More States Move to Market-Based Sourcing, Warts and All

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By Che Odom

Dec. 13 — More states will likely be adopting market-based sourcing in 2017 to determine which companies should pay what in income taxes, though criticism of the approach lingers.

Under market-based sourcing, generally speaking, a state taxing authority looks to the consumer of a business’s service. If the customer is within the state or if the benefit of a service is received within the state, then the company must pay income taxes to that state in a proportional amount.

But exactly how market-based sourcing applies to certain financial industries could be clearer, according to those who counsel such businesses and states. A model statute created by the Multistate Tax Commission (MTC) is in the final drafting stages and may lead to an improved way of addressing dividends and interest that may be less prone to litigation.

“Some of the regulations relative to specific business types still need some work,” Joe Huddleston, an executive director for Ernst & Young LLP’s Indirect Tax group in the National Tax office, told Bloomberg BNA.

Businesses that have some activity in lending and hedging can be treated the same as businesses involved solely in those activities, he said. The MTC has suggested that such problems can be addressed in Section 18 of the Uniform Division of Income for Tax Purposes Act (UDITPA), but “many in those businesses don’t think that is adequate,” he said.

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At least 21 states and the District of Columbia have adopted a market-sourcing regime for services. Most of them follow the same approach for intangibles, with Maryland, Louisiana, Oklahoma and Pennsylvania as exceptions. Nine states, while not adopting a market-sourcing regime, look to the place of performance for sourcing of services.

Market-based elections are incorporated in the cost-of-performance schemes in Arizona and Missouri.

“Politically,” market-based sourcing is an “attractive option because it is viewed as advantageous to in-state businesses,” Holly Coon, the Alabama Department of Revenue’s business audit manager, told Bloomberg BNA.

Also, tax administrators view it as “a more equitable method for sourcing receipts” that “creates more consistency of sourcing receipts from sales of tangible and intangible assets,” she said.

Louisiana enacted market sourcing for services in June based on where the service is delivered to the customer. Two states enacted market sourcing in 2015 to take effect in 2016. Connecticut’s regime is based on where the service is used by the customers, while Tennessee’s is based on where the service is delivered.

States have few reasons left for not moving to market sourcing, as tracking and sourcing sales has become increasingly more difficult as the economy trends more toward services, Huddleston said.

“Additionally many states have found some benefit in increasing the sales factor weighting in their apportionment formulas or moving entirely to single sales factor apportionment,” he said. “Those types of moves largely dictate market sourcing if anyone wishes to maintain a corporate tax base.”

UDITPA Adoption

The MTC developed UDITPA, which establishes a method of dividing income among the several taxing jurisdictions for tax purposes.

Twenty-three states and the District of Columbia have adopted the model act, while other states have used it as a basis for statutes.

Recent revisions to two sections of the act “eliminated certain receipts in the calculation of the receipts factor,” Coon, vice chair of the commission’s Uniformity Committee, said.

“We believe these revisions will provide an apportionment factor for most businesses that is less susceptible to distortion,” she said.

“However, these changes will likely create a scenario where a business has income, but all of the taxpayer’s receipts are eliminated from the calculation of the receipts factor,” she said.

Section 18 Work Ongoing

A significant number of states exclusively use the receipts factor to apportion income in their state, Coon said.

“We expect this scenario will affect a very small number of taxpayers, but it’s important that we relieve their uncertainty in meeting their filing requirements,” she said.

To that end, the Section 18 work group is finalizing a general set of sourcing rules that will provide broad guidance for most receipts that have been eliminated from Sections 1 and 17, she said.

Some in the financial industry, such as stockbrokers providing services to mutual funds, have concerns about distortion of their tax liability to a state factoring in their sales, MTC counsel Bruce Fort said.

“The controversy over the statute as a whole has been the big philosophical one of how broad it should be,” he said, adding that the debate over Section 18 also has been over how specific or broad it should be.

Coon said that states may benefit from rules that are general enough that taxpayers will be provided with a method for sourcing their income.

Avoiding Future Litigation

Ultimately, though, revisions to Section 18 may lead to less litigation over the regulation, Fort said. “We currently have very detailed regulation, a 70-page packet, which came from Massachusetts,” he said.

A broader, less-detailed regulation may give taxpayers fewer bases for challenging an apportionment claim.

Fort said a revised Section 18, which could be drafted within weeks and begin a months-long process of review and approval, would address cases such as the 2011 Tennessee Supreme Court case of Blue Bell Creameries LP v. Roberts , 2011 BL 18881, Tenn., 1/24/11 .

Blue Bell involved a one-time transfer of stock from an operating company to a holding company as part of a company reorganization. At issue was whether stock transfers were business earnings, subject to tax.

In that case, market-based sourcing as it is laid out in UDITPA wouldn’t have helped clarify tax assessments, Fort said. However, the MTC revision of Section 18 should allow states to look at where the business was operating before the reorganization to determine source of receipts, which is what the Blue Bell court did, he said.

To contact the reporter on this story: Che Odom at

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

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