Apportionment using market-based sourcing rules: a state-by-state review.

• Author: Schadewald, Michael S.

Amajor trend in state corporate income taxes is the adoption of market-based rules for sourcing sales of services in lieu of the traditional Uniform Division of Income for Tax Purposes Act (UDITPA) cost-of-performance rule. Under UDITPA Section 17, for purposes of computing the sales factor, sales of services are assigned to the state in which the income-producing activity is performed. if the corporation performs the income-producing activity in two or more states, the sale is assigned to the state in which the corporation performs a greater proportion of the income-producing activity than in any other state, based on the costs of performance.

In contrast, under a market-based approach, the corporation assigns sales of services to the state in which the service is received. Thirteen states have adopted market-based sourcing rules for sales of services, as shown in the exhibit on p. 758.

[ILLUSTRATION OMITTED]

Another major trend in state corporate income taxation magnifies the importance of using market-based rules for sourcing sales of services: the adoption of a single-factor sales apportionment formula in lieu of the traditional UDITPA three-factor property, payroll, and sales formula. In fact, most of the states that use market-based rules for sourcing sales of services have also adopted a single-factor sales apportionment formula. Examples include California (elective), Georgia, Illinois, Iowa, Maine, Michigan, Minnesota (post-2013), Utah (post-2012, for certain industries), and Wisconsin.

This article discusses issues in applying market-based sourcing rules and looks at how those rules work in the states that have adopted them. (1)

Statutory Language

The exhibit summarizes the statutory or regulatory language used by the states that have adopted market-based sourcing rules for sales of services. As the exhibit indicates, a number of states assign sales of services to the state in which the "benefit of the service" is received, whereas other states assign such sales to the state in which the "services are received," the state in which the "customers" or "marketplace" is located, or the state in which the "service is delivered."

Issues in Applying Market-Based Sourcing Rules

Issues that commonly arise when applying market-based sourcing rules for sales of services include the following:

* Does the rule vary, depending on whether the customer is an individual or a business entity?

* Is there a presumption where the service is received, e.g., are the services presumed to be received at the customer's billing address?

* Do the rules permit a taxpayer to prorate a sale among two or more states, or is an all-or-nothing approach required?

* Is there a throwback or throw-out rule if the taxpayer is not taxable in the state in which the service is received or if the state in which the service is received cannot be determined?

* Does a special rule apply if the service is related to real or tangible personal property that is located within the state?

In addition to the general rules for sourcing sales of services, many states have promulgated special rules for taxpayers in certain industries. Typically, these special rules require the use of industry-specific apportionment formulas or industry-specific rules for computing the apportionment factors. Examples of industries for which states often provide specialized apportionment rules include transportation companies (airlines, railroads, and trucking and shipping companies), financial institutions (banks, securities brokers, and mutual funds), broadcasting companies (television and radio), print media and publishing companies, telecommunication companies, pipeline companies, utility companies, construction contractors, and professional sports franchises.

State-by-State Review of Market-Based Sourcing Rules Alabama

For tax years beginning on or after Dec. 31, 2010, sales of services are included in the numerator of the Alabama sales factor "if and to the extent the service is delivered to a location in this state." (2) If the state in which the service is delivered cannot be determined, it is "reasonably approximated." Under a throw-out rule, if the taxpayer is not taxable in the state in which the service is delivered or if the state of assignment cannot be determined or reasonably approximated, the sale is excluded from the denominator of the sales factor.

Arizona

Beginning with tax years ending on or after Dec. 31, 2013, Arizona will allow a multistate service provider to elect to source its sales using a market-based rule. (3) The new rule is being phased in over several years, and it takes full effect for tax years ending on or after Dec. 31, 2016. A "multistate service provider" is a taxpayer that derives more than 85% of its sales from services provided to purchasers who receive the benefit of the service outside Arizona. In applying the 85% test, a taxpayer excludes sales to students receiving educational services at campuses physically located in Arizona. (4)

Under the market-based rule, sales of services are assigned to Arizona if "the services are received by the purchaser in this state." (5) If the state. where the services are received cannot be readily determined, the services are deemed to be received at the home of the customer or, in the case of a business, 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 location cannot be determined, the services are deemed to be received at the home or office of the customer to which the services were billed.

California

For tax years beginning on or after Jan. 1, 2011, California taxpayers that elect to use a single-factor sales apportionment formula must use a market-based rule to source sales of services. Taxpayers that do not make the election must continue to use the UDITPA cost-of-performance rule to source sales of services. Under the market-based sourcing rule, sales of services are assigned to California "to the extent the purchaser of the service received the benefit of the service in this state." (6)

In March 2012, the California Franchise Tax Board published regulations that provide guidance for applying the new market-based rule. (7) The regulations apply retroactively to tax...