State Corporation Income Tax: Apportionment of service and intangibles

On our last episode, we discussed the basics of apportionment of Income to multiple states for companies that sell tangible products. This time we will consider companies whose business is to provide services or intangible related transaction to customers.

Examples of service include, consulting service, accounting services, assembly services, etc. Examples of Intangible transaction include license fees or royalty fees among others. Unlike the movement of tangible goods, the movement of services or intangible goods are not readily apparent. Tangible goods could be easily traced by shipping or delivery documents but services and intangibles can lack such documentation. In the past, under such conditions, when service sector was relatively a budding business, the method, “cost of performance” was expediently adopted due to its simplicity. Cost of performance (“COP”) apportions service where such service was performed. Let’s look at a following simple illustration:

Company B is in the business of consulting, they consult mainly with US subsidiaries of Japanese companies. They provide human resource services such as providing compensation and benefit, health coverage issues, employee retention consultation. Company B’s only office is in California and all of their employees work exclusively in California. Under the COP method, Company B will apportion all of their consulting income to California since most of the performance (consulting) was performed in California. Therefore, their apportionment percentage will be 100 % to California. For example, if their annual taxable income was $300,000 for the year ended December 31, 2022, their California tax would be 26,520 (=300,000 * 8.84 %). So, if we assume Federal taxable Income was also 300,000, their total tax liability would be 89,520 (63,000 for federal and 26,520 for CA.)

Sourcing of Intangibles

Continuing our example, assume that Company B also has income from intangibles. They received license and royalty fees from their customers. Such fees are sourced to the location of the licensee. To the extent that the licensee uses the intangible property (patent, trademark, etc.) in California, it is sourced to California. If Company B also conducts business in Illinois or in other words, has nexus with Illinois and they have intangible income from customers located in Illinois, company B must also apportion some intangible income to Illinois.

Adoption of Market sourcing:

Under the changing and dynamic US business environment, where new technologies such as computers and internet system were developed and new businesses related to such technology were created, services including intangible asset business proliferated and became a prominent presence in US business environment. The COP method became unpopular due to its lop-sided characteristic and its unsound conceptual underpinning related to the sourcing of the service revenue. As the above illustration show, companies providing services located in a relatively high-income tax rate like California will bear huge tax cost, it will incentivize them to relocate to low-income tax states. And obviously, there is no benefit for service providers whose customers are located out of CA. To counteract such tendencies many states increasingly adopted “Market Sourcing”. As of December 31,2022, about 32 states adopted market sourcing method. This method refers to sourcing service income to the state where services or benefit were received. So, in our simple illustration above, if all of Company B’s customers were located out of California, their apportionment would be 0% and they would only be liable for $800 California franchise minimum tax. In this case their total tax liability would 63,800 (63,000 for federal and 800 for California) Their total tax liability decreased from 89,520 to 63,800, a 28.7% drop compared to the COP method. In reality, we have seen our client’s California liability decrease from 50 to 90% due to the adoption of market sourcing.

Intangible property

In the case of California, the new regulation has distinguished two types of Intangibles. One is the “Marketing Intangibles” and the other is termed “non-marketing and manufacturing” intangibles. Marketing intangibles refers to license or trademark where the value lies predominantly in the marketing of intangibles property in connection with goods or services. And Non marketing and manufacturing refers license of a patent, copyright or trade secret to be used in manufacturing, where the value of the intangible lies predominantly in its use of the (manufacturing) process. Sourcing of marketing intangibles are sourced to the location of the licensees’ s ultimate customers while non-marketing intangible are sourced to where the intangibles are used.

Issues of Market Sourcing

From the state’s point of view, the implementation of the market sourcing has been problematic. One problem that surfaced was the basic sourcing issue when there were multiple customers who benefited from the services. This often happens when the primary customer has its own customers who benefit from the service as illustrated by the example of a customer who passes the service benefit it receives from the provider to its own customers. As such, where was the benefit delivered? the primary customer only or to look through the primary customer’s customers who also benefited? In general, some states have taken a “look through” position that determines who the ultimate beneficiaries of the service were. As each state has independently developed its own regulation. It is instructive to see how CA has approach this problem. Ca has utilized the “look through” approach, CA requires that taxpayer to determine where the service was ultimately delivered, they want taxpayers to look through the first customer to determine where the services or benefit of intangible were received. This occurs when the first customer may transfer or pass the benefit of the services to their customers as illustrated in the example given by CA FTB:“Call Center Corp provides call center services for business customers. Fly Fishing Corp subcontracts its call center operation to Call Center corp. The example looks to the locations from which Fly-Fishing Corp’s customer calls originate, because the benefit of the Call Center services is where the individuals are physically present when receiving the service” The same implementation problems are present in determining the ultimate customers who have benefited from intangibles.

California’s proposal to determine ultimate customer

California has laid out 4 basic questions to help determine who the ultimate customer that received the benefit as follows:

  1. Who is the customer? Refers to customer’s customer and not third party
  2. What is the service being provided?
  3. What is the benefit of the service being received by the customer?
  4. Where is the benefit of the service being received by customer? As a result, California has laid out the following cascading rules in the order of priority to determine who the ultimate customers were as follows:
    1. “The location of benefit of the services shall be presumed to be received in the state (California) to the extent the contract between the taxpayer and the taxpayer’s customer or the taxpayer’s books and records kept in the normal course of business, notwithstanding the billing address of the taxpayer’s customer indicate the benefit of the service in the state (California).
    2. If neither the contract nor the taxpayer’s books and records provide where the benefit of the service is received then the location where the benefit is received shall be reasonably approximated
    3. If the location cannot be reasonably approximated then benefit of service will be presumed to be in the state (California) if the location from which the taxpayer’s customer placed the order for service is in this state (California).
    4. If location of benefit cannot be determined pursuant to the above steps, then the benefit of the service shall be in this state if the customer’s billing address is in this state (California). “
Throw-out rule

Let me regress briefly about sales of tangible property sold to states that the company does not have nexus. As you remember from my previous discussion, such sales are thrown back to the state where inventory was originally shipped from. So, such sales will be included in the numerator of the ratio of the state where inventory was initially located, this results in increased apportionment percentage. But what happens in the case of services where the company provides services to a state that does not have nexus? In case of services, the concept of throwback does not apply, but rather services would be thrown out, not literally thrown out but excluded from the denominator of the ratio, take a look at the following example:

California company’s business is consulting service. It is based in (California) and has service income from customers located in California, New York and Illinois. California company has nexus with California and New York but not with Illinois.

Customer locationService gross incomeApportionment
California$500,000500,000/ (1,000,000 -100,000) = 56%
New York$400,000400,000/1,000,000 = 40%

By throwing out or excluding the 100,000 of sales of the non-nexus state (Illinois) from the denominator of the ratio, it increases the apportionment ratio of the nexus state (California).

(Please note that 100,000 sold to Illinois is not thrown out of New York’s apportionment ratio since New York does not require throw out.)

Nexus standard for services or intangible income

When you are analyzing the nexus status of the states, do not use the same nexus standard for tangible goods. As I stated in earlier discussion, Federal Public Law 86-272 only applies to tangible property. This law prevents state from imposing nexus status if activities are limited to certain sale solicitation activities. So, if the sales involve services or intangible property instead of tangible property, public law 86-272 cannot protect companies from sales solicitation activities. The state would inquire taxpayers with skillfully crafted questions about its business activities to determine if taxpayer crossed the nexus line. This situation also affects the nexus status of companies who provide services to a state with factor presence. In my previous discussion, we referred to a situation where Illinois company that has no nexus with CA but sells tangible goods over California’s sale factor presence of 690,000 or over 25% of their total sales, we have said that the Illinois company will not be subject to income tax of CA because public law 86-272 protects them. However instead of tangible goods, if the business is providing services or intangible assets, then public law 86-272 cannot protect them from the factor presence test and Illinois company will be deemed to have nexus to California and subject to the full California income tax instead of a minimum tax of 800 for tangible goods.

In our next episode, we will continue with state tax related to combine returns which encompasses concept of unitary tax, water’s edge election and apportionment method under combine returns.