In two separate cases evaluating Massachusetts’ and Oregon’s virtually identical costs-of-performance (COP) rules, the unresolved fundamental difficulties in applying the nearly half-a-century old rules are highlighted in the courts differing conclusions. Under the Uniform Division for Income Tax Purposes Act (UDITPA) (as adopted by both states), receipts from sources “other than sales of tangible personal property” (e.g., services and intangibles) are sourced for income tax apportionment purposes based on a preponderance COP methodology. Specifically, this methodology requires that such receipts be included in the states’ sales factor numerator only if the preponderance of the COP associated with the income producing activity are performed in the state.
The Massachusetts Appellate Tax Board (Board) and Oregon Tax Court (Tax Court) evaluated application of the COP methodology in AT&T Corp. v. Comm’r of Revenue, Mass. ATB Findings of Fact and Reports, 2011-524 and AT&T Corp. v. Dep’t of Revenue, Oregon Tax Court, TC 4814. At issue in both cases was whether AT&T’s receipts from interstate and international voice and data telecommunication services should be included in the states’ sales factor numerator. In providing these services, AT&T utilized its vast network of telecommunications assets, including its Global Network Operations Center in New Jersey. Both states’ Departments of Revenue took the position that AT&T’s income-producing activity consisted of each individual telephone call or data transmission to customers located in the state (referred to as the “Transactional Approach”). AT&T argued that its income-producing activity consisted of its revenue streams from its various services (the “Operational Approach”) rather than the “Transactional Approach.”
On June 8, 2011, the Board issued its written decision in favor of AT&T, finding that its interstate and international telecommunication services receipts should not be included in the Massachusetts sales factor numerator. The Board concluded that AT&T’s income-producing activity was the business of providing a national, integrated telecommunications network that was operated and managed in New Jersey. Rather than requiring AT&T to apply the Transactional Approach, the Board agreed with AT&T that it should apply the Operational Approach and that a preponderance of AT&T’s costs associated with its revenue streams were located outside of Massachusetts.
Twenty days later, on June 28, 2011, the Tax Court issued a decision against AT&T concluding that its receipts from interstate and international communications services should be included in the Oregon sales factor numerator. The Tax Court rejected the Operational Approach and required AT&T to provide evidence supporting its apportionment of each and every transaction. The Tax Court concluded that Oregon’s regulations “focus on ‘transactions’” and therefore the “statutes and rules, as well as logic, dictate that the analysis must begin with transactions that are or include ‘income producing activities.’”
The Board and the Tax Court also reached opposing conclusions regarding the inclusion of third-party costs in measuring a taxpayer’s costs of performance. The Board concluded that access fees paid by AT&T to third-party local exchange operating companies were not direct costs and were thus excluded from AT&T’s costs of performance, while the Tax Court held that the access fees were direct costs included in costs of performance.
While the Massachusetts Department of Revenue has appealed to the Massachusetts Appeals Court, its does not appear that AT&T has appealed the unfavorable Tax Court decision at this time. These decisions highlight the continued unpredictability surrounding the proper application of COP. And, as more states transition toward a single-sales factor apportionment formula, controversies surrounding the application of sales factor sourcing rules will likely increase. For more details and Sutherland observations regarding these cases, see the Sutherland Legal Alert here.