A decision of 2023 was just affirmed on November 25, 2024, after an appeal [Billmatrix Corp., a group of related taxpayers’] contradicting Florida’s prior guidance related to the sourcing of service revenue.
In 2024, the court upheld that state law required the use of the cost-of-performance (“COP”) method to source taxpayers’ service revenue, for purposes of the sales apportionment factor for the corporate income tax. In simple terms, “apportionment” is the process of assigning a portion of a corporation’s income to a particular state, and that will have a direct impact on the corporation’s income tax in that state.
The plain language of the apportionment regulation in Florida points out the use of COP sourcing; therefore, the circuit court rejected the Florida Department of Revenue’s application of market-based sourcing. The circuit court also held that the Department’s inconsistent application of its COP regulation violated the Florida Taxpayer’s Bill of Rights.
Explaining COP and Market-based methods
In the Cost-of-Performance (COP) Sourcing method, revenue is sourced where the business incurs the costs of performing the service.
On the other hand, with the market-based sourcing method, revenue is sourced to the state where the customer receives the benefit of the service (deliverables). The focus of this method is on the location of the customer or market.
What are the effects of this decision?
The Department initiated corporate income tax audits of the six related taxpayers for the 2015-2017 tax years from satellite offices in Illinois and Pennsylvania. The audit reports concluded that the taxpayers’ use of the COP method to determine the sales factor was incorrect, but the audits from each office provided slightly different market-based sourcing methodologies. The audits assessed additional tax due for the five taxpayers that conducted most of their business activities outside Florida and a tax refund for the taxpayer that had performed a preponderance of its business activities within Florida. The taxpayers contested these assessments and filed a motion for summary judgment with a Florida circuit court.
Under Florida law, corporations are required to apportion their business income to the state using a three-factor formula comprised of a payroll, property, and double-weighted sales factor. For purposes of the sales factor, the Florida statute directs taxpayers to include the total sales of the taxpayer “in this state,” with no specific sourcing provision for sales of services. A Florida regulation provides a COP method to source receipts related to “Other Sales in Florida,” which generally is considered to include most types of service revenue. Under this regulation, if the income producing activity giving rise to the service revenue is not conducted solely in Florida, the revenue is attributable to Florida if the greater proportion of the income producing activity is performed in Florida, based on COP. Thus, if the greater proportion of the costs to perform the income producing activity is incurred outside Florida, none of the related receipts are apportioned to Florida. It should be noted that despite the references to COP, the Department has interpreted this regulation to apply market-based sourcing in many instances over the past several years in its published guidance.
The circuit court held that the COP method as provided in the Department’s regulation must be used to source taxpayers’ service revenue. The Department and the taxpayers agreed that the COP regulation should be applied, but they disagreed with the interpretation of the regulation language. As explained by the court, “the sole dispute in this case is whether the COP Rule requires application of a cost of performance methodology or a market-based methodology.” The court focused on the interpretation of the “income producing activity” and the “costs of performance” terminology in the regulation as well as the proper application of the regulation.
As explained by the court,
“to determine taxpayer’s income-producing activity the Department must look at the transactions and activity the taxpayer directly engages in for the ultimate purpose of obtaining gains or profits, rather than looking at the actions or location of the customer.”
The court also determined that even if the language of the COP regulation were ambiguous, the regulation must still be construed to require application of the COP method, because under Florida law, tax law ambiguities are typically resolved in favor of the taxpayer.
The circuit court also held that the Department’s inconsistent interpretation of its own regulation violates the Florida Taxpayer’s Bill of Rights, which ensures the fair and consistent application of tax laws.
Service providers that incur a greater proportion of their costs to perform their services outside Florida, but that have a significant market presence in Florida, may want to determine whether this case provides sufficient support for a COP sourcing approach. This decision further strengthens positions to consider applying a COP methodology to previous and prospective filings, at least on a protective-claim basis.
