New California Revenue Sourcing Rules-The Tax Impact On Professional Services Firms
Professional services firms, including law firms, talent agencies, insurance brokers and consulting firms (“service firms” or “taxpayers”), with a taxable presence in multiple states including California, will most likely be significantly impacted by the revenue sourcing and state apportionment rules put in place by California Proposition 39. The old cost of performance rules required that service revenues be sourced to the state where the work was being performed. The new market-based sourcing rules require that the service revenue be sourced to the state where the benefit of the services is received. For example, in the case of an attorney based in Los Angeles performing services in California for a client located in New York, the old rules would require that revenue be sourced to California. Application of the new rules most likely would require revenue to be sourced to New York.
In addition to the change from the cost of performance rules to the market-based sourcing rules, California also changed the formula used to determine the amount of taxable income apportioned to the state. The old formula used three factors, including sales, property and payroll, whereas the new formula considers only the sales factor. As a result, the allocation of taxable income among the various states in which the service firm files tax returns will be greatly impacted. This, in turn, impacts the state tax payments required at the individual partner level for firms that are taxed as partnerships.
During the period from January 1, 2011 to December 31, 2012, for purposes of determining taxable income in California, most multi-state businesses could elect to apportion income using the single-sales factor or the three-factor apportionment formula, which includes a double-weighted sales factor. Proposition 39, approved by California voters on November 6, 2012, now requires multi-state businesses, including partnerships, to use single-sales factor apportionment for tax years beginning after January 1, 2013. For service firms, the sales factor assignment must be applied using the new market-based rules.
Under the market-based sourcing rules, the taxpayer generally assigns service revenue to California if the taxpayer’s client received the benefit of the taxpayer’s services in California. Unfortunately, the determination of where the benefit of the services was received can, at times, be confusing and subjective. California has issued guidance, including a cascading method or series of steps, for how to determine where service revenue should be sourced. The application of these rules can still be quite complex and involve judgment. Furthermore, the data gathering required to support the market-based allocation can create a tremendous documentation burden for the firm’s internal accounting personnel, unless a practical approach is adopted that can also survive the scrutiny of the California tax authorities. In the case of the sale of intangibles, receipts are sourced to California to the extent the intangibles were used in California. California’s transition to a market-based sourcing approach follows the trend among other states in recent years to move away from a cost of performance methodology.
Sourcing of Receipts from Individual Clients
In the case of individual clients, California determines the location of the benefit of service based on the following order of hierarchy:
- The presumption is the benefit of services is received at the location of client’s billing address;
- The billing address presumption may be overcome if the taxpayer can demonstrate based on the preponderance of evidence that the contract terms or taxpayer’s books and records indicate where the benefit of the services were actually received;
- If the billing address presumption is overcome, but the location of the benefit of the service cannot be determined by reference to the contract or the taxpayer’s books and records, location of the benefit of the services is received may be reasonably approximated.
For example, if an individual client residing in California contracts a service provider to perform consulting services for the purchase of real estate located in Nevada and requires the service provider to send the invoice from California, it is presumed that the services were received in California. However, the presumption can be overcome through the contract terms indicating that the nature of the consulting services involves the purchase of real estate located in Nevada. Accordingly, the benefit of the consulting services is considered received in Nevada, rather than California.
Sourcing of Receipts from Business Clients
In the case of a corporation or another business entity, California determines the location of the benefit of service based on the following order of hierarchy:
- The presumption is the benefit of the service is received at the location indicated in the contract terms or taxpayer’s books and records;
- If the contract is silent on location or presumption is overcome, location of where the benefit is received may be reasonably approximated;
- If the location cannot be reasonably approximated, location of where customer placed the order is used;
- If the location of where customer placed the order cannot be determined, the customer’s billing address is used.
- Note that service revenues that are not sourced to California may or may not have to be sourced to other states. Since there is little conformity in the manner in which various states source revenue, an analysis is required, using each state’s rules, to determine what service revenue is sourced to the state. There may be situations where revenues sourced to California are also sourced to the state where services were performed. This occurs if the state in which the services were performed uses cost of performance for apportionment purposes, and the benefit of the services were received, or presumed to be received, by a client in California. It is also possible to have a situation where sales are not sourced to any state. For example, if services are provided by a California law firm for a business entity client located in a state that uses cost of performance for apportionment purposes, the revenue would not be sourced to California as the benefit of those services was not received in California. The revenues would also not be sourced to the business entity’s state since the services were not performed in that state.
- The trend towards more states adopting the single-sales factor and market-based sourcing methodology will create more complexity and uncertainty for professional service firms. In most cases, this will increase the internal administrative burden of gathering the necessary data for tax return preparation. It is no secret that revenue hungry states are aggressive in pursuing tax revenue from profitable service firms. Therefore, it is critical that service firms monitor activities that might create a taxable presence (“nexus”) in a state during the year, and maintain proper documentation supporting how the service revenue is being apportioned among the various states. An audit by a state tax authority resulting in a determination that either a state tax return should have been filed, or a different apportionment percentage should have been reflected on the return, can potentially result in additional tax, interest, and penalties at both the partnership level and at the individual partner level, for each partner within the firm.
- The change in apportionment methodology may also provide an opportunity for significant tax savings if proper tax planning and analysis are implemented on a proactive basis. In the case of a partnership, the partners who are residents of a lower tax state would greatly benefit from seeing a reduction in the overall firm apportionment to a high-tax state like California.
- Professional services firms with activities in multiple states should consult their tax advisors as soon as possible to determine how the mandatory use of single-sales factor formula and market-based sourcing rules will impact them for the 2013 tax year and going forward. Internal accounting departments must be informed of the new rules, and work with tax advisors to adopt a practical approach to gathering and documenting apportionment data that are acceptable to state taxing authorities.