The division of income for state corporate income tax purposes is an important consideration for businesses operating in multiple US states, including Canadian businesses expanding into the US. For more information on the corporate income tax considerations for Canadian companies expanding into the US, we recommend reviewing our post on this topic, available here.
A growing trend of recent years in state corporate income taxes has been the adoption of market-based rules for sourcing sales of services in lieu of the traditional cost-of-performance rules. Market-based state corporate income tax sourcing determines where a corporation should pay its income tax based on its sales location. It has replaced cost of performance (COP)-based receipts sourcing in many states. While COP-based sourcing relies on the location of service performance, market-based sourcing considers where customers benefit from the services. However, using both methods among states can lead to double taxation.
Under COP-based sourcing, service-related receipts are allocated to states based on where the taxpayer incurs service expenses. This method is straightforward as it relies on cost location. On the other hand, determining the customer’s benefit location for market-based sourcing is more complex than identifying the cost of performance.
For instance, let’s consider a consulting business in Florida that operates solely in the state but has a client with locations in California. Florida follows COP-based sourcing, while California follows market-based sourcing. Due to the different rules, the business’s revenue could be sourced to both Florida and California, resulting in double taxation.
Determining the customer’s benefit location for market-based sourcing is challenging. Factors such as retail chains with stores in multiple states and online sales to customers nationwide further complicate the assessment. This ambiguity presents both challenges and opportunities for minimizing state income taxes through careful planning.
Many states using market-based sourcing employ a single-factor sales apportionment or division method instead of the traditional three-factor approach. Single sales factor apportionment allocates taxable income to a state based on the percentage of sales occurring within that state. This method allows taxpayers to potentially pay no tax on a portion of their service revenue in states that use it. A three-factor approach allocates taxable income to a state based on a combination of sales occurring in the state, property located in the state, and payroll in the state.
To illustrate the single-factor sales apportionment method, if the consulting business mentioned earlier had offices in California instead of Florida and the client was located solely in Florida, the revenue from services provided in Florida would not be allocated to either state. This is because California follows market-based sourcing, while Florida follows COP-based sourcing.
However, reversing the locations of the consulting business and the client in the example would result in double taxation. In this case, both Florida and California would allocate revenue to their respective states, subjecting the same income to tax in both places.
Some states have “throwout” or “throwback” rules to mitigate the impact of revenue not being subject to tax in any state. These rules either exclude certain receipts from the apportionment factor or require the inclusion of receipts that are not taxed in another state. It’s important to consult a qualified tax advisor to understand these rules in detail and apply them correctly.
The mixed-use of market-based sourcing and COP-based receipts sourcing methods increases the risk of both unallocated receipts and double taxation. Taxpayers should review their operations, identify potential risks of double taxation, and maximize the opportunity for sales not subject to state taxes. They should also ensure their tax planning and compliance methods accurately allocate income to states, considering that the benefit of a service may not align with the client’s location under market-based sourcing.
For further guidance on how market-based sourcing may affect your business’s sales to US customers, it is recommended to consult with your tax advisor or reach out to RLB’s US Tax Team.
