"When was the last time the company reviewed its sales sourcing methodology?"
It is a question tax practitioners frequently find themselves asking taxpayers.
The responses they get vary, but they usually fall into three categories:
Huh? What's sales sourcing?;
We've heard of it, but do we really need to be concerned with it? The business mostly sells "stuff"; and
Yeah, we know it applies to the business and we keep meaning to take a deeper dive into the nuances, but all the rules are hard to keep up with and we're really pressed for time and budget. Besides, all these state tax sourcing concepts are so complex and talking to you state tax people is our least favorite thing to do because you just overwhelm us with excruciating detail.
Perhaps people do not actually say that last part out loud, but it is likely many them are thinking it.
With that in mind, this column shares a few pragmatic thoughts on the topic for readers who are not selfprofessed state tax geeks.
What is sales sourcing?
What is sales sourcing? If you have not made it your life's mission to obsess over the gritty details of formulary apportionment, that is a fair question.
As with most things, business was simpler in the days of yore. Folks opened brick-and-mortar stores in their hometown, sold their wares, and paid tax. Done.
However, as businesses began to grow and expand across state lines, state governments struggled to find a way to fairly tax their portion of revenue. This resulted in a hodgepodge of treatment across states.
The Uniform Division of Income for Tax Purposes Act (UDITPA) was developed by the Uniform Law Commission (ULC) in the late 1950s. The act addressed the creation of a uniform way for taxpayers to divide their tax base among multiple states. By the late 1960s, the Multistate Tax Compact (the Compact) was drafted by a broad group of state officials as a way to advise member states of recommendations for creating state tax rules and regulations. UDITPA is Article IV of the Compact. (1)
This highly technical model law was a game-changer for the world of state tax.
The Compact originally used an equally weighted three-factor formula to measure the activity of a business in a state. The three factors considered were the company's property, payroll, and sales. (2) Each factor used a fraction, the numerator of which consisted of the factor's in-state amount and the denominator of which consisted of the factor's total amounts placed in service, paid, or sold everywhere.
Recall that in the late 1960s most businesses were still selling tangible personal property. For this reason, taxpayers determined the amount of sales that should be included or "sourced" to the numerator of their sales fraction by using the destination state of the sale. This methodology, which provided tax revenue for states in which the taxpayer's customers were located, seemed to produce a fair result.
However, for sales of services, it was determined that a different methodology would be required to capture the portion of business a company transacted within a state. As a result, a cost-ofperformance rule was created. The rule considered where the income-producing activity underlying the taxpayer's resulting revenue was performed. Most of the service-based economy in the late 1960s would have been personal or professional services; think pre-internet technology lawyers, accountants, and engineers. Determining where the underlying income-producing activity took place would have been a relatively simple endeavor.
The division of income rules contained within the original Compact under Article IV stated that:
Sales, other than sales of tangible personal property, are in this State if: a) the income-producing activity is performed in the State; or b) the income-producing activity is performed both in and outside 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. Fast-forward 50 years and the U.S. economy has significantly shifted. As anyone watching the presidential election campaign last year can attest, manufacturing and production in the United States is not what it once was. The reasons for this are debatable, but service-based companies requiring the use of less property and fewer people located within a given state are now responsible for providing that state with a large portion of its revenue. To more fairly apportion revenue across states, governments have been migrating to the use of a single-sales factor for the better part of the last 15 years. (3) The result of that migration is that properly attributing sales of service income to states is more important than ever because the sales factor is essentially driving the liability in a given state.
The original cost-of-performance rules drafted in the 1960s no longer reflect the types of circumstances that a modern service business operating in a "cloud" environment faces. To combat this, many states have coincided their shift to single-sales factor with a shift to market-based-sourcing methodologies that strive to better reflect current sourcing issues faced by service companies. (4)
The Multistate Tax Commission (MTC) recognized this...