The Washington Court of Appeals recently issued a divided (2-1) decision in a case involving Washington’s “benefits received” test for apportioning service income.  The Court ruled that the “benefit” of an airplane design firm’s services were received in Washington, where the taxpayer’s direct customer, Boeing, manufactured the airplanes incorporating the taxpayer’s airplane designs, rather than the states where Boeing ultimately delivered the airplanes to its customers, individual airlines such as Delta, United, and American.

The taxpayer in Walter Dorwin Teague Associates, Inc. v. State of Washington Dep’t. of Revenue, No. 54959-0-II (Teague), was an industrial design firm headquartered in Seattle, Washington (Teague).  Teague specialized in designing the interior of passenger aircraft, including seating layouts, geometry, and brand placement.  Boeing, one of Teague’s major customers, hired Teague during tax years 2011 through 2014 to design aircraft interiors that Boeing would manufacture in Washington.  Following manufacture, Boeing delivered the aircraft to airline customers at their respective locations.  Claiming that its design services income should have been sourced to the location where the airlines were located, and not Washington where Boeing was located, Teague filed a refund claim for Washington Business and Occupations (B&O) tax.

Washington imposes B&O tax on an apportioned share of a service provider’s income, determined according to a single-receipts-factor formula, the numerator of which is the taxpayer’s gross income attributable to Washington and the denominator of which is the taxpayer’s gross income everywhere.  Wash. Rev. Code § 82.04.462.  Since 2010, receipts from services have been sourced to Washington (i.e., included in the numerator of the apportionment formula) if the “customer received the benefit of the taxpayer’s service” in Washington.  Wash. Rev. Code § 82.04.462(3)(a).

The question before the Court of Appeals in Teague was whether the “benefit” of the taxpayer’s services were received at the location of its customer, Boeing, or at the location of the individual airlines, who were Boeing’s customers.  Both the majority and dissenting opinions looked to a Department regulation to resolve that question.  Wash. Admin. Code § 458-20-19402 (Rule 19402).  That regulation provides that when the taxpayer’s service relates to tangible personal property, the “benefit is received where the tangible personal property is located or intended/expected to be located,” which the rule in turn defines to be the property’s “place of principal use.”  The rule further provides that in the case of “tangible personal property [that] will be created or delivered in the future, the principal place of use is where it is expected to be used or delivered.”

Applying the regulation, the majority determined that the “benefit” of Teague’s services were “received” in Washington because the “airline interiors were expected to be used by Boeing during the manufacturing process in Washington.”  The majority rejected Teague’s argument that the place of use should instead be where the airlines “used or received delivery of the airplane interiors,” because it “ignore[d] the key statutory inquiry, which is where the customer received the benefit of taxpayer’s service.”  Because Teague’s customer was Boeing, and not the individual airlines, the majority concluded that it was “misguided” to look to the place of use or delivery by anyone other than Teague’s direct customer, i.e., Boeing.

A dissenting opinion disagreed, finding that the taxing statute was at least ambiguous, which under Washington’s rules would require that the case be resolved in favor of the taxpayer.  The dissent stated that there was another reasonable interpretation of the statutory provisions (which Teague had advanced): “The majority concludes that Boeing received the benefit of Teague’s design services in Washington, where Boeing used the design to manufacture airplane interiors for its commercial airplanes. But another reasonable interpretation is that Boeing received the benefit of Teague’s design services when Boeing sold the completed airplanes to out-of-state airlines. Certainly that is when Boeing received the financial benefit of Teague’s design services.”  The dissent took particular issue with the majority’s application of the relevant regulation, Rule 19402, because that regulation does not “does not refer to the customer’s place of use or even contain the word ‘customer.’”  Instead, it refers “to where the tangible personal property will be used or delivered.”  And it was “equally reasonable” to conclude that the “principal place of use is where the airlines purchasing the airplanes containing the interiors are located.”

Teague is an example of the “benefits received” test being applied on the basis of the location of the taxpayer’s direct customer, instead of on a “look through” basis that looks to the location of an ultimate end user.  Look through sourcing may be beneficial or detrimental to a taxpayer depending on where a taxpayer’s customers are located.  In Teague, look-through would have benefited the taxpayer because its direct customer was in Washington and the ultimate end users were outside Washington.  But in other cases — e.g., where the taxpayer’s direct customer is located out of state and end users are in state — a look through approach would be detrimental.  Barring further appeal to the Washington Supreme Court, the case should restrict Washington from applying look-through sourcing methodology to a taxpayer’s detriment in similar circumstances in the future.

Walter Dorwin Teague Assocs., Inc. v. Dep’t of Revenue, 2021 Wash. App. LEXIS 2983 (Dec. 14, 2021).