Indiana: Market-based sourcing and income-producing activity collide
INSIGHT ARTICLE |
Over the past several years, service providers have been swept up in a legislative sea change in relation to their apportionment sales factors, as states have shifted from sourcing sales of services using an income-producing-activity approach to market-based sourcing. Conceptually, these approaches to sourcing sales of services are diametrically opposed. The income-producing-activity test focuses on where the service is performed, as measured by costs of performance, time spent, or other methods, while market-based sourcing focuses on where the benefit of the service is received, as measured by customer location, customer billing address, or geographic target. However, the Indiana Department of Revenue has blurred the edges of these two approaches through the quasi-regulatory ruling process, creating a potential trap for the unwary, opportunity for the savvy, and fertile ground for litigation.
Indiana clearly derived its statutory framework and administrative guidance regarding sourcing sales of services from Art. IV, section 17 of the Multistate Tax Compact (MTC) (previous to the adoption of amendments to the MTC on July 30, 2014) and Reg. IV.17.(2) of the MTC Allocation and Apportionment Regulations. Mirroring the pre-amendment MTC Art. IV, section 17, Indiana Code section 6-3-2-2(f) provides that receipts from sales of services are sourced 100 percent to Indiana if (1) the income-producing activity is performed entirely in Indiana, or (2) the income-producing activity is performed both within and without Indiana and a greater proportion of the income-producing activity is performed in Indiana than in any other state, based on costs of performance. Similarly, following the lead of Reg. IV.17.(2), 45 Indiana Administrative Code section 3.1-1-55 provides that income-producing activity for the purposes of Indiana Code section 6-3-2-2(f) includes the “rendering of personal services by employees or the utilization of tangible and intangible property by the taxpayer in performing a service” and that such activity is deemed to be entirely performed in Indiana if “the act or acts directly engaged in by the taxpayer for the ultimate purpose of obtaining gains or profit” occur solely in Indiana.
In applying these rules, an out-of-state service provider used to dealing with the MTC’s income-producing-activity rules in other states would expect that its sales of services to Indiana customers would be sourced outside Indiana under Indiana Code section 6-3-2-2(f)(2) if the bulk of its activities in relation to the performance of those services is performed outside Indiana and the only portion of the service activities performed within Indiana is the actual delivery of the service “end product” to the Indiana customer. However, the Indiana Department of Revenue takes a very narrow view of the term “income-producing activity” in the context of service businesses, looking solely to the final act of delivery to the Indiana customer rather than the service provider’s operations as a whole. The application of this position, which is tenuous at best, causes the apportionment result under Indiana’s income-producing-activity rules to mirror the apportionment result that would occur if Indiana were a market-based-sourcing state.
This position and its impact can be seen in a series of rulings by the Indiana Department of Revenue over the last few years. In Letter of Findings No. 02-20120316 (Nov. 1, 2012), the department determined that an out-of-state service provider’s gross receipts from sales of audience profile information services to Indiana customers were properly sourced to Indiana under Indiana Code section 6-3-2-2(f)(1) because the income-producing activity was the sale of information compilations to those customers and not the compilation and analysis services that went into generating the compilations.
In Letter of Findings No. 02-20130238 (Sept. 1, 2013), the department determined that an out-of-state service provider’s gross receipts from sales of online financial research and information services to Indiana customers were properly sourced to Indiana under Indiana Code section 6-3-2-2(f)(1) because the income-producing activity was the ultimate delivery of the services to the Indiana consumers and not the research and information-compiling activities performed by the service provider outside the state. In Letter of Findings No. 02-20130359 (Nov. 1, 2014), the department determined that an out-of-state service provider’s gross receipts from sales of online learning programs via its “eCampus” were properly sourced to Indiana under Indiana Code section 6-3-2-2(f)(1) because “Indiana is the location where the students purchased Taxpayer’s services and participated in Taxpayer’s classes.”
In all of these decisions, the department dismissed out of hand the service providers’ arguments that, even if the state considered delivery to the Indiana customer to be an income-producing activity, an essential element of providing the services rendered was the compilation and analysis of audience profiles and financial data in Letter of Findings Nos. 02-20120316 and 02-20130238, respectively, and the creation of online classes in Letter of Findings No. 02-20130359. The department denied the service providers’ arguments that these activities, which constituted the bulk of the cost of providing the services and were performed out of state, required sourcing entirely outside Indiana under Indiana Code section 6-3-2-2(f)(2).
In support of its determinations, the department found that the service providers’ customers were paying for the delivery of the service and that no payment would be due to the service providers absent that delivery. Accordingly, the activities engaged in by the service providers prior to, and in preparation for, delivery were not directly engaged in by the service providers for the ultimate purpose of obtaining gain or profit and could not be considered income-producing activities. Therefore, as delivery was the sole remaining income-producing activity, Indiana Code section 6-3-2-2(f)(1) applied to source the sales entirely to Indiana, and Indiana Code section 6-3-2-2(f)(2) could not be reached.
Example 1: Y Corp. is a state Z–based online information service provider that performs all of its information compilation, analysis, and hosting activities in Z. Y makes $1,000 in total sales of services—$100 to Indiana customers and $900 to customers in other states.
Under the generally accepted approach to the income-producing-activity test, Y would source none of its services receipts to Indiana because the preponderance of its costs of making its sales of services was incurred in Z. However, following the department’s position, Y would source its receipts based on the location of delivery, which would increase its Indiana-sourced sales from zero to 10 percent of its total sales.
Assume for the sake of comparison that Indiana was a market-based-sourcing state and had enacted services-sourcing rules similar to those of its neighbor Illinois, which provides, under 35 Illinois Compiled Statutes Section5/304(a)(3)(C-5)(iv), that sales of services received in Illinois are sourced to Illinois regardless of where the services are performed. In that scenario, Y would source 10 percent of its sales of services to Indiana, the same amount that Y would source to Indiana using the Indiana Department of Revenue’s narrow position regarding income-producing activity. Essentially, through Letter of Findings Nos. 02-20120316, 02-20130238, and 02-20130359, the department achieved market-based-sourcing results without having to push market-based sourcing through the legislative process.
Of course, what is sauce for the goose ought to be sauce for the gander. Although out-of-state service providers selling services to Indiana customers would be subject to an increased Indiana tax burden as a result of the Indiana Department of Revenue’s approach, in-state service providers with out-of-state customers should experience the opposite.
Example 2: X Corp., an Indiana-based online information service provider that performs all of its information compilation, analysis, and hosting activities in Indiana, sells $1,000 in services—$100 to Indiana customers and $900 to out-of-state customers.
Under the generally accepted approach to the income-producing-activity test, X would be required to source 100 percent of its services to Indiana. However, following the department’s position, X should source its receipts based on the location of delivery, which would reduce its Indiana-source sales from 100 percent of its total sales to 10 percent. For Indiana-based service providers in this situation that failed to apply the implications of Letter of Findings Nos. 02-20120316, 02-20130238, and 02-20130359 in preparing their prior-year returns, it is possible that refunds would be due.
Regardless of the shifting tax implications for out-of-state and in-state service providers as a result of the position taken by the Indiana Department of Revenue in these three Letters of Findings, it is difficult to fathom why the department opted for this particular path, given a landscape dominated by state legislative action and a clear trend toward market-based sourcing. Perhaps the department should have worked to drive legislative change or, at the very least, amended its regulations to provide clarity moving forward. Instead, the department created a scenario ripe for protracted litigation.