‘Looking through’ income tax apportionment for service providers

Editor: Jeffrey N. Bilsky, CPA

Income tax apportionment is an area of complexity for multistate taxpayers, practitioners, and state auditors. States use apportionment to determine the portion of a taxpayer’s business income they can tax, which often is based on the percentage of sales sourced to a state. States use two methodologies for sourcing revenue from services: cost of performance (COP) and market–based sourcing. States have recently moved away from the COP method, which is based on where costs are incurred (generally measured by payroll and property expenditure), and now predominantly apply market–based sourcing, which sources sales to the location of the customer or the market where the benefit is received.

The shift from COP to market–based sourcing — either through statutory or interpretive changes to existing law by agencies or courts — has created ambiguity and dispute. For instance, in cases such as Synthes USA HQ, Inc. v. Commonwealth of Pennsylvania, 289 A.3d 846 (Pa. 2023), courts have highlighted that states “have struggled with issues related to sourcing sales of services” (n. 54). Some confusion arises when taxpayers assume the billing address determines the customer or market location, only to find on state audit that another basis to determine sourcing applies. Taxpayers might also lack supporting documentation for their sales or incorrectly interpret “lookthrough” rules, which allow them to source receipts based not on characteristics of their customers but instead on characteristics of their customers’ customers.

This item outlines recent legislative and judicial changes in sourcing–of–services trends and provides recommendations readers should consider in determining revenue sourcing and whether using a lookthrough approach is appropriate.

Statutory approaches to market-based sourcing

Generally, statutory authority, supported by regulation or other administrative authority, governs the application of market–based sourcing. Common language and phrases appear in state statutes, with many states sourcing sales of services to the state where “the purchaser of the service received the benefit” (Cal. Rev. & Tax Code §25136(a)(1); see also Ga. Comp. R. & Regs. r. 560–7–7-.03(5)(c)(6)(ii) and N.J. Stat. Ann. §54:10A–6(B)(4)(i)). Other states source services “to the extent the service is delivered to a location” in the state (Ala. Code §40–27–1(IV)(17)(a)(3); see also Colo. Rev. Stat. §39–22–303.6(6)(a) and 72 Pa. Cons. Stat. §7401(3)(2)(a)(16.1)(C)(I)). Still others use different terminology. Maryland, for example, sources “gross receipts from contracting or service–related activities” to Maryland if they are “derived from customers” in Maryland (Md. Regs. Code tit. 03, §03.04.03.08.C(5)(c)).

While states might use similar terminology, they might not define or apply identical terms the same way. For each state, it is important to know what the statute provides and what other authorities are available (case law, regulations, administrative bulletins, etc.).

Interpretation by state agencies and courts

Many states issue regulations or other administrative guidance on how their statutes are applied — including road maps on how to source sales of services, which could involve a tiered series of complex rules. If, rather than the customer, a customer’s customer benefits from a service, administrative authority may provide guidance on when a lookthrough approach may apply.

Recently adopted regulations in New York are an example. If its special rules (N.Y. Comp. Codes R. & Regs. tit. 20, §4–4.3(a)) do not apply to a taxpayer, New York generally provides that “the benefit of the service or other business activity is presumed to be received in New York, without regard to the billing address of the corporation’s customer, if the customer receives the benefit of the service or other business activity in New York” (id.at §4–4.4(b)(1)). However, a lookthrough approach may apply in some situations, such as for intermediary transactions (id. at §§4–4.4(b)(2) and 4–4.1(c)) and services provided to passive investment customers (see id. at §§4–4.4(c) and 4–4.1(b)(3)). The terms “intermediary transaction” and “passive investment customer” have specific definitions, and the method of sourcing then requires meeting other conditions. For example, the sourcing method for passive investment customers depends on whether the investor holds an interest for a “beneficial owner,” which is another defined term (id. at §§٤–4.4(c)(2) and (4)(ii)).

States also provide sourcing guidance through other administrative publications. A Pennsylvania Department of Revenue notice (Information Notice Corporation Taxes 2014–01 (Dec. 12, 2014)) offers various examples of how market–based sourcing applies to specific transactions and industries. Lookthrough sourcing for market–based receipts might apply to mutual fund services, brokerage services, and electronic delivery, among others (but see the example for payroll processing services, where no lookthrough approach applies).

State courts often resolve questions of whether a lookthrough approach applies, and, based on a recent sampling of cases, they tend to decide in the state’s favor.

In Total Renal Care, Inc. v. Harris, No. 2023–1056 (Ohio 2024), the Ohio Supreme Court examined whether support and administrative services performed outside Ohio that were directly related to dialysis services performed in Ohio were subject to the Ohio commercial activity tax (CAT).

The state’s CAT regulations specifically provide that if health care services are performed in Ohio, 100% of the gross receipts are sourced there. If a health care service is provided partly in and partly outside Ohio, “a reasonable allocation for the services performed in Ohio must be made” (Ohio Admin. Code §5703–29–17(C)(28)).

In Total Renal Care, the taxpayer filed CAT refund claims for the period April 1, 2012, through Dec. 31, 2014, asserting that because support and administrative services directly related to the dialysis services were performed outside Ohio, a reasonable allocation outside Ohio must be made. The Ohio Department of Taxation and Board of Tax Appeals denied the claims, saying that under the general CAT statute, services are sourced to the physical location where the purchaser benefited (even though the regulation provides for multistate allocation).

On appeal, the Ohio Supreme Court denied the taxpayer’s multistate allocation. Despite the specific regulation that provides potential lookthrough sourcing for health care services, the court applied the general statutory language to source all of the taxpayer’s receipts to Ohio. The court said that because the statute was unambiguous, it should apply to source the sale to Ohio and not account for the support services performed in other states.

A Minnesota Tax Court case, Humana MarketPoint, Inc. v. Commissioner of Revenue, No. 9570–R (Minn. Tax Ct. 11/21/24), analyzed whether the applicable statute “limits the recipients of the services to ‘direct’ recipients or customers.”

Minnesota’s corporation franchise (income) tax (CIT) sources service receipts to the state where services are received. It states that receipts from the performance of services provided to a corporation may be attributed only to a state where a corporation “has a fixed place of doing business” unless the location “is not readily determinable” or the corporation has no fixed place of business (Minn. Stat. §290.191, subd. 5(j)).

In Humana, the taxpayer filed a combined CIT return for its 2016 tax year. It included in its combined report Subsidiary 1, which was a pharmacy benefit management company that provided services to affiliates. Subsidiary 1 and Subsidiary 2, a life and health insurance company located in Wisconsin, entered a services agreement under which Subsidiary 1 provided support services to Subsidiary 2, which paid Subsidiary 1 for those services.

After sourcing a portion of those receipts to Minnesota on its original 2016 CIT return, the taxpayer filed an amended return removing the receipts from its CIT sales factor numerator. It asserted that under the statute, Subsidiary 2’s fixed office location in Wisconsin was the proper sourcing location.

The Minnesota Tax Court denied the taxpayer’s position, ruling that, in effect, the statute allows “the Commissioner to source receipts from the performance of services to an ‘indirect beneficiary’ of those services.” To the court, interpreting the statute to limit sourcing to direct customers would require it to add language to a statute, which it may not do. Further, nothing in the statute directly prohibits sourcing to an indirect customer. In the court’s view, services are sourced to the location where the services are received, which allowed sourcing of the services to Subsidiary 2’s plan members in Minnesota.

Does a lookthrough approach apply to COP sourcing?

Interpretation of sourcing rules has also been a point of contention in COP states, as demonstrated in South Carolina by Mastercard International, Inc. v. South Carolina Department of Revenue, No. 20–ALJ–17–0008–CC (S.C. Admin. Law Ct. 6/3/24).

South Carolina sources sales from services to South Carolina if the entire income–producing activity is inside the state. If the income–producing activity is performed partly within and partly outside South Carolina, sales from the activity performed in South Carolina are attributable to South Carolina (S.C. Code Ann. §12–6–2295(A)(5)).

On its face, state tax practitioners may agree that this statute supports COP sourcing.

In Mastercard, the taxpayer earned revenue by charging fees for debit and credit card transactions. While the taxpayer earned fees from card use in South Carolina and had contracts with South Carolina banks, all revenue–generating transactions were processed in Missouri. The South Carolina Department of Revenue asserted that the income–producing activity did not occur in Missouri but rather at the location of the card transactions. The South Carolina Administrative Law Court agreed, ruling that providing a market for the taxpayer established sufficient nexus to assess South Carolina tax. The court also agreed that the income–producing activity was the location of the card transactions, not what it deemed the secondary processing services.

Not all courts in COP states have applied such a lookthrough approach, holding that COP sourcing language should be interpreted as it reads (see Billmatrix Corp. v. Florida DOR, No. 2020–CA–000435 (Fla. Cir. Ct. 3/1/23), and Sirius XM Radio, Inc. v. Hegar, 643 S.W.3d 402 (Tex. 2022)). Even so, taxpayers still must be cautious of state courts deciding that a lookthrough approach applies to COP sourcing language.

In Synthes USA HQ, the Pennsylvania Supreme Court held that “income–producing activity” statutory language similar to South Carolina’s is to be interpreted to source sales of services to the customer’s location. While the case interpreted statutory language that no longer applies to corporate taxpayers, the “income–producing activity” language still exists in regulations for Pennsylvania personal income tax purposes.

Insights and next steps

Service providers need to be aware of the interplay among the various state rules. While states may assert positions that increase a taxpayer’s in–state sales, they may also use sales–sourcing laws to increase the number of businesses subject to tax. As more states assert that in–state sales volume alone subjects a business to income tax, they might use sales–sourcing laws to pull in taxpayers that have no physical presence in the state.

Fortunately, having such awareness allows taxpayers to not only play defense against state auditors but also to play offense through potential refund claims from previous tax years. State statutes of limitation on refund claims typically extend three to four years, and authority that seems detrimental to one taxpayer may be beneficial to others.

In asserting positions on state sourcing, having data available to support the position is key. A taxpayer’s data systems should be able to provide proof of the positions taken (e.g., the location of the customer’s customer). If application of one state’s laws versus another’s leads to disparate results (such as resulting in transactions being “nowhere sales” that are not sourced to any state), taxpayers should have the research and authority ready to explain that disparate treatment.

Editor Notes

Jeffrey N. Bilsky, CPA, is managing principal, National Tax Office, with BDO USA LLP in Atlanta.

For additional information about these items, contact Bilsky at jbilsky@bdo.com.

Contributors are members of or associated with BDO USA LLP.