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What Market-based Sourcing Rules Mean for Private Equity Firms

By: Matthew John McNally |

Over the last few years, a transformation has been taking place in state and local income taxes—the shift to market-based sourcing for services income. Today, more than half of the states have adopted market-based sourcing. The result is more complexity and uncertainty for private equity firms.

Cost of performance vs. market-based sourcing

Historically, most states used the cost of performance (COP) method for apportioning service revenue to a particular state. With COP, the revenue is sourced to the state where the majority of the service is performed. Market-based sourcing, on the other hand, is not based on where the service is performed, but where the benefit of the service is received or used by the customer. This method drastically changes the way service-providers are taxed. Consequently, private equity firms may be required to allocate management fees to where the fund’s investors reside rather than where the firm is doing business.

Possible double taxation

With sourcing rules varying from state to state and no consistent state approach to market-based sourcing, many questions and issues arise. Potential problems such as double taxation can occur, where private equity firms may be required to source their income to multiple states. For example, if a private equity firm in Connecticut is managing investments for a client in California, Connecticut could tax 100% of the income and California could tax 20% resulting in a tax of 120% of income.

Looking to California

Given that market-based sourcing is relatively new, there are few court decisions that provide guidance to private equity firms and other service providers. Many experts are looking at developments in California for possible direction on this issue.

The state adopted market-based sourcing of services income in 2012. The rule states that benefits of the service are presumed to be in California if the billing address of the customer is in California (unless the taxpayer’s records indicate that the benefit of the service was received elsewhere). But the California Franchise Tax Board (FTB) has established that further clarification of the regulations and how it applies to specific industries is vital.

As a result, the FTB has been developing additional regulations for the last several years and most recently proposed changes in May of 2018. From an asset management perspective, these proposed regulations provide a default rule that asset management services are received where the investor, beneficial owner or shareholder resides. However, important questions exist whether these regulations meet the constitutional requirement that income tax be both “fairly apportioned” and “fairly related to the services the state provides.”

Dealing with uncertainty

Despite these questions, the shift toward market-based sourcing is growing and, unfortunately, so is the uncertainty. In fact some experts predict this issue will be the next major source of state tax controversy.

While its unclear how forcefully the states may attempt to apply these rules to the private equity industry, firms must closely monitor their state tax footprints as well as developments in state tax law and their application to the industry. The experienced tax professionals at True Partners Consulting can help you do that. To learn more, contact Matthew McNally at  Matthew.McNally@TPCtax.com.