Reed Smith Client Alert

Authors: Brent K. Beissel Michael A. Jacobs Robert E. Weyman

The first quarter of 2013 saw Massachusetts developments for some the biggest tax issues facing the state, including taxation and sourcing of cloud computing, SaaS and other web-based software products and services; application of interest and royalty add-back; apportionment of income; and recapture of incentives. In this quarterly update, we’ll take a look at some hot topics in pending litigation, and anticipated changes in the new budget.

Cost-of-Performance Sourcing

With more than half a dozen hearings on cost-of-performance sourcing issues scheduled at the Appellate Tax Board in the upcoming months, sourcing of receipts for apportionment purposes continues to be an important issue to watch in Massachusetts. This update explores three pending cases with upcoming hearings at the Appellate Tax Board, as well as proposed legislative changes that would eliminate the cost-of-performance sourcing rule going forward.

Retailer argues vendor credits are "receipts" sourced on cost-of-performance basis: In a pending case, a national retailer is arguing that vendor credits are "receipts" that should be included in its sales factor denominator, but excluded from its sales factor numerator and instead sourced to its headquarters state, where the greater proportion of the retailer’s costs of performance were incurred.

The retailer in this litigation receives credits from its suppliers for:

  • Placing supplier products in weekly circulars
  • Placing supplier products in premium locations in its stores
  • Making bulk purchases
  • Meeting sales targets
  • Activating customer accounts

The retailer is arguing that the credits constitute "receipts" and should be included in gross receipts for purposes of computing its sales factor, even though the retailer did not include the credits in its gross income reported on line 1 of its federal income tax return. Furthermore, the retailer is arguing that these "receipts" are earned for the performance of services and should be sourced on a cost-of-performance basis. Under this theory, these "receipts" are not sourced to Massachusetts because a greater proportion of the costs incurred by the retailer’s marketing operations to generate the receipts were incurred in the retailer’s headquarters state, rather than in Massachusetts.


Retailers receiving supplier credits may have a refund opportunity if they are not currently including these credits in their sales factor and sourcing them on a cost-of-performance basis.

"All or nothing" cost-of-performance sourcing—the Department joins in: Taxpayers sourcing receipts from services outside Massachusetts on an "all or nothing" or "operational" basis—especially those being challenged on that position by the Massachusetts Department of Revenue—should keep an eye on two pending cases in which the Department is arguing that sourcing receipts on such a basis is proper.

Most of the current pending cost-of-performance litigation in Massachusetts involves taxpayers with substantial out-of-state operations arguing that their receipts from sales other than tangible personal property must be excluded from the Massachusetts sales factor numerator on the basis that they incur the greatest proportion of the costs of generating the receipts in a state other than Massachusetts. Two current cases illustrate that the "all or nothing" nature of Massachusetts’ cost-of-performance rule can sometimes work in the Commonwealth’s favor, with the result that the Department finds itself arguing in support of the "all or nothing" position:

  • Management Information Services: This appeal involves a Massachusetts-based company that owned and developed proprietary software it licensed to affiliates across the country. It appears from their petition that the taxpayer sourced the licensing fees on a market basis. At audit, the Department characterized the license fees as receipts from management information services and sourced 100 percent of the fees to Massachusetts.
  • Gift Card Management Services: This appeal involves a Massachusetts-based company that manages and administers gift card operations, as well as other gift card sales, for its affiliated group. The Department has taken the position that all the company’s receipts should be sourced to Massachusetts. The taxpayer is instead arguing that costs paid to affiliates and third parties outside of Massachusetts are direct costs that should be considered in applying the cost-of-performance analysis. The Department often takes a position similar to that taken by the taxpayer in this case, arguing that amounts paid to contractors are direct costs of performance, when challenging out-of-state taxpayers that take a cost-of-performance position, so it will be interesting to examine the arguments made by the Department in this case.


Taxpayers taking cost-of-performance positions at audit or on appeal should keep a close eye on pending cases in which the Department has taken positions that could support taxpayers in other contexts. As in the Boston Bruins and Interface litigation - briefs, discovery, and other documents produced in these pending cases may show the Department making arguments that out-of-state taxpayers can use to bolster their own sourcing positions.

Taxpayers that provide services similar to the gift card management and management information services discussed in these pending cases, and that would benefit from sourcing receipts from those sources on an "all or nothing basis," should consider filing protective refund claims.

Market-based sourcing on the horizon While the Governor and the Legislature have offered competing budget proposals in the current legislative session, they both appear to agree that Massachusetts should drop the cost-of-performance sourcing method going forward, in favor of a market-based sourcing approach for sales other than sales of tangible personal property. With key Massachusetts-based industry groups supporting this change to the sourcing rules, we expect that the change will be enacted as part of any budget deal.


Sales Taxes on Software

The Department has issued draft sales tax guidance regarding cloud computing, SaaS, ASP, and other mixed software/services transactions

The Department’s working draft directive on the sales tax treatment of transactions involving software bundled with non-taxable services outlines the Department’s criteria for determining whether a purchase constitutes a taxable purchase of pre-written software, or a non-taxable purchase of non-taxable services through the application of an "object of the transaction" test. Taxpayers that have paid tax on such bundled transactions should be following a pending case in which a taxpayer is challenging the Department’s position.

Pursuant to Draft Directive 13-XX, when non-taxable services and access to pre-written software are sold for a single bundled price, Massachusetts looks to the object of the transaction to determine whether the transaction is a taxable sale of pre-written software, or a non-taxable service.1 Directive 13-XX lays out eight criteria that may indicate that the object of a transaction was the purchase of taxable software—including the vendor branding itself as a provider of ASP, SaaS, or cloud-computing services—and 10 criteria that may indicate that the object of a transaction was the purchase of a non-taxable service.

In general, under Directive 13-XX, a bundled transaction is more likely to be treated as a taxable purchase of software:

  • The more the purchaser is able to manipulate or control the software
  • The fewer services the vendor provides to the purchaser beyond maintaining and repairing the software and the network

Taxpayers should note that Directive 13-XX is still a working draft and subject to change before the Department issues its final guidance.

Reed Smith Comments:

Pending litigation challenges Department Position on Bundled Software Transactions: In a case pending at the Appellate Tax Board, a vendor that was assessed sales tax on sales involving a bundled package of software and services is challenging the Department’s application of the true object test. A taxpayer victory on this issue would likely create refund opportunities.

Some cloud-computing services not taxable under Directive 13-XX? Directive 13-XX states that cloud-computing services are presumptively taxable. However, the Directive also acknowledges that for a bundled transaction, if non-taxable services constitute the predominant value of the sale—the object of the transaction is a service and the sale is not taxable. This would seem to change the outcome of guidance provided by the Department in Letter Ruling 12-8 regarding cloud-computing services.2 In that ruling, the Department found that the purchase of a cloud-computing service was not taxable if, as part of the transaction, the customer obtained access to open source (free) software, but found that the purchase would be taxable if the customer obtained access to pre-written computer software that was not open source as part of the transaction. The only substantive difference between the two sales was that the hourly fee for accessing the open source software was lower than the hourly fee for access to the non-open source software. Under the draft directive, as long as the hourly fee for the non-open source software was not double the cost of accessing open source software, it would seem that the predominant value of the transaction would be non-taxable services and thus, the sale of these cloud-computing services would not be taxable.

Taxpayer brings multiple points-of-use apportionment challenge Ongoing litigation at the Appellate Tax Board may shed light on the application of Massachusetts multiple point-of-use apportionment rules. The appellant in the case is a software vendor bringing a refund claim on behalf of its customer applying Massachusetts’ multiple points-of-use apportionment rules. The software was located on a Massachusetts server, but available for use by the purchaser in multiple jurisdictions. The purchaser did not provide a multiple points-of-use certificate at the time of the purchase so the vendor collected and remitted Massachusetts sales tax on the full purchase price. The purchaser later provided its apportionment information and the vendor brought a refund claim on the purchaser’s behalf on the basis that tax was only due on the percentage of the sales price attributable to users in Massachusetts under Massachusetts’ multiple points-of-use regulation. The Department denied the refund claim, allegedly because a multiple points-of-use certificate was not provided by the time the taxpayer remitted sales tax to the state. The vendor is now appealing. For more information on this appeal, click here to see our alert on the case.

Taxpayers that paid Massachusetts sales tax on the full purchase price for software that was available for use in other jurisdictions should consider filing protective refund claims.

Legislature proposes to expand sales tax to computer services: The Legislature is on the verge of agreeing to a significant expansion of the Massachusetts sales tax base to include numerous computer-related services. If the House and Senate negotiators come to an agreement on this issue in coming weeks, a veto by Governor Patrick (who proposed an even larger expansion of the sales tax base) would be the only remaining hurdle.

In June 2006, the Department of Revenue’s Office of Appeals branch drafted an internal memorandum recommending that Massachusetts impose tax on custom software.3 Nearly seven years later, Governor Patrick proposed to do just that by expanding Massachusetts’ sales tax to custom software, as well as to computer and data processing services such as programming, software testing, data access, data processing and information management services.4

The Legislature has responded with a proposal that would involve a slightly narrower expansion of the sales tax base. Both the Senate and House have passed bills that would impose tax on "computer system design services," as well as on various customization and installation services performed on pre-written computer software.

The result would be that many currently non-taxable customization services performed on pre-written software would be subject to tax. Furthermore, the ambiguous definition of "computer system design services" creates the danger that an aggressive interpretation by the Department of Revenue would lead to tax being imposed on custom software as well.

Reed Smith Comment:

The governor and Legislature should work to refine the definition of "computer system design services" before enacting final legislation. As currently drafted, these services are defined as "the planning, consulting, or designing of computer systems that integrate computer hardware, software, or communication technologies…" The scope of the services to be taxed under this definition is ambiguous and could easily result in unnecessary assessments or tax overpayments by vendors and customers that are uncertain about whether certain services fall within this definition.


Supreme Judicial Court Refuses to Hear Exception to Add-Back Appeal

In our last quarterly update, we reported on the Massachusetts Appeals Court decision upholding the ATB’s decision denying Kimberly-Clark interest deductions for interest payments attributable to a cash management system, as well as royalty payments to affiliated entities.5 The appeal involved deductions for a three-year period, including a tax year (2001) before the adoption of the statutory add-back for related-party interest, and two tax years (2002-2003) after the adoption of the statutory interest add-back.6

On January 31, Kimberly-Clark filed an application for further appellate review with the Supreme Judicial Court, which was denied March 1, thus ending Kimberly-Clark’s appeal rights. For more coverage of this case, re-visit our last quarterly update.


Department Issues Guidance on Recapture of Certified Life Sciences Company Credits

The Department has issued a Technical Information Release to provide rules explaining the requirement to recapture two tax incentives received by a certified life sciences company whose certification is subsequently revoked by the Massachusetts Life Sciences Center ("Center"): the refundable research credit7 and the refundable life sciences investment tax credit.8

In general, certification granted by the Center is valid for five years starting with the tax year in which the certification was granted. However, the certification may be revoked if it is determined that representations made by a certified company in its certificate proposal materially differ from the actions of the company following certification. When the certification is revoked, the company must recapture any credits, exemptions, deductions or other benefits allowed under the original certificate.9

Reed Smith Comment:

We have recently seen increased state interest in recapturing or retroactively limiting the use of credits; for example, Governor Jerry Brown’s attempt to retroactively revoke California’s enterprise zone benefits in 2011 and calls to scale back the program this year, as well as New Jersey’s attempts to claw-back certain economic development credits. State efforts to recapture tax credits and incentives are an issue to watch in upcoming years as states look for additional sources of funding.

If you have questions about any of the items discussed in this update, please contact the authors of this alert, or the Reed Smith lawyer with whom you usually work. For more information on Reed Smith's Massachusetts tax practice, visit

About Reed Smith State Tax Reed Smith’s state and local tax practice is comprised of lawyers across seven offices nationwide. The practice focuses on state and local audit defense and refund appeals (from the administrative level through the appellate courts), as well as planning and transactional matters involving income, franchise, unclaimed property, sales and use, and property tax issues. Click here to view our State Tax team. 

1. Working Draft Directive 13-XX, "Criteria for Determining Whether a Transaction is a Taxable Sale of Pre-Written Software or a Non-taxable Service" (February 7, 2013).
2. Department of Revenue Letter Ruling 12 – 8 (July 16, 2012).
3. See Department of Revenue, Office of Appeals, "Memorandum regarding taxation of software" (June 5, 2006).
4. HB No. 1 (2013/2014).
5. Kimberly-Clark Corp. v. Commissioner, 2013 WL 119778 (Mass. App. Ct. 2013).
6. The Appeals Court also denied Kimberly-Clark’s royalty deductions for payments to an affiliate intangible holding company, as well as rebate payments to the affiliate that were deemed embedded royalties.
7. G.L. c. 63, § 38M(j).
8. G.L. c. 62, § 6(m)(2); G.L. c. 63, § 38U.
9. G.L. c. 23I, § 5(e)(3).



Client Alert 2013-111