New Developments in Sourcing Services for Telecommunication Companies

By Glenn C. McCoy Jr., J.D., and Pietro M. Stuardi, CPA, Holtz Rubenstein Reminick LLP, New York, NY

Editor: Alan Wong, CPA

State & Local Taxes

In an economy based more and more on services and the internet, the proliferation of technology-based businesses has undermined some of the historical concepts defining state taxation, posing a significant challenge for local authorities to adapt and redefine the principles governing revenue sourcing and apportionment. The issue is particularly acute in the sourcing of service revenues of businesses operating in multiple jurisdictions. A recent decision of the Massachusetts Appellate Tax Board found in favor of a communication company that excluded the receipts collected from its customers in the Commonwealth from the sales numerator of its apportionment factor because the majority of the costs underlying the services resulting in the receipts were attributable to activities performed in another state.

Many states imposing a corporate income tax have adopted the standard cost of performance apportionment formula enacted in the Uniform Division of Income for Tax Purposes Act (UDITPA) or have enacted similar legislation. UDITPA Rule 17 provides that receipts from sales other than sales of tangible personal property are sourced to the state if “a greater proportion of the income-producing activity is performed in this state than in any other state, based on costs of performance.” Identifying the activities that generate service revenue may be fairly straightforward in traditional service industries, but it becomes a much more burdensome and controversial task in industries such as telecommunications, broadcasting, and internet-based services.

Over the past few years, the cost of performance method of apportionment has been criticized on the premise that it fails to capture as a part of the formula the contribution of the local market where the services are directed but not necessarily performed. The recent trend in state taxation has been the introduction of market-based sourcing rules for services. (At this writing, the following states have adopted a market-based approach for apportionment of the sales of services: California (effective in 2011), Georgia, Illinois, Iowa, Maine, Maryland, Michigan, Minnesota, Ohio, Utah, and Wisconsin.) Under this approach, receipts are sourced to the state where the services or benefits are received, regardless of where the underlying activities that produced those services or benefits are performed.

The A T&T Decision

During the tax years at issue (1996–1999), AT&T, a New York corporation headquartered in New Jersey, provided interstate and international voice and data communication services to a vast client base, which included its customers located in Massachusetts. In October 2005, AT&T filed amended franchise tax returns in Massachusetts for the years 1996–1999, claiming that the proper apportionment of its sales under the statutory cost of performance rule resulted in a reduction of the tax liability originally reported and claiming a refund in excess of $2 million. Upon the Massachusetts Commissioner of Revenue’s denial of the application for refund, AT&T filed its petition with the Massachusetts Appellate Tax Board (the board).

In AT&T’s view, the income-producing activity creating the revenue stream from its customers—including its customers in Massachusetts—was “its business of providing a national, integrated telecommunications network, which it operated and managed from its Global Network Operations Center” located in New Jersey ( AT&T Corp. v. Commissioner of Rev. , Dkt. No. C293831 (Mass. App. Tax Bd. 6/8/11)). In order to maintain and operate its network, the communication company engaged in a number of activities and processes such as maintaining infrastructures, operating routing and rerouting transmissions, and managing network failures and congestions. According to AT&T, under this operational approach, the costs of the activities incurred in New Jersey were greater than the costs incurred in Massachusetts and therefore should be apportioned to New Jersey rather than Massachusetts.

Massachusetts contended that the income-producing activity had to be analyzed under a transactional approach—i.e., on a single transaction basis. In the Commissioner of Revenue’s opinion the “greater costs of performance” of AT&T’s activities were performed in Massachusetts as they related to servicing AT&T’s Massachusetts customers, so such receipts should have been included in the numerator of the apportionment formula and taxed as Massachusetts receipts. The statute in effect during the tax year at issue prescribed that receipts from sales other than the sale of tangible personal property (i.e., sale of services) were sourced in Massachusetts if a greater portion of the income-producing activity was performed in Massachusetts than in any other state, based on cost of performance (MA Gen Laws ch. 63, §38(f)). Thus, when a taxpayer is engaged in the sale of services, the calculation of its sales factor requires, as a first step, the determination of the taxpayer’s income-producing activity. Then, the costs of performance of such activities must be analyzed to determine if the taxpayer incurred more of those costs in Massachusetts than in any other state. Under the Massachusetts regulation, an “income-producing activity” is “a transaction, procedure, or operation directly engaged in by a taxpayer which results in a separately identifiable item of income” creating “an obligation of a particular customer to pay a specific consideration to the taxpayer” (830 MA Code Regs. 63.38.1(9)(d)(2)).

The board has interpreted this regulation in numerous previous cases. Each of those cases emphasized the contribution of the centralized activities performed at the taxpayers’ headquarters versus the cost of performance of services provided to customers located out of state. For example, the Boston Bruins hockey club was prevented from excluding from the sales numerator the receipts collected at its away games because the activities of negotiating contracts for players and broadcasters, maintaining media relations, and other managing operations conducted in Boston were considered an integral part of the benefit package that compelled the customers to pay for the Bruins’ game tickets ( Boston Professional Hockey Ass’n v. Commissioner of Rev ., Dkt. No. F250820-23 (Mass. App. Tax Bd. 6/30/03), aff’d, 820 N.E.2d 792 (Mass. 2005)).

Similarly, a tour operator headquartered in Massachusetts could not analyze the cost of performances for vacation packages in the Caribbean on a per-trip basis. Instead, the activities centrally performed at the main offices, such as negotiating accommodations in bulk at competitive prices, were an integral factor in the taxpayer’s income-producing activity of selling discounted travel packages and had to be weighted in determining the cost of performance ( The Interface Group v. Commissioner of Rev. , Dkt. No. C266670-76 ( Mass. App. Tax Bd. 10/17/08), af f ’d, No. 08-P-1861 ( Mass. App. Ct. 12/8/09)).

Application of the Operational Approach

In the AT&T decision, the board determined that the operational approach best suited the income-producing activity analysis required by the Massachusetts statutes. The board relied on the evidence presented by AT&T that a single user connection could not be separately analyzed without taking into account the integrated system of communication that AT&T maintained.

[T]he Board found that AT&T’s income-producing activity was not the connection of an individual transmission over a specifically designated wire. Through detailed and convincing evidence, [AT&T] instead established that [its] income-producing activity was providing a long-distance transmission service by means of operating a complex and comprehensive net work that routed and completed those transmissions, very often over unpredictable paths that were not necessarily the shortest geographic distance. Simply put, AT&T could not provide its long-distance service without operating its entire long-distance network. [ AT&T Corp ., slip op. at 2011-549]

In rejecting the Commissioner of Revenue’s transactional approach, the board emphasized the integrated nature of the long-distance network, in which each transmission was routed and rerouted through switching points located all over the country based on current traffic patterns. So, for example, in conditions of heavy traffic, “a transmission originating in Boston and destined for Atlanta could actually travel by way of a switch located in Los Angeles.” Given the frequency and unpredictability of this cross-country routing, the tracking of the exact path of each of the millions of transmissions would have been an extremely burdensome, if not impossible, task for AT&T to perform. The board concluded that a micro-level analysis of each transmission was not appropriate in determining AT&T’s cost of performing its business and would also have imposed an undue burden on AT&T.

Furthermore, the board noted that the use of the operational approach was consistent with its prior decisions that recognized the importance of the costs incurred at a taxpayer’s headquarters. The board had consistently rejected the adoption of a transactional approach when its application would underestimate the costs of the income-producing activities performed in the Massachusetts headquarters, as in the case of the Bruins’ away games. In turn, the board noted that “[t]he Commissioner cannot have it both ways and argue for the transactional approach when the taxpayer’s headquarters happen to be located outside of the Commonwealth” (AT&T Corp., slip op. at 2011-551).

The board was satisfied with the cost analysis that AT&T presented showing that the costs attributable to the essential network processes conducted in New Jersey were greater than the cost of performances attributable to Massachusetts, and it decided in favor of AT&T.

Planning Considerations

While consistent with prior decisions on the cost of performance methodology, the AT&T decision is relevant for its application to the telecommunication industry. Indeed, the operational approach may be applied to a broad range of nontraditional service providers and IT businesses. When services are provided that affect millions of transactions disseminated through a multi-location network, such as broadband, the telephone network, or the internet, the application of an integrated view of the income-producing activity may have an impact on the sourcing of revenue in states that currently adopt the cost of performance methodology.


The AT&T decision in Massachusetts confirms that effective planning and recordkeeping in the apportionment area, characterized by nonuniform statutes, call for an in-depth understanding of a taxpayer’s business model, including technology-based processes and the related cost accounting systems used, in order to source revenues to the appropriate jurisdiction.


Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.

For additional information about these items, contact Mr. Wong at (212) 697-6900, ext. 986, or

Unless otherwise noted, contributors are members of or associated with DFK International/USA.

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