For a technology company, determining your state and local tax liability is complicated, to say the least. Each state has its own criteria to establish jurisdiction to tax your company. Furthermore, states are continuously arbitrating whether new technologies are even taxable. This lack of consensus and confusion can make it difficult to determine where you need to file and how to allocate income. It’s prudent to maintain records with detailed information on all sales and to engage a skilled tax advisor to help navigate these complicated waters.
If you’re an early stage company still operating with losses, it’s imperative you do not neglect filing taxes or reporting your net operation loss (NOL) beyond your home state. To avoid future tax complications, analyze and appropriately file with all states that can claim nexus from the beginning.
Determining which states can claim nexus
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. Moreover, some states can have different thresholds of nexus for different tax types (i.e., income vs. sales tax). Technology 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, nexus can be created in some states by merely having sales in those states over a certain threshold amount regardless of physical presence.
In today’s environment, a technology company’s ability to determine nexus is complicated and ever changing. In a September 2014 Texas court case, a seller failed to challenge the statutory characterization of software as tangible personal property, and thus its sales in the state of electronically downloaded software and digital content was sufficient to establish sales tax nexus. Conversely, a Missouri court ruled in February 2015 that electronically downloaded software and software updates, in conjunction with optional maintenance contracts, were not subject to sales tax since the delivery of software was not delivered via a tangible medium. With no consensus on what constitutes taxable services or sales across states, and countless rulings every year, it’s imperative to engage a state and local tax professional to ensure compliance.
Sourcing your income
Once you determine what states your company has income tax nexus in, you’ll need to determine how much 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.
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 identifying 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 to be applied, and others include sales activity costs. Some states even expect to see a costing report during an audit in order to evaluate the true costs of performing each service from an economic viewpoint. This can require companies to track costs on a project-by-project basis, which can be cumbersome.
Due to the differences among the states, there are occasions to source sales to no state at all or, in contrast, to source the same sale to two states. Since state income tax laws are anything but uniform, it is essential for businesses to consult with someone well versed in every area of state tax law. Having a trusted tax advisor with the ability to navigate each state’s specific rules can mitigate issues and keep taxpayers up to date on tax changes, which can lead to opportunities for tax savings.