By Jennifer W. Karpchuk, JD
Over the past year, a number of cost-of-performance (COP) and market-based-sourcing court cases (MBS) have made headlines across the country. While most states have moved to MBS, some still maintain COP. A recent trend being embraced by some states is to interpret COP statutes so that they lead to an MBS result. Such approaches have been met with varying degrees of success in the courts.
In Sirius XM Radio Inc. v. Hegar, the Texas Supreme Court sided with the taxpayer who argued that the state of Texas statute required receipts sourcing based on COP, which bases income from the location of performed services. In support of its position that the sourcing of its receipts predominately is outside of Texas, Sirius argued that its headquarters, transmission equipment, and 70% of the radio programming were located outside Texas. Thus, Sirius claimed, its satellite programming services are performed almost entirely outside of Texas. In the comptroller’s view, the taxpayer provided the service of “unscrambling a radio signal,” not the production of satellite programming, and that service occurred “at the radio receiver” (i.e., the customer’s location). Ultimately, the Texas Supreme Court found that the Texas statute at issue adopted an origin-based test, so it rejected the receipt-producing, end-product act test proffered by the appellate court.
Florida maintains “standard” COP language: a receipt is sourced to Florida if the income-producing activity is performed wholly within Florida or the income-producing activity is performed inside and outside Florida but a greater proportion is performed in Florida, based on COP.1 In Target Enterprise Inc. v. Department of Revenue, the Florida Department of Revenue attempted to source certain receipts to its state, even though the taxpayer had no property in Florida and less than 1% of its payroll there. The DOR claimed that the taxpayer failed to provide sufficient documentation to support the use of the COP method, therefore, it argued, the DOR was permitted to use its equitable authority to construct a new method for the sales factor. The court sided with the taxpayer, finding that the COP method should be used. Since the greater proportion of the payroll costs to perform the taxpayer’s services was performed outside Florida, none of the service revenue was apportioned to Florida. Further, the court found that the DOR could not create its own method under its equitable authority because the taxpayer had provided sufficient documentation to support its COP receipts-sourcing method.
The Pennsylvania Supreme Court took a different read of what many viewed as “standard” COP language in the state’s statutes. Effective for tax years beginning in 2014, Pennsylvania adopted MBS for service receipts, or sourcing based on the location of the customers receiving the services. It left unaltered COP sourcing for the sale of intangibles. Prior to the statutory change, the state’s Department of Revenue had begun asserting that the language of the pre-2014 statute was meant to lead to an MBS result. In siding with the DOR, the Pennsylvania Supreme Court explained that it did “not view the 2013 amendments as an attempt to alter the general framework for sourcing sales, but rather as an attempt to clarify the sourcing of sales of services to the point of delivery to the customer.”2
While there has been a focus on COP cases throughout the country, MBS-sourcing states have not been spared litigation and controversy. Recent areas of contention involve attempts to look through to the ultimate customer, difficulties in identifying the customer, and arguments over who the customer is.3
Additional issues exist in determining where certain intellectual property should be sourced. A recent case in Ohio addressed that issue. In NASCAR Holdings Inc. v. McClain, the department of revenue attempted to source revenue from NASCAR’s licensing of intellectual property to Ohio. In finding for the taxpayer, the Ohio Supreme Court explained that the taxpayer’s revenue streams were not based on the right to use NASCAR’s intellectual property in Ohio since none of the licensing contracts tied payments to the right to use property in Ohio or even referred to Ohio. Thus, the court found that receipts from the right to use intellectual property could only be sourced to Ohio if the receipts were tied to a specific right to use the intellectual property in Ohio.
Some of these cases provided closure on receipts sourcing in their respective states, while others have raised further questions. Additional litigation down the road is anticipated. The sourcing of services and intangibles under MBS provisions is likely to lead to continued litigation under unique fact patterns as states attempt to claim revenue they perceive as generated in their states.
1 Fla. Stat. Ann. Section 220.15 (1).
2 Synthes v. Commonwealth of Pennsylvania, 11 MAP 2021 (Feb. 22, 2023).
3 See LendingTree LLC v. Dept. of Revenue, 460 P.3d 640 (Wash. App. 2020); Defender Security Co. v. McClain, 165 N.E.3d 1236 (Ohio 2020).
Jennifer W. Karpchuk, JD, is co-chair of the state and local tax (SALT) controversy and planning practice at Chamberlain Hrdlicka. She can be reached at firstname.lastname@example.org.
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