Compared to the complexity of cost-of-performance (COP) sourcing of services for income tax purposes, a market-based approach to apportionment sounds downright simple. Instead of comparing the location of all payroll and material costs of generating revenue as in a COP calculation, for market-based sourcing one looks only to the location of the benefit or delivery of the service. However, the devil is in the details. First, when a service is delivered to an entity with multiple points of benefit or delivery, it is difficult to decipher where the sales should be allocated. Second, the terms “benefit” and “delivery” are not well defined. This article discusses yet a third uncertainty: Who is the “customer”? One would think that the customer is the party that contracted with the service provider. The problem is that the term “customer” is also undefined, and some states have said that the customer may actually be the customer of the party that contracted with the service provider. How far into the transaction should you look to find the receipt of the benefit?
Background
Historically, states have used the COP method of sourcing services to apportion service revenue among the states. The COP method, as defined in Section 17 of the Uniform Division of Income for Tax Purposes Act (UDITPA), states that service revenue is apportioned to the state where the income-producing activity is performed. If the income-producing activity is performed in several states, the revenue is generally apportioned entirely to the state where the greatest proportion of the revenue was earned. That proportion is determined by including all costs incurred to generate the revenue, often including independent contractor costs. Many states use an all-or-nothing sourcing rule where the majority state gets assigned all the revenue with no allocation made to the other states involved, whereas still other states use a pro rata approach to sourcing. Generally, the COP method has not depended on the location of the customer to determine sourcing.
Market-based sourcing, on the other hand, shifts the focus of the source of service revenue to the state in which the benefit or delivery of the service is received and will primarily be used. In market-based sourcing, the destination of the service revenue, rather than where the revenue was earned, is the relevant location. This practice generally results in an increased tax on out-of-state service providers with in-state customers.
Among the states currently using market-based sourcing for service revenue, it should be noted that the statutory language used to determine the assignment of the service revenue for each state varies considerably. In general, the “market” can be defined in the following ways:
- where the benefit is received;
- where the service is received;
- where the service is delivered; or
- where the customer is located.
The income-producing activity could also be a factor in determining where the market is, depending on the type of revenue generated. Revenue from intangible assets, for example, could be sourced depending on where the asset is used.
Where Are We Today With Sourcing of Services?
Given the almost universal trend toward market-based sourcing for service revenue, how do individual states address the multitude of variations in sourcing strategies? California, Maine, Washington, and New York, to name a few, have issued some interesting guidance through legal challenges and regulations.
California
For taxable years beginning on or after January 1, 2013, California Revenue and Tax Code Section 25136 provides that sales from services are sourced to California “to the extent the purchaser of the service received the benefit of the services in [California].” The regulations further define the phrase to mean “the location where the taxpayer’s customer has either directly or indirectly received value from delivery of that service.”
Regulation 25136-2(c)(2) details cascading rules to determine where the benefit is received:
- The location shall be where the contract or the taxpayer’s books or records indicate the benefit of the services occurs.
- If the benefit cannot be ascertained, the location where the benefit is received shall be reasonably approximated.
- If the benefit cannot be reasonably approximated, the location where the benefit of the service is received shall be presumed to be in California, if the location from which the taxpayer’s customer placed the order for the service is in California.
However, if the location cannot be determined in any of the above analyses, the benefit of the service shall be in California if the billing address of the taxpayer’s customer is in California.
On March 25, 2022, the Franchise Tax Board issued Legal Ruling 2022-01 addressing the following considerations when determining the assignment of gross receipts from the sales of services:
- Who is the customer when third parties are involved?
- What is the service being provided, and is there a contract that details the services to be provided?
- What is the benefit of the service being received by the customer?
- Where is the benefit of the service being received by the customer?
When the taxpayer’s service is directed at its customer’s customer, the legal ruling states that the benefit received by the customer is likely located at the customer’s customer location.
Customer’s Customer Rulings
The approach to look through to the customer’s customer has been challenged in several court cases around the country.
A State Win
Maine
Last year, the Maine Supreme Judicial Court decided that the receipts the taxpayer collected from claims adjudication services in connection with the sale of pharmaceuticals were sourced to the pharmacy location. In Express Scripts Inc. et al. v. State Tax Assessor,1 the taxpayer provided services to health insurers, employers, governmental health programs, and benefits plans. These entities covered their members and employees through health plans. Maine’s market-based sourcing rules require that receipts from services are sourced to the location that the benefit of the services is received. Express Scripts argued that the benefit of the service is received at the location of its business customer, the health insurers’ commercial domicile. The Court, however, decided that the services ultimately were received by the individuals at the pharmacy location, looking through to the “customer’s customers.” The language found in the company’s public filings indicating that the ultimate recipients of the services were the client members of the taxpayer was a factor in the court’s ruling.
The Customer’s Customer
South Carolina
On June 3, the South Carolina Administrative Law Court ruled that the state could look through to the “customer’s customer” to source revenue to the state. In Mastercard International Incorporated v. South Carolina Department of Revenue,2 the Department’s determination concluded that Mastercard should have sourced to South Carolina all of the gross receipts arising from revenue generated from the merchant/cardholder transactions initiated in South Carolina.
The Department of Revenue concluded that through the use of the Mastercard network, which included the activities of cardholders, merchants, all banks, and Mastercard, transactions occurred in South Carolina when a cardholder initiated cashless purchases of goods and services from a merchant located in the state. This interaction is the income-producing activity generating revenue sourced to the state based on location of banks and cardholders—the customer’s customer.
Taxpayer Wins
Washington
LendingTree, LLC v. Department of Revenue3 addressed the question of how to attribute the service income that LendingTree earned from operating a website that matches prospective borrowers with participating lenders. Prospective borrowers submit their financial information and type of loan sought through a website, which LendingTree analyzes and then refers to potential lenders. The Department argued that LendingTree provided marketing and outreach services to enable lenders to make loans to borrowers, seeking to look through to the banks’ customers’ locations. The court disagreed, following the rule in WAC 458-20-19402(303)(c), “the benefit is received where the customer’s related business activities occur,” and characterized LendingTree’s services as providing referrals of borrower information, disallowing a look-through to the customer’s customer.
New York
Customer-based sourcing for registered securities broker-dealers has been a part of the New York State corporate franchise tax for several decades, but there have been very few cases addressing the concept. In re TD Ameritrade, Inc.,4 an administrative law judge (ALJ) held that no portion of those broker fees should be sourced to New York under the sourcing rules because the mailing addresses of the “customers” that paid the fees, two national banks, were outside New York State.
Sourcing for the receipts factor under the broker-dealer rule was generally based on the mailing address of the “customer[s] responsible for paying” the receipts. To determine the sourcing of marketing fees paid to TD Ameritrade by related banks having mailing addresses outside the state, TD Ameritrade did not source these receipts to New York. The Department of Revenue sourced these fees based on the same percentages that TD Ameritrade used to source its brokerage commissions—based on the mailing addresses of its brokerage clients. The Department maintained that TD Ameritrade’s brokerage clients, not the banks, were the “customer[s] responsible for paying” the marketing fees.
The ALJ agreed with TD Ameritrade in finding that the banks paid the fees in exchange for TD Ameritrade having deposited large amounts of funds with them and performing certain recordkeeping services, which made the out-of-state banks the “customer[s] responsible for paying” those fees. An alternative proposed by the ALJ was that if the banks were not the customers, then the broker-dealer sourcing rules were inapplicable, and the fees would then be sourced to where the services were performed by TD Ameritrade, namely Nebraska and Texas, not New York.
What’s Next?
As interest in the issue of sourcing receipts to the customer’s customer expands to other states, it remains to be seen how aggressive each state will become. Although to date California is the only state to formalize the process through regulations, any other states considering a similar change should recognize the legal constraints. In the context of the Fourteenth Amendment’s due process clause requirements, income attributed to a state for tax purposes must be rationally related to values connected with the taxing state. Any formula to apportion income to a state must be fair in that a state may tax only that portion of a company’s income that is reasonably attributable to the commercial activities carried on in the state. Questions clearly remain as to where the “market” actually is located for certain business activities and when a look-through to the customer’s customer is appropriate and fair. A close evaluation of the state definitions and consequences is warranted when providing a service that may benefit a customer’s customer.
Mark Nachbar is a principal in national tax services at Ryan. Mary Bernard is director in national tax services at Ryan.
Endnotes
- Me. Sup. Jud. Ct., No. 2023 ME 68 (November 7, 2023).
- South Carolina Administrative Law Court, Docket Number: 20-ALJ-17-0008-CC (June 3, 2024).
- 12 Wn.App.2d 887 (2020).
- N.Y. Div. of Tax App. DTA No. 829523 (April 28, 2022).
