Businesses Chasing Many 'Markets' Under State Sourcing Rules

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By Jennifer McLoughlin

May 5 — The expanding maze of markets arising from multiple market-based sourcing regimes has some practitioners anticipating further tensions between taxpayers and tax officials.

The states' migration to market sourcing has shown no signs of slowing this year, with Connecticut, Kentucky and Oregon introducing legislation this session. The Multistate Tax Commission (MTC) is also moving closer to adopting new market sourcing regulations.

While ushering in what many consider a superior sourcing framework to cost-of-performance (COP), the piecemeal approach by states has stirred concerns regarding compliance and accurate apportionment. And despite efforts to facilitate consistency among sourcing rules, absolute uniformity may be unobtainable or undesirable.

“I am prepared for a world where we are short of complete compliance,” said Richard D. Pomp, the Alva P. Loiselle professor at the University of Connecticut School of Law. “But it may be good enough.”

Market Variations

According to information gathered by Bloomberg BNA, at least 19 states, plus the District of Columbia, have adopted a market sourcing regime for services. Most of those states follow the same approach for intangibles, with Maryland, Oklahoma and Pennsylvania as exceptions (2016 Weekly State Tax Report 37, 1/15/16).

In addition to bills introduced this year, other states are mulling over the model. State officials in North Carolina and Virginia have commissioned studies regarding potential adoption, and Louisiana is contemplating a move after a study last year.

As states have forged ahead, a patchwork of definitions and rules has developed, reflecting varying classifications of the relevant market. These inconsistencies present problems for multistate businesses, explained Joe Huddleston, a Washington-based executive director for Ernst & Young LLP’s Indirect Tax group in the National Tax office.

Concerns for Multistate Companies

“Plus, there’s a real fear that since there’s no uniformity out there, then what they do this year might not be acceptable next year,” he added, noting “that’s very problematic for industry as they try to structure themselves.”

Deviations among states’ sourcing regimes further complicate compliance with the “sheer amount of time” required to satisfy the rules, said Jamie C. Yesnowitz, a Washington-based principal with Grant Thornton’s State and Local Tax practice, in an e-mail.

“To be sure, some businesses short-cut the process and take the position that if they consistently use the billing address of a customer as a proxy for market-based sourcing everywhere, everything evens out,” he stated. “But that’s not the technically accurate way to source, and by not using the specific sourcing rules in each state, these businesses may have substantial potential state tax exposure on this issue.”

On the other hand, Yesnowitz raised the risk of double taxation should businesses follow the “rules to the letter of the law,” which can yield multistate sales factors exceeding 100 percent.

MTC Movement

Meanwhile, for nearly two years, the Multistate Tax Commission has undertaken what Pomp characterized as an “intellectual tour de force” effort to encourage uniformity among market-based sourcing structures (2016 Weekly State Tax Report 21, 3/4/16).

After a March 9 hearing on its proposed market sourcing rules for services and intangibles, which will implement 2014 amendments to Article IV, Section 17 (UDITPA) of the Multistate Tax Compact, the MTC is entering the final stages of adoption. Hearing Officer Brian Hamer’s report was released May 1, which advances the rules to an Executive Committee review during its May 12 meeting (see related story, this issue).

If approved, the rules would proceed to a Bylaw 7 survey of compact states, with the goal of final adoption during the July 2016 annual meeting.

Advantages to Non-Uniformity?

States such as Alabama and Massachusetts follow the MTC approach. Others, including Rhode Island and Tennessee, have adopted or proposed regulations similar to the Massachusetts rules, which formed the template for the MTC's working regulations.

However, competing interests between states and businesses might benefit from a non-homogeneous sourcing landscape.

“While we always talk about a level playing field, neither side, neither taxpayers nor states have a tremendous interest in a level playing field,” Huddleston said, explaining that the dueling agendas of maximizing corporate profits and maximizing state revenue have created a “contentious playing field” that will never change. And although absolute uniformity is possible, it may not be desirable.

“If everything is all the same, a lot of those interests simply are unachievable,” he said. “Do states want everything to be all the same? I'm thinking they don't. Do businesses want everything to be all the same? In some sense, they certainly like predictability. But do they want everything to be the same everywhere? I'm not sure it plays to their interests either.”

Corporate Shift

Taxpayer resistance, in part, derailed early efforts to revise UDITPA. Pomp, who served as hearing officer over proposed amendments to Article IV (UDITPA) of the Multistate Tax Compact, discussed this delay in his October 2013 report (2015 Weekly State Tax Report 32, 12/4/15).

But as time passed, more states started to adopt market sourcing, increasing the number of states at odds with a model statute.

And local business voices are increasingly sounding for states to make the transition, primarily as a corollary to states' increasing weight assigned to the sales factor.

“I think most of it comes on the economic development side, where businesses in a state push very hard to move to a sales-based economy, to double, triple or single sales factor,” Huddleston said. “That's been going on for the last few years. And in states that have not adopted it, their home state industries are pushing pretty hard for it.”

Ongoing Interstate Conflicts

Notwithstanding the work to minimize complexities, some foresee ongoing “borderline issues” with market sourcing, including potential double taxation or “nowhere income.”

“We may very well have a conflict over what you mean by ‘market,'” Pomp said. “What do you mean by benefit? What do you mean by delivery?”

A market defined by “delivery” can be manipulated, he explained. Risks include taxpayers shopping for the most favorable tax treatment by delivering purposefully to a specific state—or another country. Complications can also arise under “benefit received” regimes, with multiple locations where a benefit may be derived.

However, Huddleston has heard of “a lot of willingness” among tax officials and taxpayers to sort out any confusion with the rules.

“I think you're going to see an increasing focus at the state level on advance pricing agreements, where taxpayers are going to be able to go to the states, work out these new market-based structures and come to some agreement in advance to try to avoid litigation,” he said, noting the federal equivalent often used by multinational businesses. “I don't see a lot of big benefit on either side for pushing these issues to litigation.”

Yesnowitz agreed, expecting “many sourcing controversies to be settled during the audit process, or in certain cases, other non-judicial forums,” given the time and expense of litigation.

COP States Transitioning

Conflicts between market-based sourcing states and COP states often arise over a disconnect in the interpretation or application of COP rules, potentially urging a shift away from those remaining COP regimes.

Another impetus for moving to market sourcing is revenue recovery, as in-state production can decrease while remote sales increase.

Oregon is working through Initiative Petition 28, a proposed increase of the minimum tax on C Corporations with annual sales exceeding $25 million, which might stall its market-sourcing measure. And without a “solid estimate” of the potential revenue impact of a market-based approach, progress has been slow.

Nevertheless, the “all or nothing” calculation under COP isn't intuitive, said Chris Allanach, senior economist with Oregon's Legislative Revenue Office, who noted that a market model is consistent with the state's move to single-sales apportionment. “The market-based method, for all the technicalities and nuances, that seems to make intuitive sense to people.”

COP v. Market Approach

However, not all are convinced that market sourcing deserves the merit it receives.

Pomp, a COP fan, described the transition to market-based sourcing as a demonstration of economic development trumping good policy. Driven by the migration to a single-sales factor formula, he said that market sourcing distorts income by focusing on the customer's location and ignoring capital and labor that add to the generation of income.

“No one thinks it makes sense from a policy perspective,” he said, noting that his 2013 Hearing Officer report suggested maintaining and refining COP rules.

Rather, he characterized the combination of a market-based system and a single-sales factor as a simple tax incentive to entice in-state business investment, with the promise of no penalties for in-state payroll or property.

‘Horse Out of the Barn.'

“Set up here, basically sell outside the state, and you'll pay no tax to our state,” Pomp said. “That is an abomination, as far as I'm concerned. But, it's too late, I think, to turn the clock back. The horse is out of the barn. And more states are going to be moving in this direction.”

Yesnowitz echoed that outlook, predicting a slow and steady pace of approximately one to two states annually endorsing market sourcing. At that rate, he expects 10 to 15 years will pass before nearly all states are on board—with a few potential holdouts from states that “historically have never followed UDITPA but have relied upon a pro-rata cost of performance approach.”

To contact the reporter on this story: Jennifer McLoughlin in Washington at

To contact the editor responsible for this story: Ryan Tuck at

For More Information

More information regarding the MTC's uniformity project on Section 17 model market-sourcing regulations is at

The MTC's proposed market-sourcing regulations are at

The Hearing Officer report on the market-sourcing regulations is at

Professor Pomp's October 2013 Hearing Officer Report on the proposed amendments to the Multistate Tax Compact Article IV is at

Request Weekly State Tax Report