Pennsylvania Market Based Sourcing for Corporate Tax

For tax years beginning on or after January 1, 2023, Pennsylvania apportions corporate income using a market-based sourcing model. This approach determines the income subject to the state’s Corporate Net Income Tax (CNIT) by looking at the location of a company’s customers or where its services and intangibles are used. This model replaces the former cost-of-performance method, which focused on where a company incurred costs to generate income.

The change primarily affects how multistate corporations source receipts from services and the use of intangible property. The goal is to align taxation with the economic market for a company’s offerings and create a more uniform standard for calculating tax liability.

Scope of Market-Based Sourcing

The regulations target receipts from services and the use of intangible property. Revenue from professional, consulting, or digital services is sourced based on where the customer receives the benefit. Income from the sale, lease, or license of intangible assets like patents, copyrights, and franchise agreements also falls under this methodology.

This change does not affect receipts from the sale of tangible personal property, which continue to be sourced based on their destination. The Pennsylvania Department of Revenue has issued guidance, such as Corporation Tax Bulletin 2024-01, to provide clarity on applying these new provisions.

The Sourcing Hierarchy for Service Receipts

Pennsylvania’s regulations establish a multi-step hierarchy for sourcing receipts from services to determine where the customer receives the benefit.

Contract and Business Records

The first step is to review contractual agreements. If a contract specifies the location where the benefit of the service is received, that location is used for sourcing.

If the contract is unclear, the next step is to examine the company’s books and records. If internal documentation maintained in the normal course of business indicates where the customer receives the service’s value, that information is used.

Customer’s Location

When contracts and records do not source the receipts, the focus shifts to the customer’s location. For an individual customer, the sourcing location is their billing address.

For a business customer, revenue is sourced to the commercial domicile or principal place of business where the benefit is received. If the service relates to a specific business location, the revenue is sourced there.

Reasonable Approximation

If the preceding steps do not yield a result, regulations permit a reasonable approximation. Taxpayers may use available information to estimate service use in a particular state, provided the method is reasonable, consistently applied, and reflects the market for the service.

For example, a company with a corporate client whose employees are nationwide could use the geographic distribution of the client’s employee base to approximate where the benefit of a digital service is received.

Sourcing Rules for Intangible Property

The sourcing of revenue from intangible property, such as patents, copyrights, and trademarks, also follows market-based rules. The income is sourced to the location where the intangible property is used.

For the lease or license of intangible property, gross receipts are sourced to Pennsylvania to the extent the property is used in the commonwealth. For example, royalty payments from a trademark license would be sourced based on the location of the franchisee’s operations using that trademark.

The sale or exchange of intangible property is also subject to these rules when payments depend on the property’s productivity, use, or disposition. The sourcing for these transactions is tied to the location of use.

Application and Compliance

These sourcing rules are applied when calculating the sales factor on the Pennsylvania Corporate Net Income Tax return, Form RCT-101. The sales factor is a fraction with a numerator of total receipts sourced to Pennsylvania and a denominator of total receipts from all sources. This factor is then used to apportion a company’s total taxable income to the state.

Pennsylvania’s regulations include a “throw-out” rule. This rule applies when the state where a sale should be sourced cannot be determined or if the taxpayer is not subject to tax in that state. Receipts from certain intangibles, such as goodwill, going concern value, and customer lists, are also excluded under this rule.

In these cases, the receipts are excluded from both the numerator and the denominator of the sales factor. The effect of the throw-out rule is to prevent the dilution of the sales factor with “nowhere” sales. This can increase the proportion of income apportioned to Pennsylvania and result in a greater tax liability.