In many audits, the Department has been applying a market-based approach to sales-factor sourcing of receipts from services and intangibles. Many taxpayers have filed appeals because this approach is inconsistent with the current statute. In most cases, taxpayers have been able to resolve these appeals on a very favorable basis.

Pennsylvania’s apportionment statute follows UDITPA and requires that receipts from sales other than sales of tangible personal property be sourced to the state where the income-producing activity is performed; or, if the income-producing activity is performed in more than one state, the sale is sourced to the state where the greatest proportion of the income-producing activity occurs based on costs of performance.6 Nonetheless, the Department of Revenue’s audit policy has been to source certain sales of services and intangibles to the location where the customer receives the benefit (at least in situations where a significant portion of the "benefit" was received in Pennsylvania). The Department has been issuing assessments applying this market-based sourcing method.

Taxpayers have been challenging these assessments, arguing that the Department’s sourcing method is inconsistent with the statute, and, in most cases, taxpayers have been able to negotiate very favorable settlements. Still, the Department continues to issue assessments on this basis.

Takeaway: If your business receives an assessment sourcing receipts from services or intangibles on a market-basis, your first step in developing your appeal strategy should be to consider the settlements that the Department has been entering into with other similarly situated taxpayers. Reed Smith has been keeping track of these for many years, so we have a unique understanding of the fact patterns that have resulted in the most taxpayer-favorable settlements.

While the Department continues to issue ad hoc assessments sourcing receipts from certain services and intangibles on a market basis, the Department has also been involved in drafting legislation that would change the statutory rule to a market-based approach consistent with the Department’s audit policy. (See Legislative Update, below.)