This Little Piggy Goes To Market
For three generations (rock and roll, disco and new wave) the sourcing of services for state income tax apportionment didn’t get a whole lot of attention. Sure, there were rules included in UDITPA (Uniform Division of Income for Tax Purposes Act) that applied to services, but that was just catch-all language for anything “other than tangible personnel property.” And heck, Congress didn’t even address services when it passed P.L. 86-272, maybe the only law they have ever passed that had a truly significant effect on the multistate taxation of businesses, even though the service industry comprised about 60% of the GDP at the time P.L. 86-272 hit the books.
For the better part of four decades, there were really only two methods of sourcing services; preponderance of costs of performance (COP) and percentage of COP. You simply analyzed where your costs were incurred (pretty easy before the days of the internet) and applied one of the two methods. Not that there weren’t controversies. Those typically laid in either which costs should be included in the analysis, and/or what “unit” of revenue should be analyzed. To the latter, say I bill by the hour and work on a project that takes me 40 hours. Is my unit of measurement an hour or is the unit the project. Or better yet, do I analyze all the revenue I received from the client that year for all projects? You get where I am going. With regard to the two methods, the application of those rules among several states could lead to some distortive results. Let’s say I had 40 people working out of Boston and 15 each in four other states. Historically, Massachusetts looked at preponderance of COP. Because I had more people/costs in Massachusetts than anywhere else, 100% of that revenue would be included in my Massachusetts sales apportionment numerator. But wait, what about the other states? Well if they all used the percentage of COP method, each of them would include 15% (15/100 people) of my client project revenue in their respective numerators, and voila, 160% of my revenue is being taxed. Not good. Flip that on its head and say I had 55 people in New York and 45 in Massachusetts. Massachusetts picks up nothing (because Massachusetts uses preponderance of COP) and New York picks up 55% (percentage of COP). Now the distortion goes in my favor.
Anyway, enough about history as there has been a huge trend to move away from COP and towards market-based sourcing for services, which essentially sources service revenue to where the benefit is received. Couple that with the trend towards single sales factor apportionment and sourcing determinations as they relate to services aren’t just important, they are critical.
Although market-based sourcing rules are a bit all over the place, they are typically applied on a consistent basis by each respective state. Where these sourcing rules get particularly squirrelly is in the case of states that marry market-based sourcing with a “throwout” rule. Throwout generally stands for the principal that where sales are “sourced” to a state (or country) that does not “tax” those sales, they are ignored in calculating sales apportionment. They are literally treated as if they did not exist. Problem here is that the income produced by those sales is not ignored. That income is fully includible in the tax base. This is most egregious where a state uses one set of rules for determining nexus in their state but given the same fact pattern in another state, if that other state or country chooses not to actually tax the taxpayer, the state takes the position that those sales must be ignored. This can lead to some egregious results. We recently had a state try to throw out over $2 billion (yes, with a “b”) of service revenue because it was foreign sourced under their rules but not subject to tax in the foreign country, even though the $200 million of profit on those sales was included in state taxable income. This is a classic pig/hog circumstance (pigs get fat, hogs get slaughtered) and these states are being hogs.
If you want to learn a lesson on throwout, just look to New Jersey. Without getting into too much detail, New Jersey was one of the early adopters of the throwout but had so much trouble with it they eventually, well, threw it out!
Get ready, as taxpayers and advocacy groups are lining up to challenge any regime that has one set of rules for nexus/sourcing for activity in their state and a different set of rules for the same in other states/countries. Those states might as well just hang a flag that says, “what Constitution?” As our Revolutionary war hero, Paul Revere, famously shouted “the litigious are coming, the litigious are coming” (I think that’s what he said).
GAGNONtax has been specializing in tax consulting, compliance, and technology for almost 20 years. Reach out today to see if we can help you solve your corporate tax challenges! Please contact William Gagnon for more information.