Sales Factors Based on the Benefit Received ABA Tax Section Meeting San Diego, CA February 17, 2012 Giles Sutton, Partner Grant Thornton Robert Mahon, Partner Perkins Coie LLP 704.632.6885 206.359.6260 Giles.Sutton@us.gt.com RMahon@perkinscoie.com The Topic Assigning gross receipts to the numerator based upon where the benefit of the service is received. The concept of determining where the benefit is received may be elusive Examining these provisions and the guidance provided by the states, and try to make sense of it Raise issues about the fairness and constitutionality of such a method or component of the apportionment factor 2
Trends in the Spread of Market Based Sourcing What trends are we seeing in the area of state income taxation? Increased velocity of change Greater complexity to the rules Detailed regulations being drafted in many states Alabama California Illinois New Jersey Washington 3 Applying the New Rules to a Myriad of Industries: Different Facts Require Different Analysis Health care providers; Broker-dealers; Investment advisers; Telecoms; Contract manufacturers; Providers of analytical and investigatory services; General contractors; On-line universities; Systems consultants; Contract research organizations; and Professional service firms (law and accounting). 4
Making a Supporting Determinations General issues implicated by the "benefit received" trend What data do systems currently capture? Billing address, customer ordering address, commercial domicile, etc. Are the cascading rules being properly followed? Will states second guess taxpayer determinations? 5 Current Geographic State of Play (2/2012) COP Proportionate COP All or Nothing (Plurality) No Income Tax Market-Based Sourcing WA MT ND ME OR ID WY SD MN WI MI NY VT NH MA CT RI CA NV UT CO NE KS IA MO IL IN OH KY WV PA MD DC VA NJ DE AZ NM OK AR TN SC NC AK MS AL GA TX LA FL HI 6 6
A Sampling of Service Revenue Sourcing Issues What is the primary sourcing rule? Where the benefit of the service is received? The location of the impetus of the sale? Is it important where the customer directly or indirectly receives the benefit of the service? Is the location or billing address of the customer the determinative consideration as opposed to where the benefit of the service is received? Does it matter if the customer is an individual or a business? Are there a set of cascading or ordering rules? Does it matter whether the services related to real property, tangible personal property or intangible property? Does the state have industry-specific rules for applying market-based sourcing rules to services? Will bundled transactions of services and tangible personal property have to be bifurcated to be properly sourced? Is there a throwback or throw-out rule in play for services in a given state? Will COP states choose to selectively use an equitable form of market sourcing? Is the time-spent analysis for personal services still relevant and if so, to what extent? 7 Why the Trend Towards Market Based Sourcing Proponents of market-based sourcing claim that such a methodology: Balances the origin-based property and payroll factors. Increased level of certainty for taxpayers selling services and intangibles. COP has been criticized as: Too difficult to determine, Penalizes in-state companies; and Unfair when using an all-or-nothing approach. 8
Why the Trend Towards Market Based Sourcing (Cont.) One of the more persuasive arguments for the adoption of market-based sourcing has been that state departments of revenue dislike the occurrence of nowhere sales that can result from COP. However, depending on a taxpayer s facts, the adoption of the recent market-based sourcing regimes is not likely to prevent nowhere sales in some instances or prove to be fair to taxpayers in others. 9 Example: Is Market Based Sourcing Really Fair? Potential Impact of Retroactive Amendment to Existing COP Rules Consider the following scenario for a multistate taxpayer selling services: Taxpayer has 100% of its self incurred direct cost of performance in AZ It also has 100% third party direct cost of performance in CA as specified by contract which exceed 60% of its overall direct costs of performance The customer is in Utah Result? Traditional COP in AZ - 100% sourcing to AZ Modified 3 rd party COP in CA 100% sourcing to CA (unless the taxpayers elects single factor sales and market based sourcing) Market based sourcing in UT 100% sourcing to UT Still think it s fair? 10
The Mechanics of Market Based Sourcing: What is the "Market"? While sourcing revenue to a taxpayer s market seems simple at first blush, the definitions of market vary substantially across the states. The term "market" simply can mean: The customer s actual location (where the PO is issued or billing address); Location of commercial domicile; or It can also mean the physical location where the customer receives the benefit of the services provided. 11 The Mechanics of Market Based Sourcing: Unpacking Where the "Benefit" is Received In states where a benefit received test is used, a number of issues are likely to arise, including: Who should be considered the purchaser of record? Where is the benefit actually received (commercial domicile, office taking the order, billing location of customer, service provider s billing address, or other location)? Where the service is received, performed and delivered? It will not always be easy for a taxpayer to determine the location of its market, particularly if the benefit of services received sourcing rule is used. 12
Unpacking Specific Rules: Minnesota Receipts from the performance of services provided to a corporation, partnership, or trust may only be attributed to a state where it has a fixed place of doing business. If the state where the services are received is not readily determinable or is a state where the corporation, partnership or trust receiving the service does not have a fixed place of doing business, the services shall be deemed to be received at the location of the office of the customer from which the services were ordered in the regular course of the customer s trade or business. If the ordering office cannot be determined, the services shall be deemed to be received at the office of the customer to which the services are billed. 13 Unpacking Specific Rules: Oklahoma Practical Issues in Applying Market Sourcing of Services Receipts from the performance of services shall be included in the numerator of the [sales factor] fraction if the receipts are derived from customers within this state [Oklahoma] or if the receipts are otherwise attributable to this state s marketplace. A customer within Oklahoma is either a customer that is engaged in a trade or business and maintains a regular place of business in Oklahoma, or a customer that is not engaged in a trade or business whose billing address is in Oklahoma. The billing address means the location indicated in the books and records of the taxpayer as the address of record where the bill relating to the customer s account is mailed. 14
Unpacking Specific Rules: Michigan Pro-Rata Benefits Services are in Michigan if the recipient of the services receives all of the benefit of the services in the state. To the extent that the recipient of the services receives some benefit within Michigan and some benefit outside Michigan, sales are sourced to Michigan to the extent that the recipient receives benefit of the services in Michigan Note the RAB 2010-5 provides detailed rules regarding sourcing of service revenue depending on the nature of service provided 15 Unpacking Specific Rules: Washington If the location of the customer s benefit or use cannot be ascertained, default rules source the receipts to the (in the following order): Location from which the customer ordered the service or, in the case of royalties, the customer s office from which the royalty agreement was negotiated Location to which the billing statements are sent to the customer Location from which the customer sends payments to the taxpayer Location of the customer s business address as shown in the taxpayer s business records or as otherwise obtained as part of the consummation or negotiation of the underlying contract Commercial domicile of the seller taxpayer 16
Unpacking Specific Rules: California Market-based Sourcing Election For Services Cal. Rev. & Tax. Code Sec. 25128.5 allows for an apportioning trade or business historically required to use double-weighted three-factor apportionment, to make an irrevocable annual election on an original timely filed return to apportion its income via a single sales factor (the single sales factor election ). While the statute was enacted and became effective for tax years beginning on or after January 1, 2010, the single sales factor election is only allowed to be taken for tax years beginning on or after January 1, 2011 (CAL. REV. & TAX. CODE 25128.5(a), (b).) 17 Key Analytical Issues in Service Revenue Sourcing Today What is the primary sourcing rule? Where the benefit of the service is received? The location of the impetus of the sale? Is it important where the customer directly or indirectly receives the benefit of the service? Is the location or billing address of the customer the determinative consideration as opposed to where the benefit of the service is received? Are there a set of cascading or ordering rules? Does it matter whether the services related to real property, tangible personal property or intangible property? 18
Key Analytical Issues in Service Revenue Sourcing Today (Cont.) Does the state have industry-specific rules for applying market-based sourcing rules to services? Will bundled transactions of services and tangible personal property have to be bifurcated to be properly sourced? Will COP states choose to selectively use an equitable form of market sourcing? Is the time-spent analysis for personal services still relevant and if so, to what extent? Does a throw-out or throw-back rule impact the analysis? 19 The Result of Market-based Sourcing of Service Revenue The proliferation of market-based sourcing rules make it increasingly common for taxpayers to have aggregate multistate sales factors of greater than 100 percent for service revenue As a response to (greater than 100 percent apportionment), taxpayers will need to consider the various complex and inconsistent rules states are putting in place to market-base source service revenue and take remedial steps to avoid such a result. Read: Planning! 20
To Think About States are focused on heavily weighting the sales factor States are adopting bright-line nexus standards States are moving towards market based sourcing of services They have inconsistent rules Elections Throw-back and throw-out rules Legacy consistency rules impact how taxpayers apply these rules In this environment, note, the interaction of market based sourcing of service revenue and bright-line nexus! 21 Any questions? 22
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