New developments in sourcing services for telecommunication companies.

• Author: Wong, Alan

In an economy based more and more on services and the internet, the proliferation of technology-based businesses has undermined some of the historical concepts defining state taxation, posing a significant challenge for local authorities to adapt and redefine the principles governing revenue sourcing and apportionment. The issue is particularly acute in the sourcing of service revenues of businesses operating in multiple jurisdictions. A recent decision of the Massachusetts Appellate Tax Board found in favor of a communication company that excluded the receipts collected from its customers in the Commonwealth from the sales numerator of its apportionment factor because the majority of the costs underlying the services resulting in the receipts were attributable to activities performed in another state.

Many states imposing a corporate income tax have adopted the standard cost of performance apportionment formula enacted in the Uniform Division of Income for Tax Purposes Act (UDITPA) or have enacted similar legislation. UDITPA Rule 17 provides that receipts from sales other than sales of tangible personal property are sourced to the state if "a greater proportion of the income-producing activity is performed in this state than in any other state, based on costs of performance." Identifying the activities that generate service revenue may be fairly straight forward in traditional service industries, but it becomes a much more burdensome and controversial task in industries such as telecommunications, broadcasting, and internet-based services.

Over the past few years, the cost of performance method of apportionment has been criticized on the premise that it fails to capture as a part of the formula the contribution of the local market where the services are directed but not necessarily performed. The recent trend in state taxation has been the introduction of market-based sourcing rules for services. (At this writing, the following states have adopted a market-based approach for apportionment of the sales of services: California (effective in 2011), Georgia, Illinois, Iowa, Maine, Maryland, Michigan, Minnesota, Ohio, Utah, and Wisconsin.) Under this approach, receipts are sourced to the state where the services or benefits are received, regardless of where the underlying activities that produced those services or benefits are performed.

The AT&T Decision

During the tax years at issue (1996-1999), AT&T, a New York corporation headquartered in...