Despite the larger number of COP states, taxpayers that engage in multistate sales of other than tangible personal property are at high risk of encountering state tax problems. This is a direct outcome of having their income sourced under market-based principles. First, an increasing number of states are making the transition from COP to market-based sourcing models. As noted, this tends to raise revenue from out-of-state companies while reducing adverse tax consequences for in-state taxpayers. The shift in state thinking about apportionment is further evidenced by the fact that the Multistate Tax Commission, a standard-setting body that promotes uniformity and compatibility for significant components of state tax systems, recently adopted model regulations for implementing market sourcing principles. (See “Section 17 MTC Model Market-Sourcing Regulations”.)
Additionally, taxpayers have little published guidance to follow in applying COP to their revenue streams. This makes COP difficult to apply in practice. In fact, state revenue agencies can consider where the benefit of the sale of other than tangible personal property is received (a market-based factor) in determining how to source revenue under the COP method. For example, several state courts, including Tennessee and Wisconsin, have allowed state tax authorities to rely on market-based factors in sourcing taxpayers’ income in applying the COP method. See Vodafone Americas Holdings, Inc. v. Roberts and Ameritech Publishing, Inc. v. Wisconsin Department of Revenue.
Finally, the lack of uniformity among states regarding sourcing of receipts from sales of other than tangible personal property may result in over-apportionment. In other words, depending on the combination of states in which a taxpayer conducts business, income derived from the sale of other than tangible personal property could potentially be sourced in multiple states or no state at all. Thus, a taxpayer’s total tax liability will greatly depend on whether the states in which it has nexus use the COP or market-based sourcing methods.
Consider the following example:
Company XYZ is located and headquartered in State A. State A follows the COP method and sources 100 percent of receipts to the state where the greatest portion of direct costs of performance is incurred.
Company XYZ renders legal services to a client in State B, a market-based sourcing state that assigns receipts where the customer receives the benefit of “sales of other than tangible personal property.”
The direct labor and materials costs incurred are 90 percent in State A, and 10 percent in State B.
Based on the sourcing methods of State A and State B, the revenue from these legal services will be assigned as follows:
- 100 percent to State A, where the greatest portion of costs are incurred; and
- 100 percent to State B, where the customer received the benefit.
- So, 200 percent total receipts will be included in apportionment factors of State A and State B.
Instead, assume that State A uses market-based sourcing, and State B is a COP state, but all other facts remain the same.
Now, based on the sourcing methods of State A and State B, the revenue from these legal services will be assigned as follows:
- 0 percent to State A because the customer received the benefit in State B; and
- 0 percent to State B because the greater portion of direct costs of performance were incurred in State A.
Recommendations for taxpayers engaged in sales of other than tangible personal property
Due to the different methods of computing sales receipts employed by the states, taxpayers cannot depend on collecting and using the same data as they have in the past to calculate the proper taxable amounts for state income and franchise tax compliance. Oftentimes, the accounting and billing systems that taxpayers have in place generate only customer address data or do not allocate job costs by location. They are, consequently, inadequate to compile accurate sales apportionment data for both cost-based and market-based sourcing states.
The following recommendations should assist multistate businesses that sell other than tangible personal property. Reviewing and discussing these recommendations with tax advisors may be helpful:
- Identify all types of income generated by the taxpayer’s business potentially impacted by COP and market-based sourcing;
- Determine which states the taxpayer has nexus and material business operations;
- Map out the sourcing methods the states employ in which the taxpayer has nexus;
- Analyze the type of data the accounting systems can generate relative to each method;
- Quantify the effect on state tax liabilities resulting from applying the sourcing methods in the relevant states;
- Update and enhance accounting and business reporting methods to adequately track revenue sourcing and measure sales. (For example, whether software license fees can be allocated among market states based on where users will access the software.)
In order for multistate businesses to successfully handle the changes in state sourcing methods, many will have to improve and develop their accounting and billing systems. This will be critical to sufficiently track multistate business operations and manage state tax risk.
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.