“Flexible” South Carolina Ruling Creates Sourcing Uncertainties

On May 20, 2016, an Administrative Law Court decision in South Carolina resulted in the two things that taxpayers try to avoid: uncertainty and penalties. Dish DBS Corp. v. South Carolina Department of Revenue, S.C. Admin. Law Court, No. 14-ALJ-17-0285-cc (5/20/16). It’s hard enough to advise taxpayers on the differences between states that apply a costs-of-performance method of sourcing service revenue and those that have moved to a market-based rule. The Dish decision further complicates the issue in South Carolina by concluding that the state’s approach to apportionment of service revenue is a “flexible standard based upon the . . . given industry.”

State tax practitioners typically advise taxpayers that there are two general methods used by states to source revenue from services for multistate taxpayers. These methods are “costs-of-performance” and “market-based” sourcing. The “costs-of-performance” category typically applies when state law indicates service receipts are to be sourced based on where the “income-producing activity” occurred. In laymen’s terms, the revenue is sourced to the state where the service is performed. Complications can arise when the service is performed in more than one state. States attempt to resolve this complication by applying either (1) an all-or-nothing approach, whereby all the revenue is sourced to the state if more of the work is done in that state as compared to any other state; or (2) a pro-rata approach by sourcing a portion of the revenue to the state based on the extent of in-state services. The costs incurred to perform a taxpayer’s services, such as the personal services of employees or independent contractors and the use of property, are used to source the revenue from such services to the applicable states.

States that have adopted a “market-based” rule require taxpayers to compute the sales factor based on the location to where the services are delivered or where the benefit of the service is received. Depending on how a taxpayer’s services are provided, the application of “costs-of-performance” or “market-based” sourcing can have vastly different results.

Before the decision in the Dish case, most state tax practitioners asked to advise on South Carolina’s sourcing rule would likely have concluded that it reflects some form of a “costs-of-performance” rule as opposed to a market-based rule. This is because South Carolina’s law requires receipts from services to be sourced to South Carolina “to the extent the income-producing activity is performed within this State.” The Administrative Law Court thought otherwise, and concluded it was “clear South Carolina has not adopted strict costs of performance.” Instead, the court reasoned that “South Carolina’s apportionment statute provides a flexible standard based upon the income-producing-activity for a given industry.” For purposes of the direct broadcast services industry, the court concluded that the relevant income-producing activity “is limited to the delivery of a signal into the customer’s home.” Everything that a taxpayer does in this industry prior to that point, including the acquisition of program content, the operation of satellites, and the operation of call centers, were deemed to not be income-producing. Based on this limited view of the taxpayer’s income-producing activity, the court ultimately concluded that subscription receipts from customers located in South Carolina should be used to compute the South Carolina sales factor. In short, the Court’s interpretation of South Carolina’s “income-producing-activity” rule resulted in a market-based sourcing methodology.

Many states follow the rule or a rule similar to the one utilized by the Court in Dish. It’s not an unreasonable rule. Many would argue that it makes perfect sense for the broadcast industry. However, in other states, the law clearly reflects that rule in the form of a specific provision for the industry, or through a market-based sourcing rule that applies to all service providers.

The court even refused to abate the 25% substantial understatement penalty. Assuming that the decision in Dish is not overturned on appeal, service providers taxable in South Carolina are left with a great deal of uncertainty regarding whether they are sourcing their receipts correctly. If taxpayers don’t first identify the proper income-producing activities when applying this “flexible” rule, a perfectly reasonable application of the law could result in a large assessment plus steep penalties. This is clearly an issue that can be appropriately addressed through legislation, as opposed to having taxpayers blindly guessing how the state will use the Dish ruling to interpret the state’s conveniently “flexible” sourcing rule.

Aprio’s State and Local Tax (SALT) team constantly monitors these and other important state tax topics. Contact us today if you have questions or concerns about this ruling.