Apportionment issues affecting government contractors
INSIGHT ARTICLE |
Numerous apportionment issues directly impact contractors providing services and goods to the federal government. Contractors who provide services to federal government agencies must navigate a variety of income producing activity and market-based sourcing tests, as well as special industry-specific apportionment rules. Contractors who sell products to the federal government must deal with destination, ultimate destination, and origin sourcing methods. This state-to-state variation in the apportionment rules applicable to receipts from the provision of services and the sale of inventory to the federal government creates the potential for state tax windfalls as well as traps for the unwary.
State apportionment conflicts affecting service providers
The apportionment rules for service providers have been one of the most rapidly evolving areas in state taxation. As a general rule, states fall into one of two categories when sourcing receipts derived from performing services. The first category is income producing activity, which generally sources receipts to the location where the work was performed, and, in circumstances where performance occurs in more than one state, entirely to one location or pro rata to multiple locations based upon one of a variety of methods, including costs of performance and time spent. The second category is market-based sourcing, which sources receipts to the location where the customer received the benefit of the service. As of the beginning of 2016, approximately one-half the states utilize some measure of income producing activity sourcing, while the other half use some measure of market-based sourcing, creating a very high probability of conflict between state tax regimes when crossing state lines. From a regional perspective, the District of Columbia (D.C.) and Maryland presently use market-based sourcing while Virginia uses income producing activity to source receipts from sales of services.
The conflict between the income producing activity and market-based sourcing regimes can result in double-taxed income or income that is not taxed anywhere, depending on the location where the work is performed in relation to the location of the customer. If all the work is performed at the customer’s location, it is likely that the locus for the cost of performance and the market where the benefit of such services is received are the same. However, if a contractor performs services for a government agency located in a market state from a work site in an income producing activity state, such receipts would likely be taxed in both the income producing activity state as well as the market state. In contrast, if a contractor performs services for a government agency in an income producing activity state from a work site in a market state, such receipts would likely be sourced nowhere. As such, there is a potential benefit for service providers that perform their services in Maryland and D.C. (market states) when they render services to customers located in other states, and a potential pitfall when those services are performed in Virginia (an income producing activity state) for customers in other states.
State apportionment conflicts affecting vendors of tangible personal property
For state apportionment purposes, the sale of tangible personal property is generally sourced to either the item’s destination, or ultimate destination when the item is intended for final delivery and used somewhere other than the initial ship-to point. However, approximately one-half of the states have a specific exception to this general rule when dealing with the sale of tangible personal property directly to the federal government. These states source such receipts to the location of the inventory’s origin. Again, this direct conflict of state tax laws creates a situation where a potential windfall or a trap for the unwary could exist. Regionally, D.C. sources sales of tangible personal property to the federal government to the point of origin while Maryland and Virginia source the sale of tangible personal property to the federal government to its destination.
If a government contractor sells inventory directly to the federal government from a state that follows the destination approach, and the inventory is delivered to the federal government in a state that follows the origin approach, this would give rise to a nowhere sale. However, if a government contractor sells inventory directly to the federal government from a state that follows the origin approach, and delivers the inventory to the federal government in a state that follows the destination approach, this receipt will be subject to double taxation. As such, there is a potential benefit for government contractors to warehouse their inventory in Maryland and/or Virginia as this creates the potential for “nowhere” sales. In contrast, there is a disincentive for government contractors to warehouse their inventory in D.C. as sales to the federal government may be sourced to both the destination state as well as D.C.