Background

Over the last several years, state legislatures have been searching for ways to increase their income tax revenue from business activity conducted within their borders. There has been a growing trend across the country to move away from a requirement that a taxpayer must have a physical presence within a taxing jurisdiction before the state is permitted to impose an income tax on the individual or entity conducting business activities. More specifically, many state courts have ruled that the physical presence required for purposes of sales and use taxes by the United States Supreme Court's decisions in National Bellas Hess, Incorporated v. Department of Revenue of the State of Illinois, 386 US 753, 87 S Ct 1389 (5/8/1967) and Quill Corporation v. North Dakota, 504 US 298, 112 S Ct 1904 (5/26/92) is not required for purposes of income taxation. Some examples of the state decisions departing from the physical presence requirement appeared as early as 1983 in Geoffrey, Inc. v. South Carolina Tax Commission, 313 S.C. 15 (1983), 437 S.E. 2d 13 which involved the use of intangible property in a state. Following the Quill decision, West Virginia¹ and New Jersey² issued decisions indicating that a physical presence was not required in those states for purposes of income taxation. The courts recognized that business activity had changed significantly and many business models no longer required that a particular business be located within a state for it to derive significant benefits from a state and its citizens. The concept of "economic presence" began to take hold in many states either through statutory modification, legislative action, or through case law.

Economic Presence Standard

The New Hampshire Legislature amended the definition of "business activity" in the Business Profits Tax ("BPT") during the 2007 Session of the General Court. The economic presence standard was introduced in the BPT by adding the following introductory sentence within the definition of "business activity."

"Business activity'' means a substantial economic presence evidenced by a purposeful direction of business toward the state examined in light of the frequency, quantity, and systematic nature of a business organization's economic contacts with the state. See RSA 77-A:1, XII.

New Hampshire is one of thirty-three (33) states that have adopted the economic presence doctrine to determine nexus for purposes of state income taxation. In the New England states, only Vermont has not adopted economic presence to determine its taxing jurisdiction. The BPT description of economic presence is consistent with the approach used by other states and the court decisions that have supported economic presence.

Tax practitioners must review clients' business activities as well as their own activities in all of the states for which they are currently doing any business in order to determine whether or not their business activities are considered sufficient to trigger the economic presence doctrine despite not having any physical presence either directly or indirectly through agents within the state. Failure to recognize the economic presence and not filing any required returns subjects the business to possible penalties and the statute of limitations never begins to run. Even under circumstances in which the activity may not rise to a sufficient level to trigger a significant tax liability, the minimal activity may result in the application of a minimum tax.

Once nexus has been established, an apportionment provision will be applied to determine how much of the business' income is deemed earned in the state and subject to the income tax. Practitioners have at times concluded that their clients or their own businesses had no nexus because the apportionment formula failed to produce income apportioned to a particular state. This approach is incorrect because the apportionment formula is not what triggers nexus in a state. The formula is only applied after nexus has been met. A taxpayer who does not have either property or personnel in a state other than the state of commercial domicile, for example, may have sales activity in another state. In this case, the payroll and property apportionment factors will have no numerator in the non-domicile state. The sales or receipts factor may or may not have any numerator in the case of sales of tangible personal property either because of P.L. 86-272 applying or a sales throw back to the states from where the product was shipped. Sales, other than the sales of tangible personal property, are generally located in the state where the income producing activity took place. Under the tax statutes of most states, this is determined based on where the cost of performance is the greatest. Under this theory, it is not uncommon for service revenue to be apportioned to the state where the taxpayer's commercial domicile is located. The conclusion by many taxpayers and their practitioners from this result is that no apportionment to a state means that there is no nexus to that state. This conclusion is wrong.

States were concluding that an all-or-nothing result created by the cost of performance approach when determining a situs for sales of services was not reaching the desired purpose of inserting a sales factor in the Uniform Division of Income for Tax Purposes Act ("UDITPA") model statute for apportionment, which most states followed. The sales component of the UDITPA apportionment factor is intended to reflect that providing a market to a business needed to be incorporated within apportionment as the payroll and property factors were intended to apportion income where the business had its "brick & mortar" presence — namely the location where the goods and services are manufactured or provided.

Revenue agencies and state legislatures analyzed the effect of a cost of performance methodology on sales of services as compared to sales of tangible personal property that was based on the destination of the merchandise shipped. States began modifying their sales factor essentially for sales other than the sales of tangible property. The market-based method seems to be more consistent with the approach for the sales of tangible personal property and it is more in line with the intent to reflect the market state's contribution to the viability of a business.

Market-Based Methodology For Sales Other Than the Sales of Tangible Personal Property

The sourcing of income from the sales of tangible personal property based on where such property is destined has not changed as part of the recent trend to a market-based sales factor. The old requirement has continued — P.L. 86-272 remains in effect and throwback provisions continue to be employed by states. Accordingly, as long as the taxpayer is selling tangible personal property, it is business as usual.

Although the market-based approach applies to the licensing or use of intangible property, the rental or lease of real property and other similar activities, the remainder of this article focuses on the sales of services which is where the changes have the most dramatic impact. The receipt of income from services is now determined based on where the customer is located or where the benefit of the service is received. The actual requirement for determining the location of the customer is generally spelled out in revenue agency regulations and vary from state to state, although there are some similarities, such as using the billing address of the customer.

The trend to market-based sales of services has grown steadily. Today, there are sixteen (16) states that have made the change. Three (3) of the New England States have made the change — Maine, Massachusetts and Rhode Island (starting in 2015). The other New England States have continued with the cost of performance approach.

As is the case when states are not uniform in their approach for apportionment, there are unintended results that occur. It is important to remember that all of the New England states, other than Vermont, no longer require a physical presence within the State to trigger their nexus standard. Economic presence (as New Hampshire states "…having a purposeful direction of business toward the state examined in light of the frequency, quantity, and systematic nature of a business organization's economic contacts with the state") is sufficient. The New Hampshire language is typical of what the other states examine to determine nexus under the economic presence doctrine but a review of each state's statute or regulations is advised. On the basis that economic nexus has been met in multiple states, the focus is now on where the practitioners apportion the sales income from services.

To illustrate the issues that occur from market-based apportionment in the case of income from professional services, consider a tax practitioner's practice located in Massachusetts (one of the market-based states) with clients in New Hampshire compared with a tax practitioner located in New Hampshire with clients in Massachusetts. The payroll and property apportionment factors in these examples will be included in the state where the practitioners' offices are located — no change from how the activity is currently apportioned.

Practitioner A has its sole office in New Hampshire but has 30% of the clients located in Massachusetts and 70% of the clients located in New Hampshire. All of the Massachusetts clients either come to the New Hampshire location to deliver their information or transmit the information electronically to the practitioner. Practitioner A prepares all of the returns in the New Hampshire location and either mails or electronically transmits the information to the clients in Massachusetts and sends a bill for services to the clients' home or business location. Practitioner A is subject to the Massachusetts tax statute because of the economic nexus standard.

Practitioner B has its sole office in Massachusetts and has 30% of the clients located in New Hampshire and 70% of the clients located in Massachusetts. All of the New Hampshire clients either come to the Massachusetts location to deliver their information to the practitioner or transmit the information electronically to the practitioner. Practitioner B prepares all of the returns in the Massachusetts location and either mails or electronically transmits the information to the client in New Hampshire and sends the bill for services to the clients' home or business location. Practitioner B is subject to the New Hampshire tax statute because of the economic nexus.

The New Hampshire tax return for Practitioner A will apportion all of the income of the New Hampshire and Massachusetts clients to New Hampshire because the BPT sales apportionment factor (RSA 77-A:3, I(c)) uses the cost of performance to determine where to apportion the sales. All of the costs are incurred in the New Hampshire office. Because economic nexus is met in Massachusetts, Massachusetts law requires that the receipts from the Massachusetts clients belong in the Massachusetts return's sales numerator because the service is delivered to a location in Massachusetts. The service is delivered in Massachusetts if the client is located in Massachusetts. (See Massachusetts Department of Revenue Proposed Regulation 830 CMR 63.38.1(9)(d)4d). There is no change to the assignment of the income even if the clients come to pick up their returns in New Hampshire. The result for Practitioner A is that the sales receipts are apportioned 100% to New Hampshire and essentially 30% to Massachusetts (assumes all the fees are equal for the services).

The New Hampshire tax return for Practitioner B will not include in the New Hampshire sales factor numerator any of the receipts from the Massachusetts or New Hampshire clients because using the provisions of RSA 77-A:3, I(c), the cost of performance is all within the Massachusetts office and none of the costs are in New Hampshire. The Massachusetts sales apportionment numerator would exclude all of the income from the New Hampshire clients because the service is not delivered to a client located in Massachusetts. The result for Practitioner B is that 70% of the income is included in the Massachusetts numerator and 0% is included in the New Hampshire numerator (assumes all the fees are equal for the services).

These same general concepts apply to many taxpayers who provide services to their customers rather than, or in combination with, the sale of tangible personal property. For these clients, it will be necessary to examine the tax statutes and regulations for the states in which they do business to determine whether economic or physical presence is the nexus standard and then review the sales apportionment factor requirements dealing with sales other than the sale of tangible property to see if the statute requires the use of cost of performance or market-based sourcing. Once the statutory requirements have been determined, the question becomes one of ascertaining as to how clients' records are maintained. Do the records provide the information necessary to prepare the sales apportionment analysis under both the cost of performance and the market-based methods until the states all get on the same page? Getting the necessary information to prepare the returns using both methodologies may be problematic for businesses in the first year as they may not be aware of the issue and did not change how they tracked sales information to provide what may be needed to prepare the return. Now may be the time to begin the necessary analysis with clients so there is no need for the additional effort in early March or April.

Practitioners and their clients may now find that they are required to file tax returns in more states than they previously did. If no returns get filed, then the Statute of Limitation never starts for those states and assessments are permitted. Any overpaid tax actually paid to the states where returns were filed may not be recoverable because state laws may not allow refunds after the expiration of the 3-year statute of limitations regardless of the circumstances — a costly result.

Practitioners and their clients may now find that they are required to file tax returns in more states than they previously did. If no returns get filed, then the Statute of Limitation never starts for those states and assessments are permitted. Any overpaid tax actually paid to the states where returns were filed may not be recoverable because state laws may not allow refunds after the expiration of the 3-year statute of limitations regardless of the circumstances — a costly result.

Devine Millimet's Tax Practice Group can assist you or your clients in reviewing the statutory and regulatory provisions dealing with both the economic presence doctrine and market-based apportionment. These areas of tax practice are now more complex and provide many pitfalls and planning opportunities.

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¹ State v. MBNA America Bank, 220 W.Va. 163 (2006), 640 S.E. 2d 226.
² Lanco,Inc. v. Director, Division of Taxation, 188 N.J. 380 (2006), 908 A2d 176.

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