State Tax Return. Massachusetts Applies the Operational Approach for Sourcing of Sales Other Than Sales of Tangible Personal Property

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1 December 2008 State Tax Return Volume 15 Number 5 Massachusetts Applies the Operational Approach for Sourcing of Sales Other Than Sales of Tangible Personal Property Kirk Kringelis Atlanta (404) In the recent Interface Group decision, 1 the Massachusetts Appellate Tax Board ( Board ) applied a broad operational approach to source receipts from sales of services for income tax apportionment. Under the operational approach, the cost of performance rules look to the taxpayer s entire income-producing operations during the year, not just the specific transaction, to segregate separately identifiable items of income. Using the operational approach, the Board held that all of the taxpayer s receipts from the sale of vacation travel packages should be included in the numerator of its Massachusetts sales factor based on its finding that the greater portion of its overall operational costs, including overhead, were incurred in Massachusetts. The taxpayer had sought to apply the transactional approach to determine cost of performance for out-of-state sales. Under the transactional approach, the direct cost of performance is determined on a transaction-by-transaction basis. In Interface Group, the operating process was considered to be the packaging and selling of travel packages, not the sale of individual components of air travel, hotel accommodations and ground transportation. The costs of the income producing operations included substantial personnel and overhead at the taxpayer s offices in Massachusetts. Taxpayers that are based out of state may find the Massachusetts operational approach more beneficial than a transactional approach because the costs included in a cost of performance analysis under the operational approach are generally broader than under a transactional approach. Where an operational approach is applicable, taxpayers based outside Massachusetts may be able to include a greater amount of their nonmassachusetts overhead in their cost of performance analysis, increasing the likelihood that their sales would be sourced outside Massachusetts. The operational approach is also less burdensome from a compliance perspective because taxpayers are not required to analyze their costs of performance on a transaction-by-transaction basis. 1 The Interface Group v. Comm r of Revenue, 2008 WL (Mass. App. Tax. Bd. 2008).

2 As discussed below, the operational approach adopted by Massachusetts appears to cut against the market-based trend for apportionment reflected in the Multistate Tax Commission s (MTC s) recent amendments to the sales factor regulation. BACKGROUND The Interface Group ( Interface ) 2 was a public charter tour operator that created and marketed vacation travel packages in bulk to destinations primarily in the Caribbean Islands and Mexico. After Interface assembled the travel packages, they were sold to the public through various independent travel agents. The prices of the packages were established by Interface and the travel agents passed on those prices (plus the agents commissions) to their customers, who were the ultimate consumers of the travel packages. All travel packages included air transportation, hotel accommodations, and ground transfers. Interface had employees in Massachusetts and outside Massachusetts who assembled the travel packages by contracting with various independent air carriers, hotels, and ground transportation providers for the purchase of their respective services. Because most of the vendors were located outside Massachusetts, Interface s employees often traveled outside Massachusetts to negotiate and execute bulk contracts. If Interface could not sell all of the seats or rooms for which it had contracted, it typically was still required to pay for the unused ticket or room. The guaranteed revenue stream to the airlines, hotels, and ground transportation providers enabled Interface to offer competitive prices for the various components of the travel packages. The vast majority of Interface s employees were based in its Needham, Massachusetts office. These Massachusetts based employees acted as liaisons with the destination hotels, coordinated Interface s marketing, and assembled the travel packages. Over 90% of Interface s payroll was paid to employees operating in Massachusetts. Interface also had employees or independent representatives located at each travel destination to meet its customers and assist with the overall servicing of those customers. Interface placed the funds that it received from the customers in an escrow account until the vacation was completed. In its books and records, Interface accounted for the sale of each travel package as a separate transaction for each individual customer. Based on Interface s accounting records, the costs for the airfare, hotel accommodations, and ground transportation accounted for approximately 90% of its direct costs for providing each travel package. However, in analyzing Interface s total costs on a yearly basis rather than a per-transaction basis, the costs allocated to Massachusetts, including overhead and personnel costs, were greater than the costs allocated to any single destination, even when the costs for airfare, hotel accommodations, and ground transportation were included in Interface s costs of performance and sourced to the destination locations. 2 Interface involved an S Corporation, so the majority shareholder was also subject to tax on the income attributable to Massachusetts

3 The primary issue in the case was whether, for purposes of determining the numerator of Interface s Massachusetts sales factor, Interface s income-producing activity was each individual sale of the travel packages (a transactional approach) or whether it was the overall operation of assembling, marketing, and selling travel packages (an operational approach). MASSACHUSETTS EXCISE TAX APPORTIONMENT PROVISIONS Interface was required to apportion its income to Massachusetts using a threefactor apportionment formula that consisted of a property factor, a payroll factor, and a double-weighted sales factor. 3 Only the computation of Interface s sales factor was at issue. A corporation s sales factor is a fraction, the numerator of which is the total sales of the corporation in Massachusetts during the taxable year, and the denominator of which is the total sales of the corporation everywhere during the taxable year. 4 In situations where a corporation performs income-producing activities both in and outside Massachusetts, a corporation s receipts from sales, other than sales of tangible personal property, are considered Massachusetts sales if a greater proportion of those income-producing activities is performed in Massachusetts than in any other state, based on costs of performance. 5 The Massachusetts Department of Revenue s ( Department ) regulations define an income-producing activity as: a transaction, procedure, or operation directly engaged in by a taxpayer which results in a separately identifiable item of income. In general, any activity whose performance creates an obligation of a particular customer to pay a specific consideration to the taxpayer is an income-producing activity. 6 The regulations further provide that a corporation s income-producing activities generally do not include services performed on its behalf by an independent contractor. 7 APPELLATE TAX BOARD DECISIONS This case had an interesting procedural history. The Commissioner of Revenue ( Commissioner ) issued a notice of assessment, which Interface paid while it sought an abatement. In its initial decision, 8 the Board affirmed the Commissioner s denial of the 3 See Mass. Gen. Laws ch. 63, 38(c)-(f). 4 Mass. Gen. Laws ch. 63, 38(f). 5 Id Code Mass. Regs (9)(d)(2). 7 Id. 8 The Interface Group v. Comm r of Revenue, 2006 WL (Mass. App. Tax. Bd. 2006)

4 abatement applications. Upon appeal, the Appeals Court of Massachusetts reversed and remanded the Board s decision for a reconsideration of the issues raised in the appeal. 9 Upon remand, the Board reinstated its original decision for the Commissioner. Interface had argued that 830 Code Mass. Regs (9)(d)(2) ( the Regulation ) required its income-producing activity to be determined based on a transactional approach. Specifically, Interface contended that each separate sale of a vacation travel package to an individual customer was an income-producing activity and should be separately analyzed to determine whether the sale proceeds should be allocated to Massachusetts. 10 The Board rejected Interface s transactional interpretation of the Regulation and concluded that the Regulation required an examination of a taxpayer s overall business to determine the taxpayer s income-producing activity and that an income-producing activity is activity in which the taxpayer directly engages which generates sales income to the taxpayer. 11 This analysis requires a close analysis of the particular facts and circumstances of each case to determine the activity that produces all the income which is subject to apportionment. 12 The Board noted that [t]he regulation does not permit a taxpayer to cherry-pick from among its subsidiary activities so as to characterize its income-producing activity in the manner which results in the most favorable tax treatment. 13 Based on Interface s facts, the Board determined that Interface was not directly engaged in the sale of individual vacation tours to individual customers. 14 Rather, Interface purchased the components of its tour packages in bulk and sold the packages indirectly through travel agents. 15 Accordingly, the Board ruled that the incomeproducing activity that generated Interface s sales income was its overall operation of a business which negotiates, purchases, assembles, packages and markets tours in bulk because Interface s performance of this overall operation creates its income which is subject to apportionment. 16 Thus, the Board applied an operational approach to determining Interface s income-producing activity. Based on this operational approach, the Board concluded that the separately identifiable item of income which resulted from 9 Interface Group v. Comm r of Revenue, 888 N.E.2d 969 (Mass. App. Ct. 2008). 10 See Interface, 2008 WL , at *7; Interface, 2006 WL , at * Interface, 2008 WL , at *8. 12 Id. 13 Id. Of course, taxpayers would argue that the Regulation does not permit the Commissioner to indiscriminately group together a taxpayer s various activities so as to characterize its income-producing activity in the manner which results in the least favorable tax treatment. 14 Id., 2008 WL , at *9. 15 Id. 16 Id

5 Interface s income-producing activity was the annual amount that it received for the sales of its vacation packages. 17 The Board also ruled that Interface s costs of performance necessarily included all the costs that give rise to the sales income to be apportioned, including the substantial personnel and overhead costs incurred in [Interface s] Needham office. 18 Because a greater proportion of these costs of performance were incurred in Massachusetts than in any single state other than Massachusetts, the Board upheld the Commissioner s assessment and ruled that the Commissioner properly characterized Interface s receipts from its sales of vacation travel packages as Massachusetts sales. 19 The Board s application of an operational approach to determining Interface s income-producing activity is consistent with its decision in Boston Professional Hockey Ass n, 20 in which the Board also adopted an operational approach. In situations where taxpayers believe that an operational approach should be applied for purposes of determining their income-producing activity, the Interface Group and Boston Professional Hockey Assn n decisions may provide taxpayers with some comfort that the Commissioner and/or Board will agree with their application of such an approach. However, taxpayers should not assume that the Commissioner and/or Board will always apply an operational approach. During the appeal of the Board s initial decision in Interface Group, the Board acknowledged that the Regulation does not stand for the proposition that a corporation s overall operation is, ipso facto, its income-producing activity. 21 Taxpayers based outside Massachusetts may find an operational approach more beneficial than a transactional approach because the scope of costs that are included in a cost of performance analysis under the operational approach is likely to be broader than it would be under a transactional approach. As a result, taxpayers based outside Massachusetts may be able to include a greater amount of their nonmassachusetts costs in their cost of performance analysis thereby increasing the likelihood that their sales would be sourced outside Massachusetts. The Regulation generally provides that a taxpayer s costs of performance are its direct costs determined in a manner consistent with generally accepted accounting principles. 22 In situations where a taxpayer s entire operation is considered a single income-producing activity, there may be a wider variety of costs that could be considered direct costs. For example, in Interface Group, the Board included the overhead costs associated with Interface s Massachusetts office as part of its costs of performance even though overhead costs are typically considered indirect costs. For 17 Id. at * Id. at *9. 19 Id. at * Boston Professional Hockey Ass n v. Comm r of Revenue, 820 N.E.2d 792 (Mass. 2005) 21 Interface, 888 N.E.2d 969, 975 (internal quotations omitted) Code Mass. Regs (d)(4)

6 taxpayers based outside Massachusetts, the inclusion of overhead costs in an operational cost of performance analysis may increase the likelihood that their sales would be sourced outside Massachusetts. MTC COMPARISON It is interesting to compare the operational approach adopted by the Board with the MTC s recent amendments to its model sales factor regulation, MTC Regulation IV.17 ( MTC Regulation ). In August 2007, the MTC amended the MTC Regulation s definition of the term income producing activity to include the transactions performed by independent contracts on behalf of the taxpayer. 23 The MTC also amended the MTC Regulation s definition of the term costs of performance to include payments by the taxpayer to an independent contractor for the performance of personal services. 24 For many service providers, the MTC s amendments place more emphasis on activities performed in states that represent the market for the taxpayer s services. For example, payments made by a taxpayer to independent contractors for services that are performed in the market states would increase the taxpayer s costs of performance in those states. As a result, the proportion of the taxpayer s total costs of performance would increase in the market states. In contrast, the Board s operational approach and inclusion of overhead costs in the cost of performance analysis places additional emphasis on costs incurred by the taxpayer in the state(s) where it is headquartered or performs administrative functions. For taxpayers based outside Massachusetts, these costs would likely be incurred outside Massachusetts. As a result, the proportion of a taxpayer s total costs of performance would increase in the state(s) where its headquarters are located and where its administrative functions are performed. Taxpayers should note that Massachusetts is not an MTC Compact member state that has adopted the Multistate Tax Compact into its laws. It is, however, an Associate member state that consults and cooperates with the MTC and other member states on MTC programs and projects. The Department has not amended its Regulation to conform to the MTC s amendments to the MTC Regulation. It remains to be seen whether the Department will make conforming amendments and, if so, whether the Commissioner and/or Board will continue to advocate an operational approach to sourcing sales other than sales of tangible personal property. This article is reprinted from the State Tax Return, a Jones Day monthly newsletter reporting on recent developments in state and local tax. Requests for a subscription to the State Tax Return or permission to reproduce this publication, in whole or in part, or comments and suggestions should be sent to Teresa M. Barrett-Tipton ( ) in Jones Day s Dallas Office, 2727 N. Harwood, Dallas, Texas or StateTaxReturn@jonesday.com. Jones Day All Rights Reserved. No portion of the article may be reproduced or used without express permission. Because of its generality, the information contained herein should not be construed as legal advice on any specific facts and circumstances. The contents are intended for general information purposes only. 23 MTC Regulation IV.17(2). 24 MTC Regulation IV.17(3)