A range of complex rules and interpretations associated with market-based sourcing is raising tricky questions as it continues to grow as a state tax apportionment method.

Speaking at a panel during the Paul J. Hartman State and Local Tax Forum, Zack Atkins, a State & Local Tax special counsel at Pillsbury, said another complication with cost of performance is that some states take a different perspective in defining income-producing activity than taxpayers in terms of whose activities matter. Using an example of a payment processor providing services to a bank, he said he is seeing so many states take the view that the end consumer swiping a credit card is the income-producing activity, but the payment processor’s perspective is that they are the interface between the merchant and the bank and that all of their activities take place in data centers across the country.

Atkins said that there are issues when states don’t have clearly defined rules on when they can look through to the ultimate consumer. He noted a September 2020 Ohio Supreme Court decision in Defender Security Co. v. McClain, which held that the gross receipts received by an authorized dealer of security systems from ADT Security Services Inc. for the sale of security monitoring services contracts are sitused to the location where ADT realized the benefit derived from purchasing the intangible contract rights, which was outside the state.

Atkins said that states have a cascading set of rules for sourcing receipts from services, adding that where the benefit of services is received is generally presumed based on contracts, but if the documents are not clear, the next step could be reasonable approximation. He continued that it can be difficult in practice to determine the location of delivery, particularly if the delivery was electronic, or where the benefit is received.

Atkins warned that if a state does agree that a taxpayer's approximation is reasonable, it can require a taxpayer to file the same way for years unless it seeks permission to deviate from what has been deemed reasonable for previous years. 

Atkins added that there is little guidance on who bears the burden of proof related to the use of reasonable approximation, saying that whether the state or the taxpayer bears the burden is unclear right now; however, he said he thinks there might be an answer to that question in the coming years.

But the method gives states wide latitude and is problematic for companies because it’s unpredictable, Atkins said. Each contract a business has could have a different reasonable approximation percentage for each state-specific exam, he explained.

“Cost-of-performance is arguably more predictable, but there’s no predictability here with reasonable approximation,” Atkins added.