What s News in Tax Analysis That Matters from Washington National Tax

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1 What s News in Tax Analysis That Matters from Washington National Tax Let s Get Personal About Sourcing Sales of Personal Services Out-of-state service providers should be familiar with how states source their income. This article discusses a potentially overlooked rule that sources income from the sale of personal services, focusing on how the rule applies given the disparity between several states as to the seemingly basic question: What is a personal service? Monday, September 29, 2014 by Andrew Grace and Scott Salmon, Washington National Tax Andrew Grace is a senior associate and Scott Salmon is a partner with the State and Local Tax group of WNT. In the state corporate income tax context, many states have responded to the shift to a more service-based economy by increasing the weight of the sales factor in their apportionment methodologies, with a number of states relying solely on the sales factor in apportioning income to their jurisdictions. 1 Along with this shift, a number of states have moved to a market sourcing methodology by sourcing receipts or sales to the location of the seller s market. Enactment of a single sales factor formula paired with the move to market-based sourcing rules have resulted in an exporting of the tax burden. States have effectively reduced tax on instate companies, while increasing the relative tax burden on out-of-state sellers, by reducing the formulaic representation of the property and payroll factors. While some states have accounted for the shifting economic winds by tweaking the composition of their apportionment formulas and sourcing methodologies, vestigial remnants of bygone eras relating to sales sourcing provisions remain. Specifically, many states have kept the historical costs of performance rule as their general sourcing scheme for sales other than sales of tangible personal property. This rule generally is perceived to be an all or nothing rule, sourcing either all the receipts to a single jurisdiction or nothing at all. However, a number of states with the costs of performance rule include a special, and often overlooked, rule applicable to personal services that sometimes provides a more market-based 1 Jerome R. Hellerstein, Walter Hellerstein, and John A. Swain, & Hellerstein, State Taxation 9.18 (3rd ed rev.) [hereinafter cited as Hellerstein, State Taxation Treatise]. entity. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International.

2 Let s Get Personal About Sourcing Sales of Personal Services page 2 result. 2 This article will explore that rule and how select states have defined a personal service for such purposes. Because the rule is often overlooked, this article aims to remind taxpayers and practitioners that, in certain states, the rule exists and is not optional if the subject service falls within the scope of the personal services encompassed by the state s administrative regulations and interpretations. Rule for Sourcing Receipts from Personal Services Pursuant to Section 17 of Uniform Division of Income for Tax Purposes Act ( UDITPA ), [s]ales, other than sales of tangible personal property, are in this state if (a) the income-producing activity is performed in this state; or (b) the income-producing activity is performed both in and outside this state and a greater proportion of the income-producing activity is performed in this state than in any other state, based on costs of performance. 3 This rule typically is referred to as the costs of performance rule, and works to source sales only to the numerator of the sales factor for the state that reflects the greater proportion of the costs of performance. 4 However, in the case of sales of personal services, the Multistate Tax Commission ( MTC ) model apportionment regulations, which interpret UDITPA, source such sales according to the so-called time-spread method: Gross receipts for the performance of personal services are attributable to this state to the extent that such services are performed in this state. If services relating to a single item of income are performed partly within and partly without this state, the gross receipts from the 2 Included in this list is Alaska (Alaska Admin. Code tit. 15, (d)(2)(C)), Arizona (Ariz. Admin. Code R15-2D-806(3)(c)), Hawaii (Haw. Code R (d)(3)), Idaho (Idaho Admin. Code r (5)(d)), Indiana (45 Ind. Admin. Code (d)), Kansas (Kan. Admin. Regs (b)(3)), Mississippi ( Miss. Code R (3)(f)(iii)), Missouri (Mo. Code Regs. Ann. tit. 12, (60)(C)), Montana (Mont. Admin. R (4)(c)), New Mexico (N.M. Code R (D)(2)(c)), North Carolina (Rules and Bulletins, Taxable Years 2007 & 2008, Franchise Tax, Corporate Income Tax, Privilege Tax, Insurance Premium Tax, and Excise Tax, Art. 4(I)(c)(vii)(5), p. 53, Corporate, Excise and Insurance Tax Division (N.C. Dep t of Revenue)), North Dakota (N.D. Admin. Code (4)(c)), Oregon (Or. Admin. R (4)(5)(b)(C)), South Carolina (S.C. Code Ann (A)(5)), Tennessee (Tenn. Comp. R. & Regs. R (4)(b)(3)), and West Virginia (W. Va. Code R l.4). 3 UDITPA MTC Allocation and Apportionment (MTC)Regulations, Reg. IV.17(3) defines costs of performance as direct costs determined in a manner consistent with generally accepted accounting principles and in accordance with accepted conditions or practices in the trade or business of the taxpayer to perform the income producing activity which gives rise to the particular item of income.

3 Let s Get Personal About Sourcing Sales of Personal Services page 3 performance of such services shall be attributable to this state only if the greater proportion of the services was performed in the state, based on costs of performance. Usually, where services are performed partly within and partly without this state, the services performed in each state will constitute a separate income producing activity; in such cases, the gross receipts from the performance of services attributable to this state shall be measured by the ratio which the time spent in performing the services in this state bears to the total time spent in performing the services everywhere. Time spent in performing services includes the amount of time expended in the performance of a contract or other obligation which gives rise to such gross receipts. Personal service not directly connected with the performance of the contract or other obligation, as for example time expended in negotiating the contract, is excluded from the computations. 5 The time spent performing the services only includes activities directly connected with the performance of the contract or other obligation. 6 In short, the time-spread method allocates receipts from the provision of services on the basis of time spent by the taxpayer in the state performing the services. Additionally, the MTC model apportionment regulations provide the following two examples: Example (i): Taxpayer, a road show, gave theatrical performances at various locations in State X and in this state during the tax period. All gross receipts from performances given in this state are attributed to this state. Example (ii): The taxpayer, a public opinion survey corporation, conducted a poll by means of its employees in State X and in this state for the sum of $9,000. The project required 600 man-hours to obtain the basic data and prepare the survey report. Two hundred of the MTC Allocation and Apportionment Regulations, Reg. IV.17(4)(B)c). 6 Id.

4 Let s Get Personal About Sourcing Sales of Personal Services page 4 man-hours were expended in this state. The receipts attributable to this state are $3, While seemingly straightforward, application of the time-spread method raises many interesting issues, including what constitutes a personal service. By comparing and contrasting the primary state rulings that have addressed this issue, a workable approach to defining a personal service appears to emerge. What Constitutes a Personal Service? Before a taxpayer can determine how a state s sourcing provisions apply to its receipts, it must determine whether it is providing a personal service. Neither UDITPA nor the MTC model apportionment regulations specifically provide a definition. As such, several states that have addressed the issue, being free to determine the breadth of the term, have varied in defining personal services. California Prior to shifting to a mandatory market sourcing regime for tax years beginning on or after January 1, 2013, California sourced sales of personal services pursuant to its adoption of UDITPA and the MTC model apportionment regulations. In Legal Ruling , 8 the California Franchise Tax Board ( FTB ) sought to directly answer the question of what constitutes a personal service. In reaching its conclusion, the FTB analyzed numerous authorities defining the term personal service, finding that the term could be construed broadly or narrowly. On one hand, personal service could be construed broadly to include virtually all services. Alternatively, the concept of personal services could be narrowly construed to include only specifically enumerated types of services as 7 Id. 8 Legal Ruling , 2005 Cal. FTB LEXIS 2 (Cal. Franchise Tax Bd. Mar. 21, 2005). The California Board of Equalization and the California courts may consider FTB legal rulings and accord some level of persuasive authority in construing the text of a tax statute. Yamaha Corp. of America v. State Bd. of Equalization, 19 Cal. 4th 1 (Aug. 27, 1998). Additionally, as a matter of practice, legal rulings are binding on the FTB.

5 Let s Get Personal About Sourcing Sales of Personal Services page 5 either provided by a California administrative regulation 9 or by the Internal Revenue Code. 10 The FTB rejected the broad definition on the ground that such an interpretation (1) did not comport with the California regulation, and (2) would swallow the general sourcing rule applicable to sales of services other than personal services. According to California s apportionment regulations in effect at the time, income-producing activities relating to personal services were comprised of two components joined by the disjunctive or, reading that the rendering of personal services or the utilization of tangible and intangible property by the taxpayer in performing a service constituted an income-producing activity. 11 Because of this use of the disjunctive or, the adjective personal did not modify the second use of the word service in the sentence, thus suggesting, according to the FTB, that the terms personal service and service were not coextensive. Second, the FTB noted that the rule for personal services is characterized as a special sourcing rule. If personal services included all services, there would be no circumstances to which the general, cost of performance rule would apply and the special rule would swallow the general rule, rendering the general rule irrelevant for the sourcing of services and frustrating the intent of the rule drafters. The FTB also rejected a narrow definition of personal service that would restrict the term only to include specialized services performed by one individual for the personal benefit of another, such as the services of a doctor or lawyer, or the services enumerated under the previously mentioned California regulation or Internal Revenue Code. 12 Such a narrow reading did not comport with the examples of personal services provided by the MTC model apportionment regulations adopted by California, which dealt with a traveling road show and the provision of public opinion survey services. Instead of embracing either end of the spectrum, the California FTB embraced an interpretation that shared a common thread with all the 9 Cal. Code Regs. tit. 18, (h) (2005). Services included in this definition would be limited to the practice of law, accounting, medicine or the performance of personal services in scientific and engineering discipline. 10 I.R.C. 448(d)(2)(A). Services included in this definition are limited to services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. 11 Cal. Code Regs. tit. 18, 25136(b)(1) (2005). 12 See supra note 10.

6 Let s Get Personal About Sourcing Sales of Personal Services page 6 definitions. Accordingly, the FTB ruled that the term personal service includes any service for which capital is not a material income-producing factor. 13 Thus, in determining the contours of the term, the FTB explicitly extended its breadth to apply to more than mere professional services or specialized services performed by one individual. 14 Florida If California could be said to have chosen the middle ground between a narrow and broad definition of personal services, Florida could be considered to be decisively on the narrow side. Sales of personal services are sourced to Florida if such services are performed in the state. 15 If such services are performed partly within and partly without Florida and constitute a separate income producing activity in each state in which they are performed, the receipts are sourced pursuant to the time-spread method. 16 Without providing insight on how it reached its conclusion, the Florida Department of Revenue ( FDOR ) has limited the scope of personal services only to include those services outlined in I.R.C. 448(d)(2)(A), which defines the term qualified personal service corporation for federal income tax purposes. 17 Accordingly, for Florida corporate income tax apportionment sourcing purposes, it appears that personal services only includes the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. 18 While it is unclear whether the Florida definition only applies to services performed by one individual for the personal benefit of 13 Legal Ruling uses the example of a heavy equipment construction company that enters into an earth-moving contract for which the costs are materially weighted toward the equipment rental rather than the employee costs. 14 Legal Ruling uses the example of a computer systems consulting service to design a network, provide hardware and software specifications for the network, and provide maintenance and network modifications for two years after initial installation and testing. 15 Fla. Admin. Code Ann. r. 12C (e)(1). 16 Fla. Admin. Code Ann. r. 12C (e)(3). 17 Technical Assistance Advisement 09C1-003 (Fla. Dep t of Revenue Sept. 30, 2009). Note that technical assistance advisements have no precedential value except to the taxpayer who requests the advisement and then only for the specific transaction addressed in the technical assistance advisement, unless specifically stated otherwise in the advisement. Fla. Stat (1). 18 I.R.C. 448(d)(2)(A).

7 Let s Get Personal About Sourcing Sales of Personal Services page 7 another, it is clear that the exhaustive list of services provided in the Florida advisement is narrower than the rule outlined by the FTB. California and Florida Definitions Compared For a number of reasons, the California definition of personal service is probably a more appropriate definition than the one selected by Florida. First, before addressing the substantive merits of either definition, the Florida approach falls short of the California approach simply for failing to provide any meaningful guidance. Unlike the California ruling, which outlines various potential definitions and then supports its conclusion logically and methodically, the Florida ruling is conclusory and provides no rationale for how the FDOR developed its definition. Second, the definition selected in the Florida ruling seems to be, on a substantive level, a comparatively poor choice. Initially, it is not clear that the list of personal services found in I.R.C. 448(d)(2)(A) encompasses the public opinion survey company specifically provided as an example by the MTC model apportionment regulations (although the scope of consulting is admittedly vague). Further, I.R.C. 448 itself only forbids certain taxpayers from computing taxable income under the cash receipts and disbursements method of accounting. 19 Excepted from this general rule are, among other types of business, qualified personal service corporations. 20 The word qualified implies, from a theoretical standpoint, that the list of personal services listed in I.R.C. 448 may be but a subset of a larger, more comprehensive list. In relying on I.R.C. 448, the FDOR may have limited its definition of personal services to an already purposely limited list. For those reasons, the FTB ruling seems to be a more thoughtful interpretation of the term personal service and likely is more consistent with the intent of the regulation s drafters. Conclusion The ever-shifting world of state taxation can often leave taxpayers and practitioners in the lurch. This is particularly true in instances in which states fail to define crucial, foundational terms. As described in this article, although only a few states have defined the term personal service for 19 I.R.C. 448(a). 20 I.R.C. 448(b)(2) (emphasis added).

8 Let s Get Personal About Sourcing Sales of Personal Services page 8 sales factor sourcing purposes, a number of states source personal services using the time-spread method. As a result, it is important that taxpayers and practitioners not only are cognizant to the existence of the time-spread sourcing method, but also understand the types of personal services that may fall under its umbrella. KPMG s What's News in Tax is a publication from Washington National Tax that contains thoughtful analysis of new developments and practical, relevant discussions of existing rules and recurring tax issues. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP.