Bar News - February 19, 2014
Tax Law: NH Businesses Beware: Massachusetts Has a New Apportionment Formula
By: David Heath
Last summer, our neighbor to the south enacted two changes that would have a significant impact on the tax burden of certain New Hampshire and other non-Massachusetts businesses. One provision imposed an expanded sales tax; the other changed the way a business allocates it profits to Massachusetts. Both provisions centered on sales of non-tangible property (i.e. services) to Massachusetts customers.
After a regional outcry rivaled only by the opposition to New Hampshire’s “LLC Tax” a few years ago, within three months of enactment, Massachusetts repealed the sales tax piece, but left intact its ugly step-sister: market-based sourcing.
Starting Jan. 1, 2014, this change affects the sales portion of the three-factor formula (sales, property, and payroll) that businesses use to apportion their profits across the states in which they are required to file tax returns.
Developed more than 50 years ago, this formula is what companies that do business in more than one state use to allocate their total taxable profit. Under this formula, a business identifies its sales, payroll, and property both within the particular state and in total. The theory behind the formula was that a given set of apportionment criteria consistent across all states would result in a company paying total state tax in the aggregate on not more than 100 percent of its total taxable income.
Over the years, however, this formula has evolved as many states have “tweaked” one or more of the three factors. Some double-count the sales factor; others may even ignore one of the three factors. When determining the sales factor, states are not consistent in how a particular sale gets assigned in a particular state. This inconsistency sets up the very real probability that a company will pay state income tax on more than 100 percent of its total taxable income.
The most common issue dealing with the sales factor is determining in which state the sale would be “sourced.” That is, would the sale be assigned to the state where the vendor or service provider actually performed the work or to the state in which the customer resides? With the exception of government contracts, most states assign the sale to the state in which the services are performed. When the services are performed in multiple states, a long-standing “cost of performance” principle is usually applied.
With this new Massachusetts “market-based sourcing” of sales, the location of the customer will dictate where a sale gets assigned. Proponents argue that this simplifies the process by removing the cost-of-performance debate. Others think it will merely shift more income to Massachusetts and add a further complication when the use of those services or customer is not limited to one location. More importantly, it makes it likely that a business will apportion more than 100 percent of its income to the various states in which it does business.
A simple example of this issue would be a New Hampshire service company that already has nexus in Massachusetts with total sales of $300, including $100 to a customer in Massachusetts, all of which is performed at its New Hampshire location. Under current law, $300 in sales (100 percent) would be apportioned to New Hampshire, because that is where the work was performed, and none would be assigned to Massachusetts, because no work was performed there.
Under the new rules, the New Hampshire method would not change, so all of its $300 in sales would still be sourced to New Hampshire. However, Massachusetts would now pick up $100 of sales in its apportionment, so 33 percent would be apportioned to Massachusetts. So, now our New Hampshire company is apportioning a total of $400 in its sales factor when it only had $300 of actual sales.
To avoid this additional tax burden, a business needs to perform its services in the same state where the customer is located, something the company’s legal counsel might be wise to keep in mind. One option would be for the company to only perform work for non-Massachusetts customers; probably not a desirable plan. A more likely alternative would be to perform the services in Massachusetts. The sale would still be assigned to Massachusetts (where the customer is located) and would not be assigned to New Hampshire, because the services were not provided there. This would effectively reduce the company’s New Hampshire tax to offset the increased Massachusetts tax.
There are inconsistencies in the apportionment criteria with other states as well, so we are not picking on Massachusetts. We only make note of this change because it will affect our regional businesses. It also continues to highlight the need for more uniform application of apportionment rules across state lines.
David Heath is a shareholder and tax director at Melanson Heath, a NH- based CPA firm with offices in Massachusetts and Maine. He is a member of the NH Commission to Study Business Taxes and chairman of the Governmental Advocacy Committee at the Greater Nashua Chamber of Commerce.