State Income Tax Changes Expected to Spark Litigation

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By Chris Marr

The uncertainty in states’ market-based sourcing rules for apportioning company income will yield a large number of audits and lawsuits going forward, tax practitioners predict.

Almost half of states have adopted market-based sourcing in some form, but taxpayers aren’t getting clear enough guidance from states on how to apply the rules, Michael Bryan, a director at Deloitte Tax LLP, said during a Feb. 14 Deloitte webcast on state tax controversies. This means taxpayers are increasingly likely to seek guidance in the courts, he said.

“I really think this will be fertile ground going forward for state tax auditors,” Bryan said. “Some of that will lead to litigation.”

The rules generally require that the sales factor used in apportioning multistate companies’ income for tax purposes be based on the market where a service or an intangible asset is received. The method for determining where the market should be for a particular sale is complex, and the guidance from states is lacking, said Bryan and Christopher Campbell, a principal in Deloitte Tax.

States have varying approaches to determining where the “benefit of services is received,” Campbell said. “That’s certainly difficult from a compliance perspective.”

When in doubt, Campbell suggested taxpayers and their advisers “do what’s reasonable. And it really behooves you to document” the specific facts that led a company to apportion certain transactions to certain states, he said.

Due Process Concerns

The notion that market-based sourcing will lead to lots of audits and litigation is “a pretty safe prediction, because it’s already happening,” Christopher Lutz, a state and local tax attorney at Eversheds Sutherland LLP in Washington, told Bloomberg BNA.

States are sometimes requiring a sort of “look-through apportionment” that is likely to face challenges as unfair and overly complex, he said. For example, a software maker might license a data set to include in its product, and states then could require the original data provider to apportion income based on the market where the software company sold the final product.

“You have to apportion your receipts based on your customer’s customer’s activities,” Lutz said. “I think you could see some courts pushing back and saying, ‘No, this violates due process.’”

The financial industry is particularly prone to controversy around market-based sourcing, he said.

With most major U.S. banks based in New York, states are looking for ways to claim a portion of the income related to transactions that involve in-state customers. Some states have tried to use an assumption that if a state has 4 percent of the U.S. population, then 4 percent of a major U.S. bank’s transactions should have their market there for tax purposes, Lutz said.

He pointed to the New Jersey Tax Court’s October decision in Bank of Am. Consumer Card Holdings v. Dir. of Taxation. The court sided with the state over how to source the interest received on credit card balances, agreeing that the interest derived from New Jersey cardholders should count toward the company’s New Jersey income, as opposed to the bank’s argument the interest should be counted in the state where the bank’s operations are located.

Most Cases ‘Pretty Clear.’

Practitioners like to cite examples of overly complex situations, such as lawyers’ services, to argue against market-based sourcing, said Helen Hecht, general counsel at the Multistate Tax Commission, which has advocated model legislation for market-based sourcing.

“But in the vast majority of cases, the answer is pretty clear—for example, health care, utilities of all types, most consumer sales of digital goods,” Hecht told Bloomberg BNA. “If it’s not clear, I believe uniform practices will emerge. And we’ve already adopted special rules for things like transportation and financial services.”

States are “making up for lost time” in figuring out how to source sales of services, she said, adding that disputes are to be expected, as with many other tax policies.

“The problem of locating the market for sales of services and intangible property is one that we’ve needed to work on for a long time—as the economy has moved away from a traditional manufacturing-based economy,” Hecht said.

To contact the reporter on this story: Chris Marr in Atlanta at

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

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