Over half the states that levy a corporate income tax employ the single-factor receipts formula to apportion corporate income for sales other than tangible personal property.
Market-based sourcing is the predominant approach to assigning service receipts to the appropriate state, but three states — Delaware, Mississippi, and Texas — use the service performance method, and four states — Alaska, Florida, Kansas, and North Dakota — use cost of performance.
Notably, although Florida’s regulations appear to require service providers to apportion receipts using the cost-of-performance approach, the state has released a string of technical assistance advisements that direct taxpayers to use market-based sourcing.
In states that have enacted market-based sourcing, statutory law generally prescribes a cascading, four-tier approach to determine where a taxpayer’s receipts should be sourced. Which tier applies to a particular taxpayer depends upon the extent of its customer’s information contained in the taxpayer’s books and records.
However, some revenue agencies have gone beyond statutory law, implementing by rule or on audit a “look-through” component to the market-based sourcing.
In such cases, despite that the taxpayer has contracted with its customer for services, these states look beyond the taxpayer’s customer to the customer’s customer to conclude that the latter is the party that has received the ultimate benefit of the taxpayer’s service.
Thus, for the out-of-state taxpayer, if its customer’s customer is in the state where the taxpayer is under audit, that state will lay claim to receipts that would otherwise be assigned to the taxpayer’s home state, thus increasing the taxpayer’s income tax liability to the auditing state.
When Is the Look-Through Approach Appropriate?
The appropriateness of the look-through approach to sourcing taxpayer receipts raises a few interesting questions.
First, there is no privity of contract between the taxpayer and its customer’s customers. For sourcing purposes, even if the taxpayer knows the identity and locale of its customer’s customers — which, in some cases, it does not — that knowledge is irrelevant.
The taxpayer is paid for its services by the customer, not the customer’s customers. Also, assigning receipts based on a third party that a revenue agency perceives to have received the ultimate benefit of the taxpayer’s services is suspect. The taxpayer’s customer’s customers undoubtedly benefit from the taxpayer’s services.
The actual benefit, however, falls on the taxpayer’s customer because the taxpayer’s services enhance its customer’s ability to provide its customers with the service for which they have contracted with the taxpayer’s customer. Of course, there may be instances in which the look-through approach might be appropriate, but if so, that can only be determined case by case, depending on the peculiarities of a taxpayer’s business. Yet that does not mean a look-through approach is always appropriate.
Although there is little case law on the validity of the look-through approach, thus far, most courts have sided with the taxpayer. Two examples will suffice.
In TD Ameritrade, an administrative law judge ruled that the taxpayer’s receipts paid by two New Jersey banks for marketing, recordkeeping, and support services regarding a fund that collectively belonged to the taxpayer’s brokerage clients could not be sourced to New York because it was the banks who were the taxpayer’s customers, not the individual brokerage clients.
The fees paid by the banks were for the services enumerated above, and for the banks’ use of, for its own purposes, a large pool of funds that belonged to the taxpayer’s brokerage clients. As none of the fees paid by the banks to the taxpayer for its services occurred in or were from a New York customer, the taxpayer’s receipts could not be sourced to New York.
The ALJ further found that even if the taxpayer’s brokerage clients, and not the banks, were the taxpayer’s customers, the fees paid by the banks could not be sourced to New York because the taxpayer’s services were not performed in the state.
In short, the banks were the taxpayer’s customers because they were the parties that benefited from the taxpayer’s services, not the taxpayer’s brokerage clients.
Bank sign on glass wall of business center
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In LendingTree
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, a Washington appellate court came to a similar conclusion. The taxpayer provided a service that matched potential borrowers to participating lenders.
It, not the lenders, collected the borrower’s information and then distributed it to the pool of lenders. On audit, the revenue agency determined that the taxpayer misallocated its income because it made the allocations by the lender’s location.
According to the agency, the taxpayer should have used the borrower’s location because that was the party that benefited from the taxpayer’s service, justifying its position with the argument that the taxpayer’s service is to procure customers for the lenders by promoting, marketing, and maintaining its website.
The court didn’t see it that way. The taxpayer, it said, uses its website to drive potential borrowers to use its services, not the services of individual lenders.
Indeed, the court pointed out, lenders and potential borrowers have no contact with each other until the lender reaches out to the buyer through the taxpayer’s website.
The value to the lender of the taxpayer’s service is the referral of a potential borrower; moreover, the lender’s follow-up with the borrower is no guarantee that a loan will be granted. Thus, the court concluded, the taxpayer’s receipts were properly allocated to the lender’s location, not the borrower.
Meanwhile, in California . . .
In March the California Franchise Tax Board released Legal Ruling 2022-1, which explains the state’s new approach to market-based sourcing. The ruling supersedes two earlier taxpayer-specific rulings, Chief Counsel Ruling (CCR) 2015-3 and CCR 2017-1.
CCR 2015-3 concerned a taxpayer that provided to its business customers integrated financial information services and analytical applications that, in turn, provided financial services to its own customers. By aggregating data from hundreds of disparate databases, the taxpayer provided its customers a portal through which it could access the financial data needed to adequately serve its customers.
At issue was the proper method to allocate the taxpayer’s receipts where both its customer and the customer’s customers benefited from the taxpayer’s service.
The ruling concluded that the taxpayer provided a non-marketing service to its customer because it was the customer that mainly benefited from the taxpayer’s service rather than the customer’s customers. The value of the taxpayer’s service to its customer was its ability to use the data to enhance its own business operations.
The ruling also contrasted a non-marketing service with a marketing service, which a taxpayer provides to promote a customer’s product, service, or other item, which may warrant a look-through approach to determine where the benefit of the service was received.
CCR 2017-1 concerned a taxpayer that provided healthcare plan administrative services that its healthcare plan customers would have needed to undertake themselves. Like CCR 2015-3, the ruling concluded that the taxpayer provided non-marketing services in that the benefit was to relieve the healthcare plans of their respective administrative burdens.
Thus, the taxpayer’s receipts should be sourced to the location where the healthcare plans had their current operations. The two rulings were interpreted as distinguishing non-marketing services from marketing services to determine where the customer’s benefit was received for sourcing purposes.
Legal Ruling 2022-1 did away with the distinction between non-marketing services and marketing services. It poses four questions for the taxpayer:
- 1. Who is the customer?
- 2. What service is being provided to the customer?
- What is the benefit of the service the customer is receiving?
- Where is the customer receiving the benefit?
On the first question, the ruling states that only the value to a taxpayer’s customer is considered for the analysis, even though a third party may also benefit.
The second question concerns the contract between the taxpayer and the customer, which identifies the service being provided.
The ruling answers the third question with the statement that the value of the service is the direct effect of the action or function being performed — that is, whether the service provided directly supports the taxpayer’s customer’s business operations.
The fourth question, where the benefit is received by the customer, is the location where the direct effect of the service affects the taxpayer’s customer.
The ruling goes on to present three scenarios that illustrate the application of the four questions. Depending upon the type of service the taxpayer provides to its customer, the examples clearly demonstrate the application of the look-through approach.
For example, the third scenario posits a hypothetical in which the taxpayer hires a subcontractor to provide consulting services that it would otherwise provide to a third party. According to the FTB’s interpretation, the taxpayer is classified as the customer.
Yet it defines the service provided as consulting services to the third party, even though the contract is between the taxpayer and the subcontractor. The FTB’s reasoning is that the subcontractor’s services are being used by the third party, and this is where the impact of the benefit occurs for the taxpayer.
The difficulty is that the legal ruling, by jettisoning the CCRs’ nonmarket and market service distinction, will make it harder for taxpayers to determine whether a service has a direct operational benefit to a taxpayer’s customer, or whether a look-though approach is warranted.
Unfortunately for taxpayers, given the uncertainties in sourcing receipts that are sure to follow in the wake of the ruling, litigation is almost guaranteed to follow.
Conclusion
In the past two decades, over half the states have adopted the single-factor receipts apportionment formula, and most have adopted market-based sourcing.
The question, however, is where and how to determine the right market — that is, the state where the receipts should be assigned. At present, more states are using the look-through approach, looking at the taxpayer’s customer’s customer to decide where the market lies.
Unfortunately, the look-through approach is sometimes applied by revenue agencies when it is clearly not warranted, and because there is no real framework for determining when look-through is appropriate, we are bound to see a great deal of litigation over the proper sourcing of taxpayer receipts in the future.