States fine-tune market-based sourcing rules through regulation: the devil is in the details in this complex, emerging issue.

• Author: Lard, Todd
• Position: STATE TAX

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In 2015, the rubber met the road, and states began to accelerate the adoption of detailed regulations to accompany what is often vague statutory language to source receipts from the sale of services and intangibles based on the location of the "market." In this article, we survey the key proposed and final regulations that apply market-based sourcing to service and intangible income and explore the methods by which states and the Multistate Tax Commission (MTC) are proposing to tackle market-based sourcing and the associated problems through detailed regulations. While many argue that market-based sourcing offers a principled way to source receipts from the sale of services and intangibles, in practice, market-based sourcing rules are likely to create a variety of administrative problems. These challenges are particularly heightened in states that heavily weight the sales factor or use a single-sales factor apportionment formula.

Costs of Performance

Of the forty-six states with corporate income taxes, twenty-three have adopted the Uniform Division of Income for Tax Purposes Act (UD1TPA), and the majority of others have adopted a similar methodology to apportion the business income of multistate taxpayers. Approximately twenty-two states use some variation of the costs of performance method to source receipts from sales of services and/or sales or licenses of intangibles. (1)

Under the standard UDITPA costs of performance rule, receipts from sales other than sales of tangible personal property are sourced to the state if "the greater proportion of the income-producing activity is performed in this state than in any other state, based on costs of performance." (2) Thus, the costs of performance rule requires the taxpayer to identify individual lines of income, determine the income-producing activities for each income line, and determine where the income-producing activities (and associated costs) take place. Although taxpayers and auditors may disagree as to how a company's income lines should be broken down or on which income-producing activities are associated with such income lines, the benefit of this methodology is that taxpayers generally have access to relevant cost data--or can design systems to capture such information--because the costs of performance method considers the taxpayers activities.

That said, the costs of performance rule has been criticized on several fronts--particularly in states that use the standard all-or-nothing UDITPA rule, which sources receipts to the state only if the preponderance of the income-producing activities occur within the state. An alternative approach, taken by some states, is a "proportionate" costs of performance rule that sources sales based upon the relative proportion of income-producing activities taking place in each state. (3) The proportionate method remediates some of the harshness of the all-or-nothing rule.

Additionally, as the drafters of UDITPA acknowledged, the costs of performance rule may not be appropriate for certain types of industries. As a result, the MTC has promulgated (and some states have adopted) industry-specific rules for apportioning the income of airlines, construction contractors, financial institutions, railroads, telecommunications, trucking, broadcasting, and publishing. (4)

Market-Based Sourcing

An increasing number of states have abandoned the costs of performance rules in favor of market-based sourcing, which tries to identify the market for service and intangible income. The District of Columbia, Massachusetts, Nebraska, New York, Pennsylvania, and Rhode Island have adopted market-based sourcing effective in 2014 and 2015. (5) Market-based sourcing becomes effective in Tennessee in 2016. (6) California and Alabama are also recent converts, while North Carolina and Virginia are studying the fiscal impact of market-based sourcing. Legislatures in Kentucky, New Mexico, and Virginia are all expected to consider market-based sourcing legislation in 2016 (7)

Despite a clear trend toward state adoption of market-based sourcing, a key question often remains--how does one measure the market's contribution to a taxpayer's income from sales of other than tangible personal property? Every state that has enacted market-based sourcing did so in a manner that will require regulatory guidance in order to be effectively administered. As a critical mass of states start to elaborate through regulation what constitutes a "market," many states have incorporated a simple statutory framework offered by the MTC.

MTC Model Market-Based Sourcing Statute

To facilitate some degree of uniformity as states shift to market-based sourcing, in 2014 the MTC approved a model market-based statutory regime. (8) The MTC model is simple on its surface. Sales of other than tangible personal property are attributed to a state "if the taxpayer's market for the sale is in this state." The MTC model provides that sales of services are attributed to a state "if and to the extent the service is delivered to a location" in the state. While statutory language that looks to "delivery" could be sufficient to source most personal services, the MTC drafters fully contemplated that a regime of regulations will be needed to provide guidance to source many multistate transactions and activities.

When it comes to receipts from intangibles, the MTC model requires receipts from the rental, lease, or license of intangible personal property to be sourced to a state if the intangible personal property is "used" in the state. Recognizing that it will not always be obvious where "intangible" property is "used," the model creates a special rule for "intangible property utilized in marketing a good or service" (i.e., trademarks, trade names, etc.). The MTC model requires receipts from the licensing of such property to be sourced to a state only if the associated good or service is purchased by a consumer in the state.

The MTC model also attempts to avoid disputes about the application of market-based sourcing by providing that, if the market state cannot be determined under the basic rules, "the state or states of assignment shall be reasonably approximated." The MTC model then provides that, if the state or states of assignment cannot be reasonably approximated, the sales shall be excluded from the denominator and numerator of the sales factor altogether. This exclusion, commonly referred to as "throw out," also applies if the...