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Market-Based Sourcing vs. Cost of Performance for Apportioning Receipts from Services

State and Local Tax Team

1.22.21 | Client Alert

Market-based sourcing is now a ubiquitous method for state income tax apportionment of receipts earned from the performance of services. In many states, the market-based methodology has replaced cost of performance (COP)-based receipts sourcing. Whereas COP-based receipts sources income to the location where services are performed, the market-based method sources receipts based upon the location where the taxpayer’s customer benefits from the taxpayer’s services. A risk of double taxation of receipts exists with the mixed use of COP-based receipts and market-based sourcing among the states. Widespread state adoption of market-based sourcing can mitigate the risk. However, such risk will not be reduced (and could increase) if states fail to implement uniform rules to determine where customers or clients receive the benefits from the taxpayer’s services.

The Shift Away from COP-Based Receipts to Market-Based Sourcing

Under COP-based receipts sourcing, receipts earned from the performance of services are apportioned to a state based on the location where the taxpayer incurs expenses associated with providing the services. If the income-producing activity is performed across multiple states, revenue is typically apportioned entirely to the state where the taxpayer incurred the greatest proportion of the cost of performance. However, there are some COP-based receipts sourcing states that allocate a percentage of the revenue to the state to the extent that the cost of performance is incurred within the state. In these states, it is not “all or nothing” sourcing. The COP-based receipt sourcing method is relatively easy to apply since it is based on the location where the costs of providing the service are incurred (i.e., the cost of labor, rent, etc.). Identifying the location where the taxpayer’s customer receives the benefit of the taxpayer’s service is at times far more complicated than determining COP.

For example, assume a business consulting company (BCC) and all its property and employees are located in State A. BCC’s employees perform all consulting services at the office in State A. State A uses COP for sourcing receipts from services. BCC’s client is a retailer (“R”) with stores located in States B and C. Since State A has adopted COP-based receipts sourcing rules, all of BCC’s revenue would be sourced to State A, as the COP is incurred entirely in State A. However, if State A had adopted market-based sourcing rules, BCC’s revenues could potentially be sourced to States B and C to the extent that R receives the benefit in each of those states.

Determining Where the Benefit is Received for Market-Based Sourcing Is Tricky

In the above example, if State A uses market-based sourcing, how would BCC determine the state(s) where R receives the benefit of their services?

Let’s build on the prior example with a few additional facts. R is a retail store chain headquartered in State B with stores located in States B and C. R also operates a retail website which sells to customers in all 50 states. R hires BCC, with offices and employees located solely in State B, to develop and implement a new business strategy. In this scenario is the benefit from BCC’s services received by R in State B (where R is headquartered)? Or, is a portion of the benefit received in States B and C (where R’s stores are located)? Or finally, is a portion of the benefit received in all 50 states (because R has customers in every state)? Given this fact pattern, the answer to the question “where is the benefit received?” is not as easily determined as the answer to the question “where is the cost of performance incurred?”. In this scenario, the COP is clearly based in State A (the location of all of BCC’s employees and offices). The relative grayness of the issue presented by market-based sourcing presents challenges; yet it may also present opportunities to plan to minimize state income taxes.

Single Factor Sales Apportionment and “Nowhere Sales” and “Double Taxation”

Many states using market-based sourcing use a single factor sales apportionment methodology instead of traditional three-factor apportionment (which is based on the percentage of property, payroll and sales located in a state). Single sales factor apportionment allocates revenue to a state based on the percentage of total sales occurring within the state. This percentage is determined by dividing the amount of receipts sourced within the state under either the COP-based receipts sourcing or market-sourcing rules by total receipts earned inside and outside of the state.It is possible for a taxpayer to pay no tax on a portion of their service revenue (“nowhere sales”) in states that employ single sales factor apportionment. For example, BCC has offices and employees located solely in State A. BCC has clients that are located solely in State D. The clients receive the benefits of BCC’s services in State D. State D uses COP-based receipts sourcing rules whereas State A uses market-based sourcing. Both State A and State D use a single factor sales formula. Under State A’s market-based sourcing rules the revenue derived from providing services to clients in State D would not be assigned to State A because the benefit of the service is received in State D. Under State D’s COP-based receipts sourcing rules, the revenue would not be sourced to State D because the expenses associated with providing the services are incurred in State A. Therefore, in this example, income is not allocated to either State A or D. Note that if State A used equally weighted three-factor apportionment, then two-thirds of BCC’s revenue would be apportioned to State A because 100% of the property and payroll, two out of three apportionment factors, are located in State A.

Reversing only two of the facts in the above example could result in “double taxation.” In the revised example all the facts are the same except that State D utilizes single factor market-based sourcing and State A uses single factor COP-based receipts sourcing. In this scenario, State A would allocate all of BCC’s revenue to State A (where the services are performed, and the cost of service is incurred) and State D would allocate the revenue to State D (where the benefits of the services are received). As a result, the same revenue from one or more transactions would be attributed to both states and subject to tax in both states.

Some states employ “throwout” or “throwback” rules designed to mitigate the potential impact of nowhere receipts on state tax revenue. Throwout rules exclude receipts from both the numerator and denominator of the receipts factor in the state where the sale originates if the receipt is not taxable in any state. The throwback rule requires receipts to be included in the numerator of the sales factor in the state where the sale originates if the receipts would otherwise not be taxable in any state. Please note that the foregoing is a very simplified explanation of the throwback and throwout rules (both of which are highly nuanced in application).

Market-Based Sourcing and Single-Factor Apportionment Attracts Business Investment

Traditional three-factor income tax apportionment formulas allocate income based on the percentages of property and payroll located in-state and receipts sourced in-state. Under the three-factor formula, the greater the percentage of property and payroll located in a state, the greater the amount of income that will be allocated to the state. COP-based receipts factors are relatively larger when in-state property and payroll percentages are high. This is because property and payroll drive costs. Therefore, a traditional three-factor apportionment formula that incorporates a COP-based receipts factor is a disincentive to locating property (e.g., offices, plants, warehouses, equipment, etc.) and employees within a state. States that adopt market-based sourcing and single receipts factor apportionment eliminate this disincentive.

COVID-19, Telecommuting and Apportionment

While the subject of this article was conceived prior to the COVID-19 pandemic, it would be remiss to ignore the effect the resultant growth of telecommuting on apportionment. The profound increase in telecommuting (whether permanent or temporary) adds to the complexity of state and local tax compliance and planning. This is certainly true with states that use COP-based receipts factors and/ or incorporate a wage factor in their apportionment formulas. First, the measure of the COP for the numerator of the receipts factor commonly includes the amount of compensation paid to employees working within a state. Second, the numerator of the wage factor may be based on where the employees perform their services. Therefore, the in-state receipts and payroll factors may increase or decrease when an employee telecommutes in a different state than the state where they worked prior to the COVID-19 lockdowns. Many states have announced policies designed to maintain the status-quo-ante for apportionment for as long as the state of emergency orders remain in place. However, once the state of emergency ends, the apportionment rules will likely revert to normal. Accordingly, changes in telecommuting patterns will impact the wage factor and the receipts factor (in cost of performance states). While this article is focused on apportionment, it is important to stress that telecommuting has serious nexus implications for income tax, sales tax, withholding tax and other state taxes. A heightened scrutiny of multistate apportionment (and nexus) is in order.


The coexistence of market-based sourcing and COP-based receipts sourcing methods creates the potential for both receipts that are allocated nowhere and for receipts to be allocated to more than one state (creating a risk of double or more taxation). It is recommended that taxpayers review their current operations to identify, and if possible, mitigate the risk of double taxation and maximize the opportunity for nowhere sales. Tax planning and compliance methods should be reexamined to avoid under- or over-allocating income to states. Taxpayers should remember that under market-based sourcing the benefit of the service is not necessarily received in the state where their clients are located. Finally, the rise in telecommuting resulting from the COVID-19 lockdowns creates potential apportionment traps (and nexus/filing exposures) that will require careful monitoring. By proactively addressing these apportionment issues taxpayers can avoid unpleasant surprises and potentially minimize their state tax burden.

If you have questions, contact your Berdon advisor.

This alert is for general information purposes only and is not intended, and should not be construed, as legal or tax advice.