AUDIT & BEYOND state tax notes

Transcription

1 Is a Sourcing Rule by Another Name Just as Sweet? by Clark R. Calhoun and Matthew P. Hedstrom Clark R. Calhoun Matthew P. Hedstrom Clark R. Calhoun is a partner in the Los Angeles office and Matthew P. Hedstrom is a partner in the New York office of Alston & Bird LLP. In this edition of Audit & Beyond, Calhoun and Hedstrom discuss sourcing rules in Florida, Indiana, Oregon, and South Carolina, noting that while their statutes and regulations indicate otherwise, all four effectively use market-based sourcing. According to the authors, the incorrect labeling means that taxpayers with in-state operations in market-based states must be aware of the state s position when they prepare their estimates, pay their returns, and evaluate whether they may have a refund position for prior tax years. Indiana and Florida use market-based sourcing to apportion receipts from services. Under the holding in DirecTV, 1 South Carolina is a market-based sourcing state, too unless taxpayers can identify the income-producing activity that generated their in-state receipts with laser precision. And in light of the Oregon Supreme Court s recent decision in AT&T, 2 Oregon is now a market-based sourcing state. What is notable about these four states? All four of them apply a market-based sourcing rule for the apportionment of service receipts, though their statutes and regulations say otherwise, and though not one readily admits that it applies a market-based sourcing rule. In Indiana, the Department of Revenue cannot openly acknowledge what it is doing because, according to statute, Indiana is a costs-ofperformance state, and legislative efforts to amend the statute to impose a market-based sourcing rule have failed. 3 In 1 DirecTV Inc. & Subsidiaries v. S.C. Dep t of Revenue, 2015 WL , No. 14-ALJ CC (S.C. Admin. Law Ct., May 12, 2015). 2 AT&T Corp. v. Oregon Dep t of Revenue, 358 P.3d 973 (Or. 2015). 3 Ind. Code Ann. section (f) (applicable statute concerning the sourcing of receipts on sales other than receipts from intangible property... andsales of tangible personal property ); see, e.g., Ind. (Footnote continued in next column.) AUDIT & BEYOND state tax notes Florida and South Carolina, where the statutes do not explicitly use the term costs of performance, it is less clear why the states won t just call a spade a spade, though they may also feel constrained by their statutory or regulatory references to the location of a taxpayer s income-producing activity. 4 It is less clear why the states won t just call a spade a spade, though they may also feel constrained by their statutory or regulatory references to the location of a taxpayer s income-producing activity. Ultimately, it s not that important to correctly label the applicable sourcing rule in these states; their written authorities speak for themselves. What is important, however, is that with the states positions made clear in writing, taxpayers recognize the constitutional, statutory, and administrative considerations and opportunities that correspond to the states application of a market-based sourcing rule, especially when the controlling authorities are unclear, diffuse, or otherwise difficult to square with the statute and corresponding regulations. A Trojan Horse for Market-Based Sourcing How does a state statute or regulation that on its face provides for costs-of-performance or place-of-performance sourcing get interpreted as one that effectively requires market-based sourcing? Most commonly by taking an exceedingly narrow view of what constitute the incomeproducing activities that give rise to the taxpayer s apportionable receipts. For example, Indiana s statute for the sourcing of service receipts provides: Legislature, HB 1349 (2015 First Reg. Session) (introduced Jan. 13, 2015) (proposing to amend section (f) to impose market-based sourcing for the sale of services). 4 See Fla. Stat. section ; Fla. Admin. Code 12C (2)(l); S.C. Code Ann. section (A)(5) (apportioning receipts of services to South Carolina to the extent the income producing activity is performed within this State ). In DirecTV, the South Carolina administrative court wrote that South Carolina has never adopted any blanket approach to the sourcing of service receipts. See DirecTV, 2015 WL , at 12. State Tax Notes, February 22,

2 Audit & Beyond Sales, other than receipts from intangible property... and sales of tangible personal property, are in this state if: The income-producing activity is performed in this state; or The income-producing activity is performed both within and without this state, and a greater proportion of the income-producing activity is performed in this state than in any other state, based on costs of performance. 5 By regulation, Indiana has added that income-producing activity means the act or acts directly engaged in by the taxpayer for the ultimate purpose of obtaining gains or profit. 6 Similarly, Florida s regulation apportions receipts from services based on the location where the incomeproducing activity is performed and, like the Indiana DOR, defines the phrase to mean the transactions and activity directly engaged in by the taxpayer for the ultimate purpose of obtaining gains and profit. 7 Oregon s statute is identical to Indiana s (both are based on section 17 of the Uniform Division of Income for Tax Purposes Act); by regulation, Oregon, like Florida, defines income-producing activity by reference to the transactions and activities directly engaged in by the taxpayer for the purpose of obtaining gains, while Indiana refers to the direct costs incurred in connection with such activities. 8 Through the narrow lens of the transactional approach, states thereby effectively engineer a market-based sourcing result. By focusing on the direct costs related to a taxpayer s income-producing activity, these states have traced out a transactional approach to a costs-of-performance or placeof-performance analysis that defines income-producing activity so narrowly that it excludes any activity unrelated to the receipt of the service, and that excludes any cost unrelated to the act of delivering the service. That approach ensures that the only activities deemed income producing are, ipso facto, those that actually resulted in an in-state sale. As will be discussed, through the narrow lens of the transactional approach, states thereby effectively engineer a market-based sourcing result. 5 Ind. Code Ann. section (f) Ind. Admin. Code Fla. Admin. Code 12C (2)(l). 8 Ore. Rev. Stat. section (4); Ore. Admin. R (4) (2); see also Fla. Admin. Code 12C (2)(l) ( incomeproducing activity applies to each separate item of income ); 45 Ind. Admin. Code ( The term costs of performance means direct costs determined in a manner consistent with [GAAP] ). Indiana In a letter of finding issued last year, the Indiana DOR concluded that a company that provided online educational courses entirely from out of state was nevertheless conducting income-producing activities within Indiana, because under Indiana s transactional approach, the only relevant activities are those direct activities for which value is exchanged. 9 Under that approach, the sales of services were determined to be the acts directly engaged in by the taxpayer, because it is only those sales that lead to the earning of receipts within Indiana. Accordingly, the department found the taxpayer s other activities (for example, the hiring and training of faculty members; the development of online courses; and the incursion of other overhead expenses to prepare, maintain, and deliver its courses to students) were not income-producing activities and were not relevant to the location of such activities. Thus, because the remote services provider was found to perform all of its incomeproducing activities within Indiana, the costs-ofperformance method was held entirely inappropriate. 10 Oregon and South Carolina Court decisions in Oregon and South Carolina in 2015 also marked them as market-based sourcing states for service receipts. In AT&T, the Oregon Supreme Court considered whether AT&T was required to source its service receipts to Oregon (where it incurred the costs regarding specific calls made by Oregon customers) or outside the state (where it incurred the majority of its total network costs). 11 AT&T argued that under Oregon s costs-of-performance authorities, none of its Oregon receipts should be sourced there, because its costs incurred in Oregon were far less than its costs incurred outside the state (the operational approach). 12 The Oregon Supreme Court held that because AT&T had not identified the correct income-producing activities that correlated with each individual Oregon sale, it was impossible to find that a majority of AT&T s costs were incurred outside the state. The state, however, contended that AT&T s incomeproducing activity occurred within Oregon because the only direct costs that were relevant were the costs of connecting and carrying each call for which an Oregon customer was 9 Ind. Dep t of State Rev. Letter of Finding No (Jan. 1, 2015). 10 Id. 11 AT&T Corp. v. Oregon Dep t of Revenue, 358 P.3d 973 (Ore. 2015). 12 Id. at State Tax Notes, February 22, 2016

3 arged (that is, the transactional approach). 13 The court agreed with the state and held that because AT&T seeking a refund of overpaid taxes had not identified the correct income-producing activities that correlated with each individual [Oregon] sale, it was impossible to find that a majority of AT&T s costs were incurred outside the state. 14 The Massachusetts Tax Board traditionally rejected the transactional approach when the use of that approach trivialized the actual income-producing activities performed at the taxpayer s headquarters. In a case involving similar facts, a South Carolina administrative court held that DirecTV had not sufficiently demonstrated which of its activities directly related to South Carolina sales other than the actual transmission and delivery of the signal to customers homes; therefore, because DirecTV s out-of-state costs (that is, network and satellite costs, production costs, marketing, and so forth) were merely incidental to producing income from South Carolina customers, those costs were not tied to incomeproducing activities within the meaning of that phrase. 15 Accordingly, while that court emphasized the state s flexibility in identifying a taxpayer s income-producing activities for purposes of the sourcing rule, it held that DirecTV s identification of the value drivers of its business was too nebulous. 16 Florida Finally, in a technical bulletin, the Florida DOR analyzed the proper sourcing of receipts earned by a data services provider of remote services to customers located in Florida. 17 Relying in part on Arizona and Wisconsin cases, the DOR noted that it was appropriate to source receipts from the sale of services to the state where customers were located because the direct sale to the customer at the customer s domicile is where the income-producing activity occurred. If there were any doubt that the DOR effectively intended to apply market-based sourcing, it added that the 13 Id. at Id. at DirecTV Inc. & Subsidiaries v. S.C. Dep t of Revenue, 2015 WL , No. 14-ALJ CC, at 11 (S.C. Admin. Law Ct., May 12, 2015). ( DirecTV does not sell contract negotiations. It does not sell network management services. It does not sell broadcast infrastructure or satellite triangulation. Rather, DirecTV is in the business of selling television broadcast subscriptions to customers; and without the actual delivery of that broadcast signal into South Carolina homes, it would not have generated the income at issue here. ) 16 Id. at *8, Fla. Tech. Assistance Advisement 13C1-011 (Nov. 21, 2013). Audit & Beyond income-producing activity in the present case is fees earned by the Taxpayer from transaction services provided to its customers, including customers located in Florida. 18 Transactional Approach vs. Operational Approach In contrast to the narrow transactional approach employed by the aforementioned four states, other states have applied an operational approach to determine the location of a taxpayer s income-producing activities. For example, in another case involving AT&T, the Massachusetts Tax Board rejected the state s assessment based on a transactional approach, instead emphasizing the importance of AT&T s out-of-state network activities and noting that it had traditionally rejected the transactional approach when the use of that approach trivialized the actual income-producing activities performed at the taxpayer s headquarters. 19 The board, relying in part on the expert testimony of professor Richard Pomp, cited in particular the flaws in the transactional approach: its focus on specific items of income is inconsis tent with unitary business principles; and by using in-state sales as a starting point and then evaluating what costs are directly involved in producing those sales, the approach assumes away the very issue of where such sales ought to be sourced. 20 The board therefore applied the operational approach and held that AT&T s Massachusetts receipts should be sourced outside Massachusetts, because the majority of its costs were incurred outside the state. 21 As suggested by the discussion of the transactional approach as applied by Florida, Indiana, Oregon, and South Carolina, there is some sleight of hand involved in its application: Rather than looking at a taxpayer s overall operations to determine where the taxpayer conducts activities that lead to some receipts, states adopting the transactional approach start by looking at the taxpayer s items of income that is, its in-state sales and then determine where the direct costs that produced those sales took place. But here is where the game is rigged: As noted, the states have essentially defined all of the taxpayer s costs as irrelevant, except for those necessary to produce a particular in-state 18 Id. (emphasis added). 19 AT&T Corp. v. Commissioner of Revenue, 2011 WL , No. C293831, at 11 (Mass. App. Tax Bd., June 8, 2011), aff d, 970 N.E.2d 814 (Mass. Ct. App. 2012). Massachusetts provides additional guidance in that regard. See, e.g., Boston Professional Hockey Ass n v. Commissioner of Revenue, 443 Mass. 276 (2005). 20 Id. at 5; see also id. at 12. ( Starting with a predisposed assumption that certain sales are Massachusetts sales forces a conclusion before allowing the cost-of-performance evidence to lead to the correct result. ) 21 We would be remiss if we failed to point out that the Oregon Supreme Court (in AT&T) reached the opposite conclusion on identical facts. That not only highlights the subjectivity involved but the difficulty (if not impossibility) of meeting state expectations regarding their costs-of-performance regimes. State Tax Notes, February 22,

4 Audit & Beyond sale. That reasoning belongs in the Circular Logic Hall of Fame: A service provider s receipts are sourced to the state only if its income-producing activities occurred there, but the income-producing activities are specifically defined as those activities that generated receipts within the state. For example, the Florida DOR explained regarding a data services provider that the collection of data is not [an] income-producing activity, while Indiana found that an online educational provider s many out-of-state activities that were integral to its business were not incomeproducing; rather, the state found that the taxpayer earns money within Indiana because it sells [its] services to Indiana customers within their home state. 22 South Carolina even added that all of DirecTV s national activities were irrelevant in determining the location of its incomeproducing activities because they would have occurred regardless of whether there were any subscribers in South Carolina a conclusion that is akin to finding the first egg and concluding that there must have been a chicken around to lay it. 23 Through those narrow and strained interpretations of their authorities, Indiana, Florida, Oregon, and South Carolina have all effectively transformed their costsof-performance (or place-of-performance) regimes into a market-based sourcing regime. Further proof of the flaw in those states analyses is that in Florida, Oregon, and South Carolina, the sourcing statute contains a two-part test, but as applied by them, the second portion is entirely superfluous. As noted, the statutes read: Sales, other than receipts from intangible property... and sales of tangible personal property, are in this state if: The income-producing activity is performed in this state; or The income-producing activity is performed both within and without this state, and a greater proportion of the income-producing activity is performed in this state than in any other state, based on costs of performance. 24 If a taxpayer s income-producing activity occurs only at the point of sale, what service must ever be apportioned under the second prong of the statute? You might say something like a bus trip or booze cruise that crosses state lines, but even then, under the transactional approach, what activity is relevant other than the moment when the taxpayer asks the customer to pay the bill? Given the flaws in the transactional approach, it appears that taxpayers should have opportunities to challenge its application in those states; at the same time, given the prohibition against interstate discrimination, the states applying such an approach would appear to have committed themselves to a marketbased approach regarding both out-of-state taxpayers and taxpayers with significant in-state operations. Considerations and Opportunities The states discussed in this article are effectively applying market-based sourcing for service providers, even if they twist themselves into pretzels to demonstrate how they are actually measuring taxpayers income-producing activity. However, the label for the states sourcing rules is less important than recognizing the consequences that flow from the states adoption of those rules. The states discussed in this article are effectively applying market-based sourcing for service providers, even if they twist themselves into pretzels to demonstrate how they are actually measuring taxpayers income-producing activity. As explained in an earlier column and as has been discussed in numerous contexts since the U.S. Supreme Court s decision in Wynne 25 last spring a state scheme is discriminatory and violates internal consistency if it taxes a transaction or incident more heavily when it crosses state lines than when it occurs entirely within the State. 26 As explained in that article, the imposition of a market-based sourcing regime for out-of-state taxpayers and a costs-ofperformance regime for in-state taxpayers would impose extra tax burdens on interstate businesses, thereby generating a quintessential violation of internal consistency. 27 Thus, service providers with operations in Florida, Indiana, Oregon, or South Carolina should monitor their filings to ensure their compliance with each state s market-based sourcing rules. They should also consider whether they have a refund claim for prior years. Second, out-of-state taxpayers should consider whether they may have a viable challenge that states applying a transactional approach to those types of statutes are applying a legislatively mandated sourcing rule for service providers in an ultra vires and illegal manner. In connection with that argument, they should consider whether they can demonstrate as we have argued here, and as the Massachusetts Tax Board found in AT&T that the states costs-ofperformance statutes and regulations cannot reasonably be read to impose a market-based sourcing rule. 22 See, e.g., Fla. Tech. Assistance Advisement 13C1-011 (Nov. 21, 2013); and Ind. Dep t of State Rev. Letter of Finding (Jan. 1, 2015). 23 DirecTV, 2015 WL , at See, e.g., Ind. Code Ann. section (f); Ore. Rev. Stat. section (4). 25 Comptr. of the Treasury of Md. v. Wynne, 135 S. Ct (2015). 26 Clark R. Calhoun and Liz Cha, The Internal Consistency Problem in Vodafone, State Tax Notes, May 18, 2015, p. 519 (citing Armco Inc. v. Hardesty, 467 U.S. 638 (1984)). 27 See id. at State Tax Notes, February 22, 2016

5 Finally, all taxpayers should be mindful of states requirements to comply with the federal due process clause as well as the uniformity and due process clauses that attach under many state constitutions. Among the states discussed, South Carolina said it will apply its costs-of-performance authorities in a flexible manner, depending on the industry in which a taxpayer is engaged and depending on a taxpayer s facts. 28 However, a state cannot have its cake and eat it, too, and a state may run afoul of constitutional protections if it slices and dices the treatment of different taxpayers and industries so narrowly that the state is effectively discriminating against interstate commerce. For example, a state could conceivably apply its flexible sourcing rules so as to apply a costs-of-performance rule to industries for which in-state taxpayers predominate, but a market-based sourcing rule for industries in which out-of-state taxpayers predominate. If a state were to enforce its sourcing rules so flexibly as to get the best outcome for the state in nearly every case, such disparate and discriminatory application of tax laws should be examined for satisfaction of internal consistency, due process, and any applicable uniformity or equal protection clause. Conclusion States need to be mindful that when they apply a marketbased sourcing rule to capture the receipts of a taxpayer without in-state operations, the application of that rule has consequences for the sourcing of in-state taxpayers income. By the same token, taxpayers that do have in-state operations in such a state need to be aware of the state s position when they prepare their estimates and pay their returns and of course, when they evaluate whether they may have a refund position for prior tax years. Taxpayers should be aware of the considerations that apply in those states (and other states that take similar positions in that area); likewise, states that are contemplating whether to apply a transactional approach should understand that they may have a difficult time arguing their way out of the market-based corner into which they have painted themselves. Ultimately, while states may believe that a sourcing rule by another name is just as sweet, they may find that those positions are a bit sour when turned against them. Experts don t have all the answers. They just always know where to fi nd them. Audit & Beyond Whether you re looking for the latest tax news headline or an in-depth analysis of a recent treaty, you can always turn to the leading tax policy and news source. You ll discover Tax Analysts has the timely, accurate, and comprehensive information you need. To see why experts rely on us, please visit taxanalysts.com. 28 See DirecTV, 2015 WL , at 12. State Tax Notes, February 22,