Apportionment Using Market-Based Sourcing Rules: A State-by-State Review

EXECUTIVE SUMMARY

More and more states are requiring multistate corporate taxpayers to apportion sales of services using a market-based sourcing method instead of a cost-of-performance method. Under a market-based approach, sales of services are assigned to the state in which the services or benefits of the services are received or delivered, or where the customer or marketplace is located. Most states that have adopted market-based sourcing are requiring or allowing taxpayers to use single-factor sales apportionment formulas to apportion sales among the various states in which they do business. The specific rules for market-based sourcing can vary widely from state to state and, within a particular state, may vary by industry.

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A major trend in state corporate income taxes is the adoption of market-based rules for sourcing sales of services in lieu of the traditional Uniform Division of Income for Tax Purposes Act (UDITPA) cost-of-performance rule. Under UDITPA Section 17, for purposes of computing the sales factor, sales of services are assigned to the state in which the income-producing activity is performed. If the corporation performs the income-producing activity in two or more states, the sale is assigned to the state in which the corporation performs a greater proportion of the income-producing activity than in any other state, based on the costs of performance.

In contrast, under a market-based approach, the corporation assigns sales of services to the state in which the service is received. Thirteen states have adopted market-based sourcing rules for sales of services, as shown in the exhibit.

Another major trend in state corporate income taxation magnifies the importance of using market-based rules for sourcing sales of services: the adoption of a single-factor sales apportionment formula in lieu of the traditional UDITPA three-factor property, payroll, and sales formula. In fact, most of the states that use market-based rules for sourcing sales of services have also adopted a single-factor sales apportionment formula. Examples include California (elective), Georgia, Illinois, Iowa, Maine, Michigan, Minnesota (post-2013), Utah (post-2012, for certain industries), and Wisconsin.

This article discusses issues in applying market-based sourcing rules and looks at how those rules work in the states that have adopted them.1

Statutory Language

The exhibit summarizes the statutory or regulatory language used by the states that have adopted market-based sourcing rules for sales of services. As the exhibit indicates, a number of states assign sales of services to the state in which the “benefit of the service” is received, whereas other states assign such sales to the state in which the “services are received,” the state in which the “customers” or “marketplace” is located, or the state in which the “service is delivered.”

Issues in Applying Market-Based Sourcing Rules

Issues that commonly arise when applying market-based sourcing rules for sales of services include the following:

• Does the rule vary, depending on whether the customer is an individual or a business entity?
• Is there a presumption where the service is received, e.g., are the services presumed to be received at the customer’s billing address?
• Do the rules permit a taxpayer to prorate a sale among two or more states, or is an all-or-nothing approach required?
• Is there a throwback or throw-out rule if the taxpayer is not taxable in the state in which the service is received or if the state in which the service is received cannot be determined?
• Does a special rule apply if the service is related to real or tangible personal property that is located within the state?

In addition to the general rules for sourcing sales of services, many states have promulgated special rules for taxpayers in certain industries. Typically, these special rules require the use of industry-specific apportionment formulas or industry-specific rules for computing the apportionment factors. Examples of industries for which states often provide specialized apportionment rules include transportation companies (airlines, railroads, and trucking and shipping companies), financial institutions (banks, securities brokers, and mutual funds), broadcasting companies (television and radio), print media and publishing companies, telecommunication companies, pipeline companies, utility companies, construction contractors, and professional sports franchises.

State-by-State Review of Market-Based Sourcing Rules

Alabama

For tax years beginning on or after Dec. 31, 2010, sales of services are included in the numerator of the Alabama sales factor “if and to the extent the service is delivered to a location in this state.”2 If the state in which the service is delivered cannot be determined, it is “reasonably approximated.” Under a throw-out rule, if the taxpayer is not taxable in the state in which the service is delivered or if the state of assignment cannot be determined or reasonably approximated, the sale is excluded from the denominator of the sales factor.

Arizona

Beginning with tax years ending on or after Dec. 31, 2013, Arizona will allow a multistate service provider to elect to source its sales using a market-based rule.3 The new rule is being phased in over several years, and it takes full effect for tax years ending on or after Dec. 31, 2016. A “multistate service provider” is a taxpayer that derives more than 85% of its sales from services provided to purchasers who receive the benefit of the service outside Arizona. In applying the 85% test, a taxpayer excludes sales to students receiving educational services at campuses physically located in Arizona.4

Under the market-based rule, sales of services are assigned to Arizona if “the services are received by the purchaser in this state.”5 If the state where the services are received cannot be readily determined, the services are deemed to be received at the home of the customer or, in the case of a business, the office of the customer from which the services were ordered in the regular course of the customer’s trade or business. If the ordering location cannot be determined, the services are deemed to be received at the home or office of the customer to which the services were billed.

California

For tax years beginning on or after Jan. 1, 2011, California taxpayers that elect to use a single-factor sales apportionment formula must use a market-based rule to source sales of services. Taxpayers that do not make the election must continue to use the UDITPA cost-of-performance rule to source sales of services. Under the market-based sourcing rule, sales of services are assigned to California “to the extent the purchaser of the service received the benefit of the service in this state.”6

In March 2012, the California Franchise Tax Board published regulations that provide guidance for applying the new market-based rule.7 The regulations apply retroactively to tax years beginning on or after Jan. 1, 2011. The guidance varies, depending on whether the customer is an individual or a business entity.

Customer is an individual: If the customer is an individual, it is presumed that the benefit of the service is received at the customer’s billing address, and the Franchise Tax Board will accept this method of assigning the sales to California. The taxpayer may overcome this presumption by showing, by a preponderance of the evidence, that its contract with the customer or its other books and records provide the location where the benefit of the service is received. The regulations provide the following example of a fact pattern in which the presumption is overcome:

Travel Support Corp located in this state provides travel information services to its customers, who are individuals located throughout the United States, through a call center located in this state. The contract between Travel Support Corp and its customers provides that for a fee per call, the customer can call Travel Support Corp for information regarding hotels, restaurants and other travel related information. Travel Support Corp’s books and records maintained in the regular course of business indicate that fifteen (15) percent of its customers have billing addresses in this state. However, Travel Support Corp’s books and records indicate that only seven (7) percent of the calls handled by the call center originate from this state. Because Travel Support Corp’s books and records show where the benefit of the services is actually received, the billing address presumption is overcome and the books and records of the taxpayer may be used to assign seven (7) percent of the gross receipts from the support services provided by the call center to this state.8

If the taxpayer overcomes the presumption, but the taxpayer cannot derive an alternative method by reference to the contract or its books and records, then the location where the benefit of the service is received is “reasonably approximated.” The term “reasonably approximated” means that, considering all sources of information other than the contract and the taxpayer’s books and records, the location of the market for the benefit of the service is determined in a manner that is consistent with the activities of the customer. Information, including publicly available information, such as population, that is specific in nature is preferred over information that is general in nature. If population is a reasonable approximation, the population used is based on the most recent U.S. census data.

Customer is a business entity: If the customer is a corporation or other business entity, it is presumed that the benefit of the service is received at the location (or locations) indicated by the taxpayer’s contract with the customer or the taxpayer’s other books and records, notwithstanding the customer’s billing address. The regulations provide the following example to illustrate this presumption:

Law Corp located in State C has a Client Corp that has manufacturing plants in this state and State B. Law Corp handles a major litigation matter for Client Corp concerning a manufacturing plant owned by its client in this state. All gross receipts from Law Corp’s services related to the litigation are attributable to this state because Law Corp’s books and records kept in the normal course of business indicate that the services relate to Client Corp’s operations in this state.9

The taxpayer or the Franchise Tax Board may overcome this presumption by showing, by a preponderance of the evidence, that the location indicated by the contract or other books and records is not the actual location where the service’s benefit is received. If neither the contract nor the other books and records indicate where the benefit of the service is received, or if the presumption is overcome, then the location should be reasonably approximated. If the location cannot be reasonably approximated, then it is presumed that the service’s benefit is received at the location from which the customer placed the order for the service. If the location from which the customer ordered the service cannot be determined, then the benefit of the service is received at the customer’s billing address.10

Georgia

Gross receipts are assigned to Georgia “if the receipts are derived from customers within this state or if the receipts are otherwise attributable to this state’s marketplace.”11 The term “customers within this state” means a customer that is engaged in a trade or business and maintains a regular place of business within Georgia, or a customer that is not engaged in a trade or business whose billing address is in Georgia. A “regular place of business” means an office, factory, warehouse, or other business location at which the customer regularly conducts business. A “billing address” means the location indicated in the books and records of the taxpayer as the address of record where any statement or bill relating to a customer’s account is mailed.12

If a customer receives only a portion of the benefit of the service in Georgia, the gross receipts are assigned to Georgia in proportion to the extent the customer benefits from the service in Georgia.13 The regulations provide the following example to illustrate the proportionate assignment of a sale:

A company which owns apartments in Georgia and State A contracts with a pest control corporation for pest control activities. One contract is entered into which covers 100 apartment units in Georgia and 400 apartment units in State A. Twenty percent (100/500) of the gross receipts from the pest control contract are attributable to Georgia and are included in the numerator of the apportionment factor as 20 percent of the apartment units are located in Georgia and in the absence of more accurate records, it is therefore presumed that the number of apartment units is the best measure of the extent to which the recipient of the service received benefit of the service in Georgia.14

Illinois

Sales of services are assigned to Illinois if the services are “received in this State.”15 If the customer is a corporation, partnership, or trust, the sale may be assigned only to a state where the customer has a fixed place of business. If the state where the services are received is not readily determinable or is a state where the corporation, partnership, or trust receiving the service does not have a fixed place of business, the services are deemed to be received at the office of the customer from which the services were ordered in the regular course of the customer’s trade or business.

If the ordering office cannot be determined, the services are deemed to be received at the office of the customer to which the services are billed. Under a throw-out rule, if the taxpayer is not taxable in the state in which the services are received, the sale is excluded from both the numerator and the denominator of the sales factor.

Iowa

Gross receipts are included in the numerator of the Iowa sales factor “in the proportion which the recipient of the service receives benefit of the service in this state.”16 Thus, if the customer receives all of the benefit of the service in Iowa for a specific contract or an item of income, all of the gross receipts are assigned to Iowa. On the other hand, if the customer receives only a portion of the benefit of the service in Iowa, the gross receipts are assigned to Iowa in proportion to the extent the customer receives the benefit of the service in Iowa. If the taxpayer does not believe that this method of apportionment “reasonably attributes” income to business activities within Iowa, it may request the use of an alternative method of apportionment.

Maine

Receipts from the performance of services are assigned to Maine if the “services are received” in Maine.17 If the state in which the services are received is not readily determinable, the services are deemed to be received at the home of the customer or, in the case of a business, the office of the customer from which the services were ordered in the regular course of the customer’s trade or business. If the ordering location cannot be determined, the services are deemed to be received at the office to which the services are billed. A special rule applies if the purchaser of the service is the federal government, in which case the receipts are assigned to Maine if a greater proportion of the income-producing activity is performed in Maine than in any other state, based on costs of performance.

Maryland

Gross receipts from contracting or service-related activities are included in the numerator of the Maryland sales factor if the receipts are “derived from customers within this State.”18 An individual or business enterprise is a customer “within this State” if the individual or business enterprise is domiciled in Maryland. In the case of a business enterprise, the domicile is the state in which the office or place of business that provides the “principal impetus for the sale” is located. If an office or place of business cannot be identified as providing the principal impetus for the sale, then the business enterprise is domiciled in the state in which the headquarters or principal place of management of the business enterprise is located.19 The regulations provide the following example of the principal impetus rule:

Service provider E contracts with corporation F, a multistate enterprise, to redesign all the operating software of F’s multistate computer network. If no particular office or place of business can be identified as the principal impetus for this contract, then the revenue earned from this contract shall be included in the numerator of E’s sales factor only if F’s headquarters or principal place of business management is located within Maryland.20

Under a special rule, if the service relates to the construction or improvement of real property, then the determination of whether the customer is within Maryland is based on the property’s situs.21

Michigan

Receipts from the performance of services are included in the numerator of the Michigan sales factor if the recipient of the services receives the “benefit of the services in this state.” If the recipient of the services receives only a portion of the benefit in Michigan, the sale is assigned to Michigan in proportion to the extent that the recipient receives the benefit of the services in Michigan.22 If it cannot be determined where the benefit to the customer is received, the sale is sourced based on the customer’s billing address.23

According to the guidelines provided by the Michigan Department of Treasury, the benefit of a service is received in Michigan if any of the following apply:

• The service relates to real property located in Michigan.
• The service relates to tangible personal property that is owned or leased by the purchaser and located in Michigan, or is delivered to the purchaser in Michigan.
• The service relates to the use of intangible property, such as computer software (other than prewritten computer software), licenses, designs, processes, patents, and copyrights, which is used in Michigan.
• The service is provided to a purchaser who is an individual physically present in Michigan at the time that the service is received.
• The service is provided to a purchaser that is engaged in a trade or business in Michigan and relates to the trade or business of that purchaser in the state.
• The services are received in Michigan and are in the nature of personal services, such as consulting, counseling, training, speaking, and providing entertainment, that are typically performed firsthand, on a direct, one-to-one, or one-to-many basis.
• The services are professional in nature, such as legal or accounting services, and are provided to a purchaser who is an individual domiciled in Michigan, or to a purchaser with business operations in Michigan.24

The method the taxpayer uses to determine the extent of the benefit received in Michigan must be reasonable in light of all the facts and circumstances and must be uniformly and consistently applied. Furthermore, a taxpayer may not simply use the customer’s location to source a sale of services without first making a reasonable effort, based on its books and records, to determine where the benefit of the service is received.25

Minnesota

Receipts from the performance of services are assigned to Minnesota if the “services are received” in Minnesota.26 If the customer is a corporation, partnership, or trust, the sale may be assigned only to a state where the customer has a fixed place of doing business. If the state where the services are received is not readily determinable or is a state where the corporation, partnership, or trust receiving the service does not have a fixed place of doing business, the services are deemed to be received at the office of the customer from which the services were ordered in the regular course of the customer’s trade or business. If the ordering office cannot be determined, the services are deemed to be received at the office of the customer to which the services are billed.

Oklahoma

Receipts from the performance of services are included in the numerator of the Oklahoma sales factor if the receipts are “derived from customers within this state or if the receipts are otherwise attributable to this state’s marketplace.”27 The term “customer within Oklahoma” means a customer that is engaged in a trade or business and maintains a regular place of business in Oklahoma, or a customer that is not engaged in a trade or business whose billing address is in Oklahoma. “Billing address” means the location indicated in the taxpayer’s books and records as the address of record where the bill relating to the customer’s account is mailed.

Utah

A receipt from the performance of a service is assigned to Utah “if the purchaser of the service receives a greater benefit of the service in this state than in any other state.”28 The Utah State Tax Commission has yet to issue rules to prescribe the circumstances under which a purchaser of a service receives a greater benefit of the service in Utah than in any other state.

Wisconsin

Gross receipts from services are assigned to Wisconsin “if the purchaser of the service received the benefit of the service in this state.”29 The benefit of a service is received in Wisconsin if any of the following applies:

• The service relates to real property located in Wisconsin.
• The service relates to tangible personal property located in Wisconsin at the time that the service is received or tangible personal property delivered to customers in Wisconsin.
• The service is provided to an individual who is physically present in Wisconsin at the time that the service is received.
• The service is provided to a person engaged in a trade or business in Wisconsin and relates to that person’s business in Wisconsin.

If the purchaser of a service receives the benefit of a service in more than one state, the gross receipts from the performance of the service are assigned to Wisconsin based on the portion of the service received in Wisconsin.

States Imposing Gross Receipts Taxes

Ohio and Washington both impose gross receipts taxes in lieu of a conventional corporate income tax and use market-based rules to source sales of services.

Ohio commercial activity tax: For purposes of computing the Ohio commercial activity tax, gross receipts from the sale of services are assigned to Ohio “in the proportion that the purchaser’s benefit in this state with respect to what was purchased bears to the purchaser’s benefit everywhere with respect to what was purchased.”30 The physical location where the purchaser ultimately uses or receives the benefit is “paramount” in determining the proportion of the benefit in Ohio to the benefit everywhere.31

Washington business and occupation tax: For purposes of computing the Washington business and occupation tax, gross receipts from the sale of services are assigned to the state in which “the customer received the benefit of the taxpayer’s service.” If the customer received the benefit of the service in more than one state, the gross receipts are assigned to the state in which the benefit of the service was primarily received. If the taxpayer is unable to determine where the benefit is received, the gross receipts are assigned to a state under the following cascading series of attribution rules:

• The state from which the customer ordered the service.
• The state to which the taxpayer sends the customer’s billing statements or invoices.
• The state from which the customer sends payment to the taxpayer.
• The state where the customer is located as indicated by the customer’s address.
• The commercial domicile of the taxpayer.32

Conclusion

Many states are adopting the market-based sourcing method of apportioning sales of services to a state instead of the UDITPA cost-of-performance method. In addition, most states adopting market-based sourcing require or allow taxpayers to elect to use a single-factor sales apportionment formula. Practitioners should be aware of current law in each state and keep abreast of the many changes likely to come in this area.33

 

Footnotes

¹ Note that some states, such as New York (N.Y. Comp. Codes R. & Regs. tit. 20, §4-4.3) and Texas (34 Tex. Admin. Code §3.557(e)(33)), have moved away from UDITPA’s cost-of-performance rule to source income from services to the state when the services are performed in that state. Because these states base the sourcing of income on where the taxpayer performs the services, rather than where the customer is located or receives the services, they are not considered to be using market-based sourcing and are not discussed in this article.

² Ala. Code §40-27-1.

³ Ariz. S.B. 1046 (2/21/12).

⁴ Ariz. Rev. Stat. §43-1147(D)(3).

⁵ Ariz. Rev. Stat. §43-1147(D)(4).

⁶ Cal. Rev. & Tax. Code §25136(b)(5).

⁷ Cal. Code Regs., tit. 18, §25136-2.

⁸ Cal. Code Regs., tit. 18, §25136-2(c)(1)(C)(2).

⁹ Cal. Code Regs., tit. 18, §25136-2(c)(2)(E)(2).

¹⁰ Cal. Code Regs., tit. 18, §25136-2(c)(2).

¹¹ Ga. Code §48-7-31(d)(2)(A)(i).

¹² Ga. Comp. R. & Regs. 560-7-7-.03(5)(c)(5).

¹³ Ga. Comp. R. & Regs. 560-7-7-.03(5)(c)(6)(ii).

¹⁴ Ga. Comp. R. & Regs. 560-7-7-.03(5)(c)(6)(ii)(VII).

¹⁵ 35 Ill. Comp. Stat. 5/304.

¹⁶ Iowa Admin. Code Rule 701-54.6(422).

¹⁷ Me. Rev. Stat. tit. 36, §5211.

¹⁸ Md. Code Regs. 03.04.03.08(C)(3)(c).

¹⁹ Md. Code Regs. 03.04.03.08(D)(2)(B)(ii).

²⁰ Md. Code Regs. 03.04.03.08(D)(2)(B)(iii), Example 4.

²¹ Md. Code Regs. 03.04.03.08(D)(3).

²³ Mich. Comp. Laws §206.665(2).

²³ Mich. Comp. Laws §206.669.

²⁴ Mich. Rev. Admin. Bull. 2010-5 (5/20/10).

²⁵ Id.

²⁶ Minn. Stat. §290.191, subd. 5(j).

²⁷ Okla. Admin. Code §710:50-17-71(1).

²⁸ Utah Code §59-7-319(3)(a).

²⁹ Wis. Stat. §71.25(9)(dh).

³⁰ Ohio Rev. Code §5751.033(I).

³¹ For detailed rules for sourcing gross receipts from specific types of services, see Ohio Dep’t of Tax., Commercial Activity Tax Information Release CAT 2005-06 (September 2005).

³² Wash. Rev. Code §82.04.462(3)(b).

³³ For a discussion of proposed changes to the Multistate Tax Compact, see the Tax Clinic.

EditorNotes

Michael Schadewald is a tax professor in the Lubar School of Business at the University of Wisconsin–Milwaukee in Milwaukee. For more information about this article, contact Prof. Schadewald at schade@uwm.edu.