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Corporate Tax Departments

Economic nexus & corporate income taxation: The evolving state landscape in the U.S.

Tom Corrie  Principal / Friedman LLP

Tom Corrie  Principal / Friedman LLP

Many states now require out-of-state companies to collect and remit sales taxes on in-state purchases, and more are invoking economic nexus standards in the corporate income tax area as well.

In South Dakota v. Wayfair, Inc., the U.S. Supreme Court ruled that states can levy taxes on sales even when the seller does not have a physical presence in the state. This overturned a previous ruling (Quill v. North Dakota) which required some form of in-state physical presence by an out-of-state company before that company could be subject to the sales- and use-tax nexus requirements of the state.

Following Wayfair, most states passed legislation requiring out-of-state companies to collect and remit sales taxes on in-state purchases — and now several states are invoking economic nexus standards in the corporate income tax area as well. At least six states — Hawaii, Washington, Oregon, Massachusetts, Texas, and Pennsylvania — have amended their corporate income tax regulations to reflect the level of economic activity companies have in their jurisdictions. For the most part, the new rules will go into effect for the 2020 tax year, and more states and municipalities are likely to follow suit.

Generally, state economic nexus statutes require a specific minimum amount of revenue linked to the particular state before nexus is established. For taxpayers, determining when a state’s revenue threshold has been met can be challenging when it comes to sourcing revenues that arise from the sale of services. Sourcing of such sales is a critical element in the determination of where a company is liable for filing income tax returns because it has established economic nexus.

And because an ever-increasing portion of our economy is generated through the provision of services, having a clear understanding of how services are sourced is mandatory in performing a nexus analysis.

State sourcing of revenue from services

Generally, states source revenue flowing from the sales of services based on one of three methodologies: i) cost of performance; ii) modified cost of performance; and iii) market-based sourcing.

Cost of performanceUnder a strict cost-of-performance approach, all revenue regarding the provision of services is sourced to the state where the services are performed. If the services are performed in multiple states, the revenue is sourced to the state where the greatest proportion of the income-producing activity is performed, based on cost of performance. Accordingly, under a strict cost-of-performance sourcing regime all revenue is sourced to one state.

Modified cost of performanceWhile states that follow a strict cost-of-performance format source all service income to one state, those that follow a modified cost-of-performance structure source it to more than one state if the services are performed in more than one state. Under this approach, the service revenue is divided among the states based on the percentage of total revenue arising with regard to the services performed in each respective state.

Market-based sourcing — Market-based sourcing approaches often vary from state to state, but the general premise is that revenue from services should be sourced to the state where the benefit of the services is received. Consequently, the state (or states) in which the services are performed is not the focus of a market-based sourcing framework; rather, the focal point is the state (or states) in which the benefit of the services is realized. In light of the growth of the online services market — in which out-of-state companies may provide services to their clients without ever having to come to the state — many states are moving to a market-based sourcing regime.

Revenue sourcing in the context of economic nexus

State economic nexus laws generally require a minimum amount of revenue to be generated before the nexus threshold is triggered, so having a clear understanding of how the sourcing of revenue can affect this equation is a necessary part of any nexus analysis.

For example, if Company A is performing $1 million worth of services at its home base in State Y for a client located in State X, a market-based state, the revenues generated would all be sourced to State X, even though the services were performed in State Y. Assuming State X has adopted economic nexus with a $250,000 revenue trigger, the amount of revenue to establish nexus would be exceeded and Company A would be required to file an income tax return in State X.

On the other hand, if State X sourced its revenue following a cost-of-performance methodology, all of the service revenue generated by Company A with respect to its client located in State X would be deemed to be sourced to State Y. Consequently, the minimum revenue nexus trigger amount would not be exceeded, and no return would need to be filed in State X.

The above example is, of course, simple in nature and does not contemplate the possibility of double taxation of the revenue if State Y follows a cost-of-performance methodology while State X’s sourcing rules are market-based. Nor does it consider the possibility of generating “no-where” income if the sourcing rules of the respective states were reversed. However, it does illustrate the importance of sourcing when coupled with the increasing number of states moving to an economic nexus platform.

Conclusion

As states continue to move forward in their march to market-based sourcing and economic nexus, it is becoming increasingly important to be aware of how the two methodologies relate to each other. Indeed, nexus analyses are becoming more and more complex as a result of the states’ legislation in these areas.

Taxpayers must be aware of the relevant issues when determining where income tax returns should be filed.

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