Market-Based Sourcing Becoming Popular with States
Author: Jeff Farrell
A state income tax trend 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. Within 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 a company performs the income-producing activity in two or more states, the sale is assigned to the state in which the company performs a greater proportion of the income-producing activity, based on performance costs.
State legislatures are increasingly turning to market-based sourcing to increase tax revenue from out-of-state service providers. Historically, most states used a cost-of-performance method to source these sales in the apportionment factor. This frequently resulted in out-of-state service-based businesses including few or no sales in the sales factors of nonresident states.
The fiscal effect of market-based sourcing would be less in an economy dominated by sales of tangible goods. However, sales of services are now a large part of the U.S. economy, and the cost-of-performance method would create a significant loss in state tax revenues. As a result, more than half of states imposing a corporate income or franchise tax have adopted or are investigating a market-based approach.
The differing treatment among states of the cost-of-performance and market-based methods could result in instances of double taxation. For example, consider a service provider that substantially conducts all operations in its resident cost-of-performance state. If it has income tax nexus in one or more market-based states, it could end up including revenue from the market-source states twice—once in the market state sales factor and again in its resident state sales factor.
There are variances on how to define “market” and how to source the associated revenue in state-specific authorities. Current methods to source revenue based on the market include: where the benefit of the service is received, where the service is received, where the service is delivered and the customer’s location. Whether these differences ultimately lead to varied sourcing results for taxpayers will depend on each taxpayer’s facts and circumstances. If taxpayers are unable to accurately source revenue amounts using a state’s market approach, they’re typically required to exclude the revenue from the sales factor.
Jurisdictions that more recently enacted market-based sourcing and their associated effective dates include the District of Columbia (January 1, 2015), New York City and state (January 1, 2015), Rhode Island (January 1, 2015), Missouri (optional August 28, 2015), Connecticut (January 1, 2016), Louisiana (January 1, 2016) and Tennessee (July 1, 2016). North Carolina has passed proposed amendments for market-based sourcing, with the Department of Revenue to provide proposed rules on market-based sourcing by January 20, 2017.