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The California Court of Appeal decision in Gillette Co. v. California Franchise Tax Board1 has implications for sourcing of sales of other than tangible personal property in both California and the remaining Multistate Tax Compact member states.2
In Gillette, the court found that a compact member state could not unilaterally amend the compact to prohibit a taxpayer from exercising its right under Article III, Section 1 of the compact to use the apportionment provisions under Article IV (also known as the Uniform Division of Income for Tax Purposes Act, or UDITPA) rather than those provided by the state.
Although Gillette only addressed the equally weighted three-factor apportionment formula under UDITPA Section 9, an Article III election to use Article IV would include the provisions for sourcing sales of other than tangible personal property under UDITPA Section 17. As with Section 9, several member states, including California (while it was a member), either unilaterally amended Section 17 or enacted separate provisions that explicitly or by implication supersede Section 17.
UDITPA Section 17(b) requires that sales be sourced to a state if “a greater portion of the income-producing activity is performed in [the state] than in any other State, based on costs of performance.”
Multistate Tax Commission model regulations generally define costs of performance as direct costs of the taxpayer to produce an intangible or perform a service that gives rise to a particular item of income.3
Besides the numerous practical challenges associated with computing costs of performance, costs-of-performance sourcing ultimately tends to reflect the expenditures and valuations used to compute the property and payroll factors. Thus, regardless of how such figures affect the taxpayer's tax liability, use of costs of performance may emphasize the property and payroll factors over the sales factor.
Costs of performance was never regarded as the ideal method of sourcing intangibles, and the drawbacks were recognized when the compact was drafted in 1957, but the drafters felt that it was the best method to cover the majority of situations.4 Steve Wlodychak, a principal at Ernst & Young LLP in Washington, D.C., called it “the great compromise.”
Many compact member states, as well as other states, have moved to market-based sourcing of services and intangibles. Market-based sourcing is intended to source sales to the state where the taxpayer's market is located.
States that have moved to market-based sourcing have done so without the benefit of a model act or provision, which has resulted in even less uniformity than there is in the provisions implementing costs of performance.
Joe Huddleston, executive director of the Multistate Tax Commission, said, “These are issues that states have been dealing with on their own. Some uniform provisions have been repeatedly asked for by our member states.”
Compact member states listed Section 17 as the provision that should be the primary focus of any revisions to UDITPA, according to a 2008 survey by the commission of its members.5 The survey preceded a revision drafting process that continued through 2011 when the commission's Uniformity Committee submitted proposed amendments to the Executive Committee at its December 2011 meeting.6 Pursuant to comments from interested parties, the Uniformity Committee made further revisions and again presented the proposed amendments to the Executive Committee at its May 2012 meeting, where it was tabled.7
When the California Court of Appeal issued its decision in Gillette July 24, it threw the status of member states' mandatory nonconforming apportionment provisions into question. The annual meeting of the National Conference of State Legislatures followed shortly thereafter Aug. 6-9.
In light of Gillette, “NCSL's Task Force on State and Local Taxation voted to halt work on UDITPA,” Max Behlke, a policy specialist at NCSL told Bloomberg BNA. “The task force believed lawmakers should be involved in the process, and they didn't want to go forward with the implications of Gillette unclear,” Behlke added.
MTC's Huddleston told Bloomberg BNA, “I think it's important to keep moving forward, but it is up to the commission's Executive Committee.” Huddleston also said that the commission is waiting for a letter from NCSL stating its position on the UDITPA revisions.
With no likelihood of a uniform market-based sourcing provision in the near future, sourcing will play a role in whether taxpayers will choose to pursue a refund claim based on the right to make an Article III election set forth in Gillette.
When asked whether costs of performance would benefit the same taxpayers that would benefit from an equally weighted three-factor apportionment formula, Ernst & Young's Wlodychak said, “A taxpayer must consider everything and must consider sales factor sourcing before making an election. The taxpayer must look at how the state sources revenues, and that determination must be on a case-by-case, state-by-state basis.”
Wlodychak pointed out that “a taxpayer cannot pick and choose among Article IV provisions. It's one wholesale provision. The purpose of the compact is to provide uniformity.”
Regarding uniformity, he added, “It's interesting that the compact allows a taxpayer to make an election to use the compact in one state without requiring the taxpayer to make the same election in other states. They can pick and choose among states but not compact provisions.”
John Gupta, an executive director of Ernst & Young LLP's Indirect Tax practice who is based in Denver, explained some of the nuances in making a refund claim in Colorado, a compact member state, based on the theory asserted by the taxpayers in Gillette.
Because Colorado law requires a single sales factor, the most obvious beneficiaries would be those taxpayers whose Colorado property and payroll factors were low relative to their Colorado sales factor, he said. In addition, there are more subtle differences between Colorado's and the compact's sales factor sourcing rules that could provide benefits. Since both Colorado and the compact provide for a variation of costs of performance, many service providers will not have dramatic differences in their sales factor ratios between the two regimes, he said.
However, Gupta noted some key differences between Colorado's costs of performance rules and those of the commission that could result in benefits under certain fact patterns. For example, Colorado requires determination of relative costs on a purely proportionate basis, whereas the compact uses a “greater proportion” approach, he said.
Taxpayers with significant income from intangible property may also see benefits associated with variances between Colorado law and the compact provisions because Colorado law does not source income from intangibles using costs of performance, while the compact provisions generally do, Gupta said.
Alabama adopted the compact8 and has not adopted UDITPA separately or enacted other apportionment provisions. However, in 2011, Alabama enacted H.B. 434, which amended its version of the compact to both require a double-weighted sales factor under compact Article IV, Section 9, and market-based sourcing under Article IV, Section 17.Alaska
Alaska regulations provide that gross receipts from services are attributed to Alaska based on the ratio of the amount of time spent in performing the service in the state to the amount of time spent performing the service everywhere.10Arkansas
Arkansas adopted the compact without change to Section 1711 but also adopted its own version of UDITPA.12 Sales of other than tangible property are sourced under Arkansas Code § 26-51-717(b), which uses the term “income producing activity” and provides that such sales are allocated to the state based on “the percentage that is used in the formula for allocating income to Arkansas during the year of the sale” without mention of costs of performance.13California
California adopted the compact without change to Section 1714 and separately adopted UDITPA without altering the Section 17 language.15 However, in 2009, the California Legislature amended California Revenue & Taxation Code § 25136 to require market-based sourcing of intangibles for tax years beginning on or after Jan. 1, 2011.16 The statute provides that services are sourced to the state to the extent the purchaser of the service received the benefit of the service in the state.
In 2010, the Legislature again amended the section to require that the original costs of performance sourcing be used unless the taxpayer had made an election to use the single-sales factor apportionment formula,17 in which case it must use the market-based sourcing. California subsequently adopted detailed market-based sourcing rules.18Colorado
Colorado adopted the compact without change to Section 1719 but also enacted its own unique apportionment provisions, including those for sourcing sales of other than tangible property.20 In 2008, Colorado enacted a mandatory single-sales factor apportionment formula for tax years beginning on or after Jan. 1, 2009, but re-enacted nearly identical sourcing provisions in the new apportionment section.21
Colorado regulations set forth a costs of performance methodology for sourcing of services and generally source income from intangibles to the taxpayer's commercial domicile.22 As with the statute, the regulations bear little similarity to the MTC model.
Colorado's retention of costs of performance while adopting a single-sales factor “was surprising to many observers, since it ran counter to the purported policy objectives of single-sales factor sourcing,” Gupta said.
Gupta further explained the unusual result of the Colorado apportionment provisions. “The retention of the costs of performance method of apportioning sales benefits those businesses that perform services outside of Colorado. However, there is a corresponding detriment to those who perform services within Colorado,” he said.
“With the retention of costs of performance, a service provider's apportionment continues even with a single-sales factor to be driven by the situs of its labor and capital. Thus, while the move to single-sales factor in 2009 dramatically changed the playing field for sellers of tangible property, the retention of costs of performance effectively kept the status quo for service providers,” he said.District of Columbia
Hawaii adopted the compact without change to Section 1726 and separately enacted UDITPA without altering the Section 17 language.27 Hawaii also adopted the MTC model regulations for sourcing of intangibles with a few modifications.28Idaho
Idaho adopted the compact without change to Section 1729 and separately enacted UDITPA without altering the Section 17 language.30 Idaho also adopted the MTC model regulations for sourcing of intangibles with modifications to some examples.31Kansas
Kansas adopted the compact without change to Section 17.32 The state separately enacted UDITPA with a few modifications but did not alter the Section 17 language.33 Kansas adopted the MTC model regulations with some modifications.34Michigan
The Michigan business tax (2008-2011) and the corporate income tax (2012 forward) use a market-based approach sourcing services and intangibles to the state to the extent used or benefitted from by the recipient in the state.37Minnesota
Missouri adopted the compact without change to Section 17.40 Missouri statutes do not address sourcing of services or intangibles, and the apportionment regulations merely provide that sourcing is in accordance with compact provisions.41Montana
Montana adopted the compact without change to Section 1742 and separately enacted UDITPA provisions without altering the Section 17 language.43 Montana also adopted a modified version of the MTC model regulations.44New Mexico
New Mexico adopted the compact without change to Section 1745 and separately enacted UDITPA without altering the Section 17 language.46 New Mexico also adopted the MTC model regulations with few modifications.47North Dakota
North Dakota adopted the compact without change to Section 1748 and separately enacted UDITPA without altering the Section 17 language.49 North Dakota also adopted the MTC model regulations, including the examples, with few modifications.50Oregon
Oregon adopted the compact without change to Section 17.51 Oregon moved to a mandatory single-sales factor for tax years beginning after July 1, 200552 but retained the Section 17 costs of performance language in its statutes.53
Oregon adopted the MTC model regulations with few modifications,54 and also adopted separate regulations requiring use of costs of performance for the sourcing of sales of software and database services.55South Dakota
Texas adopted the compact without change to Section 17.57 However, the current and former franchise tax regimes use a single gross receipts factor with market-based sourcing of services and intangibles.58
Texas regulations provide that services are sourced to Texas “on the basis of the fair value of the services that are rendered in Texas.”59 “Sales of intangibles are apportioned based on the location of the payor.”60Utah
Utah adopted the compact without change to Section 17.61 Utah amended the Section 17 language in its UDITPA provisions to replace costs of performance with market-based sourcing effective for tax years beginning on or after Jan. 1, 2009.62
Services are sourced to the state if the purchaser receives a greater benefit of the service in the state than in any other state.63 In contrast, intangibles are sourced to the state based on the percentage of use in the state.64Washington
Washington adopted the compact without change to Section 17.65 Washington does not have a corporate net income tax. The business and occupations tax is levied on gross receipts for the privilege of engaging in business in the state.66
A person is considered to be engaging in business in the state if that “person generates gross income of the business from sources within [the] state, such as customers or intangible property located in [the] state, regardless of whether the person is physically present in [the] state.”67
1 Gillette Co. v. California Franchise Tax Board, No. A130803 ( Cal. Ct. App. July 24, 2012). The court by its own motion vacated the opinion and ordered a rehearing following requests from both sides to clarify the validity of California Revenue & Taxation Code § 25128, which requires use of a double-weighted sales factor in the apportionment formula, and the effect of S.B. 1015, which withdrew California from the Multistate Tax Compact and was enacted prior to the release of the original Gillette opinion (154 DTR K-3, 8/10/12).
2 California withdrew from the compact pursuant to S.B. 1015 (Ch. 946), effective June 27.
3 See Multistate Tax Commission Model Regulation IV.17(2), (3).
4 Pierce, William J., The Uniform Division of Income for State Tax Purposes, 35 Taxes 747, 780-781 (1957).
5 Multistate Tax Commission, Multistate Tax Compact Article IV Recommended Amendments (2012) at http://www.mtc.gov/uploadedFiles/Multistate_Tax_Commission/Events/2011-12_Committee_Meetings/EC%20memo%20-%20Art%20IV%20%20%2805-03-2012%29.pdf.
6 Id. at 6.
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