United States: New Jersey Division Of Taxation Issues Proposed Market-Based Sourcing Regulation

On April 15, 2013, the New Jersey Division of Taxation published a proposed regulation in the New Jersey Register that, if adopted, would change the way in which New Jersey determines whether receipts from services are included in the numerator of the Corporation Business Tax ("CBT") allocation factor sales fraction. Under the new regulation, service receipts will be apportioned based upon a market-based sourcing approach, rather than sourcing according to the service provider's cost of performance. If adopted, the new regulation would become effective for tax periods beginning on or after January 1, 2014.¹

Background

New Jersey receipts are simply defined in the CBT statute and current regulations as receipts from services performed in New Jersey.² Under the current regulation, receipts from most services performed both within and outside New Jersey are apportioned according to the cost of performance incurred in New Jersey, the amount of time spent in performing the services in New Jersey or by some other reasonable method.³ For "certain service fees" (i.e., electronic transactions) receipts are currently allocated 25 percent to the state of origination, 50 percent to the state in which the service is performed and 25 percent to the state in which the transaction terminates.⁴

The Proposed Regulation

The proposed regulation redefines New Jersey receipts as "receipts derived from customers within [the] State" effective for tax periods beginning on or after January 1, 2014.⁵ A customer is within the state if it is engaged in a trade or business and maintains a regular place of business in New Jersey or is not engaged in a trade or business but has a New Jersey billing address.⁶ For these purposes, a regular place of business in New Jersey may include any office, factory, warehouse, or other business location in the state where the customer conducts business or maintains property or employees.⁷ A regular place of business is not limited to a principal place of business.⁸ A billing address is the address where notices, statements, or bills relating to the customer's account or services provided to the customer are mailed.⁹

The general intent of the proposed regulation is to attribute receipts from sales of services to New Jersey to the extent the customer receives the benefit of the service in the state.¹⁰ Thus, if the customer receives the benefit of the service within and outside New Jersey (i.e., multistate services), the proposed regulation allows a taxpayer to use the terms of the service contract and its books and records, or can consider the nature of the taxpayer's or recipient's business or the service at issue, to determine the extent the benefit of the service is received in the state.¹¹ If these methods do not provide the information necessary to determine how much benefit of the service is received in the state, a reasonable approximation may be made.¹²

The proposed regulation provides ten examples that show how this new sourcing regulation would operate in practice. Among the examples that are likely to have the widest application to service providers are the following:

• Revenues from engineering services would be attributable to New Jersey if the services relate to a building located in New Jersey.¹³
• An out-of-state computer software developer would attribute revenues derived from developing custom software to New Jersey if the software would only be used in the customer's office in New Jersey.¹⁴ However, if the customer also uses the software at a location outside New Jersey, the taxpayer would attribute the revenues to New Jersey only to the extent the software is used in the state.¹⁵
• Advertising revenues derived from a radio or television broadcast would be attributed to New Jersey to the extent the taxpayer's audience is located in New Jersey if the taxpayer's advertising rates are based upon its audience.¹⁶
• Revenues from a marketing analysis summarized in a memorandum requested by the Florida division of a New Jersey headquartered company whose accounts payable function is located in Illinois, would be attributed to Florida, not New Jersey, even though the deliverable may ultimately be incorporated into a nationwide advertising strategy.¹⁷
• Revenues from legal research subscription services would be attributed to New Jersey according to the percentage of updates received by the customer at a New Jersey location.¹⁸
• Revenues from payroll processing services provided to a customer that has offices and employees in California, New Jersey, Ohio, Pennsylvania and South Carolina would be attributed to New Jersey based upon the customer's number of New Jersey employees.¹⁹

Finally, the proposed regulation also provides a new method for allocating airline revenues according to a "revenue mile fraction."²⁰

Commentary

The Division has been working on the proposed regulation for approximately two years. Several drafts have been circulated to the Tax Director's Advisory Council which responded with substantive comments. It is clear that after this considerable expenditure of time and effort, New Jersey has made an emphatic move towards market-based sourcing and away from cost of performance. But it should be equally clear to experienced practitioners that the debate on exactly how to apportion service receipts to the Garden State is far from over.

Potential Controversies

The Division's proposed regulatory changes are sure to generate controversy. The New Jersey statute states that receipts from services are attributed to New Jersey if "performed within the State" and the Division, until now, has interpreted this provision to mean just that.²¹ The Division even went so far as to adopt a regulation to solidify its interpretation, which it has applied for many years.²² The Division now seeks to dramatically change its interpretation when there has been no change in the underlying statute.

The fact that a regulation may be invalidated where it undermines the intent of the legislature may be problematic for the Division.²³ The intent of the legislature is typically determined based upon a plain reading of the statute (unless a plain reading leads to some absurd result) and, as noted above, the CBT statute unambiguously states that receipts from services are attributed to New Jersey if the services are performed in the State.²⁴ In addition, the practical administrative construction of a statute over a period of years is evidence of its conformity with legislative intent, and as previously noted, the "performed within the State" construction has been applied by the Division for many years.²⁵

The New Jersey legislature has even acknowledged this "state of performance rule" without taking action to change it. In 2002, the CBT statute was amended to attribute sales from asset management and broker-dealer services to New Jersey if the customer is located in the state, "as opposed to where the services are performed as under current rules."²⁶ From this legislative history, one could logically conclude that if the legislature intended something other than a "state of performance" approach for other types of service receipts, it would have further amended the statute in 2002 (or in subsequent sessions) to more broadly apply the "customer location" rule that the Division now seeks to apply via its proposed regulation.²⁷ The legislature's approach suggests an intent to maintain the "state of performance" rule rather than broadly adopt the proposed "customer location" rule.

That is not to say that a taxpayer challenge to the new regulation on the preceding grounds would be easy. For example, the taxpayer would have to overcome the presumption of reasonableness that administrative regulations are generally accorded.²⁸ In addition, a taxpayer would have the heavy burden of demonstrating that the adopted regulation is arbitrary, capricious, unduly onerous or otherwise unreasonable.²⁹ The new regulation, which has gone through several iterations, has been carefully reviewed by governmental counsel within and outside of the Division. These reviews presumably have considered possible challenges to the proposed regulation and may even have considered the appropriate defenses and counter-arguments.

More prosaic disputes are likely to arise as the Division and corporate taxpayers wrestle with the regulatory language allowing the use of a "reasonable approximation" to allocate service receipts when the terms of a contract or the taxpayer's books and records do not adequately indicate where the benefit of services is received.

Sourcing Rules

The Division appears to have proposed sourcing rules that applies to business customers (maintain a place of business in the State) and non-business customers (billing address), but the proposed regulation does not make this clear. If that is the intent, it would seem to make sense for the Division to clearly state this (e.g., use the terms "business" and "individual") in the proposed regulation. Without further clarification, it is possible that revenues could be attributed to New Jersey even though the billing address is merely a post office box where a business receives payments but does not maintain a regular place of business or receive any of the benefit of the service in New Jersey.

In addition, the Division appears to have proposed one sourcing rule that applies to single-state services and another that applies to multistate services. For example, single-state services are attributed to New Jersey if the customer maintains a regular place of business in the state or has a billing address in the state, while multistate services are attributed to New Jersey to the extent that the customer's benefit from the services is in the state.

Lastly, the examples provided in the proposed regulation are not necessarily consistent with the Division's intent to source receipts where the benefit of the service is received. For example, in the Division's "marketing analysis" example, none of the receipts are attributed to New Jersey even though the customer is headquartered in New Jersey and the deliverable would ultimately be incorporated in a nationwide advertising strategy. In the Division's "legal research subscription services" example, revenues from the updates are attributed to New Jersey to the extent received by the customer in New Jersey seemingly without regard to where they are actually used. In the Division's "payroll processing services" example, a portion of the revenues are attributed to New Jersey without regard to the location of the customer's headquarters office, presumably the location that would be receiving the benefit.

Public Comment and Hearing

The Division has provided taxpayers with 60 days to comment on the proposed regulation.³⁰ Given the heavy burden of challenging a duly promulgated regulation, it may make sense for concerned taxpayers to submit comments on the proposed regulation. While the Division's history of amending proposed regulations to address taxpayer concerns raised in comments is not very notable, submitting comments may well be a taxpayer's only chance to call attention to regulatory provisions that appear to be unfair, inconsistent or illogical in practice. In particular, out-of-state service businesses, who may see a significant increase in post-2013 CBT liability due to New Jersey's intended to shift to market-based sourcing in conjunction with the full phase-in to a single sales allocation factor for tax years beginning on or after January 1, 2014, may want to comment.³¹

In addition, the Administrative Procedure Act³² and the Division's related regulations when read together require the Division to conduct a public hearing on the proposed regulation if "sufficient public interest" is shown within 30 days following publication of the proposed regulation.³³ Under the regulations, "sufficient public interest" exists when 100 or more individuals have communicated in writing as to the need for a public hearing and at least 50 of said individuals have specified in their written communication an objection to at least one provision of the proposed regulation.³⁴ A public hearing could ensure that the greatest numbers of taxpayer opinions are taken into account, and if undertaken may provide taxpayers with insight as to the Division's arguments in support of the proposed regulation and/or the way the Division intends to apply the proposed regulation in practice.

To comply with the 60-day comment period, written comments should be submitted by June 14, 2013 to: Mitchell C. Smith, Administrative Practice Officer, Division of Taxation, 50 Barrack Street, P.O. Box 269, Trenton, NJ 08695.³⁵

Footnotes

1 45 N.J. REG. 886(a) (April 15, 2013).

2 N.J. REV. STAT. § 54:10A-6(B)(4); N.J. ADMIN. CODE tit. 18, § 18-7-8.8(a)(2).

3 N.J. ADMIN. CODE tit. 18, § 18:7-8.10(a).

4 N.J. ADMIN. CODE tit. 18, § 18:7-8.10(c).

5 N.J. ADMIN. CODE tit. 18, § 18:7-8.10A(a).1 (proposed).

6 N.J. ADMIN. CODE tit. 18, § 18:7-8.10A(a).2.i (proposed).

7 N.J. ADMIN. CODE tit. 18, § 18:7-8.10A(a).2.ii (proposed).

8 Id.

9 N.J. ADMIN. CODE tit. 18, § 18:7-8.10A(a).2.iii (proposed).

10 N.J. ADMIN. CODE tit. 18, § 18:7-8.10A(a).3.ii (proposed).

11 N.J. ADMIN. CODE tit. 18, § 18:7-8.10A(a).3.iii (proposed).

12 N.J. ADMIN. CODE tit. 18, § 18:7-8.10A(a).3.iv (proposed).

13 N.J. ADMIN. CODE tit. 18, § 18:7-8.10A(a).3.iv (Example 2) (proposed).

14 N.J. ADMIN. CODE tit. 18, § 18:7-8.10A(a).3.iv (Example 3) (proposed).

15 N.J. ADMIN. CODE tit. 18, § 18:7-8.10A(a).3.iv (Example 4) (proposed).

16 N.J. ADMIN. CODE tit. 18, § 18:7-8.10A(a).3.iv (Example 5) (proposed).

17 N.J. ADMIN. CODE tit. 18, § 18:7-8.10A(a).3.iv (Example 7) (proposed).

18 N.J. ADMIN. CODE tit. 18, § 18:7-8.10A(a).3.iv (Example 9) (proposed).

19 N.J. ADMIN. CODE tit. 18, § 18:7-8.10A(a).3.iv (Example 10) (proposed).

20 N.J. ADMIN. CODE tit. 18, § 18:7-8.10A(a).6.i (proposed).

21 N.J. REV. STAT. § 54:10A-6(B)(4); N.J. ADMIN. CODE tit. 18, § 18-7-8.8(a)(2).

22 See, e.g., 29 N.J. Reg. 3426(a) (August 4, 1997). See also State Tax News, New Jersey Division of Taxation, Fall 1993.

23 See Richard's City Auto, Inc. v. Director, Division of Taxation, 659 A.2d 1360 (N.J. 1995).

24 See International Business Machines Corporation v. Director, Division of Taxation, 26 N.J. Tax. 102 (N.J. Tax Ct. 2006).

25 See Brunswick Corporation v. Director, Division of Taxation, 638 A.2d 805 (N.J. 1994).

26 N.J. REV. STAT. § 54:10A-6.2(a); A. 2501, 2002-2003 Leg. Sess. (N.J. 2002) (Assembly Budget Committee Statement to A. 2501, June 27, 2002).

27 See International Business Machines Corporation v. Director, Division of Taxation, 26 N.J. Tax. 102 (N.J. Tax Ct. 2006).

28 See Richard's City Auto, Inc. v. Director, Division of Taxation, 659 A.2d 1360 (N.J. 1995).

29 Id.

30 45 N.J. REG. 886(a) (April 15, 2013).

31 N.J. REV. STAT. § 54:10A-6.

32 (N.J. STAT. ANN. § 52:14B-1 et seq.

33 N.J. STAT. ANN. § 52:14B-4(a)(3); N.J. ADMIN. CODE tit. 18, § 18:1-2.5(a). It is unclear form the statutes and regulations whether the 60-day comment period extends to the 30-day public hearing period. However, it may make sense to adhere to a 30-day rule to avoid any mishap.

34 N.J. ADMIN. CODE tit. 18, § 18:1-2.5(b). It should be noted that it is unclear whether this definition of "sufficient public interest" would apply given that the regulation expired August 7, 2011. However the statute requires the Division to promulgate a regulation that defines this term. N.J. STAT. ANN. § 52:14B-4(a)(3). Thus, the regulation provides taxpayers with the best sense of the definition of "sufficient public interest" at this time.

35 Id.

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