New Jersey adopts market-based sourcing regs

On Sept. 8, 2020, the New Jersey Division of Taxation released final regulations providing detailed rules for sourcing receipts from service transactions for New Jersey Corporation Business Tax (CBT) purposes.¹ The regulations follow New Jersey’s transition to market-based sourcing for sales of services pursuant to a law that became effective for tax years ending on or after July 31, 2019.² In particular, the final rules provide industry-specific examples for allocating service receipts from multistate customers in accordance with the statute’s requirement that receipts be sourced to the location where the benefit of the service is received.

Background

On July 1, 2018, New Jersey enacted legislation making significant changes to the state’s CBT regime, including the adoption of mandatory combined reporting and market-based sourcing for service transactions, effective for tax years ending on or after July 31, 2019.³ Under the statute, receipts from sales of services are sourced to New Jersey if the benefit of the service is received in New Jersey.⁴ The statute set forth a set of cascading rules to be applied in sequential order. Where the benefit of a service is received on a multistate basis, the portion of the receipts allocated to New Jersey is based on the percentage of the total value of the benefit received in New Jersey, or a “reasonable approximation” of that value.⁵ When the relative value of the benefit received in New Jersey cannot be determined for an individual customer, the benefit of the service is deemed to be received at the customer’s billing address.⁶ When the relative benefit received in New Jersey cannot be determined for a business customer, the benefit of the service is deemed to be received at the location from which the services were ordered.⁷ If that location cannot be determined, the benefit of the service is deemed to be received at the business customer’s billing address.⁸ The Division first released proposed market-based sourcing regulations interpreting the statute on March 16, 2020 and accepted comments from taxpayers and practitioners through May 15, 2020.

Market-based sourcing rules

The regulations require taxpayers to include receipts from services in the sales fraction numerator if the benefit of the service is received by a customer at a New Jersey location.⁹ A customer is located within the state if the customer is either: (i) an individual located within the state; or (ii) engaged in a trade or business and maintains a “regular place of business” in the state.¹⁰ A “regular place of business” is broadly defined as any office, factory, warehouse or other business location in New Jersey where the customer conducts business in a regular and systematic manner or maintains property or employees, and is not limited to the customer’s principal place of business.¹¹

If the New Jersey recipient receives all the benefit of the service in the state, then the receipt from the service is sourced entirely to New Jersey.¹² If the recipient receives only some of the benefit in New Jersey, then the receipts are attributable to New Jersey in proportion to the extent to which the recipient receives the benefit in the state.¹³ That proportion may be determined based on the terms of a contract, the taxpayer’s books and records kept in the normal course of business, or the nature of the taxpayer’s or recipient’s business and/or the services rendered.¹⁴

If none of the above methods provide the necessary information, a taxpayer may use a “reasonable approximation” to attribute the location of receipts.¹⁵ A “reasonable approximation” means that the location where the benefit of the service is received is determined consistently with the activities of the recipient and limited to the jurisdictions or geographic areas where the recipient will receive the benefit of the service at the time of purchase, based on the information available to the taxpayer.¹⁶

The regulations provide 10 examples of how to source receipts from services under a variety of fact patterns applied to specific service industries, including receipts from the following:

1. Surveying services performed at a New Jersey property for an out-of-state real estate developer (all benefits received in New Jersey)
2. Engineering services performed within and outside New Jersey to develop an office complex in New Jersey for an out-of-state corporation (all benefits received in New Jersey)
3. Services to develop custom computer software for an out-of-state corporation for use exclusively in its New Jersey office (all benefits received in New Jersey)
4. Services to develop custom computer software for an out-of-state corporation for use in both its New Jersey and out-of-state offices (benefits in proportion of the software used in New Jersey to the software used everywhere)
5. Television, radio and internet advertisements in broadcasts to multiple states (benefits in proportion of the New Jersey audience to the audience everywhere)
6. Lump-sum payments to a prescription fulfillment service from a national pharmaceutical sales firm (benefits as percentage of sales firm employees in New Jersey, prescriptions filled in New Jersey, or some other reasonable approximation or population-based methodology)
7. A nationwide marketing analysis for a company headquartered in New Jersey, but requested by and delivered to offices outside of New Jersey (no benefits received in New Jersey)
8. The purchase of an in-dashboard GPS system and a one-year update service through an auto dealer and an option to renew directly with the GPS company (benefits received at the dealer location and, on renewal, at the customer’s billing address)
9. A contract to provide legal information services by shipping updated pocket parts and loose-leaf binder inserts to offices within and outside New Jersey (benefits in proportion of the updates received in the New Jersey office to updates received everywhere)
10. Payroll processing and remittance services to a client with offices within and outside New Jersey (benefits in proportion of the number of the client’s employees located in New Jersey to employees everywhere)¹⁷

The regulations clarify that all service receipts are allocable under these rules, irrespective of: 1) whether the services were performed by employees or independent agents; 2) whether the receipts are reported as income or a reduction of expense; or 3) where the receipts were payable or paid.¹⁸

Of note, the regulations eliminate a unique sourcing rule that allocated certain service fees to New Jersey based on whether the transaction had contact with the state at various points. Specifically, 25% of such fees were allocated to the state of origination, 50% of fees were allocated to the state in which the service was performed, and 25% of fees were allocated to the state where the transaction terminated.¹⁹ This rule is no longer applicable due to New Jersey’s transition to market-based sourcing.

The regulations also change the specific method for sourcing lump-sum payments for airline transportation where the benefit is received both within and outside New Jersey. Airline transportation revenue was previously sourced based on the ratio of departures from New Jersey to total departures in order to determine the approximate amount of services performed in New Jersey.²⁰ In the new regulations, airline revenue from the transportation of passengers or freight, or from rental of aircraft, is calculated based on the ratio of an airline’s specially defined “revenue miles” in New Jersey divided by the airline’s “total revenue miles.”²¹

The sourcing rules for certain industry-specific services remain unchanged from the regulations applicable to service transactions for tax years ending before July 31, 2019.²² For example, trucking transportation receipts are still sourced to New Jersey based on the number of miles driven in New Jersey in relation to the mileage in all jurisdictions.²³ Similarly, receipts from asset management services are still allocated based on the domicile of the individual, or the domicile of the beneficiaries of a pension plan, retirement account or institutional investor.²⁴

Finally, the regulations provide additional detail for the sourcing of receipts from a broadcaster's licensing of film programming to a broadcast customer. Specifically, such revenues are sourced to New Jersey, based on available information, in the following order: (i) in proportion of the broadcast customer's viewing audience in New Jersey to the viewing audience everywhere; (ii) in proportion of the population of New Jersey to the population of the other jurisdictions in which the broadcast customer has viewers; or (iii) alternatively, to the commercial domicile of the broadcast customer if the broadcaster can prove it does not have any viewers in New Jersey.²⁵

Commentary

New Jersey’s adoption of market-based sourcing generally follows the recent trend in other states. New Jersey’s market-based sourcing provisions, however, are applicable only to receipts from services. Sourcing of receipts from intangibles, such as royalties from patents and copyrights or income from the sale of goodwill, continue to be sourced on a cost of performance basis. This is similar to the situation in Pennsylvania, which amended its corporate net income tax sourcing statute in 2014 to market-based sourcing for services, but not for intangibles.²⁶ Thus, in New Jersey, the current regulations governing the sourcing of receipts from other than services remain in effect.²⁷

The release of final market-based sourcing regulations is a welcome development for taxpayers and practitioners seeking additional guidance in sourcing service transactions according to a statute that provides limited guidance and several undefined terms. For example, the regulations set forth specific criteria for customers maintaining a “regular place of business” in New Jersey, suggesting that receipts may be sourced outside the state if the customer does not meet such criteria. Additionally, the regulations provide a certain degree of flexibility for service businesses having customers operating on a multistate basis and receiving the benefit of the service both within and outside New Jersey. Such taxpayers may use a reasonable approximation to determine the proportion of benefits received inside New Jersey based on the information available to them, possibly through a population ratio. However, the regulations do not define the term “customer,” raising questions about the proper sourcing treatment for services provided to service providers with ultimate customers in different locations.²⁸

As a result of New Jersey’s transition to market-based sourcing, some service companies may experience a dramatic shift in the amount of tax they owe to New Jersey. Companies that had sourced their receipts outside New Jersey based on the fact that the services were performed outside that state are now required to source those receipts to their customer’s New Jersey location. Conversely, service companies based in New Jersey may now exclude any receipts from services rendered to customers in other states. Although the regulations address the CBT only, partnerships doing business in New Jersey and withholding tax for their nonresident partners may also be impacted. This is because New Jersey follows the CBT allocation methodology for purposes of nonresident withholding, while it follows Gross (Personal) Income Tax allocation rules for purposes of determining distributive share income.²⁹ Partnerships with service income should be aware of the new market-based sourcing rules and potential impact on nonresident partner withholding calculations.

Although these changes resulted from the statutory enactment in 2018, the new regulations provide concrete examples, many of which are relevant to specific industries with significant presence in New Jersey, for implementing the statute. Taxpayers expecting a change to their New Jersey tax liability should also consider the resulting impact to the utilization of tax attributes such as net operating losses and applicable tax credits.