The New Massachusetts Income Sourcing Rules For Corporate Services: Massachusetts DOR Issues Working Draft of Implementing Regulations

by M. Robinson & Company, P.C.
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Introduction

On July 24, 2013 the Massachusetts General Court enacted an $800 million transportation bill. This bill, inter alia, revised the Massachusetts corporate sourcing rules for the sale of services.[1] The bill became effective as of January 1, 2014[2] for corporations with nexus[3] in Massachusetts. Under the new rules, sales are generally sourced to Massachusetts “if the corporation’s market for the sale is in Massachusetts.” On March 25, 2014 – eight full months later – the Massachusetts Rulings and Regulations Bureau finally issued an 18-page working draft of the new regulations.[4] The comment deadline is May 1, 2014. The purpose of this article is to provide a broad overview[5]  of this complex draft regulation. Interested readers should download and read the entire regulation.[6]

Prompt Tax Planning Is Essential

Corporations subject to the new sourcing rules are advised to take immediate steps: (1) to understand how the new rules impact them; (2) to capture the information required by this regulation; and (3) to take effective action to protect their interests.[7] There are four reasons for this urgency.

First, the draft regulations represent a conscious attempt by the Massachusetts Department of Revenue to maximize Massachusetts source income to the fullest extent possible under the United States commerce clause. For example, under the draft regulation it is possible for a corporation to be subject to Massachusetts income taxation when the taxpayer corporation is located outside of Massachusetts; its customer is located outside Massachusetts; and all services for that customer are performed entirely outside of the geographical boundaries of Massachusetts. Nonetheless, if the ultimate recipients of the services (such as an advertiser’s target audience) are located in Massachusetts, the out-of-state corporation may be required to report Massachusetts sales and pay a Massachusetts corporate income tax on its services.[8]

Second, once a taxpayer has filed a tax return using a reasonable sourcing method, the taxpayer is precluded from amending its sourcing method for that taxable year.[9] While the taxpayer may change its sourcing methods for a subsequent taxable year, the taxpayer is required to disclose on its original return for the subsequent taxable year that it has made the change, the nature and extent of the change, and the reason for the change.[10] Thus, there is an advantage to getting it right the first time.

Third, “rules of reasonable approximation” can only be used if the sourcing of sales cannot otherwise be determined with reasonable certainty using a “reasonable amount of effort.”[11] The term “reasonable amount of effort” is, of course, sufficiently ambiguous to force taxpayers who need “reasonable rules of approximation” to rely on the kindness of strangers. Thus, corporations with unusual situations should consider alternative sourcing rules under M.G.L. c.63, Section 42[12] The request is made with a “duly-filed” corporate income tax return.[13] Thus, it is important to plan the request well in advance of the “duly-filed” return. Another possibility might be to request a private letter ruling.[14]

 Fourth, in a number of instances the regulations impose an “affirmative duty” in good faith[15] to identify the “primary residence” of an individual customer[16] or the state in which the contract of sale is “principally managed” by a business customer.[17]  The affirmative duty arises when the particular customer represents more than 5 percent of a corporation’s sales of services. It is generally unwise for a taxpayer to fail an “affirmative duty.” Thus, this “affirmative duty” should be performed well before the tax return is required to be prepared.

The Corporate Sourcing Rules

1.   Introduction

Given the vagueness of the term “market for the sale,”[18] the draft regulations commendably provide nuanced rules for different types of services. Some of the more important rules are summarized below.

2.   In-Person Services

In-person services include, “without limitation, warranty and repair services; cleaning services; plumbing services; pest control; landscape services; medical and dental services, including medical testing and x-rays and mental health care and treatment; child care; hair cutting and salon services; live entertainment and athletic performances; and in-person training or lessons.”[19] Generally, in-person services are sourced to the place where the service is received.[20] Thus, where in-person services are performed on an individual in Massachusetts or on real estate located in Massachusetts, the service is sourced to Massachusetts. But if tangible personal property is shipped outside of Massachusetts for repair and then reshipped to Massachusetts the sale is also sourced to Massachusetts because the repair service is “received” in Massachusetts.[21]

3.   Advertising and Product Fulfillment Services

When the recipient of advertising services (that is, the advertiser’s target audience) is located in Massachusetts, the income arising from those services is sourced to Massachusetts – regardless of where the advertiser is located and regardless of where the work is performed. The method of delivery – physical means or electronic transmission is irrelevant.[22] Similarly, fulfillment services are sourced based on the location of the recipient of the tangible personal property.[23]

4.   Software Services

Where the software is physically delivered to a location in Massachusetts, the software services are sourced to Massachusetts.[24] Where the software is delivered through electronic means, the rules are considerably more complex but are designed to source the sale to the physical location where the customer receives the service.[25]

5.   Professional Services

Professional services include “management services, bank and financial services, financial custodial services, investment and brokerage services, fiduciary services, tax preparation, payroll and accounting services, lending and credit card services, legal services, consulting services, video production services, graphic and other design services, engineering services, and architectural services.” Professional services receive the most nuanced treatment.

(a)   Type of Customer

The regulation distinguishes between individual customers and business customers. For individual customers, services are sourced to the state of “primary residence;” or if that information is not “reasonably determinable,” by the customer’s “billing address” – provided that where the taxpayer derives more than 5 percent of its sales of services from a customer, the taxpayer has an affirmative duty to identify the state where the customer maintains his or her “primary residence.” [26]

For business customers, services are sourced to the state where the contract of sale is “principally managed’ by the customer; or if that information is not “reasonably determinable,” by the “place of order;” or if that information is not “reasonably determinable,” by the customer’s “billing address” – provided that where the taxpayer derives more than 5 percent of its sales of services from a customer, the taxpayer has an affirmative duty to identify the state in which the contract of sale is “principally managed” by the customer.[27]

Important exceptions to the above sourcing rules include advertising services (discussed above) and medical services and architectural services (discussed below). Thus, the above sourcing rules based on the identity of the customer appear to apply principally to the rendition of legal and accounting services (discussed below).

(b)   Type of Services

(1)   Medical Services

In-person medical services that “significantly involve or require in-person contact” are treated as “in-person services” (described above) and are sourced to the place where the services were performed.[28]

(2)   Brokerage Services

Brokerage services are assigned to the “primary residence” of the individual customer of the brokerage services.[29]

(3)   Architectural Services

Architectural services are assigned to the location of the building project to which the design services relate.[30]

(4)   Legal and Accounting Services

In the case of an individual customer, legal services are sourced to the “primary residence” of the recipient of the services. In the case of a business customer, legal services are sourced to the state where the contract of sale is “principally managed.”[31] “It is irrelevant whether the legal documents relating to the service are mailed or otherwise delivered to a location in another state, or the litigation or other legal matter that is the underlying predicate for the services is in another state.”[32] While the draft regulation is silent regarding accounting services it seems reasonable that the sourcing rules for accounting services should follow the sourcing rules for legal services.

Carve-Outs

There are two important “carve-outs.” First, industry-specific regulations promulgated pursuant to M.G.L. c. 63, Section 38 (j) remain in full force and effect and are not affected. These regulations include, for example, the allocation of the income of interstate trucking companies based on mileage.[33] Second, taxpayers will still be able to suggest alternative apportionment methods under M.G.L. c. 63, Section 42.[34]

Overall Evaluation

The draft regulations are confusing and difficult to follow and exceptions seem to outnumber the general rules. In hindsight, it might have been advisable if the Rulings and Regulations Bureau had actively solicited the participation of major affected industries in the regulatory process and then drafted industry-specific sourcing regulations for each industry pursuant to M.G.L. c. 63, Section 38 (j).

Conclusions

The draft regulation will likely be adjusted in small ways following the receipt of comments from the practitioner community.  However, the major thrust of these regulations will remain. Thus, cautious corporate taxpayers will want to act immediately to control their tax exposure by:

(1)   Requesting appropriate changes to the draft regulation during the comment period that ends on May 1, 2014;

(2)   Adopting a reasonable sourcing methodology that minimizes Massachusetts source income and does not need to be changed; [35]

(3) Advocating for an alternative sourcing methodology under M.G.L. c. 63, Section 42;[36]

(4) Requesting a letter ruling;[37]  and/or

(5) Negotiating an industry-specific regulation under M.G.L. c. 63, Section 38(j).[38]

In addition, affected corporations will want to undertake the other tax planning steps set forth on pages 2 and 3, above.


[1] Massachusetts Session Laws, c. 46 Section 37. “Sales, other than sales of tangible personal property, are in the commonwealth if the corporation’s market for the sale is in the commonwealth.” (Emphasis added.)

[2] Massachusetts Session Laws, c. 46 Section 84.

[3] Under Massachusetts court case, nexus includes both physical nexus and economic nexus. See Geoffrey, Inc. v. Commissioner of Revenue, 453 Mass. 17 (2009) and Capital One Bank & another v. Commissioner of

Revenue, 453 Mass. 1 (2009).

[4] The entire regulation known as 830 CMR 63.38.1, including the draft amendments, runs to 58 pages.

[5] Thus, for example, this article does not consider exclusion of sales from the numerator and the denominator. See, generally, Draft Regulation 830 CMR 63.38.1(9)(d) 1. c.

[7] See the Conclusion for a listing of possible effective actions.

[8] See, for example, Draft Regulation 830 CMR 63.38.1(9)(d) 4. c. ii (A) 2. Example 2. Example 2 may well represent an unconstitutional extension of the economic nexus doctrine unless the taxpayer corporation otherwise has physical or economic nexus with Massachusetts. See footnote 4, above.

[9] Draft Regulation 830 CMR 63.38.1(9)(d) 1. d. i.

[10] Draft Regulation 830 CMR 63.38.1(9)(d) 1. d. ii.

[11] Draft Regulation 830 CMR 63.38.1(9)(d) 1. b. i.; Draft Regulation 830 CMR 63.38.1(9)(d) 1. a.

[12] “If a taxpayer claims that the allocation or apportionment provisions of 830 CMR 63.38.1 are not reasonably adapted to approximate the net income derived from business carried on in Massachusetts, a taxpayer may apply to the Commissioner to have such income determined by an alternative apportionment method pursuant to the provisions of M.G.L. c. 63, § 42 and 830 CMR 63.42.1.” 830 CMR 63.38.1(13)(a).

[13] “Such application shall be made by attaching to its duly-filed return a statement of the reasons why the corporation believes that the allocation and apportionment provisions of this chapter are not reasonably adapted to approximate its net income derived from business carried on within this commonwealth and a description of the method of allocation sought by it.” M.G.L. c. 63, Section 42.

[14] See, generally, 830 CMR 62C.3.2: Letter Rulings. It is not clear whether the Department of Revenue will issue a letter ruling to clarify the sourcing rules for a particular taxpayers. Therefore, it is best practice at the outset to ask the DOR for permission to request a letter ruling.

[15] The requirement of good faith is mentioned several times. See, for example, Draft Regulations 830 CMR 63.38.1(9)(d) 1. a. and 830 CMR 63.38.1(9)(d) 1. b. iii.

[16] See, for example, Draft Regulation 830 CMR 63.38.1(9)(d) 4. d. ii. (A) and Draft Regulation 830 CMR 63.38.1(9)(d) 4. d. v. Example 3.

[17] See, for example, Draft Regulation 830 CMR 63.38.1(9)(d) 4. d. ii. (B) and Draft Regulation 830 CMR 63.38.1(9)(d) 4. c. ii. B. 4. Example 5.

[18] See footnote 2, above.

[19] Draft Regulation 830 CMR 63.38.1(9)(d) 4.b. i.

[20] Draft Regulation 830 CMR 63.38.1(9)(d) 4. b. ii. There is a special “carve out” for professional services. See below and  Draft Regulation 830 CMR 63.38.1(9)(d) 4. d.

[21] Draft Regulation 830 CMR 63.38.1(9)(d) 4. b. ii. See, also, footnote 9, above.

[22] Draft Regulation 830 CMR 63.38.1(9)(d) 4. c.  i. See, also, Draft Regulation 830 CMR 63.38.1(9) (d) 4. c. ii (A) 2. Example 1.

[23] Draft Regulation 830 CMR 63.38.1(9)(d) 4. c. ii. (A) 2. Example 4.

[24] Draft Regulation 830 CMR 63.38.1(9)(d) 4. c. ii. (A) 2. Examples 5 and 6.

[25] Draft Regulation 830 CMR 63.38.1(9)(d) 4. c. ii. (B).

[26] Draft Regulation 830 CMR 63.38.1(9)(d) 4. d. ii. (A).

[27] Draft Regulation 830 CMR 63.38.1(9)(d) 4. d. ii. (B).

[28] Draft Regulation 830 CMR 63.38.1(9)(d) 4. d. i.

[29] Draft Regulation 830 CMR 63.38.1(9)(d) 4. d. v. Examples 1, 2 and 3.

[30] Draft Regulation 830 CMR 63.38.1(9)(d) 4. d. iii. and Draft Regulation 830 CMR 63.38.1(9)(d) 4. d. v. Example 4.

[31] See, generally, type of customer, above. See, also, the text associated with footnotes 27 and 28, above.

[32] Draft Regulation 830 CMR 63.38.1(9)(d) 4. d. v. Examples 5 and 7.

[33] See, generally, 830 CMR 63.38.2 (Apportionment of Income of Airline Corporations); 830 CMR 63.38.3 (Apportionment of Income of Motor Carriers); 830 CMR 63.38. 4 (Apportionment of Income of Courier and Package Delivery Services); etc.

[34] See footnote 13, above, and associated text.

[35] See Prompt Tax Planning Is Essential, Paragraph Second. See, also, footnotes 10 and 11, above.

[36] See Prompt Tax Planning Is Essential, Paragraph Third. See, also, footnote13, above.

[37] See footnote 15, above.

[38] See footnote 34, above.

 

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