So the big trend in the corporate income tax area at the state level is in market sourcing for what we call the receipts factor or the sales factor for the apportionment formula. So because states can’t tax 100% of the income of the business that operates in interstate commerce, they have to apportion somehow. They don’t do what internationally countries do in terms of saying we’re going to try and figure out how much you earned within our state; instead, they’ve taken what we think is a better approach and ultimately a simpler approach by saying let’s take all of your income everywhere and then let’s attribute it based on things like your payroll or your property or your sales in the state; we’ll attribute some of that income to the state based on those percentages, those ratios. And because it’s easier to determine where you’ve got your payroll or it’s easier to determine where you’ve got your sales, that’s simpler than trying to assign income based on where you think it was earned.
This apportionment formula has been around for 60 years. Originally, it was called the Massachusetts Formula, this three-factor formula: property, payroll, and sales. And over the years, the sales factor has gotten more and more attention. States say to themselves, why would we want to tax a business because it created employment in the state or invested in property in the state? Why would we want to increase the tax burden on those businesses? After all, they already pay some tax on their payroll, and they already pay property tax.
So maybe it makes more sense to use the receipts factor to apportion income, and also some of those businesses, out-of-state businesses, are exploiting the markets in our state, and we want to tax them as well.
So you see more and more of a shift to the sales factor. The problem is that in the 1950s, when they designed this general formula, this three-factor formula, the people who designed it said what are we going to do about the sale of services and the sale of intangibles? Those are hard to source, those are hard to figure out where is the customer, where is the market because you don’t have a physical good that’s changing hands, that’s going from a seller to buyer. Where is the market for things like the sale of legal services, where is the market for the things like engineering services and intangibles, software, and licenses of things that don’t have any physical form? So for a long time, it was believed that sourcing those kinds of receipts or those kinds of sales on a market basis was going to be too difficult. But recently, because some states have attempted it, we have begun to look a little bit more closely at what it means to source to the market. And as it turns out, there are lot of industries where it’s not so difficult, for example, health care. Health care is a service, and yet we know pretty much where health care services are delivered, we know where the customer is. Utilities, phone services: We have long known where the customer for phone services were, and we have even gotten outsourcing rule at the federal level that allows us to source to where the customer is.
So there are a number of things that you can source pretty easily to the market even though they are services or intangibles, and so we began to pick away at some of the remaining more difficult issues, which involved sales of services from businesses to other businesses, those can be particularly difficult to source. Certain kinds of intangibles can be particularly difficult to source, and a few services, like I mentioned, legal services and engineering services. But over time, you can sort of come down to some fairly simple rules for saying, if you know this information about the customer, then you source it there. If you don’t have that information but you have something different, then source it there, and you can come to a pretty close approximation, even if it’s not perfect, to determine where the market is for those services. So now states are able to say, OK, we are going to depend mostly on the sales factor, and we are going to look to the market for the sales, whether it’s tangibles or services or intangibles, we are going to look to where the customer is for that business, and that’s how we are going to attribute the income for that business for taxing the income.
It’s been sort of a slow but steady march for the last 10 years; now we have the Multistate Tax Commission, [which] is about ready to issue final proposed model regulations, which are very detailed and go into a lot of these more problematic areas and say, OK, this is how you will source the receipts from this service. So when you come up with your apportionment formula, you know what’s in the formula and you know where that sale goes in terms of the states that you are operating in. Those model regulations we think there is a lot of interest in those at the state level. A number of states have said very publicly that as soon as that model regulation is final, that they are going to look to adopt it. So we think that that’s going to be the way, the path that people go down moving forward.
Now having said that, we did this regulation process in the midst of this change, so states were adopting market sourcing over a number of years, and we’re a little behind the curve in a number of states where states have already tried to adopt their own sourcing regulations, but we really believe that ultimately there is probably one or two best ways to source most of these receipts, and whichever way you go, you sort of end up in the same place for most of these receipts. And we’re hoping that we’ve built enough flexibility into the rules that if you use a reasonable method and you use it consistently, that that’s going to be all right. There are some doubts about how easy it’s going to be to implement, but I think once we get over that transition period, I think it’s going to be a whole lot easier than people expected.