New Jersey approves '25-50-25' tax rule

Tax Court OK’s sourcing method for electronic messaging service

Frank Schaefer
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Bridget McCann
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Taryn Ruane
New York – Manhattan
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Jamie C. Yesnowitz
Washington, DC
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Chuck Jones
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Lori Stolly
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The New Jersey Tax Court recently approved the use of the Division of Taxation’s “25-50-25” rule to source the income of an electronic messaging services provider for Corporation Business Tax (CBT) apportionment purposes.1 Because the Court determined that the taxpayer did not qualify as a long-distance telephone provider, an example in the cost of performance regulation that sources receipts for long-distance telephone providers “based upon billings for calls originating in New Jersey” did not apply to the taxpayer.

Background The taxpayer, a telecommunications retailer that provided messaging services by using fax, e-mail and voice transmissions, primarily sold “fax blast services.” In doing so, the taxpayer delivered advertisements, messages and information for financial service companies or travel agencies. The taxpayer’s New Jersey headquarters was the hub for the application software and the location of most of the hardware. All of the orders were received in New Jersey and the telecommunications services originated in the state. The messages were transmitted using a common carrier’s least expensive telephone lines as determined by the taxpayer’s software. The taxpayer relied on third-party providers and did not own any transmission lines or network equipment. Customers were charged based on the amount of long-distance service usage and upon volume for e-mail distributions.

In May 2007, the Division audited the taxpayer for the 1998-2005 tax years. The taxpayer claimed that it had applied the cost of performance method and only apportioned approximately 5% to 7% of its receipts to New Jersey. The auditor rejected the taxpayer’s apportionment method because it did not accurately reflect the taxpayer’s receipts or business activity in the state. Following a meeting of the taxpayer’s accountants and the Division’s management, the auditor was directed to apply the 25-50-25 hybrid sourcing method authorized by the Division’s regulation. This resulted in approximately 76.36 percent of the taxpayer’s receipts being apportioned to New Jersey.

The taxpayer appealed the audit’s CBT assessment. In approving the apportionment method used at audit, the Division’s conferee rejected the taxpayer’s apportionment and determined that 100 percent of the receipts should be sourced to New Jersey using a pure cost of performance method. Despite this conclusion, the conferee upheld the auditor’s 76.36% sales factor apportionment under the 25-50-25 method. The taxpayer filed a motion for summary judgment with the New Jersey Tax Court and argued that the example in the cost of performance regulation for sourcing the income of long-distance telephone companies should be applied. In its cross-motion for summary judgment, the Division contended that its assessments were presumptively correct and 100% of the taxpayer’s receipts would be sourced to New Jersey under the cost of performance regulation. The Tax Court denied both motions because more facts were needed to decide the proper sourcing of the taxpayer’s receipts. After discovery was completed, both parties filed new motions for summary judgment.

Sourcing service income In New Jersey, the numerator of the sales factor for CBT apportionment purposes includes services performed within the state.2 If a service is performed both within and outside New Jersey, a regulation provides that the numerator of the receipts factor includes receipts from services based on the cost of performance or amount of time spent in performing the services.3 Two specific examples of how to utilize the general sourcing rule are provided. One example (general sourcing Example 2) clarifies the sourcing of income from sales of long-distance telephone communications.4 In this example, the company bills the originators of long-distance calls directly for the calls that they make. The regulation provides that the appropriate method for sourcing the company’s “long-distance toll revenues” from services performed in the state is “based upon billings for calls originating in New Jersey.”

The regulation also provides special methods for sourcing certain types of industry-specific services, including amounts characterized as service fees.5 With respect to service fees, a hybrid sourcing method is authorized. Under the 25-50-25 method, certain service fees from transactions having contact with New Jersey are sourced to the state based on the following: (i) 25% are sourced to the state of origination; (ii) 50% are sourced to the state where the service is performed; and (iii) 25% are sourced to the state in which the transaction terminates. This regulation includes examples illustrating the sourcing for a credit card issuer, and the sourcing for an Internet access provider (the hybrid sourcing examples).

Division’s apportionment methodology accepted The taxpayer filed a second motion for summary judgment and argued that its income should be sourced under general sourcing Example 2 because its filings with the Securities and Exchange Commission (SEC) proved that it was providing long-distance telephone communications services. In its cross-motion for summary judgment, the Division argued that the taxpayer was not a long-distance telephone carrier and that the apportionment of the taxpayer’s income under the 25-50-25 method should be affirmed. The Tax Court affirmed the Division’s assessments and granted its cross-motion for summary judgment.

Application of 25-50-25 apportionment method was not unreasonable

The Tax Court approved the Division’s use of the 25-50-25 sourcing method. In determining that application of the 25-50-25 method to the taxpayer was “not patently unreasonable or invalid,” the Court considered that the taxpayer received all of its customers’ orders in New Jersey and sent the messages from New Jersey to recipients both within and outside the state. Also, the hardware and software used to receive the customers’ orders and to determine the least expensive route for transmitting the messages were located in New Jersey. The Court agreed with the Division that the taxpayer’s “hub is in New Jersey, New Jersey is where the services are performed, and New Jersey is where the significant tangible and intangible property required to initiate, and perform the services is located.”

According to the Court, the 25-50-25 method applied to the taxpayer even though the rule specifically addresses the treatment of “certain service fees.” The hybrid sourcing examples address the sourcing of Internet access fees and “service income fees” charged by credit card companies. The fact that the taxpayer imposed some charges that were not flat fees for services did not render the assessment invalid or require the Court to apply general sourcing Example 2 as a default option instead of the 25-50-25 method. The Court noted that the taxpayer charged fees for its services and a “minimum commitment” fee. Even though a fee may not directly relate to services, it would still be taxable in New Jersey as “all other business receipts.”6 Because some of the switching devices were located outside New Jersey, it was not unreasonable for the Division to use the 25-50-25 method to source the taxpayer’s receipts.

Long-distance telephone example did not apply to taxpayer

The Court determined that the taxpayer was not a telephone long-distance provider that could use general sourcing Example 2 to limit its receipts sourced to the state to the “billings for calls originating in New Jersey.” This example does not define “long-distance telephone communication services,” but the Court found that the Division’s argument limiting the example to long-distance telephone carriers that are licensed and regulated by the Federal Communications Commission (FCC) was not unreasonable.7 The fact that the taxpayer leased long-distance telephone services from third-party carriers and used those carriers’ lines and equipment to perform its messaging services did not make the taxpayer a provider selling long-distance telephone services for purposes of general sourcing Example 2. Furthermore, even if the taxpayer qualified as a long-distance telephone carrier, the provision limiting the taxpayer’s receipts in the state to “billings originating in New Jersey” would not apply because 100% of its calls originated in the state.

In agreeing with the Division’s argument, the Court explained that the Division had “broad authority” to make apportionment adjustments to “accurately and fairly” represent a taxpayer’s activities in the state. Under the cost of performance method, the taxpayer’s receipts would be 100 percent sourced to New Jersey. Any ambiguity in general sourcing Example 2 did not need to be resolved in favor of the taxpayer as a means to source only 5% to 7% of its receipts as indicated on its CBT return.

Possible inconsistent treatment for sales and use tax

The Court considered the taxpayer’s argument that its treatment under the CBT was inconsistent with its treatment under sales and use tax. According to the taxpayer, because it was deemed to be selling telecommunications for sales and use tax purposes, it should be treated in the same manner for CBT purposes. The Court rejected this argument and noted that sales tax applies to most forms of telecommunications, but general sourcing Example 2 is limited to long-distance telephone services. Also, the Division applied a similar 25-50-25 method to source receipts to New Jersey for CBT purposes and determine sales tax payable based on call origin, customer billing and call destination. The Court concluded that even if the taxpayer were a retailer of telecommunications for sales tax purposes, the receipts sourced to the state did not need to be limited to its customers billed at a New Jersey address under the CBT.

Commentary This case considers the challenging aspects of determining how to classify and source service-based receipts, and focuses on the unique 25-50-25 hybrid sourcing methodology that New Jersey applies to source certain service fees. In this particular case, a high percentage of receipts were sourced to New Jersey because all of the costs originated in the state, all of the services were performed within the state and some of the transactions terminated in the state. However, this methodology could be advantageous for taxpayers with a different fact pattern. Taxpayers with data centers located outside New Jersey could source a much smaller amount of sales to New Jersey even with a substantial amount of customers located in New Jersey.

This decision limits the application of general sourcing Example 2, utilizing a pure origination billing approach, to long-distance telephone companies that are licensed by the FCC. Thus, companies in related industries but do not have FCC licenses will not be able to use general sourcing Example 2. Again, depending upon the specific facts of the taxpayer, this could be a very favorable, or very unfavorable development.

Taxpayers should note that the continuing use of the 25-50-25 hybrid methodology is limited, and that the regulations in question in this case that authorize this method will have to be revisited soon as a result of recently enacted legislation. Earlier this year, New Jersey adopted market-based sourcing for sales of services.8 However, with a four-year statute of limitations in New Jersey, there are remaining opportunities to consider use of the 25-50-25 method.

1 Xpedite Systems, Inc. v. Director, Division of Taxation, New Jersey Tax Court, No. 018847-2010, Sep. 5, 2018 (not for publication).
2 N.J. REV. STAT. § 54:10A-6(B)(4).
3 N.J. ADMIN. CODE § 18:7-8.10(a).
4 N.J. ADMIN. CODE § 18:7-8.10(a), Example 2.
5 N.J. ADMIN. CODE § 18:7-8.10(c).
6 See N.J. REV. STAT. § 54:10A-6(B)(6); N.J. ADMIN. CODE § 18:7-8.12. This classification requires sourcing of such receipts to the location where they are earned.
7 In determining that general sourcing Example 2 did not apply to the taxpayer, the Court considered that the taxpayer: (i) was not a carrier; (ii) was not licensed by the FCC; (iii) was not paying common carrier tariffs required by the FCC; (iv) was not licensed or authorized by New Jersey agencies regulating utilities as a long-distance telephone provider or carrier; and (v) was fully dependent on third-party long-distance telephone companies to perform its services.
8 Ch. 48 (A.B. 4202), Laws 2018. For a discussion of this legislation, see GT SALT Alert: New Jersey Adopts Mandatory Combined Reporting, Market-Based Sourcing. Note that market-based sourcing is scheduled to apply to tax years beginning in 2019 and thereafter. However, as a result of pending legislation, the effective date may change.

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