Friends With Benefits Received? AComparison of Market Sourcing Rules

by Jeffrey A. Friedman and Michele L. Pielsticker

Jeffrey A. Friedman Michele L. Pielsticker

As more states move toward a single-sales-factorformula for apportioning business income, so too arethey drawn toward market-based sourcing rules tosource receipts from sales of services and intan-gibles. States perceive market-based sourcing asproviding more favorable tax treatment for in-statebusinesses, but it often results in a tax increase forout-of-state businesses that are forced to transitionfrom costs of performance sourcing.

The market sourcing approach brings many newproblems, as states struggle to create a set of rulesthat provide certainty, as well as the flexibilityneeded to fairly reflect the location of the taxpayer’s‘‘market.’’ In this article, we review various aspectsof rules for sourcing receipts from the sale of servicesunder several states’ market approaches, evaluatingthe rules based on their practicality and functional-ity for accurately determining a taxpayer’s level ofeconomic activity in the state. Next we apply theserules to specific fact patterns. We conclude by sug-gesting guidelines for states to follow in developingrules that are practical and functional.

Receipts From Sales of Services

Use of Customers’ Address InformationIndeterminingwheretosourceareceipt forthesale

of a service under a market-based approach, states

often look to where the ‘‘benefit’’ of the service wasreceived. Determining the receipt of a benefit posesmany problems, and states have adopted proxies orassumptions for defining the location of a customer’sbenefit. Some first look at the billing address of thetaxpayer’s customer or the location specified in thecontract between the taxpayer and its customer. Forexample, to source receipts from sales of services toindividual customers (as opposed to business custom-ers), California’s Prop. Reg. 25136-2,1 applying a ben-efits received rule, sources the sale to the billingaddress of the taxpayer’s customer.2 The customer’sbilling address serves as a safe harbor — taxpayersmay choose it as a proxy for the location where thebenefit of the service is received.3

1Although this regulation is likely to be finalized by theFranchise Tax Board on December 1, at press time thisregulation has neither received final approval from the FTBnor been finalized by the Office of Administrative Law.

2Calif. Prop. Reg. 25136-2(c)(1)(A). Calif. Revenue andTaxation Code section 25136 (b)(1) provides the statutorybasis for sourcing receipts from sales of services.

3This presumption may be overcome only by the taxpayerand not by the FTB. Calif. Prop. Reg. 25136-2(c)(1)(A). If thecustomer’s billing address is not the location where thebenefit of the service was received, the taxpayer may show,based on a preponderance of the evidence, that its contract orbooks and records show the extent to which the benefit wasreceived in California. Id. If the taxpayer chooses not to usethe customer’s billing address but seeks to overcome thepresumption and uses an alternative method for sourcing thereceipt, the FTB is entitled to examine the taxpayer’s positionto determine whether the alternative method reasonablyreflects where the benefit of the service was received. Id. Ifthe customer’s billing address does not accurately reflectwhere the benefit of the service was received, the taxpayer ispermitted to overcome the presumption through an alterna-tive method, based on the taxpayer’s contract with its cus-tomer or on its books and records. Id. If an alternative methodcannot be determined by reference to the foregoing, thelocation where the benefit of the service is received must bereasonably approximated. Id. California’s customer billingaddress presumption provides certainty. Thus, the presump-tion likely will reduce administrative costs for both thetaxpayer and the FTB and offers a practical means of sourc-ing receipts.

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There are problems with using a customer’s bill-ing address as a sourcing rule. For example, theCalifornia Franchise Tax Board acknowledges thatwireless phone customers may have a billing ad-dress in the state but receive phone services in manylocations. In that case, the proposed regulation pro-vides an example that uses the ratio of Californianet plant facilities over the total net plant facilitiesthat are used to provide the services to estimate thelocation of the benefit of the taxpayer’s wirelessservices.4 In light of the federally required ‘‘primaryplace of use’’ rule used for state and local transactiontaxes, it is ironic that the FTB has identified mobiletelecommunications as an area in which the cus-tomer’s address may not be practical.5 The federalrule assumes that the primary place of use of amobile telecommunications customer — which isfrequently the customer’s billing address6 — is anappropriate proxy for sourcing transactions taxes.

Use of Books and Records or ContractInformation

By contrast, California does not provide a safeharbor presumption for sourcing receipts from salesof services to business customers. Instead, the pro-posed regulation provides that the location wherethe benefit of the service is received by a businesscustomer is presumed to be in California to theextent indicated in the contract between the tax-payer and its customer or the taxpayer’s books andrecords, regardless of the customer’s billing ad-dress.7

California’s proposed sourcing rules for sales ofservices to businesses create uncertainty, becausethey provide only a presumption — allowing foreither the FTB or a taxpayer to apply a morefavorable method if an undetermined evidentiary

standard is met. The proposed regulation does notspecify what type of evidence may be used to over-come the presumption or when the FTB will chal-lenge the taxpayer’s use of these items to showwhere the benefit of the service is received.

California’s proposed sourcingrules for sales of services tobusinesses create uncertainty,because they provide only apresumption.

Although California’s proposed regulation losespracticality points because it provides no safe harborfor sourcing sales of services to businesses, it scoresfunctionality points because it allows the taxpayerand the state to look beyond the taxpayer’s contractand books and records to determine where thebenefit of the service was received. Finally, it isdifficult to discern the difference between rebuttingthe presumption established in the first tier ofCalifornia’s market sourcing rules and applyingequitable apportionment relief8 available to the FTBand all taxpayers when the general rules are distor-tive of the taxpayers’ economic activity in the taxingstate.

Competing State TheoriesCalifornia’s rules for sourcing sales of services to

business and individual customers provide an ex-ample of how to define benefit received. However,California does not have a corner on the market —there are other competing approaches for definingbenefit received. Some are summarized in Table 1 onthe next page.

Use of a ‘Readily Determinable’ StandardSimilar to California’s proposed rules for sourcing

sales of services to individuals, Maine, Minnesota,and Illinois use the customer’s address as a proxy forthe location where the benefit of the service isreceived, but only after a finding that if the statewhere the service is received is ‘‘not readily deter-minable.’’9 Maine provides that if the location of thebenefit is not readily determinable, services aredeemed received at the individual customer’s home,or if the customer is a business, at the office wherethe order for services was placed in the regular

4Calif. Prop. Reg. 25136-2(c)(1(C)(1).54 U.S.C. section 122(a).6Federal law defines primary place of use as ‘‘the street

address representative of where the customer’s use of themobile telecommunications service primarily occurs, whichmust be . . . the residential street address or the primarybusiness street address of the customer; and . . . within thelicensed service area of the home service provider.’’ 4 U.S.C.section 124 (8).

7Calif. Prop. Reg. 25136-2(c)(2)(A). This presumption maybe overcome by the taxpayer or the FTB if either can demon-strate by a preponderance of the evidence that the locationwhere the benefit actually was received was not the locationspecified in the contract or the taxpayer’s books and records.Id. If the presumption is overcome or the taxpayer’s contractor books and records do not indicate where the benefit of theservice was received, the proposed regulation allows thelocation to be reasonably approximated. Id. If reasonableapproximation is impossible, only then can the location wherethe customer ordered the service be used as a proxy for thelocation where the benefit of the service was received. Id. Thecustomer’s billing address is the last resort; it can be usedonly after the other rules have been ineffective. Id.

8Cal Rev. and Tax. Code section 25137 allows either thetaxpayer to request or the FTB to require the use of analternative method of apportionment or allocation if thestandard formula is distortive of the taxpayer’s actual eco-nomic activity in the state.

9Maine Rev. Stat. Ann. Tit. 36, section 5211(16-A); Minn.Stat. Ann. section 290.191(5)(j).

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course of the customer’s business.10 If that locationcannot be determined, the services are deemed re-ceived at the customer’s billing address.11

Minnesota’s and Illinois’s laws are silent regard-ing alternative methods for determining the locationwhere services are received by individuals.12 How-ever, receipts for services provided to a corporation,partnership, or trust may be sourced only to a statewhere the business customer has a fixed place ofbusiness (the customer’s address).13 If the statewhere the customer receives the service is notreadily determinable, or the corporation, partner-ship, or trust has no fixed place of doing business,the office where the customer ordered the service inthe regular course of business is deemed to be the

location where the service is received.14 If thatlocation is not determinable, the services aredeemed received at the customer’s billing address.15

The Maine and Minnesota approaches to marketsourcing are more practical than California’s ap-proach because each tier of the cascading rulesoffers some degree of certainty. Unlike California’sproposed regulation, which allows the FTB to rejectthe location of benefit stated in the contract byreference to unspecified evidence of where the ben-efit of the service actually was received, Maine,Minnesota, and Illinois provide another ‘‘tier’’ in thecascading rules only when the location of the serviceis not readily determinable.

Taxpayers may justifiably be concerned about thereadily determinable standard. A stated location ofservice in the contract with the taxpayer’s customerwill presumably suffice in those states to determinewhere the service is received. If it doesn’t, the other

10Maine Rev. Stat. Ann. Tit. 36, section 5211(16-A).11Id.12Minn. Stat. Ann. section 290.191(5)(j); 35 Ill. Comp. Stat.

Ann. 5/304(a)(3)(C-5)(iv).13Minn. Stat. Ann. section 290.191(5)(j); 35 Ill. Comp. Stat.

Ann. 5/304(a)(3)(C-5)(iv).

14Minn. Stat. Ann. section 290.191(5)(j); 35 Ill. Comp. Stat.Ann. 5/304(a)(3)(C-5)(iv).

15Minn. Stat. Ann. section 290.191(5)(j); 35 Ill. Comp. Stat.Ann. 5/304(a)(3)(C-5)(iv).

Table 1.Key State Comparison Chart

Customer’s BillingAddress

Contract BetweenTaxpayer andCustomer/Taxpayer’s Booksand Records

Location WhereServices AreOrdered

Customer’s FixedPlace of Business

Actual Place ofBenefit

California(Proposed Reg.)a

First TierSafe Harbor(Individuals), LastTier (Businesses)

First TierRebuttablePresumption(Businesses)

Third Tier N/A Second Tier

Illinoisb Last Tierc May provideevidence thatmakes location ofbenefit ‘‘readilydeterminable’’

Second Tier First Tier(if location ofbenefit is readilydeterminable)

First Tier(if location ofbenefit is readilydeterminable andcustomer has fixedplace of businessin state)

Mained Second Tier(Individuals),Third Tier(Businesses)

May provideevidence thatmakes location ofbenefit ‘‘readilydeterminable’’

Second Tier(Businesses)

N/A First Tier(if location ofbenefit is readilydeterminable)

Minnesotae Last Tier May provideevidence thatmakes location ofbenefit ‘‘readilydeterminable’’

Second Tier First Tier(if location ofbenefit is readilydeterminable)

First Tier(if location ofbenefit is readilydeterminable andcustomer has fixedplace of businessin state)

aCalif. Proposed Regulation 25136-2(c).b35 Ill. Comp. Stat. 5/304(a)(3)(C-5)(iv).cIllinois applies a ‘‘throwout rule’’ if the taxpayer is not taxable in the state where the benefit of the service is received. 35 Ill.Comp. Stat. Ann. 5304(a)(3)(C-5)(iv).dMaine Rev. Stat. Ann. Tit. 36, section 5211(16-A).eMinn. Stat. Ann. section 290.191(5)(j).

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tiers offer proxies — the customer’s office location orthe place from which the order for services wassubmitted. Those states score lower in the function-ality ranking, however, because they don’t explicitlyprovide for the flexibility to use an alternativemethod that may more accurately estimate wherethe benefit of the service was received.

Apportioning the Benefit ReceivedOhio sources receipts from the sale of services

according to the proportion of the purchaser’sbenefit in that state compared with the benefitreceived everywhere.16 The Ohio statute providesthat ‘‘the physical location where the purchaserultimately uses or receives the benefit of what waspurchased shall be paramount in determining theproportion of the benefit in this state to the benefiteverywhere.’’17 Ohio Rule section 5703-29-17 pro-vides separate sourcing rules for 54 different typesof services for purposes of the commercial activitytax — a nightmare or nirvana, depending on yourperspective.

The Maine and Minnesotaapproaches to market sourcing aremore practical than California’sapproach because each tier of thecascading rules offers somedegree of certainty.

The functionality and practicality of Ohio’s ex-pansive sourcing rules depend on the rule in ques-tion. For example, accounting services performedboth inside and outside the state may, at the tax-payer’s election, be sourced to the purchaser’s ‘‘prin-cipal place of business’’ or the individual customer’saddress.18 The Ohio rule offers a series of cascadingfactors to use in determining the principal place ofbusiness, such as ‘‘the branch, division, or other unitwhere the client primarily receives the benefit. . . the primary location of the management opera-tions of the purchaser’s business unit,’’ and thebilling address of the customer.19 These cascadingfactors are different for each service. Like Califor-nia, Ohio seems to account for the fact that a singlemethod of substantiating the location of the benefitreceived is not uniformly workable. Unlike Califor-nia, however, Ohio provides more detailed guidanceto taxpayers, making the rule more predictable.

Wisconsin also sources receipts from sales ofservices performed in multiple states in proportion

to the benefit received.20 Unlike Ohio, Wisconsinprovides no guidance on how to determine theproportion of the benefit received in Wisconsin.21

The Wisconsin sourcing statute provides functional-ity through its flexibility, but it offers littlecertainty.

For Michigan tax purposes, sales of services per-formed within and outside the state are sourced inproportion to the benefit in each state, like in Ohioand Wisconsin.22 Michigan Revenue AdministrativeBulletin (RAB) 2010-5 provides more guidance onascertaining where the benefit of the service isreceived.23 For example, it provides that if a servicerelates to tangible personal property owned orleased by the purchaser, the service is sourced toMichigan if the tangible personal property was lo-cated in Michigan or delivered to the purchaser inMichigan.24 The guidance also states that if thepurchaser of the service is engaged in a trade orbusiness in Michigan and in one or more otherstates, and the service relates to the purchaser’strade or business, ‘‘the benefit of the service isreceived in Michigan to the extent that it relates tothe trade or business of the purchaser in Michi-gan.’’25 Similar rules are provided for services re-garding the use of intangible property and legal andaccounting services.26

The guidance is scant on the meaning of thephrase ‘‘to the extent that.’’ Thus, Michigan’s sourc-ing isn’t very practical because it offers little pre-dictability. As in Ohio and Wisconsin, the rules seekto identify the actual amount of benefit received inMichigan to determine the taxpayer’s level of eco-nomic activity in that state. Thus, the rules offerflexibility to allow for alternative methods to achievean accurate result.

Application of Market Sourcing Rules forSales of Services

Market sourcing rules lead to divergent resultswhen applied, and often can lead to double taxation.The following examples demonstrate the practicaldifferences of states’ market approaches.

Hypothetical A — Accounting Services: AcmeAccounting Firm provides accounting services toMultistate Manufacturing Corp. (MMC). MMC hasfacilities in California, Illinois, Michigan, and Min-nesota, but its principal place of business and state

16Ohio Rev. Code Ann. section 5733.05 (B)(2)(c)(ii).17Id.18Ohio Rule section 5703-29-17(C)(1)(c).19Id.

20Wis. Stat. section 71.25(9)(dh)(3).21Wisconsin does provide guidance regarding when the

gross receipts from services are sourced to Wisconsin if thepurchaser of the service received the benefit of the service inWisconsin. Wis. Stat. section 71.25(9)(dh).

22Mich. Comp. Laws section 208.1305(2)(a).23Mich. Dep’t of Treas. RAB 2010-5 (May 20, 2010).24Id. at 3.25Id.26Id.

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of commercial domicile is Illinois. MMC ordered theservices that relate to all of its facilities from itsprincipal place of business. The contract with MMCdoes not specify where the benefit of the accountingservice is received. (See Table 2.)

Hypothetical B — Software Support: Asoftware company has a call center located inMinnesota, but it provides support services only toindividual customers located in California, Illinois,and Michigan for a set monthly fee specified in itscontracts. Ten percent of the calls originate fromIllinois, 50 percent from California, and 40 percentfrom Michigan. Thirty percent of the customers’billing addresses are in California, 30 percent inIllinois, and 40 percent in Michigan. (See Table 3.)

Hypothetical C — Architectural Design Ser-vices: Design Corp. has its principal place ofbusiness in Minnesota and is designing a building

for a manufacturer located in California. DesignCorp.’s employees travel frequently to California tomeet with the manufacturer and discuss theblueprints for the building, and the manufacturer’semployees travel to Minnesota to do the same.Design Corp. drafts the blueprints in Minnesota.The contract specifies that the location where theservice is received is Minnesota. (See Table 4, nextpage.)

Conclusion

While market-based sourcing may seem appeal-ing, it may be more difficult to apply, and may leadto less predictable results than costs of performancesourcing. Thus, as states develop rules for market-based sourcing to apply to receipts from sales ofservices, they should attempt to balance practicalitywith functionality. Those two criteria often conflict.

Table 2.Hypothetical A — Accounting Services

Californiaa Illinoisb Michiganc Minnesotad

Sourcing Outcome Unclear. Mayreasonablyapproximate locationwhere benefit received.May source partially toCalifornia based onproportion of benefit.

Unclear. May arguethat actual benefitreceived among thefour facilities is notreadily determinable.May source to fixedplace of business inIllinois because that iswhere services wereordered. Taxpayer mayargue benefit receivedis spread among fourfacilities.

Unclear. Servicesourced to Michigan tothe extent that servicesrelate to thepurchaser’s Michiganoperations.

Same as Illinois.

aCalif. Proposed Regulation 25136-2(c).b35 Ill. Comp. Stat. 5/304(a)(3)(C-5)(iv).cMich. Comp. Laws Ann. section 208.1305(2)(a).dMinn. Stat. Ann. section 290.191(5)(j).

Table 3.Hypothetical B — Software Support

California Illinois Michigan Minnesota

Sourcing Outcome Customers, billingaddress createspresumption that 30percent of receiptssourced to California.

Presumably Illinoiswould look to wherethe calls originated (10percent) or tocustomer’s billingaddress (30 percent).

If the service relates toprewritten software,(tangible property)located in Michigan,the entire benefit ofthe service received inMichigan is sourced toMichigan. If the servicerelates to customsoftware (intangibleproperty), the benefitof the service issourced to Michigan tothe extent that theintangible property isused in Michigan. Thestate likely will look tothe origination of thecall to determineproportion of use.

N/A

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The rules that are easiest to administer often do notallow the flexibility to determine the location wherethe benefit of a service is received or where anintangible is used. However, more flexibility leads touncertainty and more frequent audit disputes. Stand-ards such as ‘‘reasonable’’ and ‘‘readily determin-able’’ are vague and open to interpretation. Cascad-ing rules that offer a safe harbor may help taxpayersand states strike a balance that reduces audit dis-putes but also allows taxpayers to more accuratelyestablish the location of benefit or place of use. Cleartransitions between cascading rules also would lendcertainty in application. Finally, and most impor-tant, states can improve their sourcing rules andreduce audit disputes by considering taxpayer feed-back regarding the practical application of thoserules. ✰

Table 4.Hypothetical C — Architectural Design Services

California Illinois Michigan Minnesota

Sourcing Outcome Taxpayer may arguelocation specified incontract controls. FTBmay rebut presumptionby arguing that benefitactually was receivedin California becausethat is the location ofthe building andtaxpayer met withclients in California.FTB may approximatelocation of benefit.

N/A N/A Because the taxpayerhas no fixed place ofbusiness in California,and the location of thebenefit is specified inthe contract asMinnesota, the statemay source all receiptsto Minnesota.

Jeffrey A. Friedman is a partner and Michele L. Piel-sticker is of counsel with Sutherland Asbill & BrennanLLP’s State and Local Tax Practice. Sutherland’s SALTPractice is composed of more than 25 attorneys who focuson planning and controversy associated with income, fran-chise, sales and use, and property tax matters, as well asunclaimed property matters. Sutherland’s SALT Practicealso monitors and comments on state legislative and politi-cal efforts.

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