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Myths and Considerations Regarding Market Based Sourcing


Not long ago, I was speaking with a representative at the Washington Department of Revenue about the state’s market based sourcing rules for the Business & Occupation Tax. During our discussion, I expressed my frustration at the difficulties of identifying where a customer “receives the benefit of a service” for purposes of sourcing receipts to the state. Much to my amazement, the Washington representative assured me that the reason for the switch to market based sourcing was to simplify the state’s sourcing rules. Where a service is performed, he suggested, is a much more difficult thing to determine than where the benefit of a service is received.

This is the myth that states are touting these days: market based sourcing is more easily administered and it levels the playing field between in-state and out-of-state businesses. A flood of states are jumping on the bandwagon. In the past week alone, the Tennessee and New Mexico legislatures have proposed market based sourcing bills. Last month, the District of Columbia announced that it will soon be publishing proposed market based sourcing regulations pursuant to legislation that switches DC to market based sourcing as of January 1, 2015, and Massachusetts adopted its market based sourcing regulations. The general consensus is that Massachusetts’s fairly lengthy rules will serve as the blueprint for states adopting market based sourcing prospectively. In fact, the Multistate Tax Commission (“MTC”), always one to follow the trend (and, incidentally, ignoring a hearing examiner’s suggestion to not abandon the income producing activity approach), will be presenting proposed regulations that will use the Massachusetts rules as a starting point. Add to this list New York, Nebraska, and Pennsylvania, each of which has implemented market based sourcing in the past two years. Moreover, proposals in Oregon and Kentucky indicate that these states will also be pursuing market based sourcing in the near future. Even states that have not adopted market based sourcing have imposed market based sourcing via capricious use of alternative apportionment.

The writing has been on the wall for some time that states would switch to market based sourcing of receipts from intangibles and services. Preceding this trend, of course, was the switch to a single or heavily weighted sales factor in the overwhelming majority of states over the past few years. That trend was also cited as important in order to level the playing field between in-state and out-of-state businesses. “Leveling the playing field” may make for good political sound bites, but the purpose of switching to single sales factor and market based sourcing has nothing to do with such leveling.

The switch to single sales factor apportionment and market based sourcing of receipts from intangibles and services is derived from one primary goal: to export states’ tax base. Under both of these approaches, the extent of a business’s activities in a state, the public services that business uses, and the possible externalities incurred by citizens of those states play no role in determining a business’s income tax liability. Far from leveling the playing field, both approaches subject companies that use virtually no public services in a state to the same tax consequences, or potentially more burdensome tax consequences, of those that house their entire operations with a state.

If market based sourcing were in fact easier to administer, the more nefarious intention to export a state’s tax base might be excusable. Unfortunately, except with respect to sales of tangible property, market based sourcing proves no easier, and in fact may be significantly more difficult, than sourcing the sales of services and intangibles to the location where the income producing activity occurs. Different states, for instance, apply different rules regarding where the market is located; some states point to where the benefit of a service is received, others point to where it is delivered, some point to where the service is received, and others point to where a service or intangible is used.

Consider the following example: John is an attorney working in Chicago representing a California based company regarding an intellectual property issue in Maryland. All of the work John does is from his office in Chicago, but entirely relates to the infringement of intellectual property in Maryland. Where is the market for this service? Washington State has gone so far as to suggest that the benefit of this service is received based on the manner in which John’s client earns its receipts from the intellectual property he is defending. Consequently, John may be required to look to his client’s apportionment of sales of that intellectual property in order to conclude, for Washington purposes, where the benefit of his service was received. Aside from being improbable logistically, this approach also results in John’s client’s unilateral activity subjecting his receipts to tax in a given jurisdiction, thus raising serious due process concerns. Where John performed the services, however, is clear.

Also consider the case in which services and intangibles are conveyed in digital form. States chafe at the notion that services conveyed digitally may not result in any contact even when the end customer’s billing address is in a particular state. However, many service providers house their software and databases on servers outside the state, which then routes through third parties, which then end up on a customer’s computer, phone, or tablet screen in potentially a multitude of states.

As a result of this complexity, states have defaulted to a “billing address” rule, regardless of statutory mandates to the contrary, in which the complex task of determining where the market for a particular service is received, used, delivered, etc., is set aside. To the extent states do not like the billing address information, they have indicated a willingness to set that aside as well and default to population based apportionment, the most egregious and arbitrary of last resorts.

As taxpayers adapt to the shift to market based sourcing, there are a number of important considerations to keep in mind. Principally, businesses should know how their services or intangibles are delivered, in as much technical detail as possible, to their customers. Taxpayers should also give serious consideration as to the manner in which they invoice and document sales. States may be applying these rules in order to inflate the tax liabilities of businesses with little presence in those states, and they may even apply these rules in a capricious manner, but taxpayers have more power than they realize to navigate market based sourcing schemes to their benefit.


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