Florida court rules on service sourcing matter

On March 1, 2023, a Florida circuit court granted a group of related taxpayers’ motion for summary judgment, and held that state law required the use of the cost-of-performance (COP) method to source the taxpayers’ service revenues for purposes of the sales apportionment factor applicable for the Florida corporation income tax.¹ Because the plain language of the Florida apportionment regulation provides for the use of COP sourcing, the circuit court rejected the Florida Department of Revenue’s application of market-based sourcing. Furthermore, the circuit court held that the Department’s inconsistent application of its COP regulation violated the Florida Taxpayer’s Bill of Rights.

Background

The taxpayers were six related out-of-state corporations that provided financial technology services to businesses across the country. Five of the six taxpayers provided their services from locations outside Florida and incurred most of their costs to perform these services outside the state. The sixth taxpayer provided its services from locations inside and outside Florida and incurred most of its costs inside Florida. For Florida corporation income tax purposes, the taxpayers apportioned their income from the sale of services based on the COP method described in the Florida apportionment regulation. Under this method, the taxpayers apportioned revenue to the state where they incurred the majority of their costs performing their income producing activities. The five taxpayers providing their services from outside Florida did not source any service revenue to the state, while the sixth taxpayer sourced all of its service revenue to the state through the application of the COP all-or-nothing rule requiring sourcing of sales to the state in which the preponderance of its costs was incurred.

The Department initiated corporate income tax audits of the six related taxpayers for the 2015-2017 tax years. One of the audits was performed by an auditor located in the Department’s Illinois satellite office and the remaining audits were performed by an auditor located in the Department’s Pennsylvania satellite office. All of the audit reports concluded that the taxpayers’ use of the COP method to determine the sales factor was incorrect, but the audits from each office provided slightly different market-based sourcing methodologies. The audits assessed additional tax due for the five taxpayers that conducted most of their business activities outside Florida and a tax refund for the taxpayer that had performed a preponderance of its business activities within Florida. The taxpayers contested these assessments and filed a motion for summary judgment with a Florida circuit court.

Sourcing of service receipts

Under Florida law, corporations are required to apportion their business income to the state using a three-factor formula comprised of a payroll, property, and double-weighted sales factor.² For purposes of the sales factor, as a general rule, the Florida statute directs taxpayers to include the total sales of the taxpayer “in this state,” with no specific sourcing provision for sales of services.³ A Florida regulation provides a COP method to source receipts related to “Other Sales in Florida,” which generally is considered to include most types of service revenue.⁴ Under this regulation, if the income producing activity giving rise to the service revenue is not conducted solely in Florida, the revenue is attributable to Florida if the greater proportion of the income producing activity is performed in Florida, based on COP. Thus, if the greater proportion of the costs to perform the income producing activity is incurred outside Florida, none of the related receipts are apportioned to Florida. It should be noted that despite the references to COP, the Department has interpreted this regulation to apply market-based sourcing in many instances over the past several years in its published guidance.⁵

COP sourcing method must be applied

The circuit court held that the COP method as provided in the Department’s regulation must be used to source the taxpayers’ service revenue. The Department and the taxpayers agreed that the COP regulation should be applied, but they disagreed on the interpretation of the regulation’s language. As explained by the court, “the sole dispute in this case is whether the COP Rule requires application of a cost of performance methodology, or a market-based methodology.” The court focused on the interpretation of the “income producing activity” and the “costs of performance” terminology in the regulation as well as the proper application of the regulation. 

The court explained that states generally adopt either the COP or the market-based sourcing approach to apportion service income when a company does business in more than one state. Under a COP approach, the key consideration is where the taxpayer performs a greater proportion (i.e., preponderance) of its income producing activity. In contrast, market-based sourcing is generally based on the location where the customer receives the service. The Department argued that a market-based sourcing methodology should be used in the instant case. The court noted that the taxpayers in this case were audited by two different Department branches in Illinois and Pennsylvania and that each branch applied a slightly different underlying market-based sourcing methodology. The Illinois auditor determined that a taxpayer’s income producing activities were the actual sale of services to its customers, as opposed to the costs of performing those services. Under this approach, the income producing activity occurs in Florida if the taxpayer’s customers are located in the state and the transactions and activities occur in Florida. The Pennsylvania auditor decided that when services are provided to customers, these activities occur entirely in Florida when the customer is located in Florida. The income producing activity is the taxpayer’s obligation to provide the services. 

The circuit court concluded that the plain language of the COP regulation unambiguously directs that the income from the taxpayers’ sales be determined through use of the COP method. In reaching its determination, the circuit court discussed its recent decision in Target Enterprise, Inc. v. Department of Revenue.⁶ In Target Enterprise, the court explained that COP operates in two steps. First, it is necessary to determine the taxpayer’s income producing activity. Second, the regulation requires a balancing of the costs incurred to perform the activity. If the greater proportion of the costs to perform the activity is outside Florida, none of the receipts are sourced to Florida. If the greater proportion of the costs to perform the activity is in Florida, all of the receipts are sourced to Florida.

In the instant case, the court determined that each of the taxpayers applied the plain language of the COP regulation and appropriately apportioned the income to Florida. For five of the taxpayers, none of the service income was sourced to Florida because most of their costs occurred outside the state. The service income of the sixth taxpayer was sourced to Florida because most of its costs occurred within the state. As a result, the court concluded that the assessments that the Department issued to the taxpayers using the market-based sourcing method violated the plain language of the COP regulation.⁷

The court decided that the Department’s interpretation of the COP regulation to apply a market-based sourcing approach contradicted the plain language of the regulation and Florida law. As discussed above, the report for the audit conducted in Illinois sourced the service income based on the location of the taxpayer’s customers and the location of the taxpayer’s transactions and activities. The workpapers for the Illinois audit repeatedly acknowledged application of the market-based sourcing approach, rather than the COP approach required by the COP regulation. The reports for the audits conducted in Pennsylvania explained that the sales factor determinations were based on the location of the taxpayers’ customers. The court concluded that none of the explanations provided by the Department applies the plain language of the COP regulation. As explained by the court, “to determine taxpayer’s income-producing activity the Department must look at the transactions and activity the taxpayer directly engages in for the ultimate purpose of obtaining gains or profits, rather than looking at the actions or location of the customer.”⁸ The court also determined that even if the language of the COP regulation were ambiguous, the regulation must still be construed to require application of the COP method, because under Florida law, tax law ambiguities are typically resolved in favor of the taxpayer.


 

Taxpayer’s Bill of Rights violated

The circuit court also held that the Department’s inconsistent interpretation of its own regulation violates the Florida Taxpayer’s Bill of Rights, which ensures the fair and consistent application of tax laws.⁹ As explained by the court, “the Department’s application of the apportionment methodology in different ways to different taxpayers, and in a manner that directly contradicts its plain language is not ‘fair’ or ‘consistent.’” The court noted that the Department’s auditors admitted that the varying interpretations of the COP regulation applied in the audits at issue could result in different auditors applying different interpretations of the rule.

Commentary

The circuit court’s decision that the COP regulation requires application of COP sourcing, rather than the Department’s administratively derived market-based sourcing methodologies, is consistent with the recent Target Enterprise decision from the same court. However, the court in this decision provides a deeper analysis of the underlying regulation in support for using a COP methodology. In Target Enterprise, the court endorsed the taxpayer’s ability to use COP sourcing with respect to its service revenue and rejected the Department’s use of an alternative apportionment methodology that would have applied a form of market-based sourcing. Compared to Target Enterprise, this decision is broader by directly holding that the Department’s use of market-based sourcing contradicts the COP regulation and violates the Florida Taxpayer’s Bill of Rights.  

Service providers that incur a greater proportion of their costs to perform their services outside Florida, but that have a significant market presence in Florida, may want to determine whether this case provides sufficient support for a COP sourcing approach. This decision further strengthens positions to consider applying a COP methodology to previous and prospective filings, at least on a protective-claim basis.

At the same time, however, there are several other relevant issues regarding the sourcing of service-based receipts that were not addressed in the decision that still may provide support for a market-based sourcing position. Further, the court’s findings did not address the particular COP method to use when sourcing service receipts, specifically whether a transactional or operational COP approach should be followed. The “plain-language” of the regulation appears to support a transactional approach in which the income producing activity and costs from each service-based transaction are taken into account. The analysis provided by the court, though, focuses more on the location of a “vast majority” of the taxpayers’ cost to provide the services, which may imply support for an operational approach. Finally, this decision does not address the potential impact on the numerous rulings issued by the Department that follow a market-based sourcing approach.  

This is the second recent decision from the same circuit court endorsing or requiring the use of COP sourcing. The Department is currently challenging this decision on several fronts, including an argument that the circuit court did not have jurisdiction over this case, and that the taxpayers did not meet certain requirements to be able to bring the suit to the court. The Department also may appeal the substantive decision issued in circuit court once a final judgment has been rendered (which will incorporate its findings on the procedural arguments raised by the Department), or potentially may amend the regulation to adopt a market-based sourcing methodology. Furthermore, as a response to this litigation, legislation could potentially be enacted to require market-based sourcing. Because this issue is not final, practitioners and taxpayers should continue to monitor for future developments. 

1 Billmatrix Corp. v. Department of Revenue, Circuit Court of the 2nd Judicial Circuit, Leon County, Fla., No. 2020-CA-000435, March 1, 2023. 
2 Fla. Stat. Ann. § 220.15(1).
3 Fla. Stat. Ann. § 220.15(5).
4 Fla. Admin. Code Ann. r. 12C-1.0155(2)(l).
5 For example, see Technical Assistance Advisement, No. 21C1-010, Florida Department of Revenue, March 5, 2021 (released Feb. 2022); Technical Assistance Advisement, No. 21C1-005, Florida Department of Revenue, July 2, 2021 (released Jan. 2022); Technical Assistance Advisement, No. 20C1-001, Florida Department of Revenue, Jan. 13, 2020.
6 Circuit Court of the 2nd Judicial Circuit, Leon County, Fla., No. 2021-CA-002158, Nov. 28, 2022. For further discussion of this decision, see GT SALT Alert: “Florida trial court approves use of cost-of-performance sourcing.” 
7 The court’s application of the COP regulation resulted in lower assessments for five of the taxpayers but negated the Department’s proposed refund for the sixth taxpayer.
8 Emphasis provided by court. 
9 See Fla. Stat. Ann. § 213.015(21).

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