The Governor of Colorado signed legislation H.B. 1185 into law on June 4, 2018, adding Colorado to the list of states that use a market-based sourcing rule to source receipts from the sale of services and intangibles. This change, which is applicable for tax years beginning after 2018, moves Colorado away from its current proportionate costs of performance rule for calculating a taxpayer’s sales factor.
Colorado’s legislation expands the already lengthy list of states that have adopted market-based sourcing. Those unfamiliar with the different rules applied by states when determining whether revenue from a service is an in-state sale should know that states generally use a method that is either origin-based or destination-based. Colorado’s current proportionate costs of performance rule is an origin-based rule because revenue derived from performing a service is considered a sale in Colorado, based on the portion of the service that is performed in the state. In contrast, market-based sourcing rules generally deem a sale of a service to be an in-state sale to the extent the service is delivered to a customer or location in the state.
A state’s shift to a market-based sourcing rule can have a significant impact on the portion of a multistate taxpayer’s income that is subject to tax by the state. Generally, an in-state service provider, assuming it has customers in other states, will see a reduction to the income apportioned to the state. On the other hand, out-of-state service providers that are subject to tax by the applicable state will have an increased tax liability. Assuming that the state can derive similar amounts of revenue from both methods, receiving a greater portion of tax dollars from out-of-state businesses will generally be supported by a legislature’s constituency and makes the state more attractive for businesses considering a presence there.
In the case of Colorado, the change to a market-based sourcing will seemingly result in certain out-of-state businesses that previously did not have a filing obligation in Colorado now being subject to the state’s income tax. This is because of the interaction that the new market-based rule will have with Colorado’s economic nexus statute. Colorado and a growing number of other states imposes its income tax on businesses based on whether the business exceeds certain thresholds of in-state property ($50,000), payroll ($50,000), or sales ($500,000). The current proportionate costs of performance rule requires a taxpayer to actually perform services in the state in order to potentially have an income tax filing obligation. The state’s change to market-based sourcing means that non-Colorado businesses that have no in-state presence and perform no in-state services will be subject to income tax if the business derives more than $500,000 in revenue from Colorado customers. Other states that impose a threshold-based economic nexus rule, or “factor-presence nexus,” include Alabama, California, New York, and Tennessee.
Given that market-based sourcing has become just as prominent as the origin-based costs of performance sourcing rules, multistate businesses need to be aware of the varying sourcing rules applied by the states where they have a presence and customers. Not only do taxpayers need to change how they source their receipts consistent with law changes such as Colorado’s, reassessing the over-all method of sourcing receipts can uncover unknown exposures and opportunities.
If you have questions about the multi-state apportionment, please contact our state-and-local tax advisors or Michael Colavito at 301.231.6200.