As states continue to move forward, adopting varying approaches to market-based sourcing and economic nexus, taxpayers must understand how these two methodologies relate in order to avoid costly tax consequences. In some instances, differences in sourcing rules can lead to double taxation or “no-where” income. That’s why it’s crucial to develop a clear sourcing strategy to help maximize the tax benefit your business can claim on its tax returns.
State Sourcing of Revenue From Services
Generally, states source revenue flowing from the sales of services based on one of three methodologies: 1) cost of performance; 2) modified cost of performance, and 3) market-based.
Cost of Performance
Under a strict cost of performance approach, all revenue regarding the provision of services is sourced to the state where the services are performed. If the services are performed in multiple states, the revenue is sourced to the state where the greatest proportion of the income-producing activity is performed, based on cost of performance. Accordingly, under a strict cost of performance sourcing regime, all revenue is sourced to one state.
Modified Cost of Performance
While states that follow a strict cost of performance format source all service income to one state, those that follow a modified cost of performance structure source service income to more than one state if the services are performed in more than one state. The service revenue is divided among the states based on the percentage of total revenue arising with regard to the services performed in each respective state.
Market-based sourcing approaches often vary from state to state, but the general premise is that revenue from services should be sourced to the state where the benefit of the services is received. Consequently, the state (or states) in which the services are performed is not the focus of a market-based sourcing framework. Rather, the focal point is the state(s) in which the benefit of the services is realized.
The Challenge Presented by Revenue Sourcing in Context of Economic Nexus
In general, state economic nexus statutes require some minimum amount of revenue linked to the particular state before nexus is established. More specifically, determining when the respective state revenue thresholds are met can be complicated—especially when it comes to the sourcing of revenues arising from the sales of services. Nevertheless, the sourcing of such sales is a critical component to discerning where a company is liable for income tax filing once it institutes economic nexus.
For example, if Company A is performing $400,000 of services at its home base in State Y for a client located in State X, a market based state, the revenues generated by Company A’s services would all be sourced to State X, notwithstanding the services were performed in State Y. Assuming State X is a state that has adopted economic nexus with a $250,000 revenue trigger, the amount of revenue to establish nexus would be exceeded and Company A would be required to file an income tax return. On the other hand, if State X sourced its revenue following a cost of performance methodology, all of the service revenue generated by Company A with respect to its client located in State X would be deemed to be sourced to State Y. Consequently, the minimum revenue nexus trigger amount would not be exceeded, and no return would need to be filed in State X.
Potential for Tax-Free or Double Taxation
Some states that are now using a market-based sourcing regime are also enforcing a single factor sales apportionment method—creating a tax-free loophole opportunity for some taxpayers. This occurs when a company’s home state is a market-based sourcing state with single sales factor, whereas the destination state is a cost of performance state with single sales factor apportionment. In this instance the revenue is not assigned to the home state, because the service was sent to an out-of-state customer. Further, the revenue is not associated with the destination state as the income-producing activity was conducted outside of that state.
On the other end of the spectrum, if you are a taxpayer who is based in a cost of performance state and you provide a service for a customer located in a market-based sourcing state, you may be double-taxed. If the income-producing activity is performed in the home state, the entire service revenue from that transaction would be reflected on the home state tax return. You would also need to source the entire revenue from that service to the state where the customer is located.
With an ever-increasing portion of our nation’s economy relying on the provision of services, having a clear understanding of how services are sourced is an integral aspect of performing a nexus analysis. If you have any questions regarding revenue sourcing, or economic nexus, please contact Tom Corrie at firstname.lastname@example.org, or your Friedman LLP tax advisor.