Virginia Judge Rules that Taxpayer Can’t Source Sales How It Wants

November 1, 2017

The court held that other states’ methods of taxation did not impact whether Virginia’s method was unequitable, meaning states can collectively tax more than 100 percent of the taxpayer’s income.

By Jess Johannesen, SALT manager

Under state income tax rules, for purposes of determining the numerator of the sales factor of the apportionment formula, sales of services have historically been sourced in most states using the income-producing activity approach. This approach sources sales to the state with the most “cost of performance” associated with providing that service. Over the last 10-15 years, however, more states have changed their rules in favor of a market-based sourcing method, which sources sales of services to the location where the customer receives the service. Due to this transition, some businesses may find themselves in a multistate scenario where significantly more or significantly less than 100 percent of their sales may be apportioned among the states in which the company files state income tax returns.

Looking at an extreme example, assume Call Center, Inc. is located in State A and operates a customer service call center for various companies, all of which are located in State B. In addition, assume that Call Center, Inc. has a couple of sales employees working in State B. If State A’s apportionment formula consists solely of a sales factor and it uses the market-based sourcing method, then no sales are sourced to State A (since there are no customers located in State A). If State B uses the income-producing activity method, then no sales are sourced to State B, because most, if not all, of the costs of performance to provide the services are not located in State B. In this scenario, Call Center, Inc. would have an apportionment factor of zero percent to State A as well as State B, and therefore would not have any state income tax liability in either State A or State B.

Now assume that the sourcing methodologies in State A and State B are swapped, so that State A now uses the income-producing activity method while State B uses the market-based sourcing method. State A would consider all of the sales to be sourced to State A, since all of the costs of performance are located in State A. Meanwhile, State B would consider all of the sales to be sourced to State B, since the customers are receiving the benefit of the service in State B. In this scenario, Call Center, Inc. would have a 100 percent apportionment factor in each state and would therefore pay income tax in State A on 100 percent of its income while also paying income tax in State B on 100 percent of its income.

A Virginia circuit court issued an opinion concluding that the second scenario described above was not unconstitutional or inequitable. [1] In that case, the taxpayer was headquartered in Virginia, and it was undisputed that most of its employees worked at the Virginia headquarters and “nearly all” of its cost of performance were incurred at such headquarters. The taxpayer sold a bundled product accessed by customers through the Internet which included research, executive education, and networking tools and resources used by executives to analyze business functions and processes. During the years at issue, the taxpayer sourced nearly 100 percent of its sales to Virginia when calculating the sales factor because Virginia used the income-producing activity method. [2]

However, the taxpayer argued for alternative apportionment which would utilize a destination-based or market-based sourcing method by relying upon the customers’ mailing addresses. Under this methodology, fewer than 6 percent of the taxpayer’s customers had a Virginia address, and the taxpayer argued that this method would, “more accurately reflect the actual connection between its inter-state activities and its income.” While the property and payroll factors remained constant between the two methods, the taxpayer’s proposed method would decrease the overall Virginia apportionment factor during the three-year period from 97.1 percent, 91.4 percent, and 87.5 percent down to 2.4 percent, 3.1 percent, and 5.2 percent.

The court, however, was unconvinced that the application of the Virginia taxation method was unconstitutional or inequitable. The judge explained that its taxation method would be considered inequitable only if it resulted in taxing a greater proportion of the taxpayer’s income than was reasonably attributable to the business carried on in the state. In this case, the judge noted that the employees are here performing the services, and therefore the state’s income-producing activity method did not overreach by attributing almost all of the sales to the state. The court held that other states’ methods of taxation did not impact whether Virginia’s taxation method was unconstitutional or unequitable, and the taxpayer’s proposed alternative apportionment method was ultimately denied.

This case illustrates the need to consider state income tax implications when setting up your business, especially in the context of a service business. Virginia held that it could tax roughly 90 percent or more of this taxpayer’s income; this, combined with the percentage of income taxed by other states, will likely result in states collectively taxing more than 100 percent of the taxpayer’s income each year. However, by carefully considering the multi-state tax implications of a business’ operations and analyzing apportionment factors, proper planning could achieve significant state income tax savings.

Aprio has experience assisting companies with evaluating their multistate income tax filings and positions, and we can help your new or mature company identify potential state income tax savings. We constantly monitor these and other important state tax issues in order to assist you with your specific tax situation, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Jess Johannesen at or Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at for more information.

This article was featured in the October 2017 SALT Newsletter.

[1] Corporate Executive Board v. Virginia Department of Taxation, CL16-1525, 09/01/2017.

[2] Va. Code Ann. §58.1-416.

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 the matter.

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About the Author

Jess Johannesen

Jess Johannesen, Senior Tax Manager at Aprio, is a state and local tax advisor with expertise in sales/use tax and state income tax matters, state tax credits and incentives, and state and local tax M&A due diligence. Known for quick response times and technical expertise, Jess helps business leaders and decision makers in an array of industries maximize state tax benefits, and minimize risks and exposures while keeping in compliance. Defined by kindness and passion for Georgia sports, Jess is a thoughtful, curious and detail-oriented advisor.