Market Based Sourcing – No Time To Hibernate

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It is always fascinating to watch trends develop and revisit whether the prognosticators were correct – we even enlist Punxsutawney Phil at this time of year – more on him later.

One trend we’ve been watching has been the state tax authorities’ modifications in the sourcing of revenue in order to increase the receipts from out of state taxpayers. The increasingly popular response by state taxing authorities is the adoption of a different sourcing methodology for sourcing receipts earned from revenue arising from the rendering of services.

Historically, the majority of states sourced revenue derived from the provision of services pursuant to the “Cost of Performance” method – i.e. such revenue would be sourced to the state where the income producing activity was performed. However, over the past decade, states have begun to adopt “Market-Based” sourcing in which revenue from services, as well as revenue from intangibles, are sourced to the state in which the benefit of the service is received and/or will be ultimately used.

As this post will discuss, “Market-based” sourcing may significantly increase an out of state taxpayer’s receipt factor and state tax in those states in which the taxpayer may have a significant client/customer base – even if the taxpayer has few or no employees in that remote state.

Market-based sourcing’s potential to increase taxpayers’ revenue sourced to remote states for corporate income tax purposes may be illustrated by the following example:

  • AIM Co. Corporation (“AIM”) is based in State A.
  • All of AIM’s operations and personnel are located in State A.
  • AIM derives all of its revenue from rendering consulting services that are performed exclusively at its location in State A.
  • State A is a Cost of Performance state.
  • AIM’s consulting services are distilled to a report that its clients may access electronically or in via a hard copy that is sent exclusively by common carrier to AIM’s clients.
  • All of AIM’S clients are located thousands of miles away in State C.
  • AIM’s visits to clients and potential clients located in State C are sufficient for AIM to have income tax nexus in State C.
  • AIM does not perform any services in State C.

Let’s further assume that:

  • Prior to 2015, State C was a Cost of Performance state.
  • In 2015 State C became a Market-Based sourcing state.
  • State A and C’s tax rate is 9%.
  • State A is a three factor state.
  • State C is receipt factor only state.
  • AIM’s net income before taxes is $1,000,000.

Prior to 2015, although it had nexus in State C, under State’s C Cost of Performance method of sourcing, AIM had no income soured to State C resulting in $0 tax to State C. However, AIM, under State A’s Cost of Performance sourcing had 100% apportionment to its home State A, resulting in State A tax on its net income of$90,000.

In 2015, under State C’s Market Based sourcing provisions 100% of AIM’s income is sourced to State C.

Why? Under State C’s Market Based sourcing since all of AIM’s clients are located in State C and receive the benefit of AIM’s services in State C AIM must source 100% of its income to State C.

Remarkably, State C gets to source 100% of AIM’s receipts to the State despite the following:

  • AIM does not perform any services in State C.
  • AIM does not have a location or any assets in State C.
  • AIM does not have any employees located in State C.

Despite AIM’s minimal contact with State C AIM will have State C tax of $90,000.

Wait, it GETS WORSE! Since AIM’s entire operations are located in State A (a Cost of Performance state), 100% of AIM’s income is sourced to State A as well. AIM will have State A income tax of $90,000.

AIM’s state income tax rate just increased by 100% from 9% to 18%.

This simple, but extreme example illustrates how Market-Based sourcing can significantly increase taxes on remoted based service companies.

According to CCH Smart Charts, to date the following states have adopted some form of Market-Based sourcing provisions.

  • Alabama
  • California
  • Georgia
  • Illinois
  • Iowa
  • Maine
  • Maryland
  • Massachusetts
  • Michigan
  • Minnesota
  • Nebraska
  • New York
  • Ohio
  • Oklahoma
  • Rhode Island
  • Tennessee
  • Utah
  • Wisconsin

In addition, the District of Columbia and New York City have adopted Market-Based sourcing provisions.

Multistate Taxpayers – Time To Wake Up To Market Based Sourcing

Now for a prediction even Punxsutawney Phil would make – as more states analyze the potential benefits that Market-Based sourcing may yield in their attempts to increase revenue from out of state multistate taxpayers, more states will seek to adopt Market-Based sourcing.

In an upcoming post we will discuss how Market-Based sourcing, when adopted in combination with factor based nexus, is a very potent tool for state tax administrators to increase tax revenue.

By the way, our little fellow Punxsutawney Phil did not see his shadow on this Groundhog Day.

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