Recently, both New York State (the “State”) and New York City (the “City”) have modified the methods prescribed with respect to how service revenue should be sourced. Applicable for tax years beginning on or after January 1, 2015, both the State and City have moved from a cost of performance (“COP”) based model to a market based model under certain circumstances. It is in the applicability of those circumstances that a major problem lies. Quite frankly, the sourcing rules are confusing, not only for taxpayers in general, but also for tax professionals.
Sourcing Methodologies-The Basics
Ordinarily, states source service revenue using one of two basic sourcing modes: COP and market based. Each of these approaches often has different variables in their application depending on the particular state statutes and regulations at issue.
States that follow a COP standard focus on where the services provided by a taxpayer were physically performed. Within the COP format, states follow one of two approaches. Certain state’s rules provide that only those revenues related to services performed within their boundaries need be sourced to the state. These states are known as COP percentage states. Other states laws require that in a multi-state setting, if the preponderance (note, not necessarily the majority) of the services provided by the taxpayer to a particular company occurred in that state, then all of the revenues arising from the services must be sourced to that state.
Assume Company X provides $1,000,000 of design services for Company Y at that company’s offices located in States A, B and C. Further assume that 40% of those services were provided in State A, while the remaining 60% of the services were split equally between States B and C. If State A follows a percentage COP framework, only $400,000 of the revenues from Company X’s services will be sourced to that state. On the other hand, if State A has adopted a preponderance COP approach, the entire $1,000,000 will be sourced to it.
Moreover, if either state B or C follows a sourcing methodology that differs from that followed by State A, the possibility of sourcing more or less than 100% of the total receipts exists.
Under a market based sourcing approach, the focus shifts from the location of the service provider to the location of the business receiving the services. Generally, state statutes adopting this approach look to either where the services are “delivered” or where the benefit of the services is “received.” Determining the correct market location can be challenging, particularly under a “benefit received” standard.
State A is a market based sourcing state that follows a benefit received format. Taxpayer is a non-State A design consulting firm. Customer is a retail chain headquartered in State A, with 20 in-state locations, and 40 out-of-state locations. Taxpayer delivers all of its design services in State A, but the services have applications with respect to all of Customer's retail locations. If Taxpayer provides Customer with $1,000,000 of services, only $333,333 of such services with be sourced to State A since the benefit of Taxpayer’s services was received at all of Customer’s retail locations, both in-state and out-of-state.
Conversely, if State A focused on where services are “delivered,” the entire $1,000,000 of services would be sourced to that state. Again, if the other states in which Customer has retail locations follow a different sourcing mode than State A, it is possible that more or less than 100% of the $1,000,000 fee would be subject to apportionment.
The Current State of Sourcing Services Regarding New York State and New York City
Historically, both the State and the City followed a COP percentage methodology. As a result, only services actually performed within the boundaries of those jurisdictions were sourced to them. Pursuant to recently enacted legislation, both the State and City have adopted market based sourcing models with respect to corporations. It should be noted that while the State adopted that approach for all corporate entities, the City has limited its market based sourcing mode to only Subchapter C Corporations. Even though the City does not recognize Subchapter S Corporations as pass-through entities for purposes of its General Corporation Tax, it did not extend its market based sourcing rules to federal S Corporations.
For all non-corporate entities, both the State and the City have retained their traditional COP percentage sourcing approach. Accordingly, all partnerships and LLCs treated as partnerships follow the old service sourcing rules for the respective jurisdictions. That means, for example, when sourcing revenue from services for purposes of the City’s Unincorporated Business Tax, only revenues generated in connection with services performed in the City need be sourced to the City.
Obviously, because of the different sourcing methodologies followed regarding various forms of entities, situations involving a mixed tiering of corporate and non-corporate entities can be somewhat complex in terms of sourcing service revenue.
Until more firm guidance is issued by both the State and City with respect to how the new sourcing rules should be applied, it is likely that difficulties in working with them will continue to exist. Taxpayers making good faith efforts at compliance should be treated fairly by the taxing authorities given the difficulties the new sourcing rules present them with.