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Jamie C. Yesnowitz
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On June 4, 2018, Colorado enacted legislation that introduces market-based sourcing for sales of other than tangible personal property for tax years beginning on or after January 1, 2019.1
The legislation is intended to conform the state’s sourcing methodology to the model statute endorsed by the Multistate Tax Commission (MTC). The legislation also expands on the state’s alternative apportionment provisions.
The adoption of market-based sourcing brings Colorado into uniformity with the majority of states, and in conformity with the MTC’s market-based sourcing approach. This methodology will also bring relief to Colorado-based multistate businesses, which may have been subject to double taxation under the current rules, when providing services to customers in states following market-based sourcing rules.
The new law also updates Colorado’s definitions of business and nonbusiness income, which are replaced by the MTC’s apportionable and nonapportionable income terminology. Apportionable income is broadly defined as income generated in the regular course of a taxpayer’s trade or business and any income generated by the use or disposition of property used in that trade or business.2
Nonapportionable income is defined as all income that is not apportionable income.3
The legislation retains the taxpayer’s right to make an annual irrevocable election to treat all income as apportionable (previously, business) income.4
The legislation replaces Colorado’s long-standing cost of performance rules with a market-based sourcing methodology. Revenue from sales of other than tangible personal property will be sourced to Colorado to the extent that the taxpayer’s market for the sale is in the state.5
Revenue from services will be sourced to Colorado if the service is delivered to a location in Colorado. 6
Receipts from intangibles rented, leased, or licensed are sourced to Colorado to the extent used in the state.7
To the extent these intangibles are utilized to market a good or service to a consumer, such receipts are sourced to the location of the consumer purchasing the good or service.8
Under the existing rules, Colorado similarly sourced patent and copyright royalties.9
This sourcing rule has effectively been expanded to include revenue from all types of intangible property. In addition, certain receipts from the sale of intangible property are sourced to Colorado to the extent used in the state.10
Sales of intangible property authorizing the holder to conduct a business activity in a specific geographical area are sourced to the geographical location.11
Sales of intangible property contingent on the productivity, use or disposition of the intangible property are treated as receipts from intangibles rented, leased or licensed.12
Finally, sales of intangible property not covered by these provisions are excluded from the sales factor calculation.13
Under previous law, receipts from the sale of intangibles were sourced to the state of commercial domicile.14
To the extent these sourcing rules are not determinative, the delivery location must be reasonably approximated.15
If taxpayers are unable to reasonably approximate the delivery location for any receipts, they are excluded from both the numerator and denominator of the sales factor. 16
Alternative apportionment provisions
The adoption of the MTC language for alternative apportionment expands upon Colorado’s existing provisions allowing the taxpayer or the Colorado Department of Revenue to argue for alternative apportionment. The legislation allows the Department to develop appropriate rules applied in a uniform manner on an industry-wide, transaction-wide, or activity-wide basis to the extent statutory allocation and apportionment does not fairly represent a taxpayer’s Colorado source income. 17
In addition, with respect to other alternative apportionment approaches that may be raised by the Department or the taxpayer, the law specifies that the burden of proof, to show that the application of the statutory rule is not appropriate, lies with the party requesting the alternative method.18
The party raising alternative apportionment must show by a preponderance of the evidence that the allocation and apportionment provisions do not fairly represent the extent of the taxpayer’s Colorado business activity, and the alternative to such provisions is reasonable.19
In the case of alternative apportionment required by the Department, penalties may not be imposed on the taxpayer for any underpayment of tax resulting from application of the standard statutory method.20
The legislation adopts several additional procedural rules, generally from the MTC framework, that are designed to provide further guidance with respect to how alternative apportionment is to be applied.21
Until recently, Colorado has upheld the application of its statutory cost of performance rules with respect to the sourcing of service revenue. However, when faced with new business models, the state has begun to administratively apply market-based sourcing, leading to litigation on the issue.22
The state has conceded that market-based sourcing is the most effective way to approximate the economic activity directed at the state. The legislature also points to market-based sourcing as being the more uniform approach to sourcing revenue from items other than tangible personal property. The state acknowledges market-based sourcing not as a trend, but the new standard.
Although the legislature intended to further uniformity between the states, market-based sourcing is still applied inconsistently between states. Statutory language varies, as do states’ interpretations of similar statutes, through regulations and rulings. While Colorado has adopted the location where a service is delivered as the determining fact in sourcing service revenue, this location is not further defined. Likewise, the “reasonable approximation” required, if the location of service delivery cannot be determined, is also undefined. In other states adopting similar sourcing methods, lengthy regulations have been proposed, attempting to address the many fact patterns that exist in the contemporary service economy. Colorado may look to the MTC’s expansive model regulations, or the examples of other states, to interpret the new statute.
The change in treatment of receipts from sales of intangible property may have a material effect on some taxpayers. Under previous law these receipts, whether business or nonbusiness income, were sourced to the state of the taxpayer’s commercial domicile. Under the new statute, such receipts are sourced to the state of use, to the extent the revenue is apportionable income. For nonapportionable income, the income is still sourced to the state of domicile. The differing treatment of sales of intangible property under the apportionment and allocation provisions may make the taxpayer election to treat all income as apportionable income more attractive to certain taxpayers.
The new statute may have an impact on taxpayers without physical presence in Colorado. Under Colorado’s economic nexus rule, taxpayers have nexus in the state if Colorado sales exceed $500,000 annually.23
Under this regulation, sales of services are in Colorado if used in the state, effectively a market-based sourcing method. For service-based businesses with no physical presence or operations in Colorado, this resulted in nexus, but no apportionment to the state under the cost of performance rule. While such businesses were technically required to file a Colorado return, the Department has not aggressively pursued non-filers that lack Colorado apportionment and taxable income. Beginning in 2019, these businesses will likely have taxable income or loss in the state and will need to begin filing a Colorado tax return. The fiscal impact of market-based sourcing in Colorado will depend in part on the Department’s ability to enforce filing requirements on these out-of-state taxpayers. 24
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