A pragmatic approach to sourcing sales of services

By Bridget McCann, CPA

Editor: Jennifer Jensen, CPA


“When was the last time the company reviewed its sales sourcing methodology?”

It is a question tax practitioners frequently find themselves asking taxpayers.

The responses they get vary, but they usually fall into three categories:

  1. Huh? What's sales sourcing?;
  2. We've heard of it, but do we really need to be concerned with it? The business mostly sells "stuff"; and
  3. Yeah, we know it applies to the business and we keep meaning to take a deeper dive into the nuances, but all the rules are hard to keep up with and we're really pressed for time and budget. Besides, all these state tax sourcing concepts are so complex and talking to you state tax people is our least favorite thing to do because you just overwhelm us with excruciating detail.

Perhaps people do not actually say that last part out loud, but it is likely many of them are thinking it.

With that in mind, this column shares a few pragmatic thoughts on the topic for readers who are not self-professed state tax geeks.

What is sales sourcing?

What is sales sourcing? If you have not made it your life's mission to obsess over the gritty details of formulary apportionment, that is a fair question.

As with most things, business was simpler in the days of yore. Folks opened brick-and-mortar stores in their hometown, sold their wares, and paid tax. Done.

However, as businesses began to grow and expand across state lines, state governments struggled to find a way to fairly tax their portion of revenue. This resulted in a hodgepodge of treatment across states.

The Uniform Division of Income for Tax Purposes Act (UDITPA) was developed by the Uniform Law Commission (ULC) in the late 1950s. The act addressed the creation of a uniform way for taxpayers to divide their tax base among multiple states. By the late 1960s, the Multistate Tax Compact (the Compact) was drafted by a broad group of state officials as a way to advise member states of recommendations for creating state tax rules and regulations. UDITPA is Article IV of the Compact.1

This highly technical model law was a game-changer for the world of state tax.

The Compact originally used an equally weighted three-factor formula to measure the activity of a business in a state. The three factors considered were the company's property, payroll, and sales.2 Each factor used a fraction, the numerator of which consisted of the factor's in-state amount and the denominator of which consisted of the factor's total amounts placed in service, paid, or sold everywhere.

Recall that in the late 1960s most businesses were still selling tangible personal property. For this reason, taxpayers determined the amount of sales that should be included or "sourced" to the numerator of their sales fraction by using the destination state of the sale. This methodology, which provided tax revenue for states in which the taxpayer's customers were located, seemed to produce a fair result.

However, for sales of services, it was determined that a different methodology would be required to capture the portion of business a company transacted within a state. As a result, a cost-of-performance rule was created. The rule considered where the income-producing activity underlying the taxpayer's resulting revenue was performed. Most of the service-based economy in the late 1960s would have been personal or professional services; think pre-internet technology lawyers, accountants, and engineers. Determining where the underlying income-producing activity took place would have been a relatively simple endeavor.

The division of income rules contained within the original Compact under Article IV stated that:

Sales, other than sales of tangible personal property, are in this State if:

a) the income-producing activity is performed in the State; or

b) the income-producing activity is performed both in and outside this State and a greater proportion of the income-producing activity is performed in this State than in any other State, based on costs of performance.

Fast-forward 50 years and the U.S. economy has significantly shifted. As anyone watching the presidential election campaign last year can attest, manufacturing and production in the United States is not what it once was. The reasons for this are debatable, but service-based companies requiring the use of less property and fewer people located within a given state are now responsible for providing that state with a large portion of its revenue. To more fairly apportion revenue across states, governments have been migrating to the use of a single-sales factor for the better part of the last 15 years.3 The result of that migration is that properly attributing sales of service income to states is more important than ever because the sales factor is essentially driving the liability in a given state.

The original cost-of-performance rules drafted in the 1960s no longer reflect the types of circumstances that a modern service business operating in a "cloud" environment faces. To combat this, many states have coincided their shift to single-sales factor with a shift to market-based-sourcing methodologies that strive to better reflect current sourcing issues faced by service companies.4

The Multistate Tax Commission (MTC) recognized this as well. In July 2015, Article IV of the Compact was amended so that "receipts, other than [tangible personal property] are in this State if the taxpayer's market for the sales is in this state." In particular, sales of a service are in the state "if and to the extent the service is delivered to a location in the state." The corresponding regulations were adopted in February of this year.

While these changes to sourcing rules were no doubt intended to simplify things by being more closely aligned with the current business environment, they can often be convoluted and difficult for taxpayers to employ in practice.

Additionally, the inconsistencies that still exist from state to state can sometimes lead to a distortive result or more than 100% of a taxpayer's income being apportioned across states.5 Yes, this is a thing. No, it is not really fair. Can something be done about it? Possibly, but that discussion would have enough content to fill an entire article on its own.6

Many states' rules do allow for the use of alternative apportionment or grant their tax authority discretion meant to be used in unique circumstances when application of the state's rules would not fairly reflect a business's activities in the state;7 however, the door can swing both ways, and the result is not always taxpayer favorable.8

Currently, states use one of three approaches, the most popular being market-based sourcing:

Preponderance-cost-of-performance (all-or-nothing) approach

The preponderance-cost-of-performance test was historically adopted by a significant number of states, probably because it was outlined in the MTC's original model regulation.

If the income-producing activity is performed in two or more states, all of the gross receipts resulting from that activity are sourced to the state where the greatest proportion of the income-producing activity is performed. The determination of where the income-producing activity is performed is based on where the costs associated with the performance of the activity are borne. For example, if state X uses a preponderance approach and the cost of performing a service is incurred 40% in state X, 30% in state Y, and 30% in state Z, the entire gross receipts resulting from the performance of that service activity, or 100%, would be sourced to state X for purposes of its sales factor numerator.

Pro rata cost-of-performance approach

The pro rata cost-of-performance approach differs in that it prorates gross receipts derived from the performance of a service among multiple states based on the costs performed in each state. For example, if state X follows a pro rata approach, and the cost of performing a service is incurred 35% in state X, 40% in state Y, and 25% in state Z, then 35% of gross receipts resulting from the performance of that service activity would be sourced to state X for purposes of its sales factor numerator.

Market-based approach

States that adopt a market-based approach generally source revenue based on the location of the service provider's customers, or based on the location where the customer receives the benefit of the service provided. Many states have a hierarchical approach to determining the location of the customer and offer substitutes for situations where information is not determinable. For example, if state X follows a market-based approach and the taxpayer sells $100,000 of service to customers who will benefit from that service in state X, then $100,000 will be sourced to state X for purposes of its sales factor numerator.

The information and examples provided are oversimplified, but it is easy to find excellent reading materials that discuss the intricacies and nuances for each approach.9 At a basic level, it is important to understand that there are three complex approaches, which vary by state, and can sometimes result in the same sale being required to be sourced to the numerator of multiple states.

Do we really need to be concerned with that? We mostly sell 'stuff'

What is outlined above applies to services, so if a taxpayer is only selling tangible personal property, it need not be concerned with sourcing of services.

However, is selling "stuff" all that the taxpayer is doing? And what exactly is the "stuff" it sells?

Here is the litmus test: What does the company's website say that the business does?

Does it proudly display that the company is in the business of providing customers with solutions? If so, what does that mean? Does it describe how the company sends employees on-site to train its customer's staff to use the products after the sale? Do the company's engineers provide design services upon request?

A business may only be selling tangible personal property at this point, but its marketing team or operations personnel may be looking to expand the business in new and exciting directions. Alternatively, a company may have recently acquired a new business with operational aspects that have not yet been fully considered in terms of impact to apportionment. All too often, the tax department may not be included in all acquisition discussions.

Remember, what the company's website and press releases say is important because it is often a first step in the review process for a state government or financial statement auditor.10

Consider performing an annual review of the company's activities to determine whether it has a service revenue stream that needs to be analyzed. Document the outcome so that auditor questions can be easily addressed.

We keep meaning to take a deeper dive

Not taking a deeper dive is understandable. It is laborious and time-consuming, but here are a few reasons why it is important.

Financial statements: Be a team player

While the tax provision may not be the star of the financial statement show, the federal and international taxes are at least the stuffing and mashed potatoes to the Thanksgiving turkey that is an audit. It is debatable how state taxes fit into this analogy, but they can be thought of as the gravy: the last step in the process that requires the smallest amount of space. But it can often be complex to create, has a tendency to make or break the experience, and should never be considered as an afterthought.

Considering the impact of sales sourcing on the tax provision and reserve calculations well in advance ensures that the tax component does not result in a deficiency.

In its simplest form, a company's gross current state effective tax rate is determined by multiplying the company's apportionment factor in each jurisdiction by the enacted current statutory tax rate that jurisdiction imposes and then summing the results for all jurisdictions in which the company does business. Given that we know apportionment is heavily weighted toward sales, what happens to the rate if sales are sourced incorrectly? Even if the adjustment to the current tax would not have a major impact, do not forget about the deferred rate. In particular, if deferred tax assets or liabilities are significant, you will need to assess whether an aggregate calculation is appropriate or if a separate state calculation should be considered.11 A relatively small change in the apportionment percentage can have a meaningful impact when applied to a business that has substantial deferred tax assets. For example, a 10% fluctuation in sales in one single-sales-factor-apportionment state with a 7% statutory rate applied against $15 million of deferred tax asset can result in more than $100,000 of impact.

Mergers and acquisitions: Impress company stakeholders with your knowledge of the business

Is the company owned by a private-equity group? Does it have an exit strategy? If the company is on the sell side of a transaction, it will need to be prepared to answer questions about how it sources sales for purposes of apportionment as part of the buyer's due-diligence process. The answers to these questions can indicate how much risk may be associated with the apportionment and can potentially have an impact on items such as the purchase price or terms of an agreement.

Alternatively, what is the company's overall growth strategy? If the company is acquisitive, it will need to be aware of questions it should be asking its targets when it performs the due diligence. It is important to understand the target's sales-sourcing methodologies to ensure risks have been appropriately considered for open periods as well as the integration of the business post-transaction.12

Opportunities: Be a cash hero

A review of sales sourcing could result in a decrease to the apportionment factor, which, in turn, can decrease tax liability. Most states allow taxpayers three or four years to pursue refunds and bring that cash back into the company.

Similarly, correctly sourcing sales and documenting the return position according to state rules on originally filed returns can mitigate audit risk for liabilities, interest, and penalties down the road.

What else should be considered?

While this is certainly not an exhaustive list, a few items worthy of note for anyone undertaking a review of sales sourcing include the following.

Documentation and turnover

It is important to communicate and collaborate with other departments within the company when analyzing how revenue is derived, but if those discussions are not documented or held periodically to address changes in business, the effort may not be worth the result. This holds especially true in an era when people no longer spend their entire career at one company. More often than not, key personnel in marketing, operations, accounting, and legal could change every few years. Discussions and business practices that were valid two years ago may no longer apply to how the business operates today.

Systems limitations

How friendly are you with your IT department? Do you have a good handle on what the customer invoicing looks like for the services the company provides? If you needed to "drill down" to obtain additional cost information or customer location data, do you have it? Especially as it relates to the hierarchical rules of market-based sourcing that many states have implemented, it is important to understand how much data you have access to. In a state that requires determining where the customer receives the benefit of the service, you may need or want to "look through" the address listed on the invoice to where the customer is actually using or benefiting from the service.

What happens when technology advances and the company can access better data? Does the increase in data granularity result in any year-over-year consistency issues that might need to be disclosed or addressed during the course of an audit, and is the company prepared to support its process?13

Exceptions to the rule, special circumstances, and litigation

Formulary apportionment rules can be complicated, and different facts and circumstances may require different considerations. Awareness of the complexity is an important first step, and, luckily, there is an abundance of literature available on the topic. Here are some questions taxpayers may wish to consider:

  • Has there been recent litigation that would provide an interpretation of the law?
  • Does the company use subcontractors? If so, does it include or exclude those costs in states that still require sourcing based on cost of performance?14
  • Should the company be using a transactional (individual customer) or an operational (business-as-a-whole) approach when determining its income-producing activity?15
  • Where there is insufficient information to determine the assignment of a sale in a market-based state, have you considered whether any reasonable approximation rules are available?16
  • If the company is not taxable in a state in which a sale is sourced or if assignment cannot be determined or reasonably approximated, have you considered whether the state would require the company to exclude or "throw out" the sale from the denominator of the sales factor?17

Do not forget that state sourcing rules for services do not necessarily apply to sales of intangibles and that special rules may exist for taxpayers doing business in certain industries. In particular, special rules may apply to transportation or financial service businesses.18

Agreements with service providers and consultants

Does the company outsource compliance to a service provider? What does the agreement include? While consultants use their knowledge and experience to review client-provided information with professionally skeptical judgment, an in-depth analysis of a company's sales-sourcing methodology goes beyond a standard return preparation engagement. It is important to understand that performing a review of apportionment data sufficient to meet a preparer standard for signing a return in a given state as part of a compliance engagement is different from performing an in-depth sales-sourcing study.

Does the service provider engage state subject-matter specialists to prepare or review tax returns, or does it use the same general tax consultant that prepared the federal return? Many service providers do an excellent job of preparing federal and state returns using a generalist, but it could be beneficial to consult a state subject-matter specialist when it comes to highly technical or evolving state tax concepts. Most service providers, large and small, have state specialists on hand for this type of consult even if they are not involved in your day-to-day compliance project. Consider introducing these individuals into the process.

To the extent the company switches service providers, make sure the new provider understands and agrees with the apportionment methodology. This will help avoid unpleasant surprises at filing time including inadvertent changes to methodology or an inability to sign returns due to differences of opinion regarding the reasonableness of the return position.


If you have not heard of sales sourcing, take this opportunity to further educate yourself on the issue and determine if it might apply to your business.

If the business sells tangible personal property (or mostly tangible personal property), consider updating its procedures to include an annual review of business facts. Review the company website; discuss any business changes with legal, marketing, and operations personnel; and document tax return positions.

If you have been putting off a detailed review of the company's sales sourcing, look at the upside of performing one and consider getting a jump-start on 2017. If a detailed review seems overwhelming, start the process by using the Pareto principle (20% of the input may create 80% of the result) to begin prioritizing jurisdictions. It has been the author's experience that often 80% of a company's business is performed within 10 states. After you have prioritized your states, but before you go too far down the rabbit hole of sourcing nuances, understand which basic methodology each state follows and consider modeling out some worst-case scenarios to get a feel for how much of an impact a change in methodology might make. Now you can revise and pare down your list so that you can research the specifics and gather the information you need to refine your calculations and document your positions.

When in doubt, call your friendly state tax geek—he or she will be happy to talk it over with you in excruciating detail!  


1The Compact also created the Multistate Tax Commission as an advocate for preserving the authority of states to determine their own tax policy within the limits of the U.S. Constitution.

2Amendments made to the Compact in 2014 and 2015 now recommend that a state should define its weighting fraction and recommends the use of a property, payroll, and double-weighted sales formula.

3Less than 15% of states employed an equally weighted three-factor formula (without offering an alternative election) in 2016.

4Approximately 50% of states employed a market-based-sourcing approach in 2016.

5International Harvester Co. v. Evatt, 329 U.S. 416, 422 (1947), citing Illinois Cent. R.R. Co. v. Minnesota, 309 U.S. 157, 161 (1940), held that the U.S. Supreme Court has "long realized the practical impossibility of a state's achieving a perfect apportionment of expansive, complex business activities . . . and has declared that 'rough approximation, rather than precision' is sufficient." Moorman Mfg. Co. v. Bair, 437 U.S. 267 (1978), addressed the issue of a taxpayer's apportioning more than 100% of its income across states where one used a three-factor methodology and the other a single-sales factor.

6See, e.g., Meleney and Thomas, "Alternative Apportionment: Seeking a Fairly Apportioned Tax Base in a World of Increasing Reliance on the Sales Factor," 17-49 BNA Weekly State Tax Report (Dec. 10, 2010). See MTC Reg. IV.17(h), referring to mediation and the MTC's alternative dispute resolution program.

7The MTC Uniformity Committee is currently working on updates to its "Section 18" regulations, which address alternative apportionment rules.

8See, e.g., Vodafone Americas Holdings, Inc. v. Roberts, No. M2013-00947-SC-R11-CV (Tenn. 3/23/16).

9See, e.g., Sutton, Giles, Yesnowitz, Jones, and Conley, "The Nuances of Market-Based Sourcing of Service Revenue: Not All Markets Look the Same," 21-2 J. Multistate Taxation and Incentives 6 (May 2011).

10In Chapter 8, the Field Audit Procedures section of its recently released Manual of Audit Procedures (MAP), New Jersey instructs that "the auditor should take steps to understand the nature and extent of the taxpayer's business, as this will allow the auditor to properly evaluate items such as invoices, paid bills, deductions, and the portion of the business allocable to New Jersey. The auditor should look for the business's website, online advertising, or social media that it uses to promote the business or affiliated businesses."

11FASB Accounting Standards Codification 740-10-55-25.

12See Harroch and Lipkin, "20 Key Due Diligence Activities in a Merger and Acquisition Transaction," Forbes.com (Dec. 19, 2014).

13See MTC Reg. IV.15(a)(2) regarding year-to-year consistency as additional principals for calculating the receipts factor.

14See, e.g., N.J. Admin. Code §18:7-8.10(a).

15See, e.g., AT&T Corp. v. Department of Rev., No. SC S060150 (Or. 9/11/15).

16See, e.g., 830 Mass Code Regs. 63.38.1(9)(d)1.


18See, e.g., N.J. Admin. Code §§18:7-8.10, 8.11, and 8.12.



Bridget McCann is a senior manager with Grant Thornton LLP’s State and Local Tax practice in Iselin, N.J., focusing on income and franchise tax. Jennifer Jensen is a director with PwC in Washington in State and Local Tax, focusing on indirect taxes. Ms. Jensen is chair and Ms. McCann is a member of the AICPA State & Local Tax Technical Resource Panel. For more information about this column, contact thetaxadviser@aicpa.org.



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