The shift to market-based sourcing is more than just a trend in state income tax. More than 20 states have adopted this method for the sourcing of services, with a handful of others poised to follow suit. Recently, both Missouri and Tennessee adopted market-based sourcing. Further, most states with major economic hubs are now sourcing service revenue using a market-based method, including California, Georgia, Illinois, Massachusetts, and New York (eff. 2015). When the Model Uniform Division of Income for Tax Purposes Act (UDITPA) established guidelines for the sourcing of sales of services in the late 1950s, the standard was to source sales of services to the location of the “income producing activity.” This model is no longer the norm, as almost half of the states that impose a corporate income tax now use a market-based approach.
UDITPA, which generally requires service providers to compute their sales factor numerator (i.e., source sales) based on the location from which the services are performed, did not contemplate a world of e-commerce and remote service providers. In today’s economy, services are routinely provided across state lines. Thus, the “income producing activity” sourcing method typically results in taxpayers having a high sales factor in the state where the services are performed, despite it not having any customers located in the state.
By contrast, market-based sourcing involves attributing receipts from services or intangibles to the state based on the location of the market for such services or intangibles. While many states are adopting this sourcing method, the rules do differ from state to state on how a taxpayer’s “market” is determined. The definition of a company’s market may be based on the state in which the benefit of a service is received, where the service is delivered, or where the customer is located. Granted, these approaches may sound very similar, but an attempt to accurately follow the varying state rules can result in inconsistent results from state to state.
Locally, two of the three jurisdictions have already adopted market-based sourcing:
- Maryland uses market-based sourcing based on the location of the customer.
- The District of Columbia has adopted market-based sourcing, effective January 1, 2015, based on where the service is delivered. The District is in the process of drafting regulations to further clarify their new market-based sourcing statute.
- Virginia still uses the “income producing activity” method, but there have been a number of bills in Virginia proposing the implementation of market-based sourcing and the Department of Taxation is currently conducting a study on the potential adoption of market-based sourcing in Virginia.
If your company does business in the DC metro area, it is important that you are aware of the changing rules in the region. The District’s change to market-based sourcing, in conjunction the overall apportionment factor in the District no longer taking into account property and payroll, can significantly change the amount of income that is taxable in the District. Taxpayers should also be careful in how they determine if the market-based sourcing rules in a particular state even apply to their company. Some state apportionment rules apply to corporations and pass-through entities alike. However, other states that have adopted market-based sourcing rules have only done so for purposes of corporate income tax. Consult with a qualified construction tax expert for assistance with this challenging issue.
If your company has questions about the sourcing of its sales, or about market-based sourcing in general, please contact your Aronson tax advisors Patrick Deane or Michael L. Colavito, Jr. at 301.231.6200.