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Massachusetts Releases Long Awaited Proposed Regulations on Market-Based Sourcing

On October 30, 2014, Massachusetts released what taxpayers have long awaited: the proposed regulations for the change to market-based sourcing for sales apportionment for receipts from services and transactions involving intangible property. The regulations expand on what the new law means in terms of defining “the market” for your sales. This is an update to the “working draft” released in March of 2014, and is the next step in finalizing and issuing the regulations. With the 2014 tax season around the corner, this leaves little time to implement the necessary changes for proper apportionment of sales according to Massachusetts.

Market-Based Sourcing Overview

Massachusetts has transitioned from the cost of performance approach to the market-based approach for sales apportionment for receipts from services and transactions involving intangible property as of January 1, 2014. Cost of performance has been used historically by most states, but with the shift to a service-based economy, there has been a corresponding shift in apportionment trends. Under the cost of performance method, sales are sourced to the state where the services are performed, i.e., a Massachusetts service company with only Massachusetts employees sources all sales to Massachusetts, regardless of the location of the customer. Under the new law, all sales, with the exception of sales of tangible personal property, will be sourced to wherever the “market for the sale” is. In the case of services, the type of service, method of delivery, and type of customer, all play a role in determining where the market for the sale is.

Proposed Regulations – Overview 

The proposed regulations specify three classes of services: in-person services, services delivered to the customer, through the customer, or on behalf of the customer, and professional services. In-person services, such as warranty and repair services, will be sourced to Massachusetts if the customer received the service in Massachusetts. This yields the same result as the cost of performance method because the service is both performed and received in Massachusetts. Services delivered to the customer, through the customer, or on behalf of the customer, such as advertising and certain software businesses, will be sourced to the location where the service is delivered if physically delivered, or to the location where the service is received if electronically delivered. Professional services, such as legal services, are sourced based on whether the customer is a business or an individual. Professional services provided to an individual are sourced to that customer’s state of primary residence. Professional services provided to a business are sourced to the location where the contract of sale is principally managed by the customer.

Proposed Regulations – Hierarchy 

The proposed regulations provide for various sale assignment rules that apply sequentially in a hierarchy. The taxpayer must make a reasonable effort to apply the primary rule before moving on to the next rule in the hierarchy. In the case of services delivered by electronic transmission or professional services delivered to a business customer, the taxpayer should first assign the sale to the state where the contract of sale is principally managed by the customer. If this is not reasonably determinable, the taxpayer may assign the sale to the customer’s place of order, and if this is unknown, the taxpayer may lastly assign the sale using the customer’s billing address. However, if there is an instance in which the taxpayer derives more than 5% of its sales of services from a customer, the taxpayer is required to identify the state in which the contract of sale is principally managed by that customer.

Proposed Regulations – Safe Harbor

To ease the administrative burden, the proposed regulations have provided for a safe harbor. In the case of the delivery of a service to a business customer by electronic transmission or in the case of the delivery of  professional services to a business customer – if the taxpayer cannot determine or reasonably approximate the market for a sale, the taxpayer may assign its sales to a particular customer based upon the customer’s billing address in any taxable year in which the taxpayer (1) engages in substantially similar service transactions with more than a thousand customers, whether business or individual, and (2) does not derive more than 5% of its sales of services from such customer. This aids taxpayers with large volumes of transactions in determining the market for those sales.

Proposed Regulations – Record Keeping

The proposed regulations state that the taxpayer must maintain contemporaneous records that explain the determination and application of its method of assigning its sales, including its underlying assumptions. These records must be provided to the Commissioner upon request. If the taxpayer fails to retain or provide their contemporaneous records upon request, the Commissioner may treat the taxpayer’s assignment of sales as unsubstantiated and may assign such sales in the manner that the Commissioner determines is appropriate.

Next Steps & Action Items

The changes in the law and subsequent proposed regulations have created a need to plan for implementation in the 2014 tax year. Please note that the regulations are only proposed regulations. They are not yet final and may still be amended.

Potential Changes

There is a public hearing scheduled for December 4, 2014, to discuss the proposed regulations for market-based apportionment. One potential change could be the new safe harbor benefitting a wider constituency of taxpayers.  At 1,000 customers, the threshold for the safe harbor is high and could be amended to apply to everyone, or changed to a dollar amount of sales rather than a number of customers.

Implementation

The new law will need to be implemented for the 2014 tax filings. So what does this mean for you? As a taxpayer with sales of services or intangible property, there are some things that can be done to prepare for the change:

  • Determine if the safe harbor applies to you, given the current threshold of 1,000 customers.
  • Identify out-of-state or multi-state customers that constitute more than 5% of your sales and determine which location on the hierarchy is appropriate.
  • Get in contact with these customers to understand where that location is.
  • Integrate obtaining the proper location, i.e., where the contract will be managed, into your processes for new customers going forward.

Talk to Us

If you would like to talk through how this impacts your business, please contact us.