There has been significant controversy in New York regarding whether receipts from services—particularly those that may be delivered via the Internet—constitute “service” receipts or “other business receipts” for corporate franchise tax apportionment purposes. The distinction between “service” receipts and “other business receipts” is crucial because prior to 2015, New York Tax Law generally required sourcing for “service” receipts based on the location of performance, and market sourcing for “other business receipts.”

On February 5, 2015, the New York State Division of Tax Appeals, Administrative Law Judge (“ALJ”) upheld the taxpayer’s position that travel reservation facilitation receipts and online advertising receipts constitute “service” receipts—not “other business receipts”—and thus are sourced to where the services were performed.In the Matter of the Petition of Expedia, Inc., DTA Nos. 825025 & 825026 (N.Y. Div. Tax. App. Feb. 5, 2015) (the “Determination”). In Expedia, the taxpayer successfully demonstrated that the services were performed at its headquarters, data centers, and customer service call centers—not the location of its customers’ modems. Sutherland represented Expedia in the matter.

“Service” Receipt or “Other Business Receipt”

The ALJ first addressed whether travel reservation facilitation receipts constituted “service” receipts or “other business receipts.” The ALJ looked to the plain meaning of the word “service” and concluded, “[c]learly, petitioner’s [activities were] the performance of a service as contemplated by the use of that word in the statute.”

Importantly, the ALJ rejected as “an impermissible expansion of the Tax Law” the Department’s argument that a “service” requires “human involvement” at the moment the transaction is consummated. The ALJ determined that the Department’s own regulation does not support the “human involvement” requirement. The ALJ further determined that, even if the Department’s “human involvement” requirement was a permissible interpretation of the Tax Law, the taxpayer satisfied the requirement because there was human involvement throughout the provision of the taxpayer’s service—personnel developed software and maintained websites, negotiated with travel service providers, compiled information, and provided customer service via the Internet and telephone.

Sutherland Observation: The Department has asserted the “human involvement” requirement by citing its regulation—a requirement that many taxpayers and practitioners believed did not exist.1 This Determination firmly rejects the Department’s position.

The ALJ also addressed whether online advertising receipts constituted “service” receipts or “other business receipts.” The Department asserted that advertising is not naturally a “service” because New York Tax Law provides that taxpayers engaged in publishing advertising receipts “shall be deemed to arise from services.” The ALJ rejected the Department’s argument, and determined that the taxpayer’s advertising activity “clearly was a service performed for its advertising clientele and consisted of much more than just the instantaneous viewing by one of [the taxpayer’s] purchasing customers.” Further, the Determination stated that, “as petitioners correctly note, the phrase emphasized by the [Department] is not used as a mechanism to deem the newspaper and periodical advertising as ‘services’ under Tax Law § 210 to the exclusion of all other advertising….” Therefore, the ALJ reinforced the general rule that advertising is a service.

Service Receipt Sourcing

The ALJ determined that service receipts must be sourced to the location of the “activities performed in connection with” the transactions. The ALJ applied a costs-of-performance approach, confirming that “the location of the activities performed that give rise to income in connection with the transaction is determinative.” The ALJ rejected the Department’s asserted sourcing method based on the location of each customer’s computer, because these transactions “consisted of much more than a simple, instantaneous, fully automated transaction only taking place when a customer clicked on his or her computer.”

Because the taxpayer’s online advertising activities were a service, the ALJ determined that the “receipts must be allocated to the location where the work that generated the income was performed.” Therefore, online advertising receipts should be sourced (for non-publishers) to the location where the advertising services are performed; not to the customer’s location.

Sutherland Observation: The ALJ also determined that New York tax reform’s shift to a market sourcing regime was a material change in existing law. Therefore, this Determination reinforces that New York provides, as a general rule, costs of performance sourcing for services prior to 2015 Tax Reform.

Burden of Proof

The ALJ also determined that the taxpayer satisfied its burden of proof by providing affidavits from employees, as opposed to having those employees testify in person at the hearing. The ALJ rejected the Department’s argument that affidavits are not sufficient evidence, finding that neither the Department nor the documents in the record materially contradicted the affidavits.

Sutherland Observation: This Determination is a significant taxpayer victory. The Determination reinforces that the Department cannot assert positions without proper statutory support. And the ALJ’s substantive conclusions are especially helpful for taxpayers involved in the digital economy.