Later this month, the New Jersey Division of Taxation is expected to propose a regulation that will adopt a market-based approach to source receipts from services. On the surface, it appears difficult to reconcile the language of this new apportionment regulation with the statute (which sources receipts based on location of performance). The statute remains unchanged, so taxpayers will need to decide whether to conform to the regulation or to continue following the historical statutory method.
Taxpayers that perform services in New Jersey will want to follow the regulation and use the market-sourcing method.
Taxpayers that perform services outside New Jersey will want to follow the statute and continue using the cost-of-performance method.
The new regulation will apply to tax years beginning on or after January 1, 2014, which is also when New Jersey’s single sales-factor apportionment formula takes effect.1
Mechanics of the New Rule
Under the statute, service receipts are sourced to New Jersey only if the service is "performed within the State."2 New Jersey courts as well as the Division itself have interpreted this to mean that service receipts are sourced to the location where the costs of performance are incurred, or where the time performing the service was spent.3 By contrast, under the proposed regulation, service receipts would be sourced based on the location of the customer, regardless of where the services are performed.
If a customer has operations in multiple states, the proposed regulation provides that service receipts are sourced to where the benefit is received. If the benefit is received in more than one state, a taxpayer can estimate the proportion of the benefit received in New Jersey. For example, census data may be used to determine the extent of the taxpayer’s New Jersey market. The proposed regulation will include a number of examples for specific industries, such as real estate services, engineering services, computer software services, advertising services, prescription services, market analysis services, legal information services, and payroll processing services.
Winners and Losers
Taxpayers that perform services in New Jersey could see their Corporation Business Tax liability significantly reduced beginning in 2014. Not only will such taxpayers get to use market sourcing, but the elimination of the property and payroll fractions will also mean a much lower apportionment percentage. On the other hand, many out-of-state service providers could see significant tax increases.
The new regulation will have other, though perhaps less obvious, consequences, such as:
The proposed apportionment change could affect the value of your Net Operating Loss carryover. New Jersey NOLs are carried over on a pre-apportioned basis. As a result, NOLs have less value if applied in years when the taxpayer’s apportionment percentage is lower. If a New Jersey-based service provider has NOLs that decline in value because of the new market-sourcing rule, it should consider carrying over its NOLs on a post-apportioned basis to alleviate the distortion.
Service providers that were taking advantage of the "25:50:25 option" could also face potential tax increases. Under the 25:50:25 option, certain taxpayers (including financial businesses, technology companies, and media companies) could reduce their sales fraction by 50 percent if their back-office functions were performed outside the state.4 The Division’s proposal removes this option from the regulation.
Is Cost of Performance Still an Option?
Whereas the statute sources service receipts based on where the service is performed, the new regulation looks to where the benefit is received. The Division’s proposal thus faces potential taxpayer challenges. If the regulation is challenged, it could be years before the New Jersey courts ultimately resolve the issue. In the meantime, taxpayers will have to choose which method to use. Taxpayers that benefit from the new rule can source their receipts based on market. By contrast, taxpayers that do not benefit can take the position that the statute controls, and that they are still entitled to source their services receipts based on where the service is performed.
More Expansive Nexus Standard?
New Jersey statute imposes CBT nexus over companies "deriving receipts from sources within the state .…"5 Regardless of physical presence, the Division has asserted nexus over out-of-state intangible holding companies, financial businesses, software providers, and media companies based on its historical policy that these companies derive receipts from New Jersey to the extent their customers are located in the state.
By contrast, the Division generally has not asserted nexus over out-of-state service providers unless they have physical presence in the state. Under the Division’s historical cost-of-performance rule, out-of-state service providers would not be deriving receipts from New Jersey. Therefore, these companies could not have CBT nexus. But under the proposed regulation, such companies would be deemed to be deriving receipts from New Jersey to the extent they had customers within the state. It remains to be seen whether the Division—consistent with its treatment of intangible holding companies, financial businesses, software providers, and media companies—will assert nexus over out-of-state service providers regardless of physical presence.
Sixty-Day Comment Period
Companies affected by the new rule will have until mid-June to submit written comments or request a public hearing. If the regulation were to be adopted as proposed, affected taxpayers will have the option of challenging the new rule in New Jersey Tax Court.
If you have any questions about this issue, please contact one of the authors or the Reed Smith attorney with whom you usually work. For more information on Reed Smith's New Jersey tax practice, visit www.reedsmith.com/njtax.
1. P.L.2011, c.59, amending N.J.S.A. 54:10A-6.
2. N.J.S.A. 54:10A-6(B)(4)
3. N.J.A.C. 18:7-8.10(a); Mayer & Schweitzer, Inc. v. Director, 20 N.J. Tax 217, 226 (sourcing receipts to where services are performed).
4. N.J.A.C. 18:7-8.10(c)(1) and (3).
5. N.J.S.A. 54:10A-2.