Service-based businesses challenge almost every rule about state and local taxation. State taxing methodologies were developed during a time when the economy was primarily manufacturing-based. When the economy shifted from a manufacturing base to a service base, states were not ready; many have not yet fully adapted their taxing methodologies to account for the shift. Consequently, sourcing revenues derived from manufacturing activity versus those derived from services present challenges for both the state and the taxpayer.
As many states begin to enact single sales factor apportionment formulas, the need to get the sales factor right has become a significant concern for businesses. Traditionally, service-based businesses apportioned revenue using a method called cost of performance. Because this method has often been seen as too cumbersome to administer, the perceived unfairness it created for in-state businesses, and the concern that “non-production” states were losing revenue, states have moved away from it in favor of a market-based sourcing methodology.
While states believe the adoption of market-based sourcing has solved all of the issues that existed with the former cost of performance method, it has not. There are many factors affecting the sourcing of revenues under the market-based sourcing methodology. Market-based sourcing calls for businesses to source revenue to the state where the customer is located. However, there are a number of other factors that can affect where revenues are sourced. For example, what if the service was delivered to a customer located in more than one state? Pennsylvania would tell you to source the revenue to the states based upon the portion of the total value of the contract delivered to each state. New York does not have a proportional allocation rule and it does not provide any guidance for determining where the benefit of the service was received. A potential outcome is that New York might require inclusion of all the receipts in the numerator of the receipts factor.
The states’ attempt to simplify the apportionment of revenue for service-based businesses has, no doubt, created a difficult compliance burden for companies dealing with customers operating in multiple states and countries. It is important for there to be an understanding of fundamental elements such as the primary sourcing rules, the possibility of prorating revenues, and throwback and throw-out rules for sales to states in which the business does not file state tax returns. This will allow businesses to minimize the inclusion of revenues in the sales factor numerator for more than one state and effectively manage their state tax burden.
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