In their ongoing hunt for revenue and in light of greater uncertainty over funding from a Federal Government, states are more competitive with one another today than ever before. Enter market-based sourcing. Rather than looking to the traditional criteria of cost of performance (“COP”) rules or where the services were actually performed, market-based sourcing looks to where the customer received the benefit of the services provided.
A market-based methodology offers a great economic development incentive for state and local tax jurisdictions. Combined with a single factor apportionment scheme based only on sales, market-based sourcing encourages businesses to locate their offices, property, equipment, employees, and all other valuable assets within the jurisdiction. Taxpayers can do so with little to no increase in state tax liability, as the location of their business will have no impact on the ultimate income tax liability of the business. Only in-state customers will potentially generate an apportioned tax liability to the taxing jurisdiction.
The Shift Away from Cost of Performance to Market-Based Sourcing
Historically, most states used the COP method for apportioning service revenue to a particular state. Under COP methodologies, revenue is apportioned to the state where the costs associated with the income-producing activity are incurred. If the income-producing activity is performed across multiple states, the revenue is typically apportioned entirely to the state in which the greatest proportion of the revenue was earned. The greatest proportion is determined by the costs incurred to generate the revenue. Essentially an all or nothing type sourcing rule when initially introduced, the COP method was not difficult to follow, since it only focused on the efforts and locations of the taxpayer’s own employees. With COP, the location of the recipient client is not a factor in apportioning service revenue.
The shift has now moved on to a single-sales factor with market-based sourcing. Under a market-based sourcing methodology, service revenue is allocated to the state in which the benefit of the service is received and subsequently used. This can be any revenue other than sales of tangible personal property and does include revenue from and sales of intangible assets in some states. As such, the primary factor taken into consideration is the destination of the service revenue, rather than the location where the revenue was earned. Therefore, market-based sourcing allows states to tax out-of-state service providers that have customers within their respective state.
Business income-producing activity can impact the tax implications of market-based sourcing. Service companies generally follow the rules already discussed, while holding companies frequently hold intangible assets, which may be treated differently across various states.
Economic Nexus, Single Factor Sales Apportionment, and Double Taxation
Some states using market-based sourcing also incorporate economic nexus and single factor sales apportionment methodologies. Economic nexus is a concept that is generally based on whether a business has an economic presence or market in a particular state. States with these rules will typically look to how a business is carrying on its economic activity in a particular state and if it has customer sales into a particular state. With a single sales factor method, the state calculates the overall apportionment percentage by taking the sales assigned to the state and dividing that number by total sales. It is possible for a taxpayer to pay no tax on a portion of its service revenue. For example, this occurs when the business’s home state uses market-based sourcing with a single sales factor and the destination state uses cost of performance with a single sales factor apportionment. In this case, the revenue would not be assigned to the home state since the service was delivered to an out-of-state customer. Further, the revenue would not be sourced to the destination state, since the income-producing activity was performed outside of that state. Under this example, the transaction would not be subject to state income tax, as both states would be allocated zero revenue based on their respective sourcing and apportionment methodologies. However, a company would still be required to file a tax return if it was doing business in a particular state, even though there is potentially no tax due.
Likewise, there are also cases where double taxation presents itself, such as when a taxpayer in a cost of performance state with customers in a market-based sourcing state —both using a single sales factor apportionment. If most of the income-producing activity is performed in the taxpayer’s home state, the taxpayer would source the revenue to the home state on its home state tax return. Unfortunately, the taxpayer would also have to source the entire revenue from that service to the state of the customer’s location --resulting in the revenue from one transaction being taxed in two different states. Double taxation can also bite when no cost of performance states are involved due to the complexities of each state’s market-based sourcing rules. These conditions will remain until all states have adopted some form of market based sourcing.
Impact on States and Businesses
By eliminating the loophole of the all or nothing scenario of the cost of performance model, states adopting market-based sourcing are able to tax out-of-state service providers and ensure themselves a portion of any service revenue generated from customers within their state. Also, since the sales factor within the home state typically drops as a result of market-based sourcing methods, in-state businesses may have smaller tax burdens within their home state.
While states lose out on income tax revenue from in-state companies, due to the lower apportionment figures, states would still generate more income tax revenue from out-of-state companies performing services within their state. Such states could also become more attractive for businesses looking to establish satellite or branch offices within a new state. Moreover, states also hope to see their tax revenues increase since the array of taxable sales generally increases with market-based sourcing.
Businesses will have lower taxable income in their home state since service revenue is no longer entirely assigned to their home state. Depending on the home state’s tax rate relative to the rate of the destination states, this change is either an advantage or a disadvantage for the company. Of course, the out-of-state tax burdens will likely increase.
It is clear that due to the current and expected growth in the use of market based sourcing, it is here for the long term. Continued presence of cost of performance regulations, the combination of both sourcing methods means tax-free and double-tax transactions will potentially be an issue companies may have to face for the foreseeable future. It is prudent to develop a sourcing strategy, in order to mitigate the risk of double taxation. Additionally it is important to stay alert to the fact that, since market-based sourcing generally lowers home-state tax revenues, states will be more aggressive in sourcing revenue from out-of-state service providers.
If you have questions or would like to discuss market-based sourcing in more detail, contact Terence Avella at 212.331.7690 | email@example.com or your Berdon advisor.
Berdon LLP, New York Accountants