A Pinch of Salt, September 2010- The Implementation of ‘Market’ Sourcing Rules: Practical Concerns


California is the most recent state to develop market-based rules to source receipts from the sale of services and intangibles. In this Pinch of SALT, we survey the various methods states use to apply market-based sourcing to service and intangible income and address how California and the Multistate Tax Commission are proposing to tackle market-based sourcing and the associated problems. We conclude that while market sourcing offers a principled way to source receipts from the sale of services and intangibles, in practice, marketsourcing rules are likely to create a variety of administrative problems and will not advance uniformity. These challenges are particularly concerning in states that weight the sales factor more heavily or use a single-sales-factor apportionment formula.

Costs of Performance

Of the 46 states with corporate income taxes, 23 states have adopted the Uniform Division of Income for Tax Purposes Act, and most others have adopted a similar method to apportion the business income of multistate taxpayers. Approximately 30 states use the costs-of-performance method to source receipts from sales of services or sales or licenses of intangibles. 1

Under the standard UDITPA rule, receipts from sales other than sales of tangible personal property are sourced to the state if ‘‘the greater proportion of the income-producing activity is performed in this state than in any other state, based on costs of performance.’’2 Thus, the costs-of-performance method requires the taxpayer to identify individual lines of income, determine the income-producing activities for each income line, and determine where the income-producing activities (and associated costs) take place. Although taxpayers and auditors may disagree on how a company’s income lines should be broken down or on which incomeproducing activities are associated with each income line, the benefit of this method is that taxpayers generally have access to relevant cost data — or can design systems to capture that information — because the costs-of-performance method considers the taxpayer’s activities.

That said, the costs-of-performance method has been criticized on several fronts. The purpose of the sales factor is to reflect the contribution of the market to the taxpayer’s income. This objective may not be achieved under the costs-of-performance method if the income-producing activities required to generate income take place in states other than where the taxpayer’s customers are located. This problem is particularly acute in states that use the standard all-or-nothing UDITPA rule, which sources receipts to the state only if the preponderance of the income-producing activities occur within the state, as opposed to a ‘‘proportionate’’ costs-of-performance method that sources sales based on the relative proportion of income-producing activities taking place in each state.3

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