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Apportioning Service Revenue in Corporate Tax ComplianceNavigating the Latest State Laws and Regulations

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

THURSDAY, MARCH 15, 2012

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

Peter Stathopoulos, Managing Director, State and Local Tax Group, Bennett Thrasher, Atlantap , g g , p, ,

Mark Siegel, Senior Tax Manager, BDO USA, Atlanta

Michael Wynne, Partner, Reed Smith, Chicago

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A ti i S i R i Apportioning Service Revenue in Corporate Tax Compliance Seminar

March 15, 2011

Mark Siegel, BDO [email protected]

Peter Stathopoulos, Bennett [email protected]

Michael Wynne, Reed Smith [email protected]

Today’s ProgramCost Of Performance Vs. Market-Based Sourcing Slide 7 – Slide 14[Peter Stathopoulos]

State Trends In Apportionment Formulae[Mark Siegel]

Slide 15 – Slide 21

Recent Material Developments[Michael Wynne and Mark Siegel]

I d t S ifi E l


Slid 36 Slid 37Industry Specific Examples[Michael Wynne]

Problems Arising From Market-Based Sourcing[Peter Stathopoulos and Michael Wynne]


Slide 38 – Slide 43[Peter Stathopoulos and Michael Wynne]

Recent Litigation Of Note[Peter Stathopoulos]


Practical Taxpayer Compliance Situations[Mark Siegel]


COST OF PERFORMANCE VS Peter Stathopoulos, Bennett Thrasher

COST OF PERFORMANCE VS. MARKET‐BASED SOURCING

M j i C Of P fMajority Cost Of Performance

• Origins in Uniform Division of Income For Tax Purposes Act (1957)

• Pursuant to UDIPTA §17 sales of “other than tangible personal Pursuant to UDIPTA §17, sales of other than tangible personal property” are sourced to a state if:

― The income-producing activity is performed in this state, or

― The income producing activity is performed both in and outside the state, and a greater proportion of the income-outside the state, and a greater proportion of the incomeproducing activity is performed in this state than in any other state, based on costs of performance.

8

Elements Of Majority Cost Of Performance

• All-or-nothing plurality approach

• All receipts sourced to state where majority of costs incurred

• What is “income producing activity”?• What is income producing activity ?

― Lowest discrete activity level (transactional test)

― Operational test

― Each activity resulting in discrete stream of income

• What costs are included when determining where costs incurred?

T i ll l di ― Typically only direct costs

― “But for” test

― Inclusion of third-party costsInclusion of third party costs

9

O h COP A hOther COP Approaches• Proportional cost of performance (receipts sourced proportionately • Proportional cost of performance (receipts sourced proportionately

among states based on relative proportion of costs incurred therein)

• True “majority” cost of performance (receipts only sourced to state if more than 50% of costs of IPA are attributable to any one state; if more than 50% of costs of IPA are attributable to any one state; otherwise, nowhere)

• Example

― 30% of costs in State A, 30% in State B, 40% in State C

― All receipts go to State C under UDITPA Sect. 17/plurality approachpp

― Receipts sourced nowhere under true majority approach

― Receipts sourced proportionately under proportionate approach

10

bl h f fProblems With Cost Of Performance

• Quick look backward (origins in UDITPA circa 1957)

• Appears to have been an afterthought, based on limited role of service industries in interstate commerce in 1950sof service industries in interstate commerce in 1950s

• Sales factor supposed to represent market states (payroll and property factors represent headquarters states); COP ends up being proxy for headquarters states in many instances

• “Income-producing activity” (IPA) not defined, so states have not taken a uniform approachnot taken a uniform approach

• Difficult to track costs required for sourcing purposes, especially if on a transaction basis

11

Problems With Cost Of Performance (Cont.)

• Unclear whether IPA test is lowest discrete activity level or some broader standard

• The more closely you slice it, the more COP begins to resemble a market sourcing approach.

• States attempt to “cheat” by using alternative apportionment provisions when it suits their interests So you never have any provisions when it suits their interests. So, you never have any certainty (head I win, tails you lose approach).

12

M k A hMarket Approach

• Typically based on one of following:

― Location of customer

Wh b fit f i i d i d― Where benefit of service is derived

― Where intangible personal property is utilized

13

El Of M k A hElements Of Market Approach

• Where is customer situated (billing address, commercial domicile or other)?

• Where is benefit derived (what if multiple states)?

• Ability to “look through” to customer’s customers (e.g., sale of fulfillment services to national telecom company)

• Availability of “look-through” information may be limited.

14

STATE TRENDS IN Mark Siegel, BDO USA

STATE TRENDS IN APPORTIONMENT FORMULAE

Apportionment Trends: OverviewApportionment Trends: Overview

T iti t i l l f t• Transition to single-sales factor

• Transition to market-based sourcing

• States’ positions on what “cost of performance” really means

• What do these trends mean for taxpayers?

2011 BDO Leadership Conference - Industry Groups

2006 2011Single-Sales Factor Trends

SALT – Apportionment - Sales Factor

2006 Single Sales Factor

50%<Sales Factor<100%

2011

Factor<100%

Three Factor Formula with Double-Weighted Sales

Evenly Weighed Tree-Factor Formula

Elective/Industry Elective/Industry Specific Single Sales Factor

No State Income Tax


Single-Sales Factor Trends: Mandatory

SALT – Apportionment - Sales Factor (Cont.)

Phasing In Single Sales Factor

Colorado Georgia

Illinoisg g

Minnesota (2014)

Indiana (2011)

Iowa

Maine

i hi New Jersey (2014)Michigan

Mississippi

Nebraska

N Y k New York

Oregon

Texas

Wisconsin


Wisconsin

Single-Sales Factor Trends: Election


California

• Three-factor formula with double-weighted sales or single-sales factor formula

Missouri

• Evenly-weighted three-factor formula or single-sales factor formula

ArizonaArizona

• Starting in 2017, taxpayers can elect the single-sales factor or continue using the three-factor formula with double-weighted sales.

Florida

• Starting in 2013, taxpayers can elect the single-sales factor or continue using the three-factor formula with double-weighted sales.

Utah


• Starting in 2013, taxpayers can elect the single-sales factor formula or evenly weighted three-factor formula.

Single-Sales Factor Trends: 2011 Changes


Alabama• 3-factor Formula with double-weighted sales (eff.

2011)

Arizona

Indiana • Single-sales factor (eff. 2011)

New Jersey• 2014: 87x weighted sales factor (elective)• 2015: 90x weighted sales factor (elective)• 2016: 90x weighted sales fact (elective)• 2017: Single-sales factor (elective)

y• 2012: 70x weighted sales factor• 2013: 90x weighted sales factor• 2014: Single-sales factor

UtahCalifornia• Single-sales factor (elective), eff. 2011

Minnesota• 2011: 90% sales factor

• 2011: 4x weighted sales factor (five-year non-revocable election)

• 2012: 10x weighted sales factor (five-year non-revocable election)2013 Si gl l f t (fi

• Sales factor increases 3%/yr. with property and payroll split equally (i.e., 2011 5% each; 2012 3.5% each), resulting in single-sales factor apportionment by 2014.

• 2013: Single-sales factor (five-year non-revocable election)


Sales Factor Sourcing: Market-Based SourcingMarket-Based Sourcing States

SALT – Apportionment - Sourcing

Sourcing Methods

Market-based sourcing: Receipts from sales of services or intangibles are sourced based on the

Alabama California (elective)

ConnecticutDelawareservices or intangibles are sourced based on the

location of the customer (i.e., the marketplace or destination), according to factors such as where the customer is located or where the services are performed or the intangible is used.

GeorgiaIllinoisIowa

LouisianaMaine

Cost of performance: Receipts are sourced according to where the income-producing activity occurs (greater proportion, majority or pro-rata share) examining the costs related to performing

MaineMarylandMichiganMinnesotaNew Jerseyshare), examining the costs related to performing

the service; usually, but not always, direct costs are determined using GAAP.

New YorkOhio

Rhode IslandTexasUtah


UtahWisconsin

Michael Wynne, Reed Smith

RECENT MATERIAL

Michael Wynne, Reed SmithMark Siegel, BDO USA

DEVELOPMENTS

MTC Uniformity CommitteeMTC Uniformity Committee

• Multistate Tax Compact (MTC)– Revisions to Article IV of the Compact – Areas of concern

1 Primary concern: Sales factor numerator-sourcing for sales1. Primary concern: Sales factor numerator sourcing for sales other than tangible personal property – Art. IV.17

2. Definition of sales; Art. IV.1(g)3 Definition of business income: Art IV 1(a)3. Definition of business income: Art. IV.1(a)4. Factor-weighting: Art IV.95. Distortion relief provisions: Art. IV.18

23

MTC Uniformity Committee (Cont.)MTC Uniformity Committee (Cont.)

• Definition of “sales” has taken precedence, because if transactions are not in “sales” under §1(g), they don’t need to be sourced under §17.

• Why redefine sales? Impression is that “sales” no longer just reflects the contributions of the market state, e.g., receipts of sales of:– Non-inventory assetsy– Sale, lease or license of intangible assets– Treasury function-related investment assets

24

MTC Uniformity Committee (Cont.)MTC Uniformity Committee (Cont.)Proposed MTC amendment1(g) “Sales” means amounts that give rise to apportionable income (g) g pp

and that are received by the taxpayer from:(1) Transactions and activity in the regular course of its trade or business for:

A The sale rental lease or license to a customer of goodsA. The sale, rental, lease or license to a customer of goods, products or other property that would properly be included in the inventory of the taxpayer if on had at the close of the tax period; or,

B The sale of services to a customer from:B. The sale of services to a customer from:

(2) Tangible or intangible property that is:A A contract right government license or similar intangibleA. A contract right, government license or similar intangible

property that authorizes the holder to conduct a business activity in a specific geographic are;

B. [Other?]S A f A il 14 2011 id i ifi i l i f iStatus: As of April 14, 2011, considering specific inclusions of items

excluded by the proposed definition25

Sales Factor Sourcing: New Rules For California

California Reg. 25136

Single-Sales Factor Election • Available for tax years after 2010• Elections not binding – can make a different election each

year• Cost-of –performance rule replaced with market-based

sourcing for those electing the single-factor sales apportionment

Market Sourcing for Sales of Services and Intangibles• Receipts from services and the sale or use of intangible

property• Sourced to where “the purchaser received the benefit of the

i ” h h i ibl “ i d” services ” or where the intangible “property is used” • Debate over what constitutes “use” of an intangible• Source service revenue to where customer receives

benefit of service


Microsoft Corp v Franchise Tax BoardMicrosoft Corp. v. Franchise Tax Board,Superior Court (Feb. 17, 2011)

• Facts • Facts Microsoft licensed software to OEMs to be installed on OEM computer

systems, which are sold to the ultimate computer user. Microsoft provided the OEMs with a master disk to be used to install the Microsoft provided the OEMs with a master disk to be used to install the

software. On its California returns, Microsoft sourced the royalties based on the billing

address of the OEM.• Parties’ positions

Microsoft: The royalties should not be sourced to the billing address but rather sourced entirely outside of California, because more of the costs

l d h f i d i hi h related to the software were incurred in Washington vs. any other state. California: The revenue stream is from tangible property and therefore

should be sourced based on where the master disk was delivered.


Microsoft Corporation v. Franchise Tax BoardMicrosoft Corporation v. Franchise Tax Board,Superior Court (Feb. 17, 2011), Cont.

• Court decision• Court decision The software in question is tangible personal property and therefore

should be sourced based on state of delivery based on the following:(1) C t ft i TPP b it h h i l i t • (1) Computer software is TPP because it has physical existence, takes up physical space, etc.

• (2) Similar to fact pattern in various sales tax decisions, the t f f th ft i h i l di th t ll th transfer of the software is on a physical medium that allows the OEM to transfer the software to its equipment. Without the disk, this would not be possible(3) Th ft i TPP b it i d t t i d• (3) The software is TPP because it is canned, not customized.

• (4) Other states, such as Nebraska, have considered software to be TPP.


Microsoft Corporation v. Franchise Tax BoardMicrosoft Corporation v. Franchise Tax Board,Superior Court (Feb. 17, 2011), Cont.

• Observations/questions• Observations/questions Other states may take a similar position and consider software as

TPP.W ld th t’ d i i h b th h d th ft Would the court’s decision have been the same had the software been download by the OEM, as opposed to it being delivered on a master disk?F C lif i b d ft d l /li th ld b For a California-based software developer/licensor, there could be a benefit if it ships disks out of state (especially if it was previously using the cost-of-performance approach that Microsoft tried to apply)apply).


California (Cont.)California (Cont.)

• Microsoft appealed only the OEM issue to the Court of Appeal, First Di i A131964District, A131964.

• Microsoft’s primary argument is that the royalties constitute receipts f l “ th th t ibl l t ” it li d thfrom sales “other than tangible personal property,” as it licensed the copyright to replicate and install Microsoft software on the OEM computers rather than license a right to use the software without replicating it. p g

• The appeal is fully briefed and will next be scheduled for hearing.

30

IllinoisIllinois

• Proposed Regulation §100.3373 on sourcing of publishing and advertising services, for tax years ending on or after 12/31/2008

• “Publication” includes any electronic means, including the Internet. y , g

• Sourcing is where the publishing service is received.

• Throw-out applies if the taxpayer is not taxable where the publishing service is received.

31

Illinois (Cont.)Illinois (Cont.)

• Still missing a proposed regulation on sourcing of sales other than l f ibl l f di fsales of tangible personal property for tax years ending on or after

12/31/08

Th b d tli f t t t i i i t l d ft f t th• The broad outline of treatment in prior internal drafts conforms to the proposed publishing services regulation.

• Statutory methods have been adopted for sourcing financial• Statutory methods have been adopted for sourcing financial, telecom and broadcasting services, but there is still no regulation on sourcing of electricity sales.

32

UtahUtah

• Rule R865-3C-1, filed 12/08/11, effective 2/7/2012

• When a corporation does not maintain a Utah office from which sales are “negotiated or effected,” and that derives income from Utah sources, the gross receipts attributable to Utah receipts shall , g p pinclude all receipts of the corporation.

• For the performance of a service, if the purchaser of the service receives the greater benefit of the service in Utah than in any otherreceives the greater benefit of the service in Utah than in any other state

• From other income in connection with real or intangible personal g pproperty, if the real or intangible personal property is in Utah

• In connection with intangible property, if the intangible property is used in Utahused in Utah

33

ArizonaArizona• Senate Bill 1552: Vetoed, citing revenue loss

• Allowed multi-state service providers to elect to treat sales from services as AZ sales to the extent that the purchaser of the service received the benefit of the service in AZ, beginning in TY2012

• Election would have been effective for five years.

• A multi-state service provider would be one that derives more than 85% of its sales from services provided to purchasers benefitting outside AZ.

• Services were considered to be received at the home of the customer or the ordering office of the business; or, if not known, sourced to the home or office where billedsourced to the home or office where billed.

34

Alabama: Market SourcingAlabama: Market Sourcing• Alabama has historically been a greater cost of performance state.

• Effective with taxable years beginning on or after Dec. 31, 2010, sales other than tangible personal property are sourced to Alabama if the taxpayer’s market for the sale is Alabama. Services: Delivered to Alabama location Intangible license: Property used in Alabamag p y

• If a sale is assigned based on the above to a state where the taxpayer is not subject to tax, then the sale is excluded from the sales factor.not subject to tax, then the sale is excluded from the sales factor.


INDUSTRY SPECIFIC Michael Wynne, Reed Smith

EXAMPLES

Special Industry TrendsSpecial Industry Trends

TelecommunicationsIPA/COP vs. Goldberg (benefit of service)

BroadcastingIPA/COP or intangibles vs. MTC regs/audience share (benefit of service)

Publishing/advertisingIPA/COP vs. circulation (benefit of service)

Integrated service offeringsService/intangibles

37

Peter Stathopoulos, Bennett Thrasher

PROBLEMS ARISING FROM

Peter Stathopoulos, Bennett ThrasherMichael Wynne, Reed Smith

MARKET‐BASED SOURCING

Diffi l Of D fi i TDifficulty Of Defining Terms

• Where is a customer located (its billing address, its headquarters, or place where service is received)?

• Where is benefit received? Typically, the person with superior information is the buyer of the service, not the seller; and buyer may not wish to share such information.

“Look through” sourcing makes sense but such information is • “Look-through” sourcing makes sense, but such information is not always available.

39

O h P blOther Problems

• May result in economic nexus, especially in light of states adopting “factor presence” nexus standards

• Primarily benefits in-state companies and shifts tax burden to out-of-state companies (flip side of this is that market sourcing is an economic development tool, especially with no throwback)

• Risk of double-taxation due to non-uniform administration

40

Problems In Market SourcingProblems In Market Sourcing

• UDITPA Sect. 18: Alternative apportionment– Likely to be increasingly implicated from multiplicity of methods

• All or nothing IPA/COP• Proportional IPA/COP• Stealth market approach to IPA/COP• “Benefit received” or “service received” • Default sourcing alternativesg

– Place of order placement– Place of billing

41

Problems In Market Sourcing (Cont.)Problems In Market Sourcing (Cont.)

• UDITPA Sect. 18: Alternative apportionment (Cont.)– Likely to be increasingly implicated from wide range of operative

definitions• “Sales other than sales of tangible personal property”g p p p y• “Services” – undefined• Special industry service definitions• Integrated IP/service offerings• Integrated IP/service offerings

42

Problems In Market Sourcing (Cont.)Problems In Market Sourcing (Cont.)

• Single factor inequities

• Modern business practices clash with sourcing defaults:– Outsourced procurementOutsourced procurement– Outsourced payment processing– Decentralized business functions

• Problems … or opportunities?

43

RECENT LITIGATION OF NOTEPeter Stathopoulos, Bennett Thrasher

BellSouth Advertising v. Chumley (2009)

• BellSouth sourced zero receipts to Tennessee under state’s all-or-nothing, majority cost of performance approach to sourcing service receipts.

• DOR invoked alternative apportionment rules and sought to use market sourcing.

• State court agreed, even though there was nothing extraordinary about the taxpayer’s fact pattern that would require extraordinary relief. It was just the way cookie crumbles, under the approach adopted by the state.

• Troubling decision that seriously undermines rule of law, predictability and fairnesspredictability and fairness

45

AT&T Cases (Massachusetts v. Oregon 2011)

• Two state cases involving same taxpayer and same fact • Two state cases involving same taxpayer and same fact pattern illustrate problems with the cost of performance approach.

• Taxpayer provided interstate and international calling services.

• At issue was how closely can you slice “direct costs” and At issue was how closely can you slice direct costs and “income producing activity”

• Massachusetts Board of Tax Appeals adopted a broader “operational” approach, while Oregon Tax Court adopted a stricter transactional approach (on a call-by-call basis).

• Mass. Court ruled that third-party costs (access fees paid to Mass. Court ruled that third party costs (access fees paid to LEOC) not included; Oregon court reached opposite result

46

PRACTICAL TAXPAYER Mark Siegel, BDO USA

COMPLIANCE SITUATIONS

Practical Application: Major ConsiderationsPractical Application: Major Considerations

• Identifying revenue streams• Identifying revenue streams• How is revenue generated?• Cost center data availability• Data gathering/system capabilities• Available tools: Excel vs. software• Consistencyy• Inability to generate useful reports• Cost/benefit


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