Reed Smith Client Alert

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.