United States

The challenges of factor presence nexus and market-based sourcing

INSIGHT ARTICLE  | 

Two trends—factor presence nexus standards and market-based sourcing of services for sales factor purposes—have steadily gained steam in state legislatures.

In general, under factor presence nexus standards, a business is presumed to have nexus with a state if the business has a property, payroll, or sales factor numerator in the state that exceeds a certain threshold. Under the market-based approach to sourcing receipts from sales of services in the sales factor, service businesses are required to include service receipts in the numerator of the sales factor if the market for those services is within the state rather than based upon the traditional income-producing-activity test.

As of this writing, at least nine states had adopted factor presence nexus standards, and of those states, six had adopted market-based sourcing rules for receipts from sales of services. This combination can have a particularly significant impact on multistate service providers.

Factor presence nexus standards

On Oct. 17, 2002, the Multistate Tax Commission (MTC) adopted a model rule, Factor Presence Nexus Standard for Business Activity Taxes, in an effort to promote uniformity among the states and create a simple bright-line nexus test for business activity taxes in response to the proliferation among the states of a wide variety of economic and attributional nexus schemes. Pursuant to this rule, a taxpayer establishes nexus with a state for business activity tax purposes if the taxpayer exceeds any of the following apportionment factor numerator thresholds in that state during a tax period:

  • $50,000 of property;
  • $50,000 of payroll;
  • $500,000 of sales; or
  • 25 percent of total property, total payroll, or total sales.

Not surprisingly, the true focus for states and taxpayers alike is on the sales factor threshold, as this is a purely economic measurement of activity within the state. The existence of a property factor or payroll factor in a state would indicate that the taxpayer has a physical presence within the state, which is a traditional indicator of nexus for Commerce Clause purposes.

On July 1, 2005, Ohio became the first state to impose a factor presence nexus standard with the enactment of Ohio Rev. Code Section 5751.01(H)(3), which adopted the MTC thresholds for purposes of determining whether a business is subject to the state’s commercial activity tax (CAT). Since then, factor presence nexus standards have been adopted by Alabama (Ala. Code  section 40-18-31.2); California (Cal. Rev. and Tax Code sections 23101(b) and (d)); Colorado (Colo. Code Regs. section 39-22-301.1); Connecticut (Conn. Gen. Stat. section 12-216a); Michigan (Mich. Comp. Laws section 206.621(1)); New York (N.Y. Tax Law section 209.1); Tennessee (Tenn. Code section 67-4-702); and Virginia (Va. Code section 58.1-400). However, not all of these states have entirely adhered to the MTC model rule. For example, California’s factor thresholds are indexed for inflation; Connecticut has adopted only a sales factor threshold; Michigan, like Connecticut, has adopted only a sales factor threshold, but the threshold amount is $350,000 instead of $500,000, plus Michigan also requires active solicitation of sales; similarly, New York has adopted only a sales factor threshold, but the threshold amount is $1 million; and Virginia’s standard requires only that the taxpayer have a positive apportionment factor.

While the application of these types of standards may be highly suspect in light of the U.S. Supreme Court’s recent forays back into Due Process and Commerce Clause analysis, early litigation has gone against the taxpayer (see, e.g., L.L. Bean, Inc. v. Levin, No. 2010-2853 (Ohio Bd. Tax App. 3/6/14) (settled on appeal, 11/20/14); Newegg, Inc. v. Testa, No. 2012-234 (Ohio Bd. Tax App. 2/26/15); and Crutchfield, Inc. v. Testa, No. 2012-926 (Ohio Bd. Tax App. 2/26/15)). Accordingly, it is likely that more states will adopt factor presence nexus standards in the near term and that taxpayers will be required to account for these standards in determining the states in which they have a business activity tax filing responsibility.

Market-based sourcing

Historically, states have generally adopted the Uniform Division of Income for Tax Purposes Act (UDITPA) Section 17 income-producing-activity test for sourcing receipts from sales of services. Pursuant to this test, receipts from sales of services performed are apportioned to the state in which the income-producing activity takes place. If the activity is performed in two or more states, the receipts are assigned to the state in which the taxpayer performed a greater proportion of the activity, typically determined based on the location of the direct costs of performance. Some variations on this test have been adopted, such as proportional rather than 100 percent sourcing, inclusion of indirect costs, and the application of a different variable from costs of performance, such as time spent performing the service.

In recent years, however, states have moved away from the UDITPA income-producing-activity test in favor of a market-based-sourcing approach. Market-based sourcing is fundamentally different from the UDITPA approach in that it is customer-centric and focused on the location where the service is received rather than service provider-centric and focused on the location where the service is performed. Unfortunately, as with the income-producing-activity test, adopting states have not been uniform in their application of market-based sourcing. However, in general, these rules look to where the service is delivered, where the service is received, where the benefit of the service is received, and where the customer is located, or some combination of these approaches to determining market, with additional variations based on the type of seller and buyer, the nature of the service, the appropriate method for approximating the market location, and whether the seller is taxable in the state where the service is received. As of this writing, 21 states had adopted some form of elective or mandatory market-based sourcing for sales of services, and some states, such as Indiana and Florida, had reinterpreted their application of the UDITPA income-producing-activity test to mirror a market-based approach.

Intersection between factor presence nexus standards and market-based sourcing

Of the states that have adopted a factor presence nexus standard, several have also adopted market-based sourcing for receipts from sales of services: Alabama (Ala. Code section 40-27-1(IV)(17)); California (Cal. Rev. and Tax Code section 25136 and Cal. Code Regs. tit. 18, setion 25136-2); Michigan (Mich. Comp. Laws sections 206.665(1)(e) and (2), Mich. Comp. Laws sections 208.1305(1)(e) and (2)); New York (N.Y. Tax Law sections 210(3)(a)(2) (effective until Jan. 1, 2015) and 210-A, N.Y. Comp. Codes R. and Regs. tit. 20, section 4-4.3); Ohio (Ohio Rev. Code sections 5733.05(B)(2)(c)(ii) and 5751.033(F) and (I)); and Tennessee (Tenn. Code sections 67-4-2012(i)). This combination presents a significant trap for unwary service providers, particularly those that provide remote services, such as cloud computing, and do not perform any activities outside their home state. This trap can be best illustrated through the following example.

Example: XYZ Inc. has headquarters in North Carolina and provides $1 million in cloud-based billing services to a single customer in California; 100 percent of XYZ’s activities related to its services take place in North Carolina, and it has no property or payroll outside the state. XYZ’s only contact with California is that its only client is in the state.

From a pure sourcing perspective, North Carolina, an income-producing-activity state, would require XYZ to include 100 percent of its sales in the numerator of its North Carolina sales factor, while California, a market-based-sourcing state, would likewise claim that 100 percent of XYZ’s sales should be sourced to the state. Applying solely traditional nexus principles, this double apportionment of the receipts in question would not matter, because XYZ would have a filing responsibility only in North Carolina. However, because California is a factor-presence state, XYZ would have a California filing responsibility resulting from California’s approach to apportionment, yielding a California sales factor numerator in excess of the threshold amount. Essentially, California has used its legislative power to create a sales factor numerator where one traditionally would not have existed and then relied on this factor to assert that the taxpayer has nexus with the state. In XYZ’s case, this results in demonstrable double taxation that would not necessarily run afoul of the U.S. Constitution.

Takeaway

The combination of sales factor presence standards and market-based sourcing for receipts from sales of services can create significant problems for service companies. Although only six states have currently enacted both sales factor presence and market-based sourcing, both are growing trends that show no indication of slowing. Accordingly, service providers should get in front of the issue while it is still limited in scope and prepare for wider application of both sales factor presence and market-based sourcing.

Excerpted from the April 2016 issue of The Tax Adviser. Copyright © 2016 by the American Institute of Certified Public Accountants, Inc.

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