The Implementation of ‘Market’ Sourcing Rules:...

The Implementation of ‘Market’Sourcing Rules: Practical Concerns

by Pilar Mata and Melissa J. Smith

Pilar Mata Melissa J. Smith

California is the most recent state to developmarket-based rules to source receipts from the saleof services and intangibles. In this Pinch of SALT,we survey the various methods states use to applymarket-based sourcing to service and intangibleincome and address how California and the Multi-state Tax Commission are proposing to tacklemarket-based sourcing and the associated problems.We conclude that while market sourcing offers aprincipled way to source receipts from the sale ofservices and intangibles, in practice, market-sourcing rules are likely to create a variety ofadministrative problems and will not advance uni-formity. These challenges are particularly concern-ing in states that weight the sales factor moreheavily or use a single-sales-factor apportionmentformula.

Costs of Performance

Of the 46 states with corporate income taxes, 23states have adopted the Uniform Division of Incomefor Tax Purposes Act, and most others have adopteda similar method to apportion the business income ofmultistate taxpayers. Approximately 30 states use

the costs-of-performance method to source receiptsfrom sales of services or sales or licenses of intan-gibles.1

Under the standard UDITPA rule, receipts fromsales other than sales of tangible personal propertyare sourced to the state if ‘‘the greater proportion ofthe income-producing activity is performed in thisstate than in any other state, based on costs ofperformance.’’2 Thus, the costs-of-performancemethod requires the taxpayer to identify individuallines of income, determine the income-producingactivities for each income line, and determine wherethe income-producing activities (and associatedcosts) take place. Although taxpayers and auditorsmay disagree on how a company’s income linesshould be broken down or on which income-producing activities are associated with each incomeline, the benefit of this method is that taxpayersgenerally have access to relevant cost data — or candesign systems to capture that information — be-cause the costs-of-performance method considers thetaxpayer’s activities.

1See, e.g., Ala. Code section 40-27-1, Art. IV, 17; AlaskaStat. section 43.19.010, Art. IV, 17; Ariz. Rev. Stat. section43-1147; Ark. Code Ann. section 26-51-717; Cal. Rev. & Tax.Code 25136 (a) applicable until 2011; Colo. Rev. Stat. section24-60-1301, Art. IV, 17; D.C. Code Ann. section 47-1810.02(g)(3); Fla. Admin. Code r. 12C-1.0155(2)(e)2.a (ser-vices only); Hawaii Rev. Stat. section 255-1, Art. IV, 17;IDAPA 35.01.01.550.04; Ind. Code section 6-3-2-2(f); Kan.Stat. Ann. section 79-3287; Ky. Rev. Stat. Ann. section141.120(8)(c)3; Mass. Regs. Code tit. 830, section63.38.1(9)(d)1; Mich. Comp. Laws section 206.123; Miss. Reg.35 III.8.06(III)402.9(3)(d); Mo. Rev. Stat. section 32.200, Art.IV, 17; Mont. Code Ann. section 15-31-311(2); Neb. Rev. Stat.section 77-2734.14(3); N.H. Rev. Stat. Ann. section 77-A:3(I)(c); N.M. Stat. Ann. section 7-4-18; N.C. Gen. Stat.section 105-130.4(l)(3) (services only); N.D. Cent. Code section57-38.1-17; Ore. Rev. Stat. section 314.665(4); 61 Pa. Codesection 109.5(c)(3)(iv); S.C. Code Ann. section 12-6-2295 (ser-vices only); Tenn. Code Ann. section 67-4-2012(i); Vt. Stat.Ann. Tit. 32, section 5833(a)(3); Va. Code Ann. section 58.1-416; W.Va. Code section 11-24-7(e)(12).

2UDITPA Rule 17.

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That said, the costs-of-performance method hasbeen criticized on several fronts. The purpose of thesales factor is to reflect the contribution of themarket to the taxpayer’s income. This objective maynot be achieved under the costs-of-performancemethod if the income-producing activities requiredto generate income take place in states other thanwhere the taxpayer’s customers are located. Thisproblem is particularly acute in states that use thestandard all-or-nothing UDITPA rule, which sourcesreceipts to the state only if the preponderance of theincome-producing activities occur within the state,as opposed to a ‘‘proportionate’’ costs-of-performancemethod that sources sales based on the relativeproportion of income-producing activities takingplace in each state.3

In practice, market-sourcing rulesare likely to create administrativeproblems and will not advance thegoal of uniformity.

Further, as the drafters of UDITPA have acknowl-edged, the costs-of-performance rule may not beappropriate for some types of industries. As a result,the MTC has promulgated (and some states haveadopted) industry-specific rules for apportioning theincome of airlines, construction contractors, finan-cial institutions, railroads, telecommunicationscompanies, trucking companies, television and radiobroadcasters, and publishers.4

Current Market-Sourcing RulesConcerns about the costs-of-performance method

have been raised more frequently as the economyhas shifted away from the primarily mercantile-based economy that was in existence when UDITPAwas adopted toward today’s more heavily service-and technology-based economy. This factor, as wellas the recognition that a market-based sourcing rulemay favor in-state businesses, has led several statesto consider market-based sourcing rules. The MTC’sIncome and Franchise Tax Uniformity Subcommit-tee has a task force under way to design a newmarket-based sourcing model statute.

Yet the question remains, how does one measurethe market’s contribution to a taxpayer’s income

from sales other than sales of tangible personalproperty? That question raises several more issues,including how best to ascertain the existence andlocation of a ‘‘market.’’

ServicesIn contrast to the costs-of-performance method,

which focuses on where the income-producing activi-ties are performed, market-based sourcing rulestypically focus on where the market — or customerbase — is located. For instance, Oklahoma sourcesincome from services to the state if the receipts are‘‘derived from customers’’ within the state or if thereceipts are otherwise attributable to the state’smarketplace.5 Maryland sources income from con-tracting or service-related activities to the state ifthe income is ‘‘derived from customers’’ within Mary-land.6 Minnesota sources income from services tothe location where the services are ‘‘received.’’7

These rules are most easily applied when thecustomer is an individual who receives the service(or the benefit of the service) in the state of resi-dence. For example, Maine sources income to thestate if the services are received in the state; if thestate in which the services are received cannot bedetermined, the services are deemed to be receivedat the customer’s home address; if the customer’shome address cannot be determined, the servicesare deemed to be received at the address to whichthe services are billed.8

It is often difficult to determinewhere the benefit of a service is‘received,’ particularly if acustomer is a business withlocations in multiple states.

Other states focus on where the customer receivesthe benefit of the service. Georgia,9 Iowa,10 andMichigan11 use this market-based approach. How-ever, it is often difficult to determine where thebenefit of a service is ‘‘received,’’ particularly if acustomer is a business with locations in multiplestates or if the benefits from the service transcendoperations in a single state. In such cases, manystates, using variable assumptions, will attempt toproportionately distribute the receipts among allstates in which the benefits are received.

3Four states use a proportionate costs-of-performancemethod: Arkansas, Mississippi, North Carolina (servicesonly), and South Carolina (services only). See, Ark. Code Ann.section 26-51-717; Miss. Reg. 35III.8.06(III)402.9(3)(d); N.C.Gen. Stat. section 105-130.4(1)(3); S.C. Code Ann. section12-6-2295(A).

4See Model Apportionment Regulations, available athttp://www.mtc.gov/Uniformity.aspx?id=496.

5Okla. Stat. 68 section 2358(A)(5).6Md. Regs. Code section 03.04.03.08(C)(3)(c); Md. Regs.

Code section 03.04.03.08(D)(3).7Minn. Stat. section 290.191(5)(j).8Maine Rev. Stat. Ann. Tit. 36 section 5211(16-A).9Ga. Comp. R. & Regs. 560-7-7-.03(5)(c)(6)(ii).10Iowa Admin. Code section 701—54.6(a).11Mich. Comp. Laws section 208.1305(2)(a).

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Some states provide specific guidance to deter-mine where the benefit of a service is ‘‘deemed’’ to bereceived.12 For example, Ohio law states:

The physical location where the purchaser ul-timately uses or receives the benefit of whatwas purchased is paramount in determiningthe proportion of the benefit in Ohio.13

Wisconsin provides that the benefit of the serviceis received in Wisconsin for services relating to realproperty located in the state, for services relating totangible personal property located in the state whenthe services are received, for services relating totangible personal property delivered to customers inthe state, for services provided to individuals physi-cally present in the state when the services arereceived, and for services provided to a buyer en-gaged in a trade or business in the state that relateto that trade or business.14

Some states that may claim toapply a market-sourcing methodactually source income fromservices that are ‘performed’within their state.

Finally, it bears noting that some states thatappear to apply a market-sourcing rule actuallysource income from services that are ‘‘performed’’within their state. For example, Connecticut,15 NewJersey,16 Rhode Island,17 and Texas18 use that ap-proach. This method more closely reflects the costs-of-performance method because it focuses on wherethe service provider’s activities are being performedrather than on the location of the taxpayer’s custom-ers.

IntangiblesDetermining the market associated with the use

of intangibles is particularly difficult because intan-gibles generally have no geographical location orscope. The sourcing of income related to intangiblesgenerally comes in two forms: the income from thelicensing of intangibles (for example, royalties) andthe income from the sale of intangible assets. Manystates address those situations individually.

States differ greatly in how they source the gainor loss from the outright sale of an intangible asset.Some states, such as Connecticut, will source the

receipt to the state from which the intangible assetis managed or controlled.19 Texas sources incomefrom the sale of an intangible asset to the location ofthe payer.20 Wisconsin sources the income from thesale of an intangible asset to Wisconsin if the buyeruses the intangible in the regular course of businessat a Wisconsin location, and will divide the incomeproportionately among states if the intangible isused at locations within and outside the state.21

For royalties or income earned from the licensingof an intangible, many states, including Connecticutand Georgia, source the income to the location wherethe intangible is used, based on the proportion of theuse taking place within the state.22 Some statesaddress the determination of where the use takesplace, and specify that the relevant use is that of thelicensee rather than the licensor.23 For example,Minnesota provides that an intangible is used in thestate if the purchaser of the intangible property usedthe property in the regular course of its businessoperations in Minnesota.24 Delaware provides morespecific guidance, with a focus on the manufacturingstate, stating that:

Patent and copyright royalties (less applicableor related expenses) shall be allocated propor-tionately to the states in which the product orprocess protected by the patent is manufac-tured or used or in which the publication pro-tected by the copyright is produced orprinted.25

Finally, it should be noted that when sourcingincome from intangibles to the state where they areused, some states, such as Minnesota,26 will throwout the income if it cannot be determined where theintangible is used. Michigan, for purposes of theMichigan business tax, also has a throwout rule.27

This type of provision acknowledges the difficultyinherent in sourcing income from the use of anintangible. Also, if a significant amount of royaltyincome is ‘‘thrown out’’ because it cannot be deter-mined where the intangible is being used or whatproportion of its use occurs in state, the result can bea sales factor that does not accurately reflect theextent of the taxpayer’s in-state activity.

12Ohio Rev. Code section 5733.05(B)(2)(c).13Id.14Wis. Stat. section 71.25(9)(dh).15Conn. Gen. Stat. section 12-218(c)(3).16N.J. Stat. Ann. section 54:10A-6(B)(4).17R.I. Gen. Laws section 44-11-14(a)(2)(ii).1834 Texas Admin. Code section 3.557(e)(33).

19Conn. Gen. Stat. section 12-218(c)(3).2034 Texas Admin. Code section 3.557(e)(25)(B).21Wis. Stat. section 71.25(9)(dk); Wis. Admin. Code Tax

section 2.39(2)(cm).22Conn. Gen. Stat. section 12-218(c)(3); Ga. Comp. R. &

Regs. 560-7-7-.03(5)(c)(6)(viii).23La. Rev. Stat. Ann. section 47:287.93(A)(3); La. Admin.

Code section 61:I.1130(A)(3)(a); Maine Rev. Stat. Ann. Tit. 36section 5211(16-B).

24Minn. Stat. section 290.191(5)(i).25Del. Code Ann. Title 20 section 1903(b)(2).26Minn. Stat. section 290.191(5)(i).27Mich. Comp. Laws section 208.1305(1)(e).

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The Multistate Tax Commission’s Proposal

The MTC on July 15 held its most recent meetingregarding revisions to Model Compact Art. IV.17(Model Rule 17), which is the existing costs-of-performance rule. Under the most recent version ofthe draft rule, costs-of-performance is replaced witha rule that sources receipts from sales of services tothe state ‘‘if and to the extent that the service isdelivered to a location in the state,’’ and will thenuse a reasonable approximation in the event thatthat location cannot be determined. Receipts fromthe sale, lease, or license of an intangible will besourced to a state ‘‘if and to the extent the intangibleproperty is used by the payor in this state,’’ and willthen use a reasonable approximation if the locationof that use cannot be determined. The MTC rejectedthe option of using a cascading rule to determinehow receipts are to be sourced under these provi-sions and remains committed to sourcing receipts tostates on a proportional basis to the extent that theservice is received or the intangible is used inmultiple states. Moreover, the MTC intends to throwout receipts to the extent that those receipts wouldbe sourced to a location where the taxpayer does nothave nexus with the state or where the sourcinglocation is not determinable.

California’s Market-Sourcing Approach

Effective in 2011, California Revenue and Taxa-tion Code section 25136 will require taxpayers tosource the following receipts to California:

[s]ales from services . . . to the extent thepurchaser of the service received the benefit ofthe service in this state, ‘‘[s]ales from intan-gible property . . . to the extent the property isused in this state,’’ and sales of marketablesecurities ‘‘if the purchaser is in this state.’’

On July 19 the California Franchise Tax Boardheld its second interested parties meeting to receivecomments on proposed Regulation 25136, which willinterpret the new law. The proposed regulationprovides a set of cascading rules that come intoeffect serially if the proper location cannot be deter-mined under the prior rule.

To determine when the purchaser receives thebenefit of a service, the proposed regulation differ-entiates between sales to individuals and sales tobusiness entities. For individuals the benefit of theservice is deemed to be received in the followingorder:

• according to the location set forth in the con-tract;

• according to the purchaser’s billing addressunless the taxpayer provides evidence showingthat the service was not delivered to the billingaddress; or

• based on a ‘‘reasonable approximation.’’28

When the purchaser is a business entity, thebenefit of the service is deemed to be received in thefollowing order:

• according to the location set forth in the con-tract, based on a ‘‘reasonable approximation’’;

• according to the location where the purchaserplaced the order for the service; or

• according to the purchaser’s billing address.29

To determine when the purchaserreceives the benefit of a service,the proposed California regulationdifferentiates between sales toindividuals and sales to businessentities.

When there has been a complete transfer and saleof intangible property rights, receipts are to besourced in the following order:

• if the purchaser used the property in a singlestate, to the state where the purchaser exclu-sively used the property at the time of thepurchase;

• based on the ‘‘extent of the purchaser’s locationin this state as compared to the purchaser’slocations everywhere’’;

• based on a ‘‘reasonable approximation’’; or• according to the billing address of the pur-

chaser.30

In contrast, the licensing, leasing, rental, or otheruse of intangible property is to be sourced in thefollowing order:

• based on the extent to which the property isused in the state by the taxpayer’s purchaserunder the contract;

• based on the proportion of sales of tangiblepersonal property sold by the taxpayer’s pur-chasers in the state that gives rise to thereceipts;

• based on a ‘‘reasonable approximation’’; or• according to the commercial domicile of the

taxpayer’s purchaser.31

Practical ConcernsAs the above sections illustrate, there are many

ways to determine market sourcing and little agree-ment about the best way to approach the issue.California’s decision to use a cascading rule and theMTC’s rejection of that approach is but one of thedifferences that market-sourcing states have. These

28Proposed Cal. Reg. 25136(c)(1)(A).29Proposed Cal. Reg. 25136(c)(1)(B).30Proposed Cal. Reg. 25136(d)(1).31Proposed Cal. Reg. 25136(d)(2).

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fundamental differences will undermine the goal ofuniformity among states. Also, there are many com-mon problems and practical issues with market-based sourcing rules for services and intangibles.

First, many complications arise because of thesheer breadth of those statutes. Unlike industry-specific rules, which take into account common busi-ness arrangements and provide taxpayers with clearguidance as to how specific types of receipts are to besourced, market-sourcing rules applied to all sales‘‘other than sales of tangible personal property’’reach a broad range of taxpayers and transactiontypes. Thus, there is a tension between developing arule that can be applied to ‘‘most’’ taxpayers whileensuring that the rule is applied in a consistentmanner among similarly situated taxpayers.

Defining standard terms and concepts — such aswhat is meant by the delivery or receipt of a service(that is, does this refer to physical or contractualdelivery or receipt?); what is meant by the ‘‘benefit’’of a service; what constitutes a ‘‘use’’ of an intan-gible; and whether the ‘‘customer’’ refers to thetaxpayer’s customer or the ultimate consumer —will help to advance this objective. Because of thewide variety of taxpayers and transaction types,detailed examples will be necessary to demonstratehow a market-sourcing rule should be applied indifferent situations.

Fundamental differences amongstates over market sourcing willundermine the goal of uniformity.

Second, market-based sourcing rules are difficultto apply to taxpayers making sales of services orintangibles to multistate businesses. In many cases,if a multistate business purchases a service orlicenses an intangible that benefits its businessgenerally, there will be no clear state (or states) inwhich the service is received or intangible is used.Although the customer’s billing address, commercialdomicile, or principal place of business may providea relatively easy answer to that question, sourcingreceipts to a single location under those circum-stances would create an arbitrary all-or-nothingresult, not unlike the result reached using apreponderance-based costs-of-performance rule.

Many market-sourcing rules contemplate sourc-ing those receipts to more than one state; however, itis often unclear how those receipts should be distrib-uted among various states. For example, shouldsourcing be based on the customer’s locations, thecustomer’s marketplace, or some other proxy? Underwhat circumstances should such receipts be thrownout of the taxpayer’s sales factor numerator anddenominator? And although throwout may enabletaxpayers and taxing authorities to avoid such

quandaries, it will do nothing to advance the causeof reflecting the contribution of the market to thetaxpayers’ income from services and intangibles.

Third, a market-based sourcing rule is particu-larly difficult to apply to the license of intangiblesbecause it will often raise the question whether thetaxpayer’s customer or the ultimate consumershould be considered when determining the locationof the use of the intangible. For example, suppose ataxpayer owns a patent to manufacture a widget. Ifthe taxpayer licenses the patent to a manufacturerlocated in State A, and the manufacturer sells thefinished product to a distributor located in State B,and the distributor sells to a retailer whose ware-houses are located in states C and D, and thenultimately sells the product through stores locatedin E, F and G, how should income from the tax-payer’s license of the patent be sourced? On the onehand, the taxpayer’s customer — and thus thetaxpayer’s ‘‘true’’ market — is located in State B. Onthe other hand, the market for the patented productis located in states E, F, and G. At present, the MTCand California have proposed that the taxpayershould ‘‘look through’’ to the location of the ultimateconsumers, rather than simply relying on the manu-facturer’s location in State B.

Using the location of the ultimate consumerraises many practical issues. Often it is true that alicensor/taxpayer will know where its licensee/manufacturer is entitled to use or distribute prod-ucts, and may be able to negotiate the right to obtainthat information from the licensee when it entersinto the license agreement. However, when it sellsits products to its distributor, the licensee/manufacturer may not know the specific states inwhich its products are ultimately sold, just as thedistributor may not know the breakdown of salesamong the retailers’ various locations. When forcedto source based on ‘‘downstream’’ sales, the questionthen becomes: Should the licensor/taxpayer use thelast-known information (here, that the taxpayer/licensor has licensed products to the manufacturer/licensee located in State B) or should it use anapproximation of the jurisdictions in which theproducts ultimately may be sold, based on popula-tion estimates? These policy decisions should bemade and communicated by taxing jurisdictions inadvance so that taxpayers source those receiptsconsistently.

Fourth, nearly all market-sourcing rules ac-knowledge these concerns and limitations by per-mitting the taxpayer, under some circumstances, toeither move to the next prong of the cascading rule,to use a reasonable approximation, or to throw outthe receipt when the appropriate location cannot bedetermined. Guidance must be provided to tax-payers regarding when it is appropriate to advanceto the next alternative.

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California proposes to define ‘‘cannot be deter-mined’’ to mean that ‘‘the taxpayer’s records do notindicate where the benefit of the service was re-ceived or where the intangible property was used’’and states that the FTB ‘‘shall consider the effortand expense required to obtain the necessary infor-mation.’’ Despite assurances made by the FTB at themost recent interested parties meeting, auditors willlikely apply those rules inconsistently. How thosedeterminations ultimately play out during auditsremains to be seen, particularly if the taxpayers andthe FTB interpret core terms differently.

Finally, there is the question of what is meant bya ‘‘reasonable approximation.’’ California has de-fined reasonable approximation to mean that ‘‘con-sidering all sources of information, including pub-licly available information, the location of themarket for the benefit of the services or the locationof the use of the intangible property was determinedin a manner that is consistent with the business ofthe purchaser.’’ No doubt taxpayers and auditorswill use different sources of information when an-swering sourcing questions and will have conflictinginterpretations about how receipts should besourced to be ‘‘consistent with the business of thepurchaser.’’

The practical solutions that will beapplied in a market-sourcingmethod will do no more than thecosts-of-performance method toadvance the reflection of themarket in the sales factor.

In an example in California’s proposed regula-tion, Accounting Corp. provides nationwide tax ad-vice to Car Corp., which does business throughoutthe United States. The example first suggests thatthe taxpayer use the terms of the contract to deter-mine how receipts from the accounting servicesshould be sourced, and then suggests that if thecontract does not break down the fees by state, the

receipts should be reasonably approximated usingavailable public information indicating the marketof Car Corp. in the state. Needless to say, contractsof this type rarely address the locations benefitedand the relative amount of the benefit to be allo-cated to each state in advance of an engagement, soreference to the contract is unlikely to be helpful.Similarly, Accounting Corp. should not have tosearch through vast amounts of publicly filed docu-ments regarding Car Corp.’s presence in each statein order to source the appropriate percentage ofreceipts from this particular contract to individualstates.

If a market-sourcing regime is to be successful,taxpayers attempting to comply with new market-sourcing rules need assurances that auditors willaccept reasonable efforts, information, and approxi-mations.

ConclusionAlthough market sourcing is appealing in theory,

it is far more complicated to source receipts fromsales of services and intangibles in a principled way.States will thus have to balance the quest for accu-racy against the practical realities of gathering andreporting this information. Ironically, the practicalsolutions that will be applied will do no more thanthe costs-of-performance method to advance thereflection of the market in the sales factor and arelikely to create conflicts on audit. Such limitationsshould be acknowledged before states make thedecision to move to market sourcing. ✰

Pilar Mata and Melissa J. Smith are associates withSutherland Asbill & Brennan LLP’s State and Local TaxPractice.

Sutherland’s SALT Practice is composed of 20 attorneyswho focus on planning and controversy associated withincome, franchise, sales and use, unclaimed property, andproperty tax matters. Sutherland’s SALT Practice alsomonitors and comments on state tax legislative and policyefforts.

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