United States: Tennessee Issues Regulations To Clarify Application Of New Market-Based Sourcing Rules

On June 28, 2016, the Tennessee Department of Revenue approved regulations which clarify certain provisions of the 2015 Revenue Modernization Act. Specifically, the new regulations address market-based sourcing rules for sales of items other than tangible personal property and the tax treatment of disregarded entities. The regulations specify the application of the sourcing rules to revenue from in-person services, services delivered to or on behalf of the customer and professional services. Barring any additional filings prior to the effective date, the regulations, as currently drafted, will go into effect on September 26, 2016.

Background

On May 20, 2015, the Revenue Modernization Act was signed into law by Governor Bill Haslam. The Act includes various amendments concerning excise and franchise taxes, business tax and sales and use tax.¹ Included in the amendments were provisions adopting market-based sourcing for sales of other than tangible personal property, but exactly how such sales would be sourced to the Tennessee market had not been addressed until the adoption of the regulations.

Market-Based Sourcing

For tax years beginning on or after July 1, 2016, Tennessee follows the market-based method of sourcing sales of items other than tangible personal property.² The newly issued regulations provide specific guidance on: (1) determining whether and to what extent the market for a sale of items other than tangible personal property is in Tennessee; (2) reasonably approximating the state or states of assignment where such state or states cannot be determined; and (3) excluding the sale where the state or states of assignment cannot be determined or reasonably approximated.³

General Rules of Application and Contemporaneous Records

The regulation requires that a taxpayer look to its books and records and assign sales based on good faith determination and application, on a consistent basis with respect to similar transactions and from year to year.⁴ The taxpayer is directed to retain contemporaneous records to support its determination and application of the sourcing rules.⁵ As many of the sourcing rules are applicable in a hierarchy, the taxpayer also must make a reasonable effort to apply the first sourcing rule applicable to a sale before determining to use a secondary or lower-tier sourcing rule.⁶

Rules of Reasonable Approximation

In the event that a portion of the sales cannot be accurately assigned, the regulations set forth uniform rules for approximating the undeterminable sales. The general rules apply unless the regulations specify otherwise.⁷ If a taxpayer can ascertain most but not all of its sales, the remaining sales can be assigned based on the sales factor if the sales factor is an accurate representation of the geographic distribution of the sales.⁸ If a taxpayer cannot in good faith determine the state of assignment based on the hierarchy of rules, including reasonable approximation, the sale is excluded from the sales factor calculation.⁹ Sale of Real Property, and Rental, Lease or License of Real and Tangible Personal Property In the case of a sale of real property, and the rental, lease or license of real and tangible personal property, the sale is sourced to Tennessee if and to the extent the property is located in Tennessee.¹⁰ If property is mobile property that is located within and outside Tennessee during the contract period, the receipts assigned to Tennessee equal the receipts from the contract period multiplied by the property factor fraction.¹¹

Sale of a Service

In general, the sale of a service is in Tennessee if and to the extent the service is delivered at a location in Tennessee. The term "delivered" refers to the location of the taxpayer market for the service provided, not the location of the property or payroll of the taxpayer as otherwise determined for apportionment purposes.¹²

The regulation explains the sourcing of four specific buckets of sales designed to cover most common service transactions: (i) in-person services; (ii) services delivered to or on behalf of the customer; (iii) professional services; and (iv) broadcast advertising. In-person services are physically provided in person by the taxpayer, where the customer or the customer's real or tangible property upon which the services are performed is in the same location as the service provider at the time of service performance.¹³ Sales of in-person services are assigned to Tennessee if and to the extent the customer receives the service in Tennessee.¹⁴ To assign sales of in-person services, a taxpayer should first determine the location where the service is received, as follows:

1. The service is received in Tennessee if the service is performed with respect to the body of an individual customer in Tennessee or in the physical presence of the customer in Tennessee.¹⁵
2. The service is received in Tennessee if the service is performed with respect to the customer's real estate or tangible personal property in Tennessee.¹⁶
3. In the instance where the service is performed with respect to the customer's tangible personal property and such property is to be shipped or delivered to the customer, whether the service is performed within or outside Tennessee, the service is received in Tennessee.¹⁷

If these rules of determination are inconclusive, the taxpayer is required to reasonably approximate the location if sufficient information exists to do so.¹⁸

In general, where the service provided is not an in-person service or a professional service, and the service is delivered to or on behalf of the customer, or delivered electronically through the customer, the sale is in Tennessee if and to the extent that the service is delivered in Tennessee.¹⁹

Sales that are delivered to or on behalf of the customer, or delivered electronically through the customer are assigned depending upon the method of delivery and the nature of the customer. There are separate assignment rules for sales delivered by physical means and sales delivered by electronic means. The rules below depend on whether the customer is a business or individual.²⁰

1. When the sale is delivered to or on behalf of the customer by physical means, whether to an individual or business, a taxpayer must first attempt to determine the state or states where such services are delivered.²¹ The rules of reasonable approximation apply when the taxpayer cannot determine where the service is delivered.²²
2. Services delivered by electronic means to an individual or business customer²³ are assigned to Tennessee if and to the extent the customer receives the service in Tennessee.²⁴ If the primary rule of determination for individual customers is inconclusive, the taxpayer is required to reasonably approximate the location if sufficient information exists to do so.²⁵ For business customers, it is intended that the state or states where the service is received reflect the location at which the service is directly used by the employees of the customer.²⁶ Given the potentially complicated nature of sourcing these types of sales, if the primary rule of determination for business customers is inconclusive, the taxpayer is required to either reasonably approximate, or apply one of several alternative sourcing rules under a secondary rule of reasonable approximation.²⁷ As a final alternative, a taxpayer can potentially rely on a safe harbor allowing for sourcing according to billing address in the case where the taxpayer engages in substantially similar transactions with more than 250 customers and does not derive more than 5 percent of its sales of services from one customer.²⁸
3. Services delivered electronically through or on behalf of an individual or business customer include services in which a third party is involved.²⁹ In this case, the service is delivered in Tennessee if and to the extent that the end-user or other third-party recipients are in Tennessee.³⁰ Again, if the primary rule of determination is inconclusive, the taxpayer is required to either reasonably approximate, or utilize select secondary rules of reasonable approximation.³¹

Professional services are defined as services requiring specialized knowledge, and in some cases, require a professional certification, license or degree.³² Professional services can be assigned in multiple ways by emphasizing different elements of the service provided, no one of which will consistently represent the market for the services. For the purposes of consistent application of the market-sourcing rule, professional services are not susceptible to a general rule of determination, and must be reasonably approximated.³³

The general rules for assigning a professional service are as follows:

1. Professional services delivered to an individual customer should be assigned to the customer's state of primary residence. If the taxpayer cannot reasonably identify the customer's primary residence, the sale is to be sourced to the state of the customer's billing address. However, if more than 5 percent of the total sales are derived from a single customer, the primary state of residence must be identified.³⁴
2. Professional services delivered to business customers should be assigned first by assigning the receipts to the state where the contract sale is principally managed by the customer. Second, if such place cannot be identified, the sale is to be assigned to the customer's place of order. Lastly, if the customer's place of order cannot be determined, the sale is to be sourced to the customer's billing address, though if more than 5 percent of the total sales are derived from a single customer, the primary state of residence must be identified.³⁵
3. In the event that a taxpayer has a large volume of transactions, it can choose to source its sales using the safe harbor method. A taxpayer may assign its sales based on the customer's billing address if the taxpayer engages in substantially similar service transactions with more than 250 customers and does not derive more than 5 percent of its sales of services from any customer.³⁶

Special sourcing rules apply to professional services that are architectural and engineering services with respect to real or tangible personal property, in which case sourcing typically follows the location of the property.³⁷

Finally, receipts from a broadcaster's sale of advertising services to a broadcast customer are assigned to Tennessee if the commercial domicile of the customer is in Tennessee.³⁸

Rental, Lease, or License of Intangible Property

The receipts from the rental, lease, or license of intangible property are in Tennessee if and to the extent the intangible is used in Tennessee. The term "use" refers to the location of the taxpayer's market, not the location of the property or payroll of the taxpayer.³⁹ Intangible property rented, leased or licensed as part of the sale or lease of tangible property is treated as the sale or lease of tangible property.⁴⁰ Several specific sourcing rules are provided for sales from the license of a marketing, production, broadcasting and mixed intangible, as well as the license of intangible property where the substance of the transaction resembles the sale of goods and services.⁴¹

Sale of Intangible Property

The sourcing of sales of intangible property depends on the nature of the intangible property:

" Contract rights or government licenses that authorize business activity in specific geographic areas are assigned to Tennessee if and to the extent that the intangible property is used or otherwise associated in the state.⁴²

" Non-compete agreements are sources based upon the percentage of the state's population to the total United States population as specified in the contract.⁴³

" Sales resembling a license are sourced by using the general sourcing rules applicable to a license or lease of intangible property. Sales resembling a sale of goods and services are sourced by using the general sourcing rules applicable to licenses of intangible property that resemble sales of goods and services.⁴⁴

Intangibles that are not referenced in the above rules are excluded from the numerator and denominator of the sales factor.⁴⁵

Software Transactions

A license or sale of pre-written software for purposes other than commercial reproduction, when transferred on a tangible medium, is treated as the sale of tangible personal property. The receipts are assigned to Tennessee as a sale of tangible personal property. In all other instances, the receipts from a license or sale of software are assigned to Tennessee as determined otherwise under the regulations.⁴⁶

Disregarded Entities

In addition to the market-based sourcing regulations, Tennessee has provided regulations interpreting provisions in the Act. Notably, a newly adopted Tennessee regulation addresses the treatment of disregarded entities for excise and franchise tax purposes.⁴⁷ In general, a limited liability company (LLC) is disregarded for excise and franchise tax purposes only if it is disregarded for federal income tax purposes and its single member is classified as a corporation for federal income tax purposes.⁴⁸

Tiered Entities

When an LLC is only indirectly owned by a corporation, a "top down" approach is taken to determine whether or not the entity is also disregarded for Tennessee excise and franchise tax purposes. The analysis begins with the corporation and all directly-owned entities that directly or indirectly own the LLC.⁴⁹ Accordingly, in a structure in which a federally classified corporation is the owner of a federally disregarded single-member LLC, which in turn is the owner of a lower-tier federally disregarded single-member LLC, both LLCs are disregarded for purposes of the Tennessee excise and franchise tax.⁵⁰

Commentary

The Tennessee market-based sourcing regulations are largely based on the model regulations under consideration by the Multistate Tax Commission. With an increasing number of states adopting market-sourcing rules and the lack of uniformity in the application of such rules, taxpayers continue to face the challenge of accurately sourcing revenue among the states. Many taxpayers struggle with collecting the data necessary to comply with the various sourcing rules and find themselves making good faith efforts to source receipts. Despite Tennessee's best efforts to clarify the state's market-based sourcing rules, not every type of transaction could possibly be contemplated. As a result, further interpretation of the application of the rules through rulings, and eventually audit practice, is to be expected.

Footnotes

1 H.B. 644, Laws 2015. For a discussion of this legislation, see GT SALT Alert: Tennessee Enacts Major Legislation Expanding Nexus, Adopting Market-Based Sourcing.

2 TENN. CODE ANN. § 67-4-2012(a)(1).

3 TENN. COMP R. & REGS. 1320-06-01.42(1).

4 TENN. COMP R. & REGS. 1320-06-01.42(1)(d).1.

5 Id.

6 TENN. COMP R. & REGS. 1320-06-01.42(1)(d).2.

7 TENN. COMP R. & REGS. 1320-06-01.42(1)(e).1.

8 TENN. COMP R. & REGS. 1320-06-01.42(1)(e).2.

9 TENN. COMP R. & REGS. 1320-06-01.42(1)(f).

10 TENN. COMP R. & REGS. 1320-06-01.42(2), (3).

11 TENN. COMP R. & REGS. 1320-06-01.42(3).

12 TENN. COMP R. & REGS. 1320-06-01.42(4)(a).

13 TENN. COMP R. & REGS. 1320-06-01.42(4)(b).1.

14 TENN. COMP R. & REGS. 1320-06-01.42(4)(b).2.

15 TENN. COMP R. & REGS. 1320-06-01.42(4)(b).2.(i)(I).

16 TENN. COMP R. & REGS. 1320-06-01.42(4)(b).2.(i)(II).

17 TENN. COMP R. & REGS. 1320-06-01.42(4)(b).2.(i)(III).

18 TENN. COMP R. & REGS. 1320-06-01.42(4)(b).2.(ii).

19 TENN. COMP R. & REGS. 1320-06-01.42(4)(c).1.

20 TENN. COMP R. & REGS. 1320-06-01.42(4)(c).2.

21 TENN. COMP R. & REGS. 1320-06-01.42(4)(c).2.(i)(I).

22 TENN. COMP R. & REGS. 1320-06-01.42(4)(c).2.(i)(II).

23 A business customer is any customer operating a business in any form including a sole proprietorship, and a non-profit organization, a trust, or a government customer is treated as a business customer. An individual customer is any customer who is not a business customer. TENN. COMP R. & REGS. 1320-06-01.42(1)(c).4, 7.

24 TENN. COMP R. & REGS. 1320-06-01.42(4)(c).2.(ii)(I), (II). Sales or licenses of digital goods and services are also subject to sourcing through these rules. TENN. COMP R. & REGS. 1320-06- 01.42(7)(b).

25 TENN. COMP R. & REGS. 1320-06-01.42(4)(c).2.(ii)(I).II.

26 TENN. COMP R. & REGS. 1320-06-01.42(4)(c).2.(ii)(II).

27 TENN. COMP R. & REGS. 1320-06-01.42(4)(c).2.(ii)(II).II, III.

28 TENN. COMP R. & REGS. 1320-06-01.42(4)(c).2.(ii)(II).IV.

29 TENN. COMP R. & REGS. 1320-06-01.42(4)(c).2.(iii). Again, sales or licenses of digital goods and services are also subject to sourcing through these rules. TENN. COMP R. & REGS. 1320-06- 01.42(7)(b).

30 TENN. COMP R. & REGS. 1320-06-01.42(4)(c).2.(iii)(I).

31 TENN. COMP R. & REGS. 1320-06-01.42(4)(c).2.(iii)(II), (III).

32 TENN. COMP R. & REGS. 1320-06-01.42(4)(d).1. Rules governing the overlap of professional services with other categories of services addressed in the regulation are provided. See TENN. COMP R. & REGS. 1320-06-01.42(4)(d).2.

33 TENN. COMP R. & REGS. 1320-06-01.42(4)(d).3.

34 TENN. COMP R. & REGS. 1320-06-01.42(4)(d).3.(i)(I).

35 TENN. COMP R. & REGS. 1320-06-01.42(4)(d).3.(i)(II).

36 TENN. COMP R. & REGS. 1320-06-01.42(4)(d).3.(i)(III).

37 TENN. COMP R. & REGS. 1320-06-01.42(4)(d).3.(ii).

38 TENN. COMP R. & REGS. 1320-06-01.42(4)(e).

39 TENN. COMP R. & REGS. 1320-06-01.42(5)(a)(1).

40 TENN. COMP R. & REGS. 1320-06-01.42(5)(a)(3).

41 TENN. COMP R. & REGS. 1320-06-01.42(5)(b)-(f).

42 TENN. COMP R. & REGS. 1320-06-01.42(6)(a).1.

43 TENN. COMP R. & REGS. 1320-06-01.42(6)(a).2.

44 TENN. COMP R. & REGS. 1320-06-01.42(6)(a).3, 4.

45 TENN. COMP R. & REGS. 1320-06-01.42(6)(a).5. Sales from the protection or enforcement of legal rights are also specifically excluded from the sales factor. TENN. COMP R. & REGS. 1320-06- 01.42(7)(c).

46 TENN. COMP R. & REGS. 1320-06-01.42(7)(a).

47 TENN. COMP R. & REGS. 1320-06-01.40.

48 TENN. COMP R. & REGS. 1320-06-01.40(1).

49 TENN. COMP R. & REGS. 1320-06-01.40(3).

50 See TENN. COMP R. & REGS. 1320-06-01.40(3)(example 1).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.