Sales tax nexus laws across the country got a fresh makeover starting in the summer of 2018 with the Supreme Court decision in Wayfair. Now, states are updating their income tax sourcing laws, hoping to lure more businesses to reside there while simultaneously gaining more tax revenues from businesses that do not. The method? Market-based sourcing.
Cost of Performance Sourcing
Traditionally, states used some sort of cost of performance (COP) rules. Under this method, income was apportioned to the state where the costs associated with the income-producing activity occurred. If the activity was performed across multiple states (i.e., employees working on the activity resided in several different states), the revenue was typically apportioned to the state in which the greatest proportion of the revenue was earned. Under COP, the jurisdiction in which the recipient of the activity did not factor into the sourcing or apportionment. This is oftentimes why businesses are domiciled in states that do not have an income tax.
This sourcing type is about the exact opposite of the traditional COP rules. Under market-based sourcing, service revenue is allocated to the state in which the benefit of the service is received. Therefore, the primary factor in considering taxation is the destination, much like sales tax considerations on tangible personal property.
Market-based sourcing can offer several economic incentives for states and local tax jurisdictions. When a state uses this sourcing method and combines it with a single sales factor apportionment scheme, businesses can locate all offices, property, equipment, and employees within the jurisdiction with no increase in state tax liability. Tax liability to the sate would be solely based on in-state customers.
Benefits and Drawbacks
One exciting strategic concept businesses can take advantage of right now as states are still shifting over to market-based sourcing, is the possibility of a business having to pay no tax on a portion of its service revenue. This occurs when the business’s home state uses market-based sourcing with a single sales factor and the destination state uses COP with a single sales factor apportionment. In this scenario, the revenue would not be sourced to the home state since the service was delivered out of state, and the revenue would not be sourced to the destination state since no COP was done in the delivery state.
However, if you flip the example on its head, and the business is domiciled in a COP state delivering a service to a market-based state, double taxation can occur. These situations will continue to be planning points until all states have adopted market-based sourcing rules.
States will lose out on income tax revenue from their in-state businesses under the market-based sourcing method. But, they should still generate more income tax revenue overall with all other out-of-state businesses performing a service in their state. This method will also allow businesses to establish satellite or branch offices within a new state.
It can be extremely beneficial for businesses to start conducting income tax studies to determine what may be the best move to avoid double taxation and take advantage of no taxation opportunities.
Consult with a tax advisor that has experience handling state income tax matters to make sure your business stays compliant. For any questions or concerns, please contact Brian Ess, J.D., Supervisor; BrianE@hhcpa.com; (480) 483-1170.