In 2015, the rubber met the road, and states began to accelerate the adoption of detailed regulations to accompany what is often vague statutory language to source receipts from the sale of services and intangibles based on the location of the “market.” In this article, we survey the key proposed and final regulations that apply market-based sourcing to service and intangible income and explore the methods by which states and the Multistate Tax Commission (MTC) are proposing to tackle market-based sourcing and the associated problems through detailed regulations. While many argue that market-based sourcing offers a principled way to source receipts from the sale of services and intangibles, in practice, market-based sourcing rules are likely to create a variety of administrative problems. These challenges are particularly heightened in states that heavily weight the sales factor or use a single-sales factor apportionment formula.
Costs of Performance
Of the forty-six states with corporate income taxes, twenty-three have adopted the Uniform Division of Income for Tax Purposes Act (UDITPA), and the majority of others have adopted a similar methodology to apportion the business income of multistate taxpayers. Approximately twenty-two states use some variation of the costs of performance method to source receipts from sales of services and/or sales or licenses of intangibles.1
Under the standard UDITPA costs of performance rule, receipts from sales other than sales of tangible personal property are sourced to the state if “the greater proportion of the income-producing activity is performed in this state than in any other state, based on costs of performance.”2 Thus, the costs of performance rule requires the taxpayer to identify individual lines of income, determine the income-producing activities for each income line, and determine where the income-producing activities (and associated costs) take place. Although taxpayers and auditors may disagree as to how a company’s income lines should be broken down or on which income-producing activities are associated with such income lines, the benefit of this methodology is that taxpayers generally have access to relevant cost data—or can design systems to capture such information—because the costs of performance method considers the taxpayer’s activities.
That said, the costs of performance rule has been criticized on several fronts—particularly in states that use the standard all-or-nothing UDITPA rule, which sources receipts to the state only if the preponderance of the income-producing activities occur within the state. An alternative approach, taken by some states, is a “proportionate” costs of performance rule that sources sales based upon the relative proportion of income-producing activities taking place in each state.3 The proportionate method remediates some of the harshness of the all-or-nothing rule.
Additionally, as the drafters of UDITPA acknowledged, the costs of performance rule may not be appropriate for certain types of industries. As a result, the MTC has promulgated (and some states have adopted) industry-specific rules for apportioning the income of airlines, construction contractors, financial institutions, railroads, telecommunications, trucking, broadcasting, and publishing.4
Despite a clear trend toward state adoption of market-based sourcing, a key question often remains—how does one measure the market’s contribution to a taxpayer’s income from sales of other than tangible personal property?
An increasing number of states have abandoned the costs of performance rules in favor of market-based sourcing, which tries to identify the market for service and intangible income. The District of Columbia, Massachusetts, Nebraska, New York, Pennsylvania, and Rhode Island have adopted market-based sourcing effective in 2014 and 2015.5 Market-based sourcing becomes effective in Tennessee in 2016.6 California and Alabama are also recent converts, while North Carolina and Virginia are studying the fiscal impact of market-based sourcing. Legislatures in Kentucky, New Mexico, and Virginia are all expected to consider market-based sourcing legislation in 2016.7
Despite a clear trend toward state adoption of market-based sourcing, a key question often remains—how does one measure the market’s contribution to a taxpayer’s income from sales of other than tangible personal property? Every state that has enacted market-based sourcing did so in a manner that will require regulatory guidance in order to be effectively administered. As a critical mass of states start to elaborate through regulation what constitutes a “market,” many states have incorporated a simple statutory framework offered by the MTC.
MTC Model Market-Based Sourcing Statute
To facilitate some degree of uniformity as states shift to market-based sourcing, in 2014 the MTC approved a model market-based statutory regime.8 The MTC model is simple on its surface. Sales of other than tangible personal property are attributed to a state “if the taxpayer’s market for the sale is in this state.” The MTC model provides that sales of services are attributed to a state “if and to the extent the service is delivered to a location” in the state. While statutory language that looks to “delivery” could be sufficient to source most personal services, the MTC drafters fully contemplated that a regime of regulations will be needed to provide guidance to source many multistate transactions and activities.
When it comes to receipts from intangibles, the MTC model requires receipts from the rental, lease, or license of intangible personal property to be sourced to a state if the intangible personal property is “used” in the state. Recognizing that it will not always be obvious where “intangible” property is “used,” the model creates a special rule for “intangible property utilized in marketing a good or service” (i.e., trademarks, trade names, etc.). The MTC model requires receipts from the licensing of such property to be sourced to a state only if the associated good or service is purchased by a consumer in the state.
The MTC model also attempts to avoid disputes about the application of market-based sourcing by providing that, if the market state cannot be determined under the basic rules, “the state or states of assignment shall be reasonably approximated.” The MTC model then provides that, if the state or states of assignment cannot be reasonably approximated, the sales shall be excluded from the denominator and numerator of the sales factor altogether. This exclusion, commonly referred to as “throw out,” also applies if the taxpayer is not subject to tax in the jurisdiction to where the receipt is sourced.
California was the first jurisdiction to provide substantial regulations for applying market-based sourcing, and it introduced the concept of “cascading” rules. Generally, California Revenue and Taxation Code section 25136 requires taxpayers to source the following receipts to California: “[s]ales from services … to the extent the purchaser of the service received the benefit of the service in this state,” “[s]ales from intangible property … to the extent the property is used in this state,” and sales of marketable securities “if the purchaser is in this state.” To apply that standard, California adopted a regulation that provides a set of cascading rules that come into effect serially if the proper location cannot be determined under the prior rule.
To determine where the purchaser receives the benefit of a service, the regulation differentiates between sales to individuals and sales to business entities. With respect to individuals, the benefit of the service is deemed to be received (1) according to the location set forth in the contract; (2) according to the purchaser’s billing address, unless the taxpayer provides evidence showing that the service was not delivered to the billing address; or (3) based upon a “reasonable approximation.”9 In contrast, where the purchaser is a business entity, the benefit of the service is deemed to be received (1) according to the location set forth in the contract, (2) based upon a “reasonable approximation,” (3) according to the location where the purchaser placed the order for the service, or (4) according to the purchaser’s billing address.10
When there has been a complete transfer and sale of intangible property rights, sales are to be sourced (1) if the purchaser used the property in a single state, to the state where the purchaser exclusively used the property at the time of the purchase; (2) based upon the “extent of the purchaser’s location in this state as compared to the purchaser’s locations everywhere”; (3) based upon a “reasonable approximation”; or (4) according to the billing address of the purchaser.11 In contrast, the licensing, leasing, rental, or other use of intangible property is to be sourced (1) based upon the extent to which the property is used in the state by the taxpayer’s purchaser under the contract, (2) based upon the proportion of sales of tangible personal property sold by the taxpayer’s purchasers in the state that gives rise to the receipts, (3) based upon a “reasonable approximation,” or (4) according to the commercial domicile of the taxpayer’s purchaser.12
Massachusetts and MTC Regulations
On January 2, 2015, the Massachusetts Department of Revenue repealed and replaced section 63.38.1 of Title 830 of the Code of Massachusetts Regulations to supplement the market-based sales sourcing apportionment law applied to receipts from sales of other than tangible personal property under section 38(f) of Chapter 63 of the General Laws of the Commonwealth of Massachusetts, which was enacted in 2014.13 The regulation is very lengthy and provides detailed rules pertaining to assigning a receipt from the sale of other than tangible personal property, including a sale of an in-person service, a transportation/delivery service, and a professional service, as well as licensing, leasing, and selling of intangible property, among others. The Massachusetts regulation is significant in that it served as the starting point for the MTC model regulation that is currently under review.
Under the regulations, Massachusetts establishes guidelines of what is considered a taxpayer’s market for sales other than sales of tangible personal property and to what extent a sale is considered to be in the state. In general, a taxpayer’s market for sales other than sales of tangible personal property in Massachusetts is as follows:
- For sales of services, the taxpayer’s market is determined based on the place of delivery in Massachusetts.14 In-person services—services physically provided in person by the taxpayer or third-party contractor where the customer is located—establish the taxpayer’s market for apportionment purposes as the customer location where the service is delivered and received. Examples of in-person services include warranty and repair services, cleaning services, plumbing or carpentry services, landscape services, medical and dental services, and in-person training or lessons. For professional services that require specialized knowledge or certification and a higher level of approximation (legal, accounting, consulting, etc.), sourcing generally depends on whether the customer is an individual or a business customer and how much information is available related to the customer’s primary residence or location where the contract is managed. In cases in which the service is neither an in-person service nor a professional service, the service falls into the “other services” category. For these, the final regulation distinguishes between services that are delivered to a customer and services that are delivered on behalf of a customer to a third party, and by the type of methodology—either through physical or electronic means. Depending on type of delivery and methodology, the sourcing of the other sales could be based on the state of delivery, on reasonable approximation, or on the customer’s address.
- For the license and lease of intangible property, the receipts are in Massachusetts if and to the extent the intangible is used in Massachusetts, with “use” being defined as the location of the taxpayer’s market rather than the location of the taxpayer’s property or payroll.15 In addition, the determination of the “location” is predicated on the classification of the intangible being licensed in the transaction as either a marketing intangible, which includes the license of a trademark or trade name (receipts sourced to the location of customers purchasing goods or services), or a production intangible, which includes the license of a patent, copyright, or trade secret to be used in a manufacturing process (receipts sourced to location of use of the intangible). If the taxpayer is not taxable in the state to which the license of the intangible is assigned, or the license is structured as a sale of goodwill or other similar intangibles, the license receipts are excluded from both the numerator and denominator for apportionment purposes.
- For the sale of intangible property, the receipts from the sale or exchange of intangible property previously assigned to the state of the taxpayer’s commercial domicile would default to be excluded from both the numerator and denominator, exclusive of a few specific situations based on the nature of the intangible property being transferred, or if the sale is of a partnership interest.
In situations in which the market cannot be determined, the regulation also establishes a methodology to “reasonably approximate” which state or states should include the sale and exclude from the sales factor calculation any sales that cannot be assigned to a state through reasonable approximation. The methodology requires the taxpayer to apply a level of judgment “in good faith, on a consistent basis from year to year, and based on all sources of information available to the taxpayer.” The taxpayer is also required to maintain contemporaneous records to substantiate the reasonable approximation methodology and the assumptions for assignment of its sales and have them available for the Massachusetts Department of Revenue upon request.
Once a taxpayer establishes a methodology of reasonable approximation for assignment of sales in an originally filed return, the methodology is assumed to be correct, and neither the taxpayer nor the commissioner may modify the methodology applied (through either an amended return or state audit adjustments). However, a change of methodology can be requested by the taxpayer in subsequent years, through the proper disclosures, which may or may not be approved by the commissioner.
On January 28, 2016, the MTC’s Executive Committee voted to send a draft model market-based sourcing regulation to a public hearing for comments.16 The model is substantially similar to the Massachusetts regulation, with a few subtle differences. It is expected that states like Alabama and the District of Columbia, which have adopted the MTC model in some form, will quickly move to adopt all or part of the MTC model regulation.
In October 2015, the Michigan Department of Treasury issued guidance on how taxpayers should determine where the recipient of services receives the benefit of those services for purposes of calculating the sales factor under Michigan’s corporate income tax (CIT) apportionment provisions.17 Under the CIT statutes, sales from the performance of services generally must be sourced to Michigan if the recipient of the services receives the benefit of the services in Michigan. Rather than enact a structured cascade approach like California, the guidance offers a number of a specific conclusions and examples on how to source services. The guidance concludes that the following services, among others, will be sourced to Michigan:
- The service relates to tangible personal property that (1) is owned or leased by the purchaser and located in this state at the time that the service is received, or (2) is delivered to the purchaser or the purchaser’s designee(s) in this state.
- The service is received in this state and provided to a purchaser who is an individual physically present in this state at the time that the service is received.
- The service relates to the use of intangible property such as custom computer software, licenses, designs, processes, patents, and copyrights, which is used entirely in this state.
Also in October 2015, the New York Department of Taxation and Finance issued draft proposed sales factor sourcing regulations that describe how to source receipts under the hierarchies described in Tax Law section 210-A.4 for digital products, and Tax Law section 210-A.10 for other services and other business activities.18 Both draft regulations go through each step in the hierarchy, explaining how the terms are defined, and providing examples for each method in the hierarchy as they will be applied.
In 2014, New York overhauled its corporate tax code, including its apportionment rules with the implementation of New York State Tax Law section 210-A. For receipts from services or other receipts not specifically addressed in the statute there is a catchall provision in New York State Tax Law section 210-A(10) that provides a hierarchy of methods for determining whether receipts are to be included in the numerator of the state’s apportionment factor. In October 2015, the New York State Department of Taxation and Finance released draft amendments to New York State Business Corporation Franchise Tax Regulations Sections 4-4.6 (Other Business Receipts) and new 4-4.9 (Receipts From Sales of Digital Products).
Both sections of draft regulations describe the rules for applying the hierarchies for sourcing receipts found under New York State Tax Law section 210-A(10) for other services and receipts and New York State Tax Law section 210-A(4) for receipts from sales of digital products. When sourcing receipts that fall into these categories, taxpayers must exercise due diligence under each method in the corresponding hierarchy before they can reject it and move to the next method, if it does not apply. For example, the first method in the hierarchy for other services and receipts listed under New York State Tax Law section 210-A(10) is the benefit of the service is received in the state. Once a taxpayer has done its due diligence and is unable to determine if the benefit was received in New York, he may move on to using the delivery destination as the next method. A similar hierarchy exists in New York State Tax Law section 210-A(4) for sales of digital products, for which the first method is that the state of the customer’s primary use location of the digital product is the state to which the receipt is sourced.
In December 2015, the Rhode Island Division of Taxation issued its final regulation on market-based sourcing.19 The regulation took effect January 12, 2016. In general, the new regulation provides that sourced receipts from the lease or license of intangible property are based on where the intangible property is used, while receipts from sales of services are sourced to where the “benefit of the service is received.” The regulation provides various rules depending on the type of service, the method of delivery, and/or the type of customer. The regulation is modeled closely after the market-based sourcing regulation adopted by Massachusetts. Following the Massachusetts template, the regulation divides the sourcing of services into three broad categories—“in-person” services; “services delivered to the customer or on behalf of the customer, or delivered electronically through the customer”; and “professional services.” For each category, the Rhode Island regulation establishes a separate set of cascading rules that must be followed to source the revenue for that category to the state.
In late 2015, the Tennessee Department of Revenue issued a preliminary version of the revised Tennessee Comprehensive Rules and Regulations 1320-6-1-.34 to incorporate market-based sourcing rules for sales other than sales of tangible personal property. Similar to Massachusetts, the draft provides detailed applications of the sourcing rules to in-person services, professional services, and services delivered to the customer or on behalf of the customer or delivered electronically to the customer.
The preliminary regulation sources receipts from the rental, lease, or license of intangible property to Tennessee if the intangible is used in Tennessee. The regulation provides guidance on the applications of the rules for the license of various intangibles, including marketing intangibles, production intangibles, mixed intangibles, and intangible property where the substance of the transaction resembles a sale of goods or services. Similarly, the receipts from the sale of intangible property will also depend on the nature of the intangible property sold.
The regulation divides the sourcing of services into three broad categories—”in-person” services; “services delivered to the customer or on behalf of the customer, or delivered electronically through the customer”; and “professional services.”
The draft also provides special rules for software transactions and the sale or license of digital goods and services. A license or sale of prewritten software will be treated as the sale of tangible personal property if it is transferred using a tangible medium. In all other cases, a license or sale of prewritten software will be assigned to Tennessee based on the regulation’s rules regarding the sale of custom software or the sale of intangibles. The sale and license of digital goods and services will be sourced using the same rules as if the transaction were a service delivered to an individual or business customer or delivered through or on behalf of an individual or business customer.
As the previous sections illustrate, there are many ways to determine market sourcing. While we are seeing a slight trend toward uniformity, there is still no clear agreement about the best way to approach the issue. Many common problems and practical issues are encountered with market-based sourcing rules for services and intangibles.
First, many complications arise due to the sheer breadth of such statutes. Unlike industry-specific rules, which take into account common business arrangements and provide taxpayers with clear guidance as to how specific types of receipts are to be sourced, market-sourcing rules applied to all sales “other than sales of tangible personal property” reach a broad range of taxpayers and transaction types. Thus, there is a tension between developing a rule that can be applied to “most” taxpayers and ensuring that the rule is applied in a consistent manner among similarly situated taxpayers. Regulation examples help, but they cannot cover every circumstance.
Because of the wide variety of taxpayers and transaction types, more detailed examples are likely to be required to demonstrate how a market-sourcing rule should be applied in different situations.
Defining standard terms and concepts—such as what is meant by the “delivery” or “receipt” of a service (i.e., does this reference physical or contractual delivery or receipt), what is meant by the “benefit” of a service, what constitutes a “use” of an intangible, and whether the “customer” refers to the taxpayer’s customer or the ultimate consumer—do help to advance this objective. Because of the wide variety of taxpayers and transaction types, more detailed examples are likely to be required to demonstrate how a market-sourcing rule should be applied in different situations.
Second, market-based sourcing rules are difficult to apply to taxpayers making sales of services or intangibles to multistate businesses. In many cases, if a multistate business purchases a service or licenses an intangible that benefits its business generally, there will be no clear state (or states) in which the service is received or intangible is used. While the customer’s billing address, commercial domicile, or principal place of business may provide a relatively easy answer to this question, sourcing receipts to a single location under such circumstances would create an arbitrary “all or nothing” result, not unlike the result reached using a preponderance-based costs of performance rule.
Many market-sourcing rules contemplate sourcing such receipts to more than one state by using language like “to the extent”; however, it is often unclear how such receipts should be distributed among various states. For example, should sourcing be based upon all of the customer’s locations, the customer’s marketplace, or some other proxy? And under what circumstances should such receipts be thrown out of the taxpayer’s sales factor numerator and denominator?
Third, a market-based sourcing rule is particularly difficult to apply to the license of intangibles, because it will often raise the question of whether the taxpayer’s customer or the ultimate consumer should be considered when determining the location of the use of the intangible. For example, suppose a taxpayer owns a patent to manufacture a widget. If the taxpayer licenses the patent to a manufacturer located in State A, and the manufacturer sells the finished product to a distributor located in State B, and the distributor sells to a retailer whose warehouses are in States C and D and then ultimately sells the product through stores in States E, F, and G, how should the taxpayer’s license of the patent be sourced? On one hand, the taxpayer’s customer—and thus the taxpayer’s “true” market—is in State B. On the other hand, the market for the patented product is in States E, F, and G. The concept of marketing intangibles may require a taxpayer to “look through” to the location of the ultimate consumers, rather than simply relying on the location of the manufacturer’s location in State B.
Using the location of the ultimate consumer raises many practical issues. Often it is true that a licensor/taxpayer will know where its licensee/manufacturer is entitled to use or distribute products, and it may be able to negotiate the right to obtain this information from the licensee at the time they enter into the license agreement. However, the licensee/manufacturer may not know the specific states in which its products are ultimately sold when it sells its products to its distributor, just as the distributor may not know the breakdown of sales among the retailers’ various locations. When forced to source based on “downstream” sales, the question then becomes, Should the licensor/taxpayer use the last known information (in this case, that the taxpayer/licensor has licensed products to the manufacturer/licensee located in State B), or should it use an approximation of the jurisdictions in which the products ultimately may be sold, based upon population estimates? These policy decisions should be made and communicated by taxing jurisdictions in advance so taxpayers source such receipts consistently.
Nearly all market-sourcing rules acknowledge these concerns and limitations by permitting the taxpayer, under certain circumstances, to either move to the next prong on the cascading rule, to use a reasonable approximation, or to throw out the receipt when the appropriate location cannot be determined. Guidance must be provided to taxpayers regarding when it is appropriate to advance to the next alternative.
Finally, there is the question of what is meant by a “reasonable approximation.” California has defined “reasonable approximation” to mean that “considering all sources of information, including publicly available information, the location of the market for the benefit of the services or the location of the use of the intangible property was determined in a manner that is consistent with the business of the purchaser.” No doubt, taxpayers and auditors will use different sources of information when answering sourcing questions and will have conflicting interpretations about how receipts should be sourced in order to be “consistent with the business of the purchaser.”
Taxpayers attempting to comply with new market sourcing rules need assurances that auditors will accept reasonable efforts, information, and approximations to make a market-sourcing regime successful.
Accuracy v. Practicality
While the numerous recent regulations have helped clarify state positions on some of the market sourcing quandaries, it is far more complicated to source receipts from such sales in a principled way. States will thus be required to balance the quest for accuracy against the practical realities of gathering and reporting this information.
Todd Lard is a partner and Stephanie Do is an associate with Sutherland, Asbill & Brennan LLP.
- See, e.g., Alaska Stat. § 43.19.010, Art. IV, 17; Ariz. Rev. Stat. § 43-1147 (unless the taxpayer is a multistate service provider and elects otherwise); Ark. Code Ann. § 26-51-717; Colo. Rev. Stat. § 24-60-1301, Art. IV, 17; Fla. Admin. Code r. 12C-1.0155(2)(e)2.a (services only); Haw. Rev. Stat. § 255-1, Art. IV, 17; Idaho Code § 63-3027(r); Ind. Code § 6-3-2-2(f); Kan. Stat. Ann. § 79-3287; Ky. Rev. Stat. Ann. § 141.120(8)(c)3; Miss. Reg. 35 III.8.06(III)402.9(3)(d); Mo. Rev. Stat. § 32.200, Art. IV, 17; Mont. Code Ann. § 15-31-311(2); N.H. Rev. Stat. Ann. § 77-A:3(I)(c); N.M. Stat. Ann. § 7-4-18; N.C. Gen. Stat. § 105-130.4(l)(3) (services only); N.D. Cent. Code § 57-38.1-17; Or. Rev. Stat. § 314.665(4); S.C. Code Ann. § 12-6-2295 (services only); Vt. Stat. Ann. Tit. 32, § 5833(a)(3); Va. Code Ann. § 58.1-416; W. Va. Code § 11-24-7(e)(12).
- UDITPA Rule 17.
- Four states use a proportionate costs of performance method: Arkansas, Mississippi, North Carolina (services only), and South Carolina (services only). See Ark. Code Ann. § 26-51-717; Miss. Reg. 35III.8.06(III)402.9(3)(d); N.C. Gen. Stat. § 105-130.4(1)(3); S.C. Code Ann. § 12-6-2295(A).
- See Model Apportionment Regulations, available at www.mtc.gov/Uniformity.aspx?id=496.
- D.C. Code Ann. § 47-1810.02(g)(3)(A); Mass. Gen. L. Ch. 63 § 38(f); Neb. Rev. Stat. §§ 77-2734.04 and 77-2734.14; N.Y. Tax Law § 210-A; H.B. 465 (Pa. 2013); R.I. Gen. Laws § 44-11-14.
- H.B. 644 (Tenn. 2015).
- S.B. 22 (N.M. 2016); H.B. 86 (Ky. 2016); H.B. 966 (Va. 2016).
- Multistate Tax Compact, Art. IV.
- Cal. Reg. 25136(c)(1)(A).
- Cal. Reg. 25136(c)(1)(B).
- Cal. Reg. 25136(d)(1).
- Cal. Reg. 25136(d)(2).
- 830 CMR 18.104.22.168.
- 830 CMR 22.214.171.124(d)(4)(a).
- 830 CMR 126.96.36.199(d)(5).
- 830 CMR 188.8.131.52(d)(1)(e).
- Mich. Revenue Admin. Bulletin 2015-20.
- Draft Proposed Amended Regulation Section 4-4.6 (Receipts From Other Services and Other Business Activities) and Draft Proposed New Regulation Section 4-4.9 (Receipts From Sales of Digital Products), N.Y. Dept. of Tax. & Fin. (Oct. 15, 2015).
- Regulation CT 15-04.