Service Revenue Subject to Out-of-State Taxation

The old rule that a company needs to be “physically present” in a state in order to be subject to tax may no longer apply.  New legislation in certain jurisdictions means that service revenue may now be subject to out-of-state taxation.  New York and Tennessee are the newest states to adopt the market-based sourcing rules for service revenue apportionment.  These states, along with others, are looking for new ways to fund budgets and increase their income tax revenue from business activity within their borders.  At the same time, they are looking at their tax systems to attract and retain businesses and thus bolster economic growth and employment.
Over the last few years, certain states have passed legislation that shifts some of the tax and administrative burden from in-state businesses to out-of-state businesses.  With the 2015 financial and tax planning season underway, AAFCPAs reminds clients and friends of the firm who perform services for customers in multiple states to familiarize themselves with the current landscape of these state and local tax authorities and determine the  impact to your business.
Economic Nexus
Many states are using the concept of “Economic Nexus” in which physical presence is not required as long as there is a significant economic connection to the state.  This standard surpasses the physical presence standard that required actual property or payroll in the state, and adds the burden of tax to businesses that have only sales in the state.  However, many of these states have added a factor-based standard requiring a minimum level of sales, property or payroll in the state to trigger economic nexus.
Market-Based Sourcing
In connection with the “Economic Nexus” standard, many states have adopted market-based sourcing for service revenue apportionment. This method is a deviation from traditional methods, which use costs of performance (COP), where revenue is sourced based on the state where the “majority” of the work is performed. Another method used is pro rata allocation, which apportions revenue to each state where services are physically performed. For market based sourcing, revenue is typically apportioned to the state where the customer receives the benefit of the service.  Depending on the sourcing rules of the various states involved, market-based sourcing, in some cases, leads to “nowhere” sales (i.e. sales that may not be subject to tax in any jurisdiction), or that may lead to sales that are subject to tax in multiple jurisdictions.
Regulations Vary by State
State and Local Tax (or multistate taxation) is more complex and demanding than ever before.  Effective January 1, 2015, New York has adopted an economic nexus and market-based sourcing apportionment for corporations taxed under Article 9A.  Effective January 1, 2015, Alabama has adopted a factor-based economic nexus standard and market-based sourcing apportionment. New York and Alabama now follow the path of other states, which previously adopted both an economic nexus standard and market-based sourcing sales factor. As of January 1, 2016, Tennessee will also join this group of states. To further eliminate the “nowhere” sales, some states with market-based sourcing have also implemented a “throw-out-rule.” Under this rule, receipts for services in a state where the business is not taxable are excluded from the sales factor entirely.
Other states have codified the economic nexus standard, but are still using a revenue apportionment methodology that is COP, pro rata or a hybrid method; or they have adopted market-based sourcing but have not implemented an Economic Nexus standard. Some of these states imply the economic standard in various publications but have not passed specific regulations to codify these standards.
Due to the nuances of the business activities performed by each taxpayer, as well as the varying regulations adopted by the state and local tax regimes, nexus and revenue apportionment analyses can be complex and need to be conducted with respect to each business and jurisdiction. AAFCPAs advises that clients and friends of the firm closely re-examine states’ taxing jurisdiction at least annually to ensure compliance with all relevant tax regulations, and to optimize tax savings.
If you have any questions about multi-state tax planning or compliance, please contact your AAFCPAs partner.