Apportioning income across the states where one does business is one of the most complicated areas of state and local tax law.
That is especially true, given that states continue to change their apportionment rules and the guidance on those rules — it takes a deep, well-resourced tax bench to keep up with the ever-evolving state and local tax landscape. However, amid that constant evolution, it’s possible to turn complex state tax concepts into tax planning strategies by leveraging state apportionment rules, such as those involving the sales factor.
Location Matters
Over the past 20 years, almost all states have moved from a three-factor apportionment formula to a single-sales formula. Consistent with that change, states have shifted from sourcing sales of services and intangibles using a cost-of-performance approach to a market-based approach. The market-based approach sources revenue from the sales of services or intangibles based on the location of a company’s market for its sales, focusing on characteristics of the customer. The characteristics that are used vary depending on the statutory language adopted by each state.
For example, a state may determine the taxpayer’s market based on where the benefit of the service is received; where the service is delivered or used; or the location of the office of the customer that entered the contract. Although all those approaches are generally meant to reflect the market for the taxpayer’s services, states could interpret them differently, resulting in disparate answers. To add to the complexity, some states have rules based on the type of service involved (e.g., in-person services, professional services, and services delivered by electronic means), and some even have industry-specific rules that apply in lieu of their regular regimes (e.g., for financial, transportation, and broadcasting services).
Moreover, numerous states have cascading rules specifying that if a taxpayer is unable to determine location under the first sourcing rule, it must move to the next rule; again, each of those rules could result in a different answer. On top of that, some states may even require the use of an alternative sourcing method (such as a reasonable approximation method) if the location cannot be accurately determined.
Although some states have provided guidance, ambiguities still exist on how to interpret it, which can lead to multiple interpretations of the same language. For example, states that require a reasonable approximation method, could consider more than one method reasonable and appropriate under the company’s facts.
Importantly, the facts surrounding a taxpayer’s specific revenue stream can change the regime that applies and the resulting sourcing answer. For example, installation services performed in person might not be sourced the same as services performed electronically (such as access to a database providing market information). Even in the latter scenario, one jurisdiction may decide that those receipts should be sourced based on, for example, where the customer’s employees access the database or where the customer makes use of the market information.
Bottom line: Applying the sales factor sourcing rules can be convoluted.
Why an Apportionment Study?
That’s where an apportionment study comes in. A proper analysis could uncover potential state tax exposures and savings opportunities.
While market-based sourcing may appear straightforward at first glance — for instance, as simple as locating the customer’s billing address — it often involves a deeper analysis to properly reflect the income taxable by states. The regimes are not uniform, and even states that use similar language might interpret that language differently. Without drilling down on the details, opportunities might be missed. Taxpayers may find they are overreporting in some states and underreporting in others.
Examining a company’s facts is imperative to determining the state rules that should apply and where tax planning opportunities may exist. Considerations such as the company’s business activities, revenue streams, industry, and overall structure (such as whether the company is a C corporation or pass-through entity), will help choose the path to pursue.
Many states also allow a company to request that the state tax agency use an alternative apportionment method if standard apportionment does not fairly reflect the company’s activities in the state. That option could result in a more favorable apportionment method. However, the procedures for making such requests vary, and failure to properly follow the process can result in their denial.
That’s not the last piece of the apportionment puzzle. Just because states offer alternative sourcing options doesn’t mean they will automatically accept their use. States have the authority to examine a company’s state tax returns, and a company’s sales factor sourcing methodologies are typically reviewed. Documentation is therefore a critical piece to properly position a company for any unforeseen audits.
Case Study
A company provided security escorts for people in transit at the direction of an agency. Upon review, BDO noted that the company had a significant Texas franchise tax liability and one of the company’s largest contracts was with an agency based in Texas. Even though the services were being rendered nationwide, the revenue from the contract was sourced wholly to Texas. The company indicated that transport could start and end in Texas, but was not always entirely in Texas.
The company engaged BDO to delve into its data to develop a methodology to source the revenue by identifying transit time in- and out-of-state. As part of that process, BDO tried to determine what kind of data would support where the services were being performed and devised a methodology that analyzed the airplane routes to track transportation hours in Texas versus outside of Texas.
The Texas Comptroller’s Office accepted the methodology developed by BDO and allowed BDO to file Texas refund claims on the company’s behalf, resulting in millions of dollars of refunds and prospective annual savings for the company.
BDO also analyzed how the sales factor was affected in the other states where the company did business, reducing risk of exposure for underpayment of taxes in those states.
How BDO Can Help
Our national network of State Income Tax professionals has the technical and industry experience to assist clients with apportionment reviews that evaluate and properly apply state rules to their various revenue streams, as well as consider whether more taxpayer-favorable positions could be taken based on the company’s facts. That may include reviewing state tax returns from prior years if the statute of limitations remains open and filing refund claims with state tax agencies. We also assist in filing requests with state tax agencies to secure more favorable apportionment methodologies. Moreover, our professionals help clients properly document their apportionment positions through matrices, memoranda, and audit defense binders and represent them in examinations with state tax agencies.
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