Sourcing service receipts.

• Author: Salmon, Scott A.

Past items in TTA have discussed state taxation of service providers. However, with the advent of telecommuting and the explosion of electronic commerce, "sourcing" a taxpayer's receipts to a particular state has become much more challenging. While the terms "duty days" and "games played" have become common among practitioners when sourcing services of professional athletes, "sourcing" receipts of other service providers (e.g., systems consultants, architects, outsourcing agencies and trainers) has challenged tax advisers, due to a lack of formal guidance and states' inconsistent positions. (1)

Overview

When it comes to the apportionment and allocation of income, many states have adopted the general provisions of both the Uniform Division of Income for Tax Purposes Act (UDITPA) and the Multistate Tax Commission (MTC) regulations interpreting them. Accordingly, practitioners often use these provisions as general guides to the multistate income tax treatment of personal and professional services. However, as is discussed below, a growing minority of states employ several other methods for sourcing service income.

Sourcing Service Revenue

The UDITPA provision on the sourcing of service income is short and straightforward. It simply provides that sales, other than sales of tangible personal property, are in a state if the income-producing activity is performed (1) in the state; or (2) both in and outside the state and a greater proportion of the income-producing activity is performed in the state than in any other state, based on costs of performance. (2) This is often referred to as the "greater of costs of performance" rule or the "all or nothing" rule.

Example 1: Consulting firm X collects $200,000 from a chent in state A, for services provided by an X employee, M, solely in A. X would assign the $200,000 to the A numerator.

Example 2: M from Example 1 has a home office in state B, while X's main office is in state C. Several employees in C worked on the project ($80,000 associated payroll and project costs); M spent 60% of her project time in B, with $34,000 associated payroll and project costs. In providing the consulting service, M spent only 40% of her time in A; approximately $26,000 in payroll travel, meals, lodging, etc. was related to the project in A. Including project costs, X's entire costs of performance were $140,000. Using the all-or-nothing rule, X incurred more than 50% of the costs of performance in C ($80,000/$140,000); thus, the $200,000 in sales receipts would be assigned there.

Defining income-producing activity: The UDITPA does not define "income producing activity." The MTC regulations provide only a general definition of the term. MTC Regulation IV.17(2) defines an "income producing activity" as applying to "each separate item of income" and meaning the "transactions and activity directly engaged in by the taxpayer in the regular course of its trade or business for the ultimate purpose of obtaining gains or profit"

Individual or aggregate evaluation: As noted above, the definition of income-producing activity found in the MTC regulations is not specific. One area of confusion is how strictly the phrase "each separate item of income" should be interpreted. Two states have addressed this general issue in the last year, with very different results.

In July 2006, the Massachusetts Appellate Tax Board (ATB) held (3) that a Massachusetts-based company that assembled vacation packages was required to source all its receipts to that state under the state's costs-of-performance rule. The state did not conform to the MTC regulations in this case, but implemented substantially similar provisions. The ATB rejected the taxpayer's argument that each separate vacation package should be treated as a separate income-producing activity, finding that the relevant activity was the overall operation of a business that sold tour packages, the costs of which were incurred in Massachusetts. The ATB stated that the taxpayer was engaged in the activity of marketing vacation packages, and its receipts should not be fractured into mini-transactions for purposes of defining income-producing activity. This decision was consistent with a 2003 ATB ruling that ultimately was upheld by the state's Supreme Judicial Court. (4)

In contrast, the Michigan Department of Treasury (MDOT), in late 2006, released guidance on the proper application of the costs-of-performance rule. (5) Although Michigan does not adopt the MTC regulations, sales of other than tangible personal property are attributed to the state if a greater proportion of the income-producing activity is performed there, based on costs of performance, and many of the core provisions are functionally...