The Pennsylvania Department of Revenue (PA Department) released a draft Information Notice containing guidance on how to source services under Pennsylvania’s new market-based sourcing scheme for tax years beginning after December 31, 2013. 72 Pa. Stat. Ann. § 7401(3)(2)(a)(16.1)(C). By statute, service receipts are sourced to Pennsylvania if the service is delivered to a location in Pennsylvania. If the service is delivered both to a location in and outside Pennsylvania, the sale is sourced to Pennsylvania based upon the portion of the total value of the service delivered to a location in Pennsylvania. In the case of customers who are individuals (other than sole proprietors), if the state or states of delivery cannot be determined for the customer, the service is deemed to be delivered at the customer’s billing address. In the case of other customers (e.g., corporations), if the state or states of delivery cannot be determined for the customer, the service is deemed to be delivered at the location from which the service was ordered in the customer’s regular course of operations. If the location from which the service was ordered in the customer’s regular course of operations cannot be determined, the service is deemed to be delivered at the customer’s billing address.
Despite the new statutory scheme, taxpayers have been wondering exactly what “delivery” of a service to a Pennsylvania location means. The draft Information Notice released by the PA Department on June 16, 2014, attempts to answer that question.
According to the PA Department, delivery occurs “at a location where a person or entity may use the service.” The PA Department believes that this definition eliminates those parties that simply pay for the service (but do not actually use it) or other intermediaries. The PA Department’s view is that the statute’s use of billing address (for individual customers) and location of purchase or billing address (for corporate customers) are mere “defaults”—neither of which may represent the true marketplace for the service and should only be used as a last resort.
The PA Department’s guidance also addresses delivery in the context of electronically delivered services, stating that delivery may be established through IP address records or other network data. Interestingly, the PA Department’s guidance also provides that delivery of certain electronic data services to “the cloud” or other data storage device does not constitute delivery of those services—because those locations are not considered to be the locations of the user.
While the PA Department’s guidance provides some clarity it also exemplifies the ever divergent market sourcing regimes. See our article discussing the wide variety of market-based sourcing rules. For example, the PA Department draft guidance contains the following example:
Taxpayer is a provider of third-party payroll processing services for Company A. Half of Company A’s employees are located in PA and half are located in New York. Company A’s headquarters and human resources functions are located in PA. Taxpayer sources all of the payroll services to PA. Note in this example that payroll services are really used by the corporation and not the employee because the service is designed to meet the needs of the company, and it is the company that uses the processing service, not the employee.
This result is directly contrary to California’s regulation, which provides that the payroll servicing company should assign its receipts by determining the ratio of employees of the customer in California compared to all employees of the customer and assign that percentage of the receipts to California. Cal. Code Regs. 25136-2(b)(1).
Could this very different result be due to Pennsylvania’s “delivery” market-sourcing approach as opposed to California’s “benefit of the services” approach? If both states are trying to source the receipts to the state that is the true marketplace for the service, the results should be the same. Clearly the perceived benefits of a “uniform” destination-based market-sourcing regime have not come to fruition.
While not the main focus of the PA Department’s guidance, the guidance also contains a discussion of the application of Pennsylvania’s income-producing activity test (otherwise known as costs of performance) to the sale of intangibles (a test that had applied to services before December 31, 2013). The Pennsylvania income-producing activity test sources receipts from intangibles to Pennsylvania if the greater proportion of the income-producing activity is performed in Pennsylvania than in any other state, based on costs of performance. 72 Pa. Stat. Ann. § 7401(3)(2)(a)(17).
The PA Department’s view is apparently that “performance” of the income-producing activity occurs at the place where accomplished or fulfilled. The draft Information Notice provides the following example:
Taxpayer is a Maryland-based restaurant chain that grants franchises to individuals in specific locations throughout Maryland and Pennsylvania. In exchange for granting a franchise to an individual, Taxpayer leases its trademarks and patented food-processing techniques to its franchisees. The leases are paid annually and entitle the franchisee to use those intangibles in specific restaurants throughout Pennsylvania and Maryland. The receipts from intangibles leased to Pennsylvania-based franchisees are sourced to Pennsylvania because the income-producing activity (use of the intangible) occurs in Pennsylvania.
Based on this, it seems as though the PA Department is attempting to transform a costs of performance statute into a market-based sourcing result. If the Department maintains this position in the final draft, it will likely face challenges.