On December 12, 2014, the Pennsylvania Department of Revenue (DOR) issued Information Notice Corporation Taxes 2014-1 (Notice). The Notice provides guidance for taxpayers in understanding Pennsylvania’s new market-based sourcing provisions, which apply to all tax years beginning on or after January 1, 2014. Under these provisions, the sales of services are no longer subject to the income-producing activity and cost of performance rules found in 72 P.S. § 7401(17).
The Notice provides three different rules for sourcing sales of services.1 Initially, all taxpayers should attempt to apply the first rule to the applicable sale of services. Taxpayers should only proceed beyond the first rule when it does not result in a "reasonably accurate apportionment." In that event, taxpayers should apply the second rule if dealing with sales of services to customers who are individuals and not sole proprietors. Taxpayers should apply the third rule when dealing with all other types of customers. In the event that the third rule cannot be applied accurately, taxpayers should revert back and apply the second rule to all other types of customers.
Under the general rule, receipts from the sale of a service are sourced based on the location where the service is delivered — a so-called "market-sourcing approach." Consequently, services delivered in Pennsylvania are included in the Pennsylvania sales factor. In the case of a service delivered to locations within and without Pennsylvania, the sale is sourced proportionately to Pennsylvania and the other locations based on the percentage of the total value of the service delivered to each location.
If the application of the general rule does not result in "reasonably accurate" apportionment, the second rule states that receipts from the sale of a service should be deemed to have been delivered at the customer’s billing address, provided the customer is an individual and not a sole proprietor. Essentially, when a taxpayer is unable to identify the exact location where services are delivered and cannot apply the general rule accurately, the taxpayer should source the receipts from the sale of a service based on the location of the customer’s billing address.
If the first two rules do not result in a reasonably accurate apportionment, the third rule states that taxpayers are required to source receipts from the sale of a service based on the location from which the services were ordered in the customer’s regular course of operations. In the event that the location from which the services were ordered in the customer’s regular course of operations cannot be determined, taxpayers are to revert back to the second rule, using the customer’s billing address.
Determining the Point of Delivery
In order to properly apply the three new rules, it is essential to understand the DOR’s definition of "location" and "delivery," because an incorrect assumption of what constitutes either term could result in a misapplication of the rule. The term "location" refers to the location of the customer. The term "delivery" refers to a location where (1) the customer is actually located and (2) the customer actually receives the services. If a service is delivered to a location where the customer is not located, then that location does not represent the final point of delivery. For example, the provision of a service by a provider to a third-party delivery agent does not constitute "delivery." Rather, delivery of this service occurs where the customer representative of the market for this service actually receives it from the third-party delivery agent.
To properly address the delivery location when services are delivered electronically, a taxpayer may use IP address records or other network data when individual street addresses of customers are unavailable. Network data should only be used if it corresponds reasonably well to locations where the data is delivered to actual customers. Under the application of the general rule, electronically delivered services will be considered to be delivered in Pennsylvania if the delivery occurs in a location in Pennsylvania where the customer is located. If the user of the services is both in Pennsylvania and other states, the services shall be sourced among the states in a reasonably proportionate manner. When trying to properly apportion the electronically delivered services, it is important to consider the usage of the service in each state, the number of recipients in each state and/or the value of the service consumed in each state.
Taxpayers who develop their own sourcing methodology should do so after careful consideration, as they must consistently apply the single selected method for all receipts in following years.
Industry Examples Applying the Notice’s New Rules
The Notice provides a variety of examples of the applicability of the new rules to sales of services. A personal or professional service is considered delivered in Pennsylvania if the service is both delivered in the state and is of the nature of a personal service that is typical conducted on a first-hand, direct basis (such as training, speaking engagements or consulting), even if the service is delivered remotely via electronic means. Services provided to a trade or business are considered to be delivered at the business location where the trade or business is located. In this capacity, "trade or business" may include administration, marketing, sales, manufacturing and any other operation that supports the trade or business itself.
When a taxpayer receives payment for separately stated charges for the use of intangible property, those receipts should still be sourced in accordance with 72 P.S. § 7401(17), and not in accordance with the new market-based sourcing provisions. The Notice reinforces the DOR’s position that intangible income will continue to be apportioned to Pennsylvania if the income-producing activity is performed in the state. The DOR interprets the term "performance" to occur when the performance is accomplished or fulfilled. Subsequently, the location where performance is fulfilled is the location of the income-producing activity. Additionally, income-producing activities will be identified at the transaction level, rather than the operational level, focusing on the location of the completed performance. This means that an activity that a customer would not normally pay for separately is not an income-producing activity. In instances where the income-producing activity of a single transaction is fulfilled or completed in more than one state, it may be necessary to apply the costs-of-performance method for assigning the sales activity to a particular state. In calculating those costs of performance in each state, taxpayers may include only costs related to the income-producing activities that are directly responsible for income generated in Pennsylvania.
Taxpayers should carefully review the Notice to determine the effect that market sourcing will have on their apportionment factor. It is likely that, overall, the change to market sourcing will result in reduced taxes from Pennsylvania-based businesses that had higher costs of performance in Pennsylvania. Likewise, it will result in increased taxes from businesses based outside of Pennsylvania whose costs of performance were greatest outside of the state, but that nonetheless delivered services to customers in Pennsylvania.