Market Source-ry: How States Are Magically Changing Tax Rules

Issue # 2024-20

Summary

While many state legislatures have moved from costs of performance sourcing to market sourcing for services, many state taxing agencies have not waited for the required statute changes. These taxing agencies have taken aggressive approaches to shift to market sourcing, often without the requisite statutory backing. These law changes by administrative fiat can create opportunities for taxpayers who can benefit from choosing their sourcing method.

In Detail

States largely adopted sourcing provisions modeled after the Uniform Division of Income for Tax Purposes Act (UDITPA), which requires sourcing service receipts to where the income-producing activities occurred based on performance costs. Over the last two decades, many states have changed how they source service receipts to a market-based method. This has the benefit of taxing out-of-state companies whose costs are incurred outside of the taxing state, effectively “exporting” their tax base by shifting the incidence of tax from in-state to out-of-state companies.

Tax agencies have an incentive to increase tax on out-of-state companies by applying a market sourcing approach to taxpayers that would otherwise report a small or zero sales factor. This approach sources receipts to the state that would otherwise not be sourced to the state under an operational cost of performance interpretation.

Most states that have made the shift to market sourcing have done so through a thorough legislative process that involves thorough reasoning and public input. However, many state taxing agencies have disagreed with legislative inaction by attempting to take matters into their own hands. These states have aggressively attempted to achieve market sourcing even when the underlying statutes do not appear to explicitly provide for market sourcing.

Below are some examples of these taxing agencies attempts at changing the law. These results speak for themselves. We implore readers to review guidance in light of their legislative and historical context to ensure that the proper sourcing methodology is used.

One approach used by states in Sirius (TX), Billmatrix (FL), and Synthes (PA) is to deem the income-producing activity to occur in the states where the taxpayer’s customers are located. Effectively, this shifts the costs of producing to the market. The interpretation was overturned in Sirius XM and Billmatrix but upheld in Synthes. In Sirius XM, the Texas Supreme Court held that receipts should be sourced based upon the fair value of the services performed in each state and not the Comptroller’s market-sourcing approach using the customer-location decryption of the taxpayer’s transmissions as the situs of the sales. In Billmatrix, the Florida Circuit Court rejected the Department of Revenue’s argument that the income-producing activity was based upon the location of the taxpayer’s customer and held that sales should be sourced to the state in which the taxpayer’s greater proportion of costs of performance was incurred. However in Synthes, the Pennsylvania Supreme Court held that income-producing activity should be determined based upon the location of the taxpayer’s customers. The Supreme Court upheld the Department of Revenue’s interpretation.

Another methodology that states have taken is to use agency discretion to attempt a change in law. In Target Enterprise, the Florida circuit court rejected the Department of Revenue’s attempt to invoke agency discretion to achieve a market sourcing result. The DOR had argued that the taxpayer’s cost of performance information was insufficient, and the circuit court rejected the argument.

States have also taken a transactional approach, as they successfully did in Oregon in AT&T. In that case, the Oregon Supreme Court accepted the Department of Revenue’s transactional interpretation of the cost of performance. Under the transactional approach, only the incremental cost of each additional transaction can be entered into the cost of performance analysis, which resulted in sourcing receipts for each transaction to the customer’s location.

States have also attempted to change the sourcing methodology to attack so-called “nowhere sales.” In NASCAR, the Ohio Department of Revenue attempted to source revenues related to contracts covering the United States by using a population approach. However the Ohio Supreme Court held that NASCAR’s revenues should be sourced based on the statute, which requires sourcing based on the location where intellectual property is used.

These recent cases should make practitioners wary of relying solely on taxing agency guidance to determine proper sourcing. The varying attempts to achieve market sourcing by tax agencies in the absence of clear statutory authority highlight a more general consideration regarding reliance upon tax agency guidance. Taxpayers should seek assistance from their state tax experts when tax agencies adopt changes by administrative rulemaking in the absence of changes by the legislature. Often the tax agency’s rulemaking can be challenged as being in contravention of the statute.

The taxing agencies’ interpretations can also create opportunities for taxpayers, depending on the taxpayer’s particular facts and circumstances. Taxpayers may be stuck between statutes and guidance. But in doing so, the choice may sometimes simply be following an agency interpretation that results in a lower tax liability. On the other hand, taxpayers that face a detriment from an agency interpretation may challenge the interpretation as being contrary to statute if the agency interpretation is incorrect. However, before any such positions are taken, the risks and rewards of the position should always be considered.

Insights

Taxpayers should consider their prior year's state filings to determine apportionment opportunities and potential risks regarding their sales factor sourcing approach. The recent case law may provide an opportunity to revisit the approach to sourcing receipts.

NOW Expertise

Steve Kralik