State Taxation: Sourcing Rules for Sales of Services and Intangible Property

by Robert Desiderio *

... For sales of tangible personal property, the guiding [state income taxation] principle for sourcing is that those sales are attributed to the place-of-delivery of the property--the destination state or market state. For sourcing sales of services and intangible property, however, UDITPA has a different sourcing rule. The principle on which the sourcing of sales of services or intangible property is based is the place-of-performance--the origin or production state...

Section 17 of UDITPA assigns all sales other than sales of tangible personal property to the taxing state if one of the following two conditions is applicable:

  1. the income-producing activity is performed in the taxing state; or
  2. the income-producing activity is performed in the taxing and one or more other states and a greater portion of the income-producing activity is performed in the taxing state. A greater portion of the income-producing activity is performed in the taxing state if a greater proportion of the taxpayer's costs of performing the income-producing activity was incurred in the taxing state.

...

Services

The attribution of receipts from sale of services raises both policy and practical questions. The policy inquiring is whether the taxing state should be the market state of the services and not the production state... The practical question concerns the application of Section 17's income-producing activity and cost of performance tests.

... [I]nclusion of the receipts from services in the numerator of the sales factor in the taxing state turns on the meaning of an income-producing activity and the relevant costs related to that activity.

The MTC Regulation defines income-producing activity, as "transactions and activity engaged in by the taxpayer in the regular course of its trade or business for the ultimate purpose of producing that item of income." [MTC Reg IV.17.(2)]...

The rule applies "to each separate item of income." Here lies the rub: when a taxpayer is engaged in certain business activity, is that activity one or many "income-producing activities." [See, e.g., Boston Prof'l Hockey Ass'n v. Comm'r of Revenue, 443 Mass. 276 (Mass. 2005)].

...

The place of performance test for sourcing sales of services has caused compliance and administrative difficulties and criticism. Summarizing other commentaries, one author has stated:

Commentators have found the rules to be "confusing and indefinite" and plagued by "vagueness," "ambiguity," "substantial debate," "lack of clear guidance," "whipsaw [eng]," "tremendous flexibility, and hence [tax planning] opportunely," "frequent litigation," "inconsistency," and "confusion for taxpayers and taxing authorities alike." [John A. Swarm, Reforming the State Income Tax: A Market State Approach to the Sourcing of Service Receipts, 83 Tulane L Rev 285, 306 (2008) (internal citations omitted).]

Market-Based Sourcing

... [S]ome sixteen states had switched to market-based sourcing. [Alabama, Ala Code § 40-27-1(IV)(17); Arizona, Ariz Rev State § 43-1147 (D)(3); California, Cal Rev & Tax Code § 25136; Georgia, Ga Comp R & Regs, 560-7-7-03; Illinois, 35 ILCS 5/304(a)(3)(B-1); Iowa, Iowa Admin Code 701.54.6; Maine, Me Rev Stat Til 36, § 5211.16-A; Maryland, COMAR 03.04.03.08(C)(3)(c); Michigan, Mich Comp L § 206.669 Mich Comp Laws 208.1306(2)(a), see McIntyre § R. Pomp, A Policy Analysis of Michigan's Mislabeled Gross Receipts Tax, Tax 53 Wayne L Rev 1275 (2008); Minnesota, MSA § 290.191(5); Nebraska, Neb Rev Stat § 77-2734, 14(3)(a); Ohio, Ohio Admin Code § 5703-29-17; Oklahoma, Ok Admin Code § 710: 50-50-17-71; Utah, Utah R 865-6 F-8 (10)(f); Washington; Wash Rev Code § 82.04.462; Wisconsin, Wis Stat ANN § 71.25(9)(dh).] There are different applications of the market-based approach, however, among those states. [For a review of these approaches, see Kathleen K. Wright, "An Update on Market-Based Sourcing: Not Such a Simple Alternative," taxanalysts® State Tax Today, Aug. 20, 2012.]...

Intangibles

The sourcing of receipts from intangible property is at best confusing. The confusion emanates from the somewhat conflicting rules found in UDITPA and the MTC Regulations, and the multitude of property rights included within the label intangible property. [Intangible property generally means personal property that does not have physical attributes; its value comes from what the intangible property represents.] The intangible property may be intellectual property, which are the rights a person has to the use of knowledge or ideas, to exploit them for some benefit. Or the intangible property can reflect the value the holder has in some underlying asset, like investment assets such as securities and bank accounts. Or the intangible property may evidence the holdee's rights to recover value from another, such as an unsecured debt...

...

Some states have adopted a destination, or market-based, principle for the sourcing of business income from intangible property. For example, royalties are attributed to the state in which a licensee uses the intellectual property. [See Kmart Props., Inc. v. Taxation & Revenue Dep't, 139 N.M. 177 (N.M. Ct. App. 2001), cert quashed, Kmart Corp. v. Taxation & Revenue Dep't of N.M., 139 N.M. 172 (N.M. 2005) (relying on the equitable apportionment section, UDITPA § 18 the court held that the situs of a trademark was New Mexico, the state of the use of the trademark.)

A controversial issue surrounds the sourcing of receipts from the sale or redemption of short-term investments held by taxpayers which have large cash balances. The controversy is best illustrated by Microsoft Corp. v. Franchise Tax Bd., 39 Cal. 4th 750 (Cal. 2006).

...

The California Supreme Court reviewed two issues: whether the meaning of "gross receipts" includes the total receipts from the redemption of short-term marketable securities and, if not, whether the sales factor should include only the gain from the redemption under the equitable apportionment doctrine...

...

* ROBERT J. DESIDERIO practices with Sanchez, Mowrer and Desiderio, P.C., Albuquerque, New Mexico, in the areas of tax law, tax-exempt organizations, and business and commercial transactions. He was dean of the University of New Mexico School of Law from 1979 to 1985 and from 1997 to 2003, and served as a professor of law for the school over several decades. He is currently Professor Emeritus at UNM, teaching State and Local Taxation, Tax-Exempt Organizations and Remedies.

 

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