Apportionment of Service Revenue - An Overview
By Merrill Barter, Managing Director, Tax Practice
Many readers are familiar with the need for multistate businesses to apportion income between the states in which they do business. Arguably, the most straightforward of the rules relate to entities that deal with a tangible product, and the rules are based on the connection the product has to the various states (sales into a state, sales from a state, or product moving through or being stored in a state, etc.) However, the analysis is very different when the product is intangible, like the provision of a service (consulting, for instance). This article will provide an overview of the methods of apportioning service revenue for income tax purposes, and some of the issues that can be encountered.
Service revenue apportionment generally is calculated in one of three ways - using the “Costs of Performance” method (COP), based on the actual work done within the state, or using the “Market Based” approach (MB). These apportionment methods are typically used for all business entities – C corporations, S corporations and partnerships (LLCs).
Costs of Performance:
The COP method is an “all or nothing” means of apportioning service revenue; 100% of the revenue from an income producing activity (IPA) is sourced to the state in which a greater proportion of the “income producing activity” was performed than in any other state. This doesn’t mean the majority (> 50%) of the work was done in the state, it only means that more work was done there than was performed anywhere else. Under the COP method, service revenue is apportioned to the state if:
- the income-producing activity was performed entirely in the state; or
- the income-producing activity was performed both inside and outside the state, but a greater proportion of the income-producing activity is performed in the state based on costs of performance.
An income producing activity is a separate item of income that results from any transaction, procedure, or operation directly engaged in by a business resulting in a separately identifiable item of income, or an activity which creates an obligation for a customer to pay a specific amount to the business. The rendering of personal services by employees and use of tangible and intangible property in performing services are common examples of an IPA.
The costs of performance generally include the direct costs of providing a service (IPA) determined in a manner consistent with generally accepted accounting principles and in accordance with accepted conditions or practices in the trade or business of the person. These direct costs typically do not include payments to independent contractors (although there are exceptions).
Some questions that can arise when using the COP method are:
- What is the IPA? For example, if an architectural firm is hired to complete plans for a new building (a service), is the IPA the completion of the plans, or is each hour of work in developing the plans a separate IPA?
- If the business providing the service has multiple locations, and the work for a specific client is performed in multiple offices, how should the revenue be apportioned? Does the business have a process in place to track the work done and related revenue?
- What costs should be included in the COP calculation? Does the business have the ability to identify and track these costs?
For tax years beginning in 2013, of the 46 jurisdictions that impose a corporate income tax, 26 use the COP method to apportion service revenue, including Massachusetts (changing for 2014, see below), New Hampshire and Vermont.
Actual Work Performed:
Under this method, which is used by 8 jurisdictions for tax years beginning in 2013 including Connecticut, Rhode Island and New York, service revenue is apportioned to a state based on the actual work done in that state. A very simplistic example would be an accounting firm that has a client in New York completes a project that took 100 hours, with a total fee of $15,000 ($150/hour). If 30 hours of work was actually done in New York, then $4,500 of the revenue attributable to the project would be sourced to the State.
While this method sounds simple, some issues that can arise are similar to those faced under the COP method:
- If the business has multiple locations, and work for a client is done in more than one office, how is the revenue apportioned between the offices? Is it based on hours or some other metric? Does the business have the ability to track the work done and related revenue?
- What costs should be included when determining the work done? In New York, for example, the receipts from services performed by an independent contractor or agent on behalf of the business providing the service are included in the revenue sourced to the State.
There are 12 states that use this method for tax years beginning in 2013, including Maine. Generally, receipts from the performance of services are attributed to the state where the services are received – the customer’s location. Similar to the “Actual Work Performed” method, this would appear to be very straight forward – it sounds similar to the destination rule used for the sourcing of revenue from the sale of products. However, questions can arise, including:
- Where were the services actually received? For example, if a business consultant completes a project for a client that has multiple locations in states that use the market based (MB) approach and the implementation of the consultant’s recommendations impacts multiple locations, where should the revenue be sourced?
- What if the state where the services are received is not readily determinable? For example, the billing address for the client may be in Maine, but the benefits of the services performed may accrue to other business locations of the customer.
- Does the type of customer impact the apportionment method used? In Maine for example, services performed for the U.S. Government are sourced based on the COP method – so if the work is done primarily in Maine, then the revenue is sourced to Maine (even if the Government location receiving the benefits of the services is in another state).
The states’ use of differing methods for apportioning service revenue can lead to unexpected – and often unfavorable – tax results.
- Service Company (SC) is located in New Hampshire (COP state) and performs a project for a client located in Maine (MB state). SC does not have a filing requirement in Maine, and 100% of the work is done in New Hampshire. All of the revenue is apportioned to New Hampshire.
- Assume the same facts as #1, except that SC has a business presence and therefore a filing requirement in Maine. Now, 100% of the revenue is apportioned to both Maine and New Hampshire, because the benefits of the services were received in Maine, but all of the work was done in New Hampshire. This is a terrible tax result, as the income related to the project will be double-taxed.
- Assume that SC has locations in New Hampshire and Connecticut from which its employees complete a project for a client located in Maine. SC has a filing requirement in all 3 states. If 60% of the work is done in New Hampshire (based on the costs of performance), and 40% of the work is done in Connecticut, the tax result would be even worse than in example #2. Under the COP method, 100% of the revenue would be sourced to New Hampshire; under the MB method, 100% of the revenue would also be sourced to Maine (where the benefits are received); and under the “actual work performed” method, 40% of the revenue would be sourced to Connecticut.
- SC is located in Maine and does a project for a client (non-government) located in New Hampshire. All of the work is done in Maine. The revenue from the project would not be sourced to Maine or New Hampshire – these would be “nowhere sales” – a favorable tax result.
Massachusetts – Special Considerations:
As mentioned above, Massachusetts uses the COP method for tax years beginning on or before December 31, 2013. For tax years beginning after December 31, 2013, Massachusetts is changing to the market based approach for sourcing service revenue (like Maine). This could be very important for businesses with customers in Massachusetts, which have not been required to apportion revenue to the State in the past. For example, service businesses located in New Hampshire that have done work for Massachusetts clients – with the majority of work being done in New Hampshire – would not have been required to apportion revenue to Massachusetts in the past. However, beginning in 2014, if the New Hampshire business has a filing requirement in Massachusetts, it will be required to apportion 100% of the revenue from its Massachusetts clients to the State. This could result in the income being double-taxed (see Example #2 above).
The sourcing rules related to service revenue can be complex, and can be impacted by the type of work being done, where it’s being done, the types of customers being served, and the locations of the customers. The rules are very different from those that are used to apportion sales of tangible products. The use of varying apportionment methods among the states increases this complexity. This article and the examples used are meant to provide a high-level overview of the sourcing rules and related considerations. Please contact Merrill Barter or your BNN tax advisor at 1-800-244-7444 for assistance applying these rules to your specific circumstances.
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