Co-contributor: Jonathan Kocon

Service providers with customers located in multiple states are finding out that apportioning revenues amongst the states they may be required to file in isn’t as easy as it may seem.  States are changing their laws on what constitutes revenue within their state with some adopting a market-based sourcing approach, which is a shift from the traditional cost-of-performance approach.

Cost-of-performance Vs. Market-based Sourcing Approach
The battle between companies’ and states’ definitions of what they consider doing business in a state is a long one.  The general standard until recently was that if you didn’t have a physical presence in the state, you were not subject to that state’s income tax.  The “cost-of-performance rule” states that income is taxed to the state where the income-producing activity is performed.  For example, an Ohio company would only be subject to tax in Indiana if activities were physically performed in Indiana that generated income.

Commercial Activities Tax Expands Tax Base
However, in recent history, states have passed legislation to help expand their tax base.  A perfect example in our own backyard is Ohio’s creation of the Commercial Activities Tax (CAT), which subjects  taxpayers to a tax on gross receipts of $150,000 or more for the privilege of selling in Ohio.  Companies that sell products or services into Ohio that are ultimately used in Ohio may be subject to the CAT regardless of whether or not they physically enter Ohio, thus avoiding the physical presence requirement. In place since 2005, the CAT was one of the first tax of its kind to circumvent the physical presence requirement and has helped pave the way for the market-based sourcing approach.

The market-based sourcing approach says that revenues are assigned to states in which the service is ultimately received.  Thus, an Ohio company performing architecture services solely in Ohio, but for customers outside of Ohio, may be subject to tax in that customer’s state.   However, based on what state the Ohio company performs these services for is located in, these revenues may or may not be assigned to that other state.  The reason for that is that not all states have adopted the market-based sourcing approach.

For example, services performed in Ohio for an Indiana customer would not be subject to tax in Indiana, as they have not yet adopted the market-based sourcing approach; however, the same services performed for a Pennsylvania customer would be taxable, as they have adopted the market-based sourcing approach.  To further complicate matters, each state has their own interpretation for how the market-based sourcing approach is applied in their state, creating slightly different results depending on the state in question.

Where Services are Performed Determine Company’s Tax
Market-based sourcing looks at revenues from services performed to determine a service company’s tax liability, instead of the customary three factor apportionment method.Traditionally, a three factor apportionment method looks at wages earned in the state versus wages earned everywhere else, as well as property located in a particular state versus property located everywhere.  By not including these other factors in their apportionment, which would most likely be zero from a service company, there is a greater weight placed on sales into a state, meaning a larger apportionment factor, and ultimately, more tax revenue for the state.

Service providers should be aware of the sourcing and apportionment methods that are used in states where they do business.  If unchecked, a state may be made aware of a service provider’s activities through other means, such as a routine audit of a customer of a service provider.  If tax returns are never filed, states can go back many years and ask for old tax returns to be filed, which can be costly from a tax standpoint and an administrative standpoint.

Additionally, income taxes that were paid to another state in previous years that should not have been, due to the complexity of these sourcing rules, may be lost forever, as taxpayers only have a certain number of years to amend incorrectly filed tax returns.

Stay Up-to-date with State Taxes
Keeping up with how states tax service revenues is not an easy task.  Taxpayers should contact their tax advisors to make sure they are compliant with the applicable state tax laws and regulations to avoid penalties and interest, as well as to take advantage of planning opportunities to minimize their tax liabilities.