Taxing marketplace facilitators: Sourcing issues

Editor: Mary Van Leuven, J.D., LL.M.

Every state that imposes a sales and use tax has in some manner shifted the responsibility for collecting and remitting these taxes to marketplace facilitators. In many states, a marketplace facilitator is deemed to be the “retailer” for all aspects of a facilitated sale. This, of course, has significant sales and use tax implications for the facilitator. But does this fiction — that the facilitator is the “retailer” — extend to corporate income taxes? In other words, does P.L. 86-272 (the Interstate Income Act of 1959) protect a marketplace facilitator if it is facilitating sales of tangible personal property? Do facilitated sales “count” toward state corporate income tax economic nexus standards? More importantly, should a marketplace facilitator’s receipts be sourced to the same location as the sale of the underlying product/service through the marketplace?

At least with respect to the last question, certain states appear to be taking this position on audit and are trying to align sales and use taxes remitted on facilitated sales with the marketplace facilitator’s sales factor numerator in the state. The basis for this approach is not entirely clear. However, as is demonstrated below, it does appear clear that applying existing state sourcing rules to fees and commissions earned by a marketplace facilitator is not a particularly easy task. The challenges that stem from being deemed a marketplace facilitator for sales and use tax purposes have received extensive coverage; however, far less attention has been paid to the income tax considerations. This discussion examines how various types of revenue earned by marketplace facilitators may be sourced under state laws and regulations.

Background

In general, a marketplace facilitator is a person that contracts with third-party “marketplace sellers” to facilitate sales between the seller and a purchaser through a platform, website, or app operated by the person. Marketplace facilitator definitions vary by state, but a majority of states require the facilitator to directly or indirectly process or collect payments on behalf of the seller. Other states consider a person to be a marketplace facilitator if it engages in certain enumerated activities, regardless of whether the person processes or collects payments. The marketplace laws may capture facilitated sales of tangible personal property, taxable services, and/or digital goods.

Depending on the marketplace’s business model, a marketplace facilitator may have a variety of revenue streams. Fee structures may include a flat fee per product listed for sale on the marketplace and/or a percentage or fixed fee or commission per item sold (with the rate often varying based on the category of product). Certain facilitators offer membership programs to sellers that reduce the per-listing fees and provide additional services in exchange for an annual or monthly membership fee.

Sourcing marketplace revenues

For any business, the critical first step in applying a state’s corporate tax apportionment rules is determining the character of the receipt at issue (e.g., whether is it derived from the sale of tangible personal property, the provision of a service, or some other activity). While state sales and use tax laws often dictate that the marketplace facilitator step into the shoes of a retailer for purposes of facilitated sales, the reality is that a marketplace facilitator is an intermediary in a transaction between the marketplace seller and the purchaser. Likely, the marketplace facilitator views its role as providing facilitation services to the seller. Depending on the state, service receipts will generally be sourced under the “income-producing-activity test” to the location where the services are performed or by applying a state’s market-based sourcing rules for services.

Income-producing-activity test: Fewer than 10 states currently apply a traditional income-producing-activity test to source receipts from sales of other than tangible personal property. Under this test, if the taxpayer’s income producing activities that gave rise to the receipts are performed entirely in one state, the receipts will be sourced to that state. If services are performed in multiple states, the receipts are sourced to the state where the greatest proportion of the income-producing activity is performed, based on costs of performance. For a marketplace facilitator primarily in one state or country, this is most likely where the facilitator’s employees are based and/or facilities are located.

A facilitator with employees and offices in multiple states and/or countries will have to perform a more complex analysis to determine where the relevant income-producing activities occurred and calculate the associated costs. How the services are delivered and the nature of the customer may be factored into this analysis, but the focus will likely be on the taxpayer’s activities that gave rise to the receipts, assuming the state does not interpret the income-producingactivity test in a way that equates to a market-based result. A few states source service receipts to the location where services are performed; the sourcing result will likely resemble an income producing- activity state.

Market-based sourcing rules: Most states today apply market-based sourcing rules to source service receipts. There are, however, variations on the theme of market-based sourcing laws, and the devil is in the details. In certain states, a taxpayer is required to source service receipts to the location where its customer receives the benefit of the service. Other states source such receipts to the location where the service is delivered or used, or where the ultimate beneficiary of the service is located. Market-based sourcing regulations commonly offer extensive guidance on the application of the provisions and often set forth differing rules depending on (1) the type of customer (e.g., business or individual); (2) how the service is delivered (e.g., in person, by electronic transmission, or digitally); or (3) the type of service (e.g., personal or professional).

Before applying market-based sourcing provisions to a marketplace facilitator’s revenue streams, the facilitator should carefully analyze the nature of the fee/commission earned. Not all fees are alike, and the nuances may matter when trying to apply a state’s market-based sourcing guidance. For example, a marketplace facilitator may earn fees simply for listing or advertising a marketplace seller’s goods for sale on the marketplace. These fees may be required to be paid regardless of whether a buyer ever makes a purchase. Other fees or commissions may be paid only after a sale is completed.

The next important consideration is determining who is the customer. In many states, determining the location where a service is delivered, or the benefit is received, requires a taxpayer to have certain information about its customer. In a marketplace transaction, three parties are involved — the facilitator, the seller, and the purchaser. This gives rise to the question of who is the relevant customer for sourcing a fee or commission. It is not uncommon for some states to apply (or attempt to apply) lookthrough sourcing when auditing service providers generally. Lookthrough sourcing is the sourcing of a service receipt to the location of the taxpayer’s customer’s customer rather than the taxpayer’s direct customer.

Often, the rationale is that the taxpayer’s customer’s customer has received a benefit from a service provided by the taxpayer to its own customer. However, it is important to remember that the taxpayer has a contract with and is likely being paid by its direct customer. Recent court decisions addressing the issue have rejected this approach and focused on the entity that is the taxpayer’s direct customer. In marketplace transactions, the marketplace facilitator’s customer is arguably the marketplace seller for which it is performing facilitation services in exchange for consideration.

An example — Texas: Few states appear to have specific guidance on sourcing receipts of marketplace facilitators. Texas is one of those states, although the guidance may not be particularly helpful. For Texas franchise tax purposes, gross receipts from a service are generally sourced to the location where the service is performed, which has been interpreted by the Texas Supreme Court to mean the place where the taxpayer’s personnel or equipment is physically doing useful work for the customer. However, a regulation (34 Tex. Admin. Code §3.591(e)(13)(B) (vi)) defines “internet hosting services” to include “marketplace provider services.” Internet hosting services are sourced to Texas if the customer is located in Texas. As such, the regulation sources a marketplace provider’s service receipts to the customer location, but the general Texas rule is to source these receipts to where the service is performed. One must question whether the regulation exceeds the scope of the statute. Furthermore, the regulation is silent as to which customer it is referring to — the marketplace seller or the ultimate buyer of a good or service purchased through a marketplace.

New York: New York also has guidance on sourcing marketplace facilitator services, albeit in draft form. Part 4-3 of the draft Article 9-A regulations addresses “Receipts From the Sale of, Rental of, License to Use, and Granting of Remote Access to Digital Products and Digital Services.” Under the general rule, a taxpayer must include a receipt in the New York receipts factor when the digital service is primarily used by the taxpayer’s customer in New York. However, there are special rules for “digital services related to tangible personal property,” “digital facilitation of in-person services,” and “digital services related to real property.” In these instances, the receipts are sourced, respectively, to where the underlying tangible personal property is received, the in-person service is performed, or the real property is located.

Example 13 in the draft regulation addresses a marketplace that receives (1) fees from listing tangible property on its website and (2) commissions from sales of the tangible property made via the taxpayer’s website. Both revenue streams are services related to tangible personal property subject to the special rules. Because the marketplace receives the first fee regardless of whether the tangible property is ever sold and there is no known consumer yet in the transaction, this fee is sourced based on the primary use location of the seller. In contrast, the second revenue stream is paid after the tangible property is sold and the marketplace has information on where the tangible property will be delivered to the consumer. Under the draft regulation, the marketplace will source these receipts to New York to the extent the commission was received for facilitating the sale of tangible personal property delivered into New York. Thus, while New York’s draft regulation looks to the marketplace’s customer (i.e., the seller) for sourcing fees from listing tangible property on the marketplace’s website, a lookthrough approach appears to be applied to source commissions based on completed sales of tangible property made via a marketplace’s website.

Limited guidance in a complex area

As demonstrated above, applying state sourcing rules to a marketplace’s fees and commissions is not without complexity, even in the few states with guidance. Absent guidance, an approach that sources these receipts to the location where a marketplace facilitator reports sales and use taxes appears to disregard the nature of the marketplace facilitator’s service activities and its customer relationships. It also discounts differences between the nature of these taxes — one is based on what the purchaser pays for an item, while the other is focused on the nature of the taxpayer’s activities. States are still promulgating and refining guidance on the sales and use tax questions that arise for marketplace facilitators. Perhaps answers to income tax questions will be next.

Editor notes

Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C. Contributors are members of or associated with KPMG LLP. For additional information about these items, contact Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

The information in these articles is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230. The information contained in these articles is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. The articles represent the views of the authors only, and do not necessarily represent the views or professional advice of KPMG LLP.