Not a COP-Out: Clarifying the Cost-of-Performance Test for Service Providers
In an increasingly service-based economy, one of the most bewildering issues facing tax professionals is the application of income-producing activity/greater cost-of-performance test to various types of services. Although market-based sourcing is quickly supplanting this test, it can have a substantial effect on taxpayers. While the application of this test to service receipts is found in the 1957 Uniform Division of Income Tax Purposes Act (UDITPA), it has even earlier roots as applied to receipts from services. The definition of “sales” for sales factor purposes can be traced to the model apportionment acts developed by the National Tax Association that were designed to assist taxpayers who derive their income from the sale of tangible goods. In a 1951 model apportionment and allocation act, ultimately adopted in large part by UDITPA, the “sales” factor was broadened to encompass both receipts from sales of tangible personal property and other receipts. However, UDITPA did not specifically address the sourcing of receipts other than tangible personal property, but it did include a catch-all provision—the income-producing activity/greater cost-of-performance test.
The test is essentially a two-step process:
1.) If the income-producing activity is entirely performed in the state, the service receipts are sourced to the state.
2.) If the income-producing activity is performed in two or more states, the service receipts are sourced to the state where the amount of costs incurred exceed incurred costs in the other states. For example, assume if 40 percent, 30 percent, and 30 percent of the costs are incurred in states A, B, and C, respectively; 100 percent of the service receipt would be sourced to state A.
Whether the income-producing activity occurs entirely in one state has been subject to a great deal of litigation over the years. Nonetheless, to properly apply the language to arrive at the most prudent result, a very careful parsing is required based on each taxpayer’s business model.
The most common definition of income-producing activity in states reads as follows:
- The term “income-producing activity” applies to each separate item of income and means the transactions and activity directly engaged in by the taxpayer for the ultimate purpose of obtaining gains or profits.
The provision, broken down, requires the following:
- Each item of income must be examined
- Both the transactions and the activity of the taxpayer must be examined
- The transactions and activity must be directly engaged in by the taxpayer
- The transactions and activity must be for the ultimate purpose of obtaining gains and profits
If the income-producing activity is performed in two or more states, the next step is to apply the greater cost-of-performance test. “Costs of performance” means direct costs determined in a manner consistent with generally accepted accounting principles and in accordance with accepted conditions or practices in the taxpayer’s trade or business. The state where the greatest amount of costs are incurred is the state where the service receipt ought to be sourced. A key observation is that this definition only looks at the direct costs rather than indirect costs in making the sourcing determination. Also, “generally accepted accounting principles” does not mean financial accounting principles in this context. Rather, the reference is to cost/managerial accounting principles. “Back office” costs—advertising, administrative payroll, office expense, etc.—are not direct costs. A common mistake is to view the costs of performance as being incurred at the taxpayer’s commercial domicile or the location of the taxpayer’s personnel even if such personnel do not directly provide the service. Recently, in University of Phoenix, Inc. v. Indiana Dept. of State Revenue, 88 NE3d 805 (Ind. Tax 2017), the Indiana Tax Court held that an online university’s cost-of-performance analysis was faulty because the university viewed costs “based on an operational-level approach rather than a transaction-by-transaction approach.”
Typically, with service providers, the hours of labor spent by personnel directly performing the service that generated the receipt must be examined to properly make a sourcing determination.
For additional guidance on the income-producing activity/greater cost-of-performance test, contact your BKD Trusted Advisor™ or submit the Contact Us form below.