On May 12, 2015, the South Carolina Administrative Law Court (ALC) rejected a taxpayer's attempt to source subscription receipts from South Carolina customers outside of South Carolina based upon a cost of performance methodology. The ALC concluded that the taxpayer's income-producing activity was the delivery of a signal to the customer's home. Therefore, all of the subscription receipts from South Carolina customers were sourced to the numerator of the gross receipts ratio.1
Background
The taxpayer, DIRECTV, is a multistate business that offers direct broadcast satellite video services to customers. DIRECTV earns the bulk of its revenues through subscription fees and the lease and sale of set-top boxes to customers.2 With respect to its subscription fees, DIRECTV originally filed its 2006-2008 South Carolina corporate tax returns sourcing all of its South Carolina customer subscription receipts to South Carolina. DIRECTV later amended these corporate tax returns to source all of the South Carolina subscription receipts outside of the state. DIRECTV asserted that South Carolina sales of services were sourced under a pro-rata cost of performance methodology claiming that all income-producing activity for the South Carolina sales occurred outside of the state. After review, the Department denied DIRECTV's amended returns and accepted the originally filed returns. DIRECTV also filed its 2009-2011 South Carolina corporate tax returns using the same pro-rata cost of performance methodology to source subscription receipts. In 2009 and 2010, DIRECTV again asserted that all incomeproducing activity occurred outside South Carolina. In 2011, DIRECTV asserted that a small portion of its subscription fees should be sourced to South Carolina on the basis of a ratio of in-state to everywhere payroll. The Department denied the use of this sales sourcing methodology on the 2009-2011 returns and assessed additional tax, including penalties and interest.
Income-Producing Activity
South Carolina does not explicitly adopt market-based or cost-of-performance sourcing for services, but instead uses an income-producing activity approach.3 Historically, the income-producing activity approach has been viewed to be similar to the pro rata cost of performance method. South Carolina statutes provide that if the income-producing activity is performed partly within and partly outside South Carolina, sales are attributable to South Carolina to the extent the income-producing activity is performed within the state.4 Neither the South Carolina statutes nor any other guidance provide a definition of income-producing activity.
DIRECTV argued that its subscription revenue should be sourced utilizing the location of the payroll and assets used to generate the subscription content. This methodology was based on concepts that were presented in a 1987 case, Lockwood Greene Engineers, Inc. v. South Carolina Tax Commission.5 In this case, the taxpayer unsuccessfully argued that the applicable statute at that time (S.C. Code Sec. Ann. 12-7-1190) prescribed one rule, the origin of payment rule, for all businesses that do not deal in tangible personal property. The South Carolina Supreme Court in Lockwood Greene ultimately ruled that the revenue received for providing engineering services should be based on a pro-rata "place of activity" or the amount of payroll and property utilized in the state to deliver the service, in part because the taxpayer's clients paid the taxpayer for the expertise and time of its employees. The ALC distinguished Lockwood Greene from the case at hand, noting that DIRECTV customers did not pay for or hire distinct professionals for their expertise or time.
DIRECTV argued that its income-producing activities could be identified using four value drivers including content and programming, acquisition and distribution of the content to customers, marketing and sale of service, and customer service. However, the ALC found that DIRECTV failed to quantify these income-producing activities and also failed to identify how they determined the location where these activities occurred. Based upon the South Carolina Supreme Court's recent decision in CarMax, DIRECTV had the burden of proof for providing evidence to demonstrate that the income-producing activity occurred outside of South Carolina, but was unsuccessful in doing so.6
The ALC ruled that DIRECTV's income-producing activity was the delivery of the signal into the homes and the conversion of the signal via a DIRECTV box. This led to the conclusion that all of the income-producing activity related to the South Carolina customers occurred in South Carolina, and DIRECTV must source all of the South Carolina customer subscription revenue to South Carolina. The ALC concluded that there is no single methodology to determine income-producing activity for all service industries and did not impose a one-rule "place of activity" test for all taxpayers. The ALC simply agreed that the Department's use of different methods for different industries and taxpayers was appropriate. As a result, DIRECTV was assessed $6,646,168 in tax and license fees, plus an additional $653,425 in interest, and $1,661,541 in penalties imposed on the underpayment resulting from a substantial understatement of tax liability.
In its findings, the ALC clearly agreed with the Department's position that receipts are to be apportioned to South Carolina to the extent that the income-producing activity occurs within the state, rejecting the pure cost of performance approach the taxpayer attempted to apply. The area of focus was more on what the definition of the income-producing activity was for this industry and where the activity occurred. Further, the ALC indicated that DIRECTV did not provide enough evidence to define its income-producing activities and did not quantify how much income-producing activity occurred in any other state. Specifically, the ALC indicated that DIRECTV did not provide adequate information on how to apportion the subscription revenue between states in which it believed incomeproducing activities occurred.
Commentary
It should be noted that this case reflects potential apportionment opportunities and/or risks that may exist for taxpayers classified as service providers. Taxpayers with more complex service offerings should evaluate their current sourcing methodology used for calculating the South Carolina gross receipts factor. Specifically, South Carolina sales sourcing methods should be evaluated for service providers whose income-producing activity (property and payroll) is not always in the same location as the customer receiving the benefit. Additionally, this case confirms that the Department may be applying more of an ad hoc market-based sourcing approach to some industries and taxpayers providing services, even under the cloak of the income-producing activity method. This case will likely be appealed and should be followed to see how the South Carolina courts ultimately interpret this issue. Additionally, in light of other significant alternative apportionment cases in South Carolina (including CarMax and Media General7), taxpayers will have to wait and see if the South Carolina legislature chooses to resolve some of the uncertainty surrounding these apportionment issues via legislative action.
Footnotes
1 DIRECTV Inc. & Subsidiaries v. S.C. Dept. of Revenue, South Carolina Administrative Law Court, Docket No. 14-ALJ-17-0158-CC, May 12, 2015.
2 The ALC summarily determined (and agreed with the taxpayer and the Department) that receipts received from South Carolina customers with respect to the lease and sale of set-top boxes should be sourced to South Carolina.
3 S.C. CODE ANN. § 12-6-2320(A).
4 S.C. CODE ANN. § 12-6-2295.
5 Lockwood Greene Engineers Inc. v. S.C. Tax Commission, 361 S.E. 2d 346 (Ct. App. 1987).
6 CarMax Auto Superstores West Coast, Inc. v. Department of Revenue, 767 S.E.2d 195 (S.C. 2014). In CarMax, it was determined that the party seeking an alternative apportionment methodology bears the burden of proving that its alternative methodology more accurately reflects the business activity in South Carolina.
7 Media General Communications, Inc. v. South Carolina Department of Revenue, 694 S.E.2d 525 (S.C. 2010).
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