Massachusetts Legislation Alters Income Tax Apportionment and Sales & Use Tax
Merrill Barter, Managing Director, Tax Practice
Late last month, the Massachusetts Legislature overrode Gov. Deval Patrick’s veto of the transportation bill. This bill included two significant tax law changes: It altered apportionment of service revenue, and made computer system design services taxable for sales and use tax purposes.Apportionment of Service Revenue:
Historically, when computing the sales factor for income tax apportionment, Massachusetts has used the “cost-of-performance” method. This method of apportioning service revenue looks to where the performance of the services occurred – the location that the “income producing activities” were completed.
Applicable for tax years after 2013, sales of services will be sourced to Massachusetts to the extent that the services are delivered to a location in the State. This method, called the “market based” method, is similar to the apportionment of tangible personal property, which typically is based on the location where the property is delivered (the destination).
The State also adopted a “throw-out” rule for sales other than sales of tangible personal property. Under the throw-out rule, service revenue from sales to customers in a state where the taxpayer is not taxable, or from sales where the location cannot be determined or reasonably approximated, are excluded from both the numerator and the denominator of the sales factor. The taxpayer has the burden of proving whether or not it is taxable in the other state – either subject to a tax based on net income or subject to the other state’s jurisdiction to impose a net income tax. The Department of Revenue has not yet defined “taxable in another state” for purposes of the throw-out rule.
The change to market-based sourcing of service revenue could have a significant impact on a business’ apportionment – both favorable and unfavorable.
Example 1 (Favorable):
A Massachusetts based service provider (taxpayer) generated consulting revenue from clients located in New Hampshire (all service revenue). The taxpayer’s activities in New Hampshire made it subject to New Hampshire’s Business Profits Tax, but all of the income producing activities related to the revenue were performed in Massachusetts. The revenue from the New Hampshire clients would be “nowhere revenue” - it would not be included in the sales factor numerator for either Massachusetts or New Hampshire. Under Massachusetts’ market-based apportionment method, the revenue would be sourced to New Hampshire because the recipient of the services is located there. However, New Hampshire uses a cost-of-performance method that apportions income to the state in which the costs of providing the service were incurred. In this example, if the taxpayer’s costs were incurred in Massachusetts (employee research, analysis, etc.), New Hampshire would deem this to be Massachusetts revenue. The revenue would be excluded from the numerator of both states, but included in the denominator, thereby lowering apportionment in both states.
Example 2 (Unfavorable):
Assume the locations in the above example are reversed: A New Hampshire based service provider generated consulting income from clients located in Massachusetts. The taxpayer’s activities in Massachusetts made it subject to Massachusetts’ income tax, but all of the income producing activities related to the revenue were performed in New Hampshire. The revenue from the Massachusetts clients would be included in the numerator and denominator of the sales factor in both states. New Hampshire would include it because the income producing activities were performed in that state. Massachusetts would include it because the services were “delivered” to customers in the state. The income from these customers would be “double-taxed.”
The change to the Massachusetts apportionment method presents important planning opportunities for service businesses doing business in the state.Sales and Use Tax – Computer System Design Services:
The transportation bill imposes sales and use tax on computer system design services and the modification, integration, enhancement, installation, or configuration of standardized software. This change is effective July 31, 2013.
Computer system design services includes the planning, consulting, or designing of computer systems that integrate computer hardware, software, or communication technologies and are provided by a vendor or a third party. Tax does not apply to data access, data processing, or information management services.
On July 25, the Massachusetts Department of Revenue issued Technical Information Release (TIR) 13-10 to provide initial guidance related to this law change. The TIR states that with regard to the imposition of sales/use tax on “modification, integration, enhancement, installation, or configuration of standardized software” (referred to as “software modification services,” the law is “generally intending to tax software services that modify, enable, or adapt prewritten software to meet the business or technical requirements of a particular purchaser. The tax will apply regardless of how those services are described or billed to the customer.
The TIR further indicated that services that are not directly related to the sale of computer hardware or software are not taxable. Two examples provided in the TIR are “(a) consulting and evaluation services with respect to existing computer systems to identify deficiencies and needs, and (b) services to prepare a business to use modified software, such as training.”
Importantly, the TIR provided a transition rule for existing contacts that may include the above services, which were not taxable at the time the contracts were entered into. For contracts entered into prior to July 31, payments invoiced, billed or due prior to this date are not taxable. Payments that are invoiced, billed or due after July 31 are taxable to the extent that the payment relates to services actually performed after this date.
This change to the sales and use tax laws could impact many businesses in the Commonwealth. Those entities who rely on computer service providers from outside the State will need to be especially diligent in reviewing contracts and invoices, as their vendors may not be aware of the law changes, or may not be required to collect the Massachusetts sales tax.
Please contact Merrill Barter if you have any questions regarding these recent changes.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.
IRS CIRCULAR 230 DISCLOSURE:
Pursuant to requirements imposed by the Internal Revenue Service, any tax advice contained in this communication (including any attachments) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any tax-related matter. Please contact us if you wish to have formal written advice on this matter.