Cost of Performance vs. Market-Based Sourcing
State tax apportionment for services hinges on where revenue is sourced: the location of the work performed or where the customer receives the benefit.
Businesses operating across state lines must divide their income among those states to determine their tax obligations. For service-based companies, this involves sourcing their revenue, which is the process of figuring out where it was earned. This determination dictates which state has the right to tax that income.
Two primary methods for this are Cost of Performance (COP) and Market-Based Sourcing (MBS). COP sources income to where a business’s work is performed, while MBS sources it to the location of its customers. The choice between these methods has financial implications, potentially shifting tax liability from one state to another.
The Cost of Performance Method
The Cost of Performance method sources service revenue to the state where the work is physically performed. Under this framework, the customer’s location is irrelevant. What matters is where the business incurs the direct costs of generating that income, which is known as the “income-producing activity.”
To calculate sourcing under COP, a business analyzes the direct costs for a service contract, such as employee wages and materials directly used. General and administrative overhead costs, like executive salaries or corporate rent, are not included because they do not relate to a specific income-producing activity.
For example, consider a consulting firm with its only office in State A, a COP state. If the firm earns a $200,000 fee from a client in State B, but all work is done in State A, the entire $200,000 is sourced to State A. This is because all direct costs were incurred there.
If work is performed in multiple locations, the revenue may be split. If the firm incurred 90% of its direct labor costs in State A and 10% in State B, then $180,000 would be sourced to State A. However, some COP states use an “all-or-nothing” rule, sourcing all revenue to the state where the greatest proportion of the work is done.
The Market-Based Sourcing Method
Market-Based Sourcing takes a different approach. Instead of focusing on where the work is performed, MBS sources revenue to the location where the customer receives the benefit of the service. This method shifts the taxable location from the seller’s state to the buyer’s, aligning the tax base with the market for the services.
This approach is designed to capture revenue from out-of-state businesses that have a customer base within a state but little to no physical presence there. It connects the tax liability directly to a company’s sales in a state, regardless of where its offices or employees are located.
Revisiting the consulting firm example, the firm is in State A and the client is in State B, now an MBS state. Although all work was done in State A, the benefit of the service is received in State B. Under MBS rules, the entire $200,000 in revenue would be sourced to State B.
Under COP, State A would tax the income, but under MBS, State B would claim that right. This highlights the shift in tax liability depending on the sourcing method used.
Locating the Customer in Market-Based Sourcing
The practical application of MBS hinges on determining where a customer receives the benefit of a service. States using MBS establish a hierarchy of rules to make this determination, and these can vary by state and the type of service.
The analysis starts with the customer contract; if it specifies where the benefit is received, that location may govern the decision. If the contract is not decisive, other factors are considered, with the customer’s billing address being a common proxy. The goal is to find where the service was delivered or its benefit was realized, which may require identifying an ultimate beneficiary who is not the contracting party.
The analysis is more complex for services provided to large corporations with a national footprint. For example, a marketing service for a company headquartered in one state might benefit sales operations across the country. In these cases, regulations often require the service provider to reasonably apportion the revenue among the states where the benefit is received, based on factors like the client’s sales data or number of locations in each state.
State Sourcing Rules and Trends
The landscape of service revenue sourcing is defined by a trend of states moving away from the Cost of Performance method. A majority of states with an income tax have now adopted Market-Based Sourcing. This shift in tax policy is aimed at taxing economic activity connected to a state’s market, regardless of the seller’s physical location.
A smaller group of states continues to adhere to COP rules, where the focus remains on where direct costs are incurred. This divide requires multistate service providers to run two different sets of sourcing calculations for their state tax returns.
The driver for this trend is the desire by states to tax profits generated from their residents and in-state businesses. As commerce becomes more digital, MBS allows states to tax revenue from out-of-state service providers that sell to their citizens. This prevents erosion of the state’s corporate tax base and levels the playing field between in-state and out-of-state companies.
This divergence in rules creates compliance burdens and tax risks. For instance, a business in a COP state selling to a customer in an MBS state could face double taxation if both jurisdictions claim the income. Conversely, planning can result in “nowhere income” not taxed by any state, a situation some jurisdictions address with “throwback” or “throw-out” rules to re-capture that revenue.