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New Market-Based Sourcing in DC: Major Compliance Date Problem Fixed… For Now

The Problem

On September 23, 2014, the District of Columbia Council enacted market-based sourcing provisions for sales of intangibles and services as part of the 2015 Budget Support Act (BSA), as we previously discussed in more detail here.  Most notably the BSA adopts a single sales factor formula for the DC franchise tax, which is applicable for tax years beginning after December 31, 2014.  But the market-based sourcing provisions in the BSA did not align with the rest of the tax legislation.  Specifically, the BSA market-based sourcing provisions were made applicable as of October 1, 2014—creating instant tax implications on 2014 returns.  Absent a legislative fix, this seemingly minor discrepancy will trigger a giant compliance burden that will require a part-year calculation for both taxpayers and the Office of Tax and Revenue (OTR) before the 2014 franchise return deadline on March 15.  For example, taxpayers filing based on the new BSA provisions, as originally enacted in September, will have to use the cost-of-performance approach for the first nine months of the 2014 tax year and the new market-based sourcing approach for the remaining three.

The Fix

Citing to the unintended compliance burden, the Council recently enacted emergency legislation to temporarily fix the unintended compliance burden.  However they have not solved the problem going forward.  On December 17, 2014, Finance and Revenue Committee Chairman Jack Evans introduced identical pieces of legislation that included both a temporary and emergency amendment to quickly fix on the problem (both pieces of legislation share the name “The Market-Based Sourcing Inter Alia Clarification Act of 2014”).  These legislative amendments explicitly make the applicability of market-based sourcing provisions synonymous with the other provisions of the BSA, beginning for tax years after December 31, 2014.  In DC, “emergency” legislation may be enacted without the typical 30-day congressional review period required of all other legislation, but is limited to an effective period of no longer than 90 days.  Because the emergency market-based sourcing legislation was signed by Mayor Muriel Bowser on January 13, it will expire on April 13.  Important to DC franchise taxpayers, this date is before the September 15 deadline for extended filers.

The second piece of legislation was introduced on a “temporary” basis.  Unlike emergency legislation, temporary legislation simply bypasses assignment to a committee but must still undergo a second reading, mayoral review and the 30-day congressional review period.  The review period is 30 days that Congress is in session (not 30 calendar days).  Because the temporary Act is still awaiting Mayor Bowser’s approval at the moment, which is due by this Friday (February 6), it will not become effective until after the 2014 DC Franchise Tax regular filing deadline of March 15—even if it is approved by the Mayor and not subjected to a joint-resolution by Congress.  Neither the House nor Senate is in session the week of February 15, which pushes the 30-day review period to roughly April 1 (assuming it is immediately submitted to Congress).  However, once passed, [...]

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Rate Reduction for D.C. QHTC Capital Gains to Begin… in 2019

Investors keeping a close eye on pending legislation (the Promoting Economic Growth and Job Creation Through Technology Act of 2014, Bill 20-0945) promoting investments in D.C. Qualified High Technology Companies (QHTC) will be happy to know it passed—but not without a serious caveat. While the bill was originally set to allow investors to cash in their investments after being held continuously for a 24-month period, the enrolled Act (D.C. Act 20-514) was amended to make the rate reduction applicable January 1, 2019 (at the earliest).

Background

In September 2014, the D.C. Council began reviewing a proposal from Mayor Gray that would lower the tax rate to 3 percent for capital gains from the sale or exchange of eligible investments in QHTCs, as previously discussed by the authors here. As introduced, the bill was set to be applicable immediately; however, all that changed when an amendment was made on December 2 that restricts applicability of the Act to the latter of:

  • January 1, 2019 to the extent it reduces revenues below the financial plan; or
  • Upon implementation of the provisions in § 47-181(c)(17).

As noted in the engrossed amendment, this was done to “ensure that the tax cuts . . . codified by the 2015 Budget Support Act (BSA) take precedence.” These cuts, previously discussed by the authors here and here, include the implementation of a single sales factor, a reduction in the business franchise tax rate for both incorporated and unincorporated businesses, and switch from cost of performance sourcing to market-based sourcing for sale of intangibles and services.

The Act was quickly passed on December 22 with the amendment language included and a heavy dose of uncertainty regarding when the reduced rate will apply (if at all), since it is tied to the financial plan and BSA. Practically, this leaves potential investors with the green light to begin purchasing interests in QHTCs, since the Act is effective now, yet leaves these same investors with uncertainty about the applicability of the reduced rate.

Practical Questions Unresolved 

The enrolled Act retains the same questionable provisions that were originally present upon its introduction, raised by the authors here. Specifically the language provides that the Act applies “notwithstanding any other provision” of the income tax statute and only to “investments in common or preferred stock.” The common or preferred stock provisions appear to arbitrarily exclude investments in pass-through entities, despite the fact that they are classified as QHTCs, disallowing investors that otherwise would be able to take advantage of the rate reduction. In addition, the Act lacks clarity regarding the practical application of basic tax calculations, such as allocation and apportionment. The Act seems to stand for the proposition that the investments should be set apart from the rest of the income of an investor, but to what extent? Absent regulations or guidance from the Office of Tax and Revenue (OTR), taxpayers [...]

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Pennsylvania Unwraps Final Market-Sourcing Guidance

The Pennsylvania Department of Revenue (the Department) recently finalized its Information Notice on sourcing of services for purposes of determining the appropriate net income and capital franchise tax apportionment factors.  The guidance also addresses the Department’s views on the sourcing of intangibles under the income producing activity test.  Since Pennsylvania is not a member of the Multistate Tax Compact, it is no surprise that the Department did not wait for the Multistate Tax Commission to complete its model market sourcing regulation before it issued its guidance.

Under the Pennsylvania statute (72 Pa. Stat. Ann. § 7401(3)(2)(a)(16.1)(C)), for tax years beginning after December 31, 2013, receipts from services are to be sourced according to the location where the service is delivered.  If the service is delivered both to a location in and outside Pennsylvania, the sale is sourced to Pennsylvania based upon the percentage of the total value of services 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 customers who are not individuals or who are sole proprietors, 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.

The statute generated more questions than it answered.  Key terms such as “delivered” and “location” were not defined.  The Department’s Information Notice provides answers to many of taxpayers’ questions.  However, unlike the draft Information Notice released in June 2014, the final Information Notice shies away from providing a succinct definition of “delivery” and resorts to defining the term through various examples.  (For our coverage of the Department’s draft Information Notice, click here.)  However, the Information Notice does define “location” stating that “location” generally means the location of the customer and, thus, delivery to a location not representative of where the customer for the service is located does not represent completed delivery of the service.

The Information Notice is chock full of examples to guide taxpayers.  The Department’s views relating to various scenarios when services are performed remotely on tangible personal property owned by customers are of interest.  If a customer ships a damaged cell phone to a repair facility that repairs and returns it, the Department deems the service to be delivered at the address of the customer.  Contrast that with a situation when a customer drops a car off for repair at a garage and later returns to pick it up.  One may conclude that the service should also be deemed to be delivered at the address of [...]

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Take Two: Massachusetts Department of Revenue Releases Revised Market-Based Sourcing Regulation

Late last week, the Massachusetts Department of Revenue (the Department) released a revised draft regulation on Massachusetts’s new market-based sourcing law.  The changes made by the Department to purportedly address practitioner and taxpayer concerns were relatively modest.  The rules remain lengthy, complex and cumbersome.  There are still various assignment rules that apply to each of the following types of transactions: (1) in-person services, (2) professional services, and (3) services delivered to the customer, or through or on behalf of the customer (described in the new regulation as services delivered to the customer, on behalf of the customer, or delivered electronically through the customer, hereinafter “sales delivered to, by, or through a customer”).  For a more detailed discussion of these rules see our State Tax Notes article on market-based sourcing

The most noteworthy changes from the initial draft relate to the taxpayer’s ability to use a “reasonable approximation” method.  The initial draft regulation provided taxpayer’s with the ability to use a “reasonable approximation” when “the state or states of assignment” could not be determined.  The new regulation clarifies that a taxpayer must, in good faith, make a reasonable effort to apply the primary rule applicable to the sale (e.g., the specific assignment rules for in-person services, professional services, or sales to, by, or through a customer) before it may reasonably approximate.  Additionally, the regulation explicitly states that a method of reasonable approximation “must reflect an attempt to obtain the most accurate assignment of sales consistent with the regulatory standards set forth in [the regulation], rather than an attempt to lower the taxpayer’s tax liability.”  There is no guidance as to how a taxpayer would demonstrate that its reasonable approximation attempt was made to “obtain the most accurate assignment of sales.”  This raises a number of questions–for example, if a taxpayer determines that there are two equally reasonable methods by which it can reasonably approximate its Massachusetts sales, can it use the method that results in less tax?  Additionally, there does not seem to be any converse requirement that the Department make a similar demonstration (i.e., that any modifications to a taxpayer’s sourcing methodology not be an attempt to increase a taxpayer’s liability) when exercising its authority to adjust a taxpayer’s return (as discussed below).

In an attempt to make the regulation more even-handed, the Department’s revisions provide that neither a taxpayer nor the Department may adjust a “proper” method of assignment, including a method of reasonable approximation, unless it is to correct factual or calculation errors.  However, the revision isn’t all that meaningful because there are still a broad number of scenarios in which the Department can make changes, one of which is when a taxpayer uses a method of approximation and the Commissioner determines that the method of approximation employed by the taxpayer is not “reasonable.”  Additionally, when a taxpayer excludes a sale from both the numerator and denominator of its sales factor because it has determined that the assignment of the sale cannot be reasonably approximated, [...]

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MTC’s Market-Based Sourcing Recommendations for UDITPA: Too Little, Too Late?

Member states of the Multistate Tax Commission (MTC) voted to adopt proposed amendments to Article IV of the Multistate Tax Compact during their annual meeting in late July.  The proposed amendments likely to have the most widespread impact on taxpayers are the amendments to the Uniform Division of Income for Tax Purposes Act (UDITPA) Article IV section 17 sourcing rules that change the sales factor sourcing methodology for services and intangibles from a costs of performance (COP) method to a market-based sourcing method. 

The MTC’s recommended market approach provides that sales of services and intangibles “are in [the] State if the taxpayer’s market for the sales is in [the] state.”  In the case of services, a taxpayer’s market for sales is in the state “if and to the extent the service is delivered to a location in the state.”  The proposed amendments also provide that if the state of delivery cannot be determined, taxpayers are permitted to use a reasonable approximation.  At this point, there is no additional guidance from the MTC on the meaning of “delivered,” how to determine the location of delivery in the event that a service is delivered to multiple jurisdictions, or what constitutes a reasonable approximation.

While the proposed amendments may be touted by some as the death knell of COP sourcing, for these changes to take effect, they will still need to be adopted individually by legislatures in Compact member states or in any other states that may choose to adopt them.  As we have seen over the last several years, many states have already forged their own paths in this area.  (See our article discussing the wide variety of market-based sourcing rules.)  Moreover, while many states have enacted market-based sourcing provisions with respect to the sale of services, certain states, unlike the MTC proposed amendments, have declined to convert to market-based sourcing for intangibles (e.g., Pennsylvania).

The proposed amendments leave taxpayers with many unanswered questions.  For example, assume a corporate taxpayer (Corporation A) is in the business of offering a payroll processing service.  Corporation A provides this service to Corporation B.  Corporation B’s management of the contractual arrangement with Corporation A occurs in Massachusetts, which is also the location of Corporation B’s human resources function.  Corporation B has 10,000 employees, 2,000 of whom are located in a jurisdiction that has adopted the MTC’s market-based sourcing recommendation (State X).  What portion of Corporation A’s receipts from the performance of its payroll processing service for Corporation B should be sourced to State X?

One can reasonably argue that the service is delivered to Corporation B as a corporation (i.e., that the human resources function is the true beneficiary) and not individually to Corporation B’s employees—leaving State X with nothing.  However, does the MTC’s language “if and to the extent the service is delivered” create an opportunity for State X to argue that it should receive 1/5 (2,000 employees/10,000 employees) of Corporation A’s receipts?

In late August, the MTC launched a project to [...]

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Pennsylvania Issues Draft Guidance on Market-Based Sourcing of Services

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 [...]

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