Massachusetts DOR publishes working draft on market-based sourcing rules
Commentary period runs through May 19, 2014
TAX ALERT |
Following the trend amongst the states, Massachusetts in 2013 changed its rule with respect to sourcing gross receipts from the sale of services and intangibles from a traditional cost-of-performance rule to a market-based approach. The 2013 legislation, previously covered in this alert, went into effect for tax years beginning after Jan. 1, 2014, without much-needed interpretive regulations. On March 25, 2014, the Massachusetts Department of Revenue (the Department) took an important step in correcting this issue by releasing working draft revisions to 830 CMR 63.38.1, the Department's apportionment regulation. However, while the draft regulation does help clarify some of the outstanding issues pertaining to Massachusetts' market-based sourcing legislation, there are still some significant open questions as to how the rules will be applied to sales of services and intangibles.
The Department is accepting comments on the draft regulation through May 19, 2014. Taxpayers and practitioners are encouraged to consider how the draft language will impact companies' Massachusetts tax liabilities and whether there are gaps in the language that should be addressed. A summary of key points in the draft regulation follows.
I. General rule–sales of services
Pursuant to the statutory language, a corporation's market for the sale of a service is in Massachusetts to the extent the service is delivered in Massachusetts. The draft regulation identifies three types of services (in-person services, professional services and other services) and specifies how to determine the extent to which each of these types of service is delivered in Massachusetts. Further, the draft regulation indicates that in any situation where the taxpayer cannot assign the sale according to the following rules, the taxpayer shall make a reasonable approximation as to the state or states of assignment (see part III below). Finally, in any case where the taxpayer can neither assign the sale nor make a reasonable approximation, the taxpayer shall exclude the sale from both the numerator and denominator of the sales factor (see part IV below).
An in-person service is a service “physically provided in person by the taxpayer, where the customer or the customer's real or tangible property upon which the services are performed is in the same location as the service provider at the time the services are performed.” Examples of in-person services include those associated with warranty and repair, cleaning, plumbing, pest control, landscaping, medical, dental, child care, haircuts, live entertainment and athletic performances.
According to the draft regulation, the sale of an in-person service is in Massachusetts to the extent the service is received in Massachusetts. Where the service is performed with respect to tangible personal property, it is sufficient that the property is delivered to the customer in Massachusetts. The draft regulation provides the following example to illustrate that point:
Camera Corp. provides camera repair services. Sometimes the repairs happen at a facility outside of Massachusetts, but then the camera is returned to the customer in Massachusetts. Even if the customer mails the camera directly to the out of state facility, if the customer receives the repaired camera in Massachusetts, the sale is in Massachusetts.
Professional services are services that require specialized knowledge and, in some cases, require a professional certification, license or degree, such as accounting or legal services. However, professional services that require or significantly involve in-person contact (e.g., medical and dental services) are considered in-person services rather than professional services.
In general, sourcing of professional services depends on whether the client is an individual or a business.
- If provided to an individual customer– the sale is assigned to the customer's primary residence or, if that is not known, the customer's billing address, provided, if the taxpayer derives more than 5 percent of its sales of services from that customer, the taxpayer has an affirmative duty to determine the customer's state of primary residence.
- If provided to a business customer–the sale is assigned to the state where the contract of sale is principally managed. If the place of customer management is not reasonably determinable, the sale should be assigned based on the place of order and, if that is not reasonably determinable, the sale should be assigned based on the billing address. The taxpayer has an affirmative duty to identify the state in which the contract of sale is principally managed if the taxpayer derives more than 5 percent of its sales of services from that customer.
Services delivered to the customer or through or on behalf of the customer
A service will fall into this catch-all category if it is not an in-person service or a professional service. There are separate rules depending on whether the sale is delivered by physical means or electronically; thus, the categorization of services of this type will be relevant for the sourcing rules.
- Services delivered by physical means: Examples of delivery by physical means include the delivery of brochures, the delivery of advertising to the customer's intended audience in the form of a physical medium, or other direct mail services. Such sales are sourced to the location where the service is delivered. It should be noted that the draft regulation states that the sale of custom software that is installed at the customer's site is considered a sale of services by physical means under these rules.
- Services delivered electronically: Examples of electronically delivered services include delivery through the means of wire, lines, cable, fiber optics, electronic signals, satellite transmission, or audio or radio waves. Such a sale is sourced to the location where the customer receives the service. It should be noted that the treatment of services delivered electronically differs by customer as follows:
- When the service is delivered to an individual customer and the place of receipt cannot be determined or reasonably approximated, the sale shall be sourced to the customer's billing address.
- When the service is delivered to a business customer and the place of receipt cannot be determined or reasonably approximated, the sale shall be sourced to the state where the contract is principally managed or, if that is not known, to the place from which the order was made or, if that is not known, to the billing address. If a taxpayer derives more than 5 percent of its sales of services from any one customer, it has an affirmative duty to identify the state in which that contract is principally managed.
- When the service is delivered through electronic transmission to a third-party recipient through or on behalf of the customer, the taxpayer shall assign the sale to the state or states where the services are delivered to the third-party recipient or recipients on behalf of the customer (e.g., receipts from placement of television advertising is sourced to the location of the viewers). It is notable that this look-through sourcing approach is unique to this category of services and is not present in the in-person services sourcing rules or professional services sourcing rules.
II. Receipts from intangible property
The working draft regulation also provides guidance with respect to sourcing receipts from intangibles, which adds to and modifies existing sourcing rules for such receipts. It specifies sourcing rules for the licensing of certain intangible property, as well as the sale of intangible property. The draft regulation also identifies situations where a transaction labeled a license will be treated as a sale and where a transaction labeled a sale will be treated as a license. A license of intangible property that conveys all substantial rights in such property is treated as a sale of intangible property. A sale or exchange where payments are contingent on the productivity, use or disposition of the property is treated as a license of such property.
The sourcing rules for the sale of intangible property only cover two specific types of intangible property: (1) the sale of a contract right or governmental license that authorizes business activity in a specific geographic area, and (2) an agreement or covenant not to compete in a specified geographic area. All other sales of intangible property shall be excluded from the taxpayers' numerator and denominator of the sales factor.
Receipts from the license or lease of intangible property
Receipts are in Massachusetts if and to the extent the intangible property is used in Massachusetts. The draft regulation clarifies that “use” refers to the location of the taxpayer's market for the license and is not to be construed to refer to the location of the property or payroll of the taxpayer. The rule indicates that if the amount of use in Massachusetts is unknown, the receipts would be sourced based on the Massachusetts population over the total U.S. population in the specified geographic region in which the retail sales are made.
Sale of intangible property
The draft regulation proposes rules for the sourcing of receipts from the sale of two specific types of intangible property:
- Contract rights or a governmental license that authorizes business activity in a specific geographic area: The sale is in Massachusetts to the extent that the intangible property is used or otherwise associated with Massachusetts. For example, Sports League Corp. (based outside Massachusetts) sells the rights to broadcast the sporting events played by the teams in its league in all 50 states to Network Corp. The games played by Sports League Corp. will be broadcast in all 50 states, but the games are of greater interest in the northeast region of the country, including Massachusetts. Because the intangible property sold is a contract right that authorizes the holder to conduct a business activity in a specified geographic area, Sports League Corp. must reasonably approximate the extent to which the intangible property is used in or associated with Massachusetts. Sports League Corp. may rely on audience measurement information that identifies the percentage of the audience for its sporting event in Massachusetts and other states.
- Agreement not to compete: The receipts are to be sourced to Massachusetts to the extent that the U.S. geographic area governed by the contract is in Massachusetts.
All receipts from sales of other intangible property are excluded from the numerator and the denominator.
III. Reasonable approximation rule
The draft regulation provides that, if the state or states of assignment cannot be determined pursuant to one of the applicable rules discussed above, the taxpayer should make a reasonable approximation considering all the relevant sources of information, including, but not limited to, the taxpayer's books and records kept in the normal course of business. If the taxpayer cannot determine or reasonably approximate the assignment of a substantial amount of the sales and the taxpayer reasonably believes that the geographic distribution of those sales generally tracks to that of the assigned sales, it includes the sales it cannot approximate in its sales factor in the same proportion as its assigned sales.
Although the draft regulation provides no specific methodology or examples of acceptable methods of reasonable approximation, it does state that the method should be determined in good faith, applied in good faith, and applied consistently with respect to similar transactions and year-to-year. The draft regulation also outlines limitation rules for changing a method of reasonable approximation as follows:
- If a taxpayer files an original return for a taxable year using a method of reasonable approximation, the taxpayer may subsequently correct factual errors or calculation errors but cannot modify the method through an amended return for that taxable year.
- If a taxpayer changes the method in the next year, the taxpayer must disclose the change on the original return for that year and explain the nature, extent and reason for the change.
- If the commissioner determines that the method used by the taxpayer is not reasonable, the commissioner can substitute a method or exclude the sales from the taxpayer's numerator or denominator, as applicable.
IV. Throw-out rule
The draft regulation provides that if a taxpayer cannot determine or reasonably approximate the state or states to which a sale should be assigned or is not taxable in the state to which it assigns a sale, then the sale is excluded from the numerator and the denominator of the taxpayer's sales factor.
For sales of tangible personal property in foreign jurisdictions, if a taxpayer has the right to apportion, then, for purposes of calculating the sales factor, the taxpayer is deemed to be taxable in a foreign state where it makes the sale and, thus, the sale is automatically excluded from numerator of the sales factor. The draft regulation makes clear that this rule does not apply where a taxpayer is engaged in selling services or licensing intangible property in a foreign state. This means that sales of services attributable to foreign jurisdictions are subject to the throw-out rule unless the taxpayer is actually subject to tax in the foreign jurisdiction.
V. Impact on financial institutions
M.G.L. c. 63 section 2A provides specialized apportionment rules for financial institutions with respect to specifically enumerated services. Financial institutions use the general sourcing rules under G.L. c. 63 section 38(f) for any services not enumerated in section 2A. The draft regulation states that in any instance in which a financial institution performs services that are to be assigned pursuant to M.G.L. c. 63 section 38(f) (e.g., financial custodial services), those services shall be considered professional services and assigned according to the method prescribed in the draft regulation.
VI. Other notable special rules
Prior guidance from the Department has stated that the transfer of prewritten software, regardless of the method of distribution, generally will be considered the transfer of tangible personal property for apportionment purposes. The draft regulation, however, states that, “A license of pre-written software for purposes other than commercial reproduction, when transferred on a tangible medium, is treated as the sale of tangible personal property rather than as either the license of intangible property or the performance of a service.” This wording raises a question as to the Department's position on the transfer of pre-written software through means other than a tangible medium.
The draft regulation also clarifies that where items of gross income are excluded from the federal gross income of the taxpayer, the gross receipts to which such items of gross income are directly attributable are similarly excluded from the numerator and denominator of the taxpayer's sales factor. Also, any property or payroll (or appropriate portion thereof) that relates to such receipts is similarly excluded from the property or payroll factor of the taxpayer.
Finally, the proposed changes to sourcing receipts from services or intangibles will apply not only to C corporations, but also to S corporations, partnerships and limited liability companies. Thus, S corporations subject to the Massachusetts “sting tax” at the entity level, as well as nonresident partners, members and shareholders of pass through entities, also need to evaluate the impact of these rules.
VI. Next steps
The Department has solicited comments from practitioners and taxpayers in relation to the impact of and issues that may be associated with the draft regulation. This comment period is open until May 19, 2014.
We strongly encourage taxpayers to review the impact of the draft regulatory language on their Massachusetts tax liability, as well as areas where holes in the draft language may lead to future issues, and submit comments to the Department.
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