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Indiana tax court adopts operational cost of performance approach for sourcing services

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On November 30, the Indiana Tax Court overturned an Indiana Department of Revenue adjusted gross income tax (AGIT) assessment on a taxpayer providing online education services, as the taxpayer had a greater proportion of income-producing activities located outside Indiana than within the state. In doing so, the Tax Court endorsed the taxpayer’s use of a cost study, and considered case law in other states dealing with similar fact patterns before concluding that the state’s own statute and regulation required an operational cost of performance (COP) sourcing approach.1

Facts The taxpayer, a private, accredited education service provider headquartered in Phoenix, Arizona, offers both online educational and educational services through “ground campuses,” which take place offline. The online educational services offered by the taxpayer fall within four general categories: access to an online eCampus platform, online faculty instruction, curriculum development, and graduation assistance. The taxpayer’s activities related to the eCampus platform, online faculty instruction, curriculum development, and graduation assistance all took place outside Indiana, with the exception of one individual who performed eCampus-related services within Indiana during 2011.  

The taxpayer filed Form IT-20, Indiana Corporation Adjusted Gross Income Tax Return, for the 2009-2011 tax years. When computing its Indiana adjusted gross income, for purposes of sales factor apportionment, the taxpayer sourced 100 percent of its receipts attributable to its Indiana ground campus students to Indiana as Indiana receipts, but sourced none of its receipts attributable to its online campus students to Indiana.

Following an audit, the Department issued the taxpayer an assessment for additional AGIT liabilities, interest, and penalties, relying on a market-based sourcing approach for receipts attributable to all of the taxpayer’s students located in Indiana. The taxpayer protested the assessments, and the Department denied the protest, though the Department abated the penalties. The taxpayer then filed a formal appeal with the Indiana Tax Court.

Indiana Cost of Performance Sourcing
In sourcing sales of items other than tangible personal property for purposes of determining the Indiana sales factor, an all-or-nothing COP method is statutorily authorized.2 This means if income-producing activities take place only within Indiana, then the income is entirely attributable to Indiana. However, if the income-producing activities take place both within and outside Indiana, the revenue is sourced for sales factor purposes to Indiana only if a greater proportion of the activities are performed in Indiana than any other state, based on COP.

A Department regulation provides further guidance on the definition of income producing activity and COP. Income producing activity includes “the act or acts directly engaged in by the taxpayer for the ultimate purpose of obtaining gains or profit.”3 COP is defined as “direct costs determined in a manner consistent with generally accepted accounting principles and in accordance with accepted conditions or practices in the trade or business of the taxpayer.”4

Historic Department Position in Letters of Findings
The Department’s assessment was in line with its historic position taken under several Letters of Findings,5 under which it has utilized market-based sourcing via a transactional approach to source receipts from services. In one of these rulings, the Department addressed the sourcing of receipts from a taxpayer that provided services relating to online education programs.6 The Department determined that all receipts from Indiana students participating in these programs should be sourced to Indiana because the state was the location where the students purchased the services from the taxpayer and participated in the classes. The Department examined these sales on a transactional level, as the services related to these particular transactions were obtained in Indiana by Indiana residents, making the receipts related to the service attributable to the state. The Department reached similar conclusions in other Letters of Findings with relatively similar fact patterns. The Department argued that this consistent approach provided substantial detail and support for the Department’s position on the sourcing of receipts to Indiana.

Identification of Income-Producing Activities Through Cost Study
At the Tax Court, the taxpayer argued that it engages in four “income-producing activities.” To support their reasoning, the taxpayer presented a cost study to show the geographic location where the taxpayer generated its income. The study provided detail on: (i) the taxpayer’s items of income; (ii) the income-producing activities associated with the items of income; (iii) the direct costs incurred in performing those income-producing activities; and (iv) the location where the direct costs were incurred. The income-producing activities, as defined by the cost study, were the activities that directly benefitted a student, or customer. These activities included its eCampus platform, classroom instruction, curriculum development and the graduation team.

The Department argued that the taxpayer’s only income-producing activity was “providing the opportunity to attend a class online in return for payment and an Indiana resident agreeing to do so.” Therefore, it was asserted that this income-producing activity would have been performed entirely in Indiana. The Department claimed that the location of performance was not relevant as long as the Indiana resident had the opportunity to take the class and accepted the opportunity, asserting that the income would be attributable to Indiana. Accordingly, the Department’s definition of “income-producing activities” was derived from the student’s perspective, focusing on the activities that provide a student the opportunity to attend an online class in exchange for the student’s payment for that class.

The Tax Court ultimately held that Indiana Code Sec. 6-3-2-2(f) provides that revenue received by the taxpayer is sourced based on the acts of the seller, not the location of the purchaser. As the Department’s argument contradicted the statute, the Department’s claim was regarded as insufficient by the Court, and the Department was found as failing to produce substantial evidence to rebut the evidence presented by the taxpayer in the cost study.

COP Sourcing Method Through Operational Approach Endorsed
Following the determination that the taxpayer’s conception of its income-producing activities was correct, the Tax Court then considered whether COP sourcing that resulted in none of the taxpayer’s sales from online education sourced to Indiana was appropriate. The taxpayer maintained that its income-producing activities were performed both within and outside Indiana, and that the market-based sourcing approach taken by the Department was contradictory to the sourcing approach as prescribed under the statute.  The cost study provided by the taxpayer concluded that the direct costs related to the University’s four income-producing activities did, in fact, take place both within and outside Indiana, with a large majority of those costs being incurred outside of Indiana. The Department did not dispute this.

The Department did not contest that it used a market-based approach to source the taxpayer’s receipts to the extent that payments were linked to an Indiana billing address. Furthermore, no argument was made by the Department as to why it was permissible to utilize a market-based sourcing methodology under the given circumstances. Therefore, the Court saw the sourcing methodology utilized by the Department as contradictory to the COP statute addressing the sourcing of receipts to Indiana.

The taxpayer maintained that none of its revenue related to online services could be sourced to Indiana because a greater proportion of the income-producing activities in conjunction with this income were performed outside of the state based on COP.  Utilizing an operational rather than transactional approach, the cost study presented by the taxpayer identified that a substantially disproportionate amount of direct costs were incurred in Arizona (its headquarters) rather than Indiana.

The Department argued that the identification and location of costs incurred to perform the University’s income-producing activities was unreliable and that a transactional approach should instead be used. In doing so, the Department relied on Oregon and Idaho case law in other states in defense of the transactional approach.”7

Noting that this case was a matter of first impression, the Tax Court reviewed the Department’s own regulation on the subject. The Tax Court determined that even though the regulation referenced the word “transaction” in determining the COP calculation, such term was used to describe the types of transactions subject to the regulation, not how the regulation was to be applied. While the Tax Court was entitled to look at reasoning in cases outside Indiana, the Tax Court determined that the Indiana statute and regulation did not contain any language that could support the Department’s use of a transactional approach. Therefore, the Tax Court affirmed that the cost study presented by the taxpayer was sufficient and persuasive evidence to support the taxpayer’s sourcing calculation, and dismissed the Department’s assessment.

Commentary
The Indiana Tax Court decision has provided taxpayers with significant service revenue streams a standard for what the Tax Court will recognize as an income-producing activity and the appropriate sourcing of the associated receipts. With no such prior Indiana court decision, the Tax Court reviewed other state court decisions, but came to the conclusion that the operational approach was appropriate under the existing Indiana statute and regulation rather than a transactional approach. In this instance, a transactional approach could have resulted in some level of Indiana sales, due to the fact that the taxpayer likely incurred some transaction-specific costs in Indiana. The decision stands in relative contrast to a recent decision by the Oregon Tax Court involving the same taxpayer, in which a relatively broad transactional approach using a narrow conception of the costs that qualified as COP was adopted.8

Additionally, the Tax Court’s recognition of the taxpayer’s cost study as sufficient evidence is worth noting for taxpayers that will contest these types of matters. This should encourage all taxpayers with complex multistate service revenue streams to consider developing their own cost studies on a proactive, contemporaneous basis.

The Tax Court’s decision also invalidates the Department’s conclusions reached in each of the Letters of Findings it has released that are based on the transactional method for identifying and sourcing receipts related to an income-producing activity. Given the potential far-reaching impact, this decision is likely to be appealed by the Department. In the meantime, however, multistate taxpayers involved in providing services to Indiana residents, should review their historic and current sales factor sourcing methodology to determine whether income is being correctly attributed to the state.



1 The University of Phoenix, Inc. v. Indiana Department of State Revenue, Indiana Tax Court, No. 49T10-1411-TA-00065, Nov. 30, 2017.
2 IND. CODE § 6-3-2-2(f).
3 IND. ADMIN. CODE tit. 45, r. 3.1-1-55.
4 Id.
5 Letter of Findings No. 02-20120316, Indiana Department of Revenue, November 28, 2012; Letter of Findings No. 02-20130238, Indiana Department of Revenue, September 25, 2013; Letter of Findings No. 02-20130359, Indiana Department of Revenue, November 26, 2014.
6 Letter of Findings No. 02-20130359, Indiana Department of Revenue, November 26, 2014.
7 AT&T Corp. v. Dep’t of Revenue, 358 P.3d 973 (Or. 2015); Cable One, Inc. v. Idaho State Tax Comm’n, 337 P.3d 595 (Idaho 2014).
8 See Apollo Education Group, Inc. v. Department of Revenue, Oregon Tax Court, Magistrate Division, No. TC-MD 150352C, Aug. 24, 2017.



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