Multistate Tax Commission Releases Working Draft of Model Market-Sourcing Regulations: Part II

The Multistate Tax Commission is attempting to provide a model rule to assist in clarifying market-based sourcing of revenue. This article covers the third type of service transaction, other services.

By Tina Chunn, SALT senior manager

As discussed in Part 1 of our article included in the August 2015 newsletter, the Multistate Tax Commission (MTC) recently issued a working draft of model regulations in July 2015 to be used for market-based sourcing of revenue for sales factor purposes from sales of other than tangible personal property. This sourcing methodology replaces the cost of performance approach that states have historically used, whereby service revenue was typically sourced to the state where most of the service was performed. Due to continued confusion in this area with the states adopting similar guidelines but using different concepts to define the “market” and the difficulty in applying these rules to service revenues, the MTC is attempting to provide a model rule to assist in clarifying these issues and promote uniformity among the states.

We previously addressed the guidelines for sourcing service revenue for two of the specific types of service transactions: in-person services and professional services. In this article, we will address the third type of service transaction: other services.

The model regulations specifically categorize this group as services delivered to or on behalf of the customer (by physical or electronic means), or services delivered electronically through the customer. A service delivered “to” a customer is a service that is received directly by the customer and not a third party. However, a service in which the customer contracts for the service but it is actually delivered to one or more third parties, rather than the customer, is considered to be delivered “on behalf” of a customer. Examples of this type of service include fulfillment services and direct or indirect delivery of advertising to the customer’s audience. Both of these types of services can be delivered by physical means or electronically. Finally, a service that is delivered “through” a customer is one that is delivered solely by electronic means to a customer for the purpose of resale and is subsequently delivered solely by electronic means in substantially identical form to an end user or other third-party recipient.

Services that are delivered either (i) to or on behalf of a customer by physical or electronic means or (ii) solely by electronic means through a customer are assigned to the state (or states) where the service is delivered. A service is considered delivered to a state when the end-user customer/consumer (or third-party recipient) receives the service in that state. If it is unclear where the service is actually delivered, the service may be assigned based on supporting information that can reasonably approximate where the service is delivered.

If the service is delivered electronically to a customer and there is not sufficient supporting information to reasonably approximate where the service is delivered, the sourcing of receipts will depend on whether the customer is an individual or business. [1] For an individual customer, the receipts should be sourced based on the customer’s billing address. For a business customer, the receipts shall be sourced using the following hierarchy: 1) to the state where the contract of sale is principally managed by the customer, 2) to the customer’s place of order and 3) to the customer’s billing address. [2] As an alternate provision, a taxpayer may elect to apply a safe harbor to assign its receipts from sales to a particular business customer based on the customer’s billing address in any taxable year that the taxpayer engages in similar service transactions with more than 250 customers (business or individual), provided it does not derive more than five percent of its receipts from sales of services from this customer.

If the service is delivered electronically on behalf of or through a customer and there is not sufficient supporting information to reasonably approximate where the service is delivered, there is also a secondary rule of approximation specifically available for electronic delivery of advertising on behalf of a customer and delivery of a service to a customer that acts as an intermediary in reselling such services to end users or other third-party recipients.

For electronic delivery of advertising on behalf of its customer to the customer’s intended audience of a known list of subscribers, the taxpayer can approximate the receipts in a state using a ratio of the state’s subscribers in a specific geographic area to the total subscribers in the area. If this is not available, the receipts can be sourced based on the ratio of the state’s population in a specific geographic area to the total population of the area. For services delivered to a customer that acts as an intermediary in reselling the service to end users or other third-party recipients, the receipts can be sourced based on the ratio of the state’s population in a specific geographic area in which the intermediary resells such services to the total population of such area. [3]

It is important to note that, for all services categorized in this third group of other services as discussed in this article, if it can be determined to which state the sales are to be assigned (or reasonably approximated) and the taxpayer is not taxable in that state, then the corresponding receipts are excluded from the numerator and denominator of the receipts factor, thus preventing the taxpayer from further diluting the sales factor of the states in which the taxpayer files.

As noted in our prior article, these model regulations do not completely eliminate the complexity in sourcing receipts from services using a market-based approach. There will continue to be areas of ambiguity and uncertainty due to state interpretation or insufficient data to make such a sourcing determination. Although this can be frustrating, opportunities do exist in reviewing these guidelines and how it could apply to specific service revenues in order to achieve a more favorable sourcing methodology.

HA&W’s SALT team is able to provide guidance in uncertain tax areas such as this and assist in any analysis that may be necessary. We constantly strive to keep our clients advised of these important issues in order to help them address their specific tax situations. We will continue to monitor these and other significant income tax developments and include any updates in future issues of the HA&W SALT Newsletter.

Contact Tina Chunn, SALT senior manager, at tina.chunn@aprio.com or Jeff Glickman, partner-in-charge of HA&W’s SALT practice, at jeff.glickman@aprio.com for more information.

[1] If the taxpayer acting in good faith cannot reasonably determine whether the customer is a business or an individual, the taxpayer shall treat the customer as a business customer.

[2] If the taxpayer derives more than five percent of its receipts from sales of services from a customer, it is required to identify the state where the contract of sales is principally managed.

[3] In both instances, the specific geographic area of delivery shall only include areas where the service was substantially and materially delivered or resold. Unless the taxpayer can prove otherwise, it is presumed that this area does not include areas outside the United States.

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding this matter.

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