SALT has service companies all shook up
The year was 1957. Elvis’ “All Shook Up” was No. 1, Sputnik was launched, and the Uniform Division of Income Tax Purposes Act (UDITPA) was passed. Tax professionals took a sigh of relief. Finally there was going to be uniformity and simplification in state taxation! Well, perhaps for a time, but the United States was mainly a manufacturing-based economy. Move ahead over 50 years: most of that manufacturing is overseas and replaced with services and technology. While our economy and everyday life has adapted to the changes, our state tax laws have not. Laws written more than 20 years ago are being applied to things like digital goods and cloud computing. This is causing tremendous confusion for taxpayers who are trying to understand where and how they are subject to income tax.
Before a state can tax anyone, it must first have the right to do so. This is called nexus. More specifically, nexus is a minimum connection within a taxing jurisdiction that allows that jurisdiction the right to impose a tax upon a taxpayer. Nexus standards vary greatly among states and even among industries. For instance, sellers of tangible personal property (manufacturers, distributors, etc.) are given more protection from income tax nexus. However, service providers are not afforded these same nexus protections. As a result, service companies can create nexus in a state simply by having an employee travel or work in that state, no matter what they are doing. While nexus is typically triggered by having a physical presence in a state, some states have imposed economic nexus standards. This means that the mere act of having sales in a state over a certain threshold amount will create nexus. To many this seems far reaching and potentially unconstitutional, but it has yet to be successfully litigated.
Once taxpayers have determined where they have filing requirements, they then must figure out how much of their income is subject to tax in each jurisdiction. This process of dividing income among the states is called apportionment. Each state has a different method to apportion income, and the difficulty for service-based companies usually lies in determining the sales factor. The two general approaches used to source sales are market-based sourcing and cost-of-performance sourcing. And not only are there two different ways to source sales, there are also different rules and ways within each approach.
Market-based sourcing sources a sale in the state where the service’s benefit is being enjoyed. In theory, that sounds simple. However, between the different languages used in each state’s laws and the complex nature of some services, it can be very difficult to figure out where the sale should be sourced. Some states say the service should be sourced where “the benefit of the service is received,” while others have written the service must be “derived from customers in the state.” For example, ABC Co. provides a market analysis software license to its customers. The software is accessed through the Internet by a customer in State A where he analyzes the reports. The customer is headquartered in State B. The server that hosts the software is in State C. How should ABC Co. source this sale? They could say the benefit was received in State B (the customer’s home state) or State A (where the software was actually used). A third argument could even be made to source the sale to State C, where the actual software is being run. Market-based sourcing is the newest trend among state apportionment, but many questions still surround its application.
On the other hand, cost-of-performance sourcing does not look to where the end product goes, but rather to where the service is performed. For this, the difficulty lies in determining and tracing the costs that are associated with the service for each customer. It starts with what costs are even included. All states require direct costs to be included; however, that is where the similarities among states end. Some states require an amount of overhead costs be applied, and others include sales activity costs. Some states even expect to see a costing report under audit, in order to evaluate the true costs of performing each service from an economic viewpoint.
Due to the differences among the states, there are opportunities that sales could be sourced to no state, or the opposite, with the same sale being sourced to two states. Clearly, state income tax laws are anything but uniform, so it is essential for businesses to have someone well versed in every area of state law. Having a trusted tax advisor with the ability to navigate each state’s specific rules can mitigate issues and keep taxpayers’ liabilities to the appropriate level.
Before a state can tax anyone, it must first have the right to do so. This is called nexus. More specifically, nexus is a minimum connection within a taxing jurisdiction that allows that jurisdiction the right to impose a tax upon a taxpayer. Nexus standards vary greatly among states and even among industries. For instance, sellers of tangible personal property (manufacturers, distributors, etc.) are given more protection from income tax nexus. However, service providers are not afforded these same nexus protections. As a result, service companies can create nexus in a state simply by having an employee travel or work in that state, no matter what they are doing. While nexus is typically triggered by having a physical presence in a state, some states have imposed economic nexus standards. This means that the mere act of having sales in a state over a certain threshold amount will create nexus. To many this seems far reaching and potentially unconstitutional, but it has yet to be successfully litigated.
Once taxpayers have determined where they have filing requirements, they then must figure out how much of their income is subject to tax in each jurisdiction. This process of dividing income among the states is called apportionment. Each state has a different method to apportion income, and the difficulty for service-based companies usually lies in determining the sales factor. The two general approaches used to source sales are market-based sourcing and cost-of-performance sourcing. And not only are there two different ways to source sales, there are also different rules and ways within each approach.
Market-based sourcing sources a sale in the state where the service’s benefit is being enjoyed. In theory, that sounds simple. However, between the different languages used in each state’s laws and the complex nature of some services, it can be very difficult to figure out where the sale should be sourced. Some states say the service should be sourced where “the benefit of the service is received,” while others have written the service must be “derived from customers in the state.” For example, ABC Co. provides a market analysis software license to its customers. The software is accessed through the Internet by a customer in State A where he analyzes the reports. The customer is headquartered in State B. The server that hosts the software is in State C. How should ABC Co. source this sale? They could say the benefit was received in State B (the customer’s home state) or State A (where the software was actually used). A third argument could even be made to source the sale to State C, where the actual software is being run. Market-based sourcing is the newest trend among state apportionment, but many questions still surround its application.
On the other hand, cost-of-performance sourcing does not look to where the end product goes, but rather to where the service is performed. For this, the difficulty lies in determining and tracing the costs that are associated with the service for each customer. It starts with what costs are even included. All states require direct costs to be included; however, that is where the similarities among states end. Some states require an amount of overhead costs be applied, and others include sales activity costs. Some states even expect to see a costing report under audit, in order to evaluate the true costs of performing each service from an economic viewpoint.
Due to the differences among the states, there are opportunities that sales could be sourced to no state, or the opposite, with the same sale being sourced to two states. Clearly, state income tax laws are anything but uniform, so it is essential for businesses to have someone well versed in every area of state law. Having a trusted tax advisor with the ability to navigate each state’s specific rules can mitigate issues and keep taxpayers’ liabilities to the appropriate level.
