North Carolina Moves Towards Single Sales Factor and Market Sourcing
An earlier Tax Alert discussed the possibility that North Carolina would adopt the single sales factor method of apportioning the business income of multi-state corporations. During the current legislative session, single sales factor legislation has indeed been introduced in both the House (House Bill 117) and Senate (Senate Bill 526). Senate Bill 526 includes another provision that will be of interest to multi-state taxpayers: a proposal to replace North Carolina’s current method of sourcing receipts from services and intangibles with a market sourcing rule.
Single Sales Factor
As discussed in the earlier Tax Alert, North Carolina currently requires multi-state corporations to apportion their business income using a four-factor formula expressing the ratio of the corporation’s in-state property, payroll and sales to its total property, payroll and sales and giving double weight to the sales factor.
Senate Bill 526 would triple-weight the sales factor for 2016 and move to single sales factor apportionment beginning in 2017. House Bill 117 would move to single sales factor immediately next year. Although the fate of these bills remains uncertain, single sales factor appears to have significant support in both chambers.
Current Sourcing Rules
If North Carolina does adopt single sales factor apportionment, the rules for computing the sales factor, and in particular the rules for determining which sales go into the numerator of the fraction, will become the linchpin of the whole apportionment system.
Under current law, receipts are sourced to North Carolina, and thus included in the numerator of the sales fraction, using different rules depending on whether the receipts are derived from sales of tangible personal property, services or intangibles.
Sales of tangible personal property are sourced to North Carolina if they are sold to a resident of the state. Sales of services are sourced based on where the activities that produce the income take place (the “income-producing activities” or “percentage cost of performance” rule). Receipts from intangibles are sourced to North Carolina under administrative guidelines for specific types of intangibles, often based on the commercial domicile of the payor.
Senate Bill 526 would replace the existing rules for sourcing income from services and intangibles with a “market sourcing” approach. Specifically, service income would be sourced to North Carolina if the services were “delivered” in North Carolina, and income from intangibles would be sourced here if the intangibles were “used” in the State.
A change to market sourcing can have profound consequences. For instance, assume a New York architecture firm is hired to design a building in North Carolina. The firm performs all of the design work in New York and periodically sends staff here to oversee construction. Under current law, the firm would source a portion of its project revenues to North Carolina based on the relative value of the work done here. The firm likely would consider the lion’s share of its fee to be attributable to the design work performed in New York, and its sales factor would be relatively low. Under a market sourcing approach, the entire fee would be sourced to North Carolina if, as is likely, the design services were treated as having been delivered here.
Pros and Cons
Proponents of market sourcing argue that the purpose of the sales factor is to reflect the contribution of the market to the production of income. Market sourcing achieves this goal by sourcing sales to the location of the market, while the cost of performance approach counterintuitively sources sales based largely on the location of the taxpayer’s capital and labor.
Market sourcing also tends to favor multi-state taxpayers that have a major presence in the State and thus functions as an economic incentive tool. While market sourcing may benefit some taxpayers, many tax administrators also favor the approach because they believe they can collect more revenue from out-of-state taxpayers with in-state sales by coupling market sourcing with aggressive nexus enforcement.
Proponents also point out that market sourcing eliminates controversies about how much revenue to source to each place where the taxpayer performs income-producing activities.
Market sourcing has its own challenges. The principal issue is how to determine where a service is delivered or an intangible is used. While it might be easy to determine where in-person services for individual customers are delivered, it is not so easy to know where business services are delivered. For instance, if a management consulting firm provides services for a multi-state client, is that service delivered at the customer’s headquarters office or at each location where the customer has a presence? Similarly, is an intangible, such as a patent license, “used” where the licensee manufactures products using the patent or where the licensee sells the products to its own customers?
Transition and Implementation
Moving to market sourcing raises a number of difficult implementation issues. Legislators must first decide whether to draft a series of detailed rules for specific industries or one set of general rules for all taxpayers, leaving the Department of Revenue to flesh out their specific application. The challenge of developing detailed guidance, at either the legislative or administrative level, should not be underestimated (the Massachusetts regulation on market sourcing runs to 74 pages) and will take time. The legislation’s effective date and any legislative charge to the Department of Revenue regarding administrative guidance will be crucial.
Many states that have adopted general rules for all or most taxpayers use a “cascading” or “waterfall” approach. For instance, the statute might include a first-tier rule that sources sales based on where a service is delivered or where the customer receives the benefit of the service. If this cannot be determined, one or more subsidiary rules would permit the taxpayer to source the sale based on the customer’s commercial domicile or billing address or using rules of “reasonable approximation.”
These subsidiary rules are very important because in many cases the taxpayer will not have enough information to apply the first-tier rule. It is also important to know how much due diligence about the customer’s business the taxpayer must undertake before it can apply the subsidiary rules. If the statute includes a bottom-tier rule of “reasonable approximation,” standards will have to be developed to give meaning to that concept.
Taxpayers should begin now to study how a move to market sourcing will affect their North Carolina tax liability.