The Pennsylvania Department of Revenue (the “Department”) has been taking aggressive positions to source sales of services to Pennsylvania for corporate tax purposes.  For tax years beginning on or prior to December 31, 2013, Pennsylvania had a costs-of-performance statutory provision that applied to all sales, other than sales of tangible personal property. Effective for tax years beginning after December 31, 2013, Pennsylvania changed its statute to adopt market-based sourcing for services. However, the Department has been issuing assessments that effectively adopt market-based sourcing for tax years prior to the effective date of the statute change by adjusting companies’ sales factors to source sales from services based on the location of the companies’ customers. Moreover, as the costs-of-performance provision remains in effect for other sales, the Department’s interpretation of the provision will continue to impact companies for tax years that begin after December 31, 2013.

The Statute

Effective for tax years beginning after December 31, 2013, Section 401(3)2.(a)(16.1)(C)(I) of the Pennsylvania Tax Reform Code of 1971 (the “Market-Based Sourcing Provision”) provides that “[s]ales from the sale of [a] service [are in this State], if the service is delivered to a location in this State.  If the service is delivered both to a location in and outside this State, the sale is in this State based upon the percentage of total value of the service delivered to a location in this State.”

The statute also addresses when sales from the sale, rental, lease or licensing of tangible personal property are in Pennsylvania, and when sales from the sale, lease, rental or other use of real property are in Pennsylvania.

All other sales are in Pennsylvania if: (1) “[t]he income-producing activity is performed in this State”; or (2) “[t]he income-producing activity is performed both in and outside this State and a greater proportion of the income-producing activity is performed in this State than in any other state, based on costs of performance” (the “Costs-of-Performance Provision”).

Prior to the effective date of the Market-Based Sourcing Provision, all sales, other than sales of tangible personal property, were sourced to Pennsylvania pursuant to the Costs-of-Performance Provision.

The statute authorizes an alternative method of allocation or apportionment if the standard allocation and apportionment provisions do not fairly represent the extent of the company’s business activity in Pennsylvania.

Insights

The enactment of the Market-Based Sourcing Provision clearly indicates that the Pennsylvania Legislature intended to change from costs-of-performance sourcing for services to market-based sourcing for services for tax years beginning after December 31, 2013.  Nevertheless, the Department has issued assessments asserting that sales of services for tax years beginning on or prior to December 31, 2013 are sourced to Pennsylvania where companies’ customers are located in Pennsylvania, effectively imposing market-based sourcing prior to the effective date of the Market-Based Sourcing Provision.  The Department’s position is that the income-producing activity occurs where a company’s customers are located and, therefore, that all sales to Pennsylvania customers are sourced to Pennsylvania even under the Costs-of-Performance Provision.

Other state taxing departments have interpreted their states’ statutes to achieve market-based sourcing under costs-of-performance provisions. However, in Pennsylvania the Department’s position is particularly unfounded and susceptible to attack due to the Legislature’s enactment of the Market-Based Sourcing Provision, which clearly signals that the Legislature did not intend for market-based sourcing to apply to services under the Costs-of-Performance Provision.

Moreover, although the Market-Based Sourcing Provision adopts market-based sourcing for services for tax years that begin after December 31, 2013, the Department’s aggressive position on sourcing is not limited to sales of services and, as the Costs-of-Performance Provision remains in effect for other sales, the Department’s interpretation of the Costs-of-Performance Provision will continue to impact companies for tax years that begin after December 31, 2013.

Finally, companies should be aware that, although the Department has the authority to require a company to use an alternative apportionment methodology, the Department may not invoke this authority unless it first establishes that the standard apportionment provisions do not fairly represent the extent of the company’s business activity in Pennsylvania.