Companies that need to allocate their income or loss among the various states they do business in, whether they perform services or sell or license intangibles, have a major challenge: how to allocate to different states with vastly different rules.
The common solution is for companies to apportion their income or loss where they have a nexus, otherwise known as a taxable presence. The idea is to allocate income or loss based on taxable activities in each state. Measures used are usually based on physical presence, economic presence, or both. The two methods available are—
- the cost of performance (COP) method, or
- the market-based (MB) method.
Under the COP method, sales are sourced to the state where actual work is performed. In the MB method, sales are sourced to the state where the customer receives the benefit. The idea of MB is to collect more tax from out-of-state companies with significant economic activity but little in the way of actual payroll or property in the state. States are split, but they appear to be increasingly moving toward using MB. The Exhibit shows which states currently use each method.
States Using Market-based Sourcing vs. Cost of Performance (as of January 1, 2017)
Another issue is that companies have little published guidance for applying COP to the revenue they generate, which makes COP difficult to apply in real-world situations. Some states that use COP might incorporate the MB approach in actual allocation. The lack of uniformity among states could also result in overapportionment. Depending on the combination of states in which a taxpayer conducts business, income derived could be possibly sourced in multiple states or no state at all.
Suppose that Company A performs services in Montana, but the economic benefit lies in North Dakota; the result is no allocation of tax. North Dakota is a COP state, and no services were performed there, so there is no income to allocate. Montana is an MB state, but since the economic benefit was not in an MB state, there is no income allocated to Montana. This concept is called “nowhere income.”
In instances where the application of either method results in nowhere income, some states have created either a throwback or throw-out rule. Both the throwback and throw-out rule require that 100% of the income be thrown back into a state where it will be taxed, even if it was not earned in that state. For example, if a company is located in California and performs services in Utah (an MB state) where the true economic benefit is in South Carolina (a COP state), California’s throwback rule means that all the income would be taxable in California. The difference between the throwback and throw-out rule is in how the nowhere income is treated. In both situations, the state is using a fraction: the amount of sales associated with the state over total sales. With the throwback rule, nowhere income is placed in the numerator (the amount allocated to the state); with the throw-out rule, it is removed from the denominator (the amount of total sales). Both of these situations increase in-state tax liability, though throwback rules are more aggressive than throw-out rules.
If the services in the above example were performed in North Dakota, but the economic benefit was in Montana, the opposite effect would result, and the income would be taxed in North Dakota (since the services were performed there) and in Montana (since the economic benefit was there). This double taxation would have no notable relief, as the concept of credit for taxes paid to other jurisdictions is only applicable to personal income tax. This issue will continue to exist until all states move to some sort of market-based sourcing method. Owners of flow-through entities, however, can claim credit for taxes paid to other jurisdictions on their personal returns relating to the state they claim residence in.
With all the differences between the various states, it is more important than ever for companies to improve and develop their accounting and billing systems to property track the relevant data and manage state tax risk.