Florida Court Requires Cost-of-Performance Sourcing Method for Service Revenues

May 31, 2023

By: Camille Gregory, SALT Senior Associate

At a glance

  • The main takeaway: A Florida court opinion illustrates that not every state is successful when attempting to apply market-based sourcing to service revenue when the rules require the cost- of-performance sourcing method. 
  • Assess the impact: While this case is not the first time a state has tried and failed at applying market-based sourcing over cost-of-performance, it’s important to note that apportionment rules and interpretations vary among the states. 
  • Take the next step: Aprio’s State and Local Tax (SALT) team can assist your business in determining if there is a more favorable method to apportion income that could reduce your multistate income tax liability. 

Schedule a free consultation today to learn more!

The full story:

When computing a state’s sales (or gross receipts) factor for income tax apportionment purposes, states employ one of two methods to source service revenue — cost-of-performance (COP) sourcing or market-based sourcing. Under COP sourcing, sales are generally sourced to the location where the taxpayer performs its income producing activity that gives rise to those revenues, and under market-based sourcing, sales are generally sourced to where the customer receives the benefit of the service.

Historically, all states used the COP method. However, over the last few decades, many states have switched to the market-based method, such that only about one-third of states continue to use COP. Even so, among the states that use COP, several have attempted to interpret those rules to achieve a market-based result, with mixed outcomes. 

For example, in an article from our April 2023 SALT Newsletter, we wrote about a Pennsylvania Supreme Court decision that upheld the state’s “market-based” interpretation of its former “cost-of-performance” sourcing rule for corporate net income tax purposes. On the other hand, on March 1, 2023, a Florida circuit court opinion struck down the state’s attempt to interpret its COP rule to apply a market-based result.1

A closer look at the case

The taxpayers in the case were six related companies that provided financial technology services to customers. Of the six companies, five provided their services from locations outside Florida and incurred most of the costs of providing those services outside Florida. The sixth company provided its services from locations both in and outside Florida and incurred most of its costs of providing services in Florida. All six companies sourced their service revenue according to the state’s COP regulation, which states:

Gross receipts from other sales shall be attributed to Florida if the income producing activity which gave rise to the receipts is performed wholly within Florida. Also, gross receipts shall be attributed to Florida if the income producing activity is performed within and without Florida but the greater proportion of the income producing activity is performed in Florida, based on costs of performance. The term “income producing activity” applies to each separate item of income and means the transactions and activity directly engaged in by the taxpayer for the ultimate purpose of obtaining gains or profits.2

In other words, this rule requires taxpayers to source service revenue to Florida when a greater proportion of the income-producing activity that generated the sales revenue is performed by the taxpayer in the state, based on the costs of performing those services. As such, five of the six companies sourced all their service revenue outside Florida, while the sixth company sourced all its service revenue to Florida. 

However, the Department asserted during an audit that the companies’ income producing activities occurred where their customers were located, which is an application of market-based sourcing. The discrepancy stemmed from two auditors’ different applications of the meaning of income producing activity. 

The ruling explained

The auditor for five of the entities interpreted the income producing activity as the taxpayer’s obligation to provide various services associated with the software that they licensed to their customers. When services are provided to customers, these activities occur entirely in Florida because the customer is located within Florida. As a result, the auditor sourced service revenue based on those customers that were located in Florida. The second auditor for the sixth entity had a slightly different interpretation of income producing activity. The second auditor viewed income producing activity to be the actual sale of services to customers as opposed to the costs of performing those services, and thus, sourced the service revenues to Florida if the customer was located in the state.

The court rejected the auditors’ interpretations and held that the plain language of the regulation commands the use of COP sourcing. The court found that the Department’s inconsistent interpretation of its own regulations violated the Taxpayer’s Bill of Rights, which ensures the fair and consistent application of tax laws to all taxpayers. 

The bottom line

The is not the first time the Department has tried to avoid applying its COP regulation. Late last year, the same judge rejected the Department’s attempt to source service revenues using an alternative market-based apportionment method instead of its COP rule.3

Apportionment rules and state interpretations vary among the states, and Aprio’s SALT team has experience analyzing these issues. We can assist your business in determining if there is a more favorable way to apportion income that could reduce your multistate income tax liability. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

This article was featured in the May 2023 SALT newsletter.

1 Billmatrix Corp., et. al v. Florida Department of Revenue, Circuit Court, 2nd Dist., Leon County, No. 2020 CA 000435 (3/1/23)

2 Fla. Admin. Code r. 12C-1.0155(2)(l)

3 Target Enterprise, Inc. v. State of Florida Department of Revenue, No. 2021-CA-002158 (Fla. 2d Cir. Ct. Nov. 28, 2022). The state’s approach in this case was slightly different as it argued that the taxpayer did not provide sufficient documentation to support the COP sourcing.

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