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New Jersey’s Proposed Market-Based Sourcing Reg — Invalid Lawmaking

At long last, the New Jersey Division of Taxation has released its proposed regulation for sourcing receipts from services. Appearing in the April 15 New Jersey Register, the proposed regulation reflects a customer-based sourcing approach for most service receipts.1 The statute controlling apportionment of service receipts, however, unequivocally requires receipts to be sourced based on where performed.2 Sometimes the place where a service is performed and the place where the customer receives the benefit of that service will align, and in those scenarios, the results under the proposed regulation would be acceptable. But in many scenarios, where a service is performed and where the customer would be treated as receiving the benefit will differ. In those scenarios, the division will have exceeded its authority by adopting a regulation that reaches a result contrary to that required by the statute.

In many scenarios, the division will have exceeded its authority by adopting a regulation that reaches a result contrary to that required under the statute.

This viewpoint does not take a position as to whether a performance-based or customer-based approach for computing the sales factor is the ‘‘better’’ approach. Some taxpayers (particularly in-state taxpayers with substantial direct costs of performance within New Jersey) will likely pay less corporate business tax under a customer-based method than under the statutory method, while other taxpayers (such as out-of-state taxpayers with few or no direct costs of performance within New Jersey) will likely pay greater corporate business tax under a customer-based sourcing regime, but that adoption should be done by the State Legislature rather than by the division.

The proposed regulatory changes include amendments to Administrative Code sections 18:7-1.6 and 18:7-8.10, as well as the creation of a new regulation numbered 18:7-8.10A (together ‘‘the proposed regulatory changes’’). The proposed regulatory changes indicate that the current rules found in section 18:7-8.10 will continue to apply to periods beginning before January 1, 2014, while proposed rule 18:7- 8.10A will apply to periods beginning on or after January 1, 2014.

The Statute Being Interpreted Requires Service Receipts to Be Assigned to Where the Service Is Performed

The proposed regulatory changes are designed to implement and interpret N.J.S.A. 54:10A-6(b)(4) prospectively. Section 54:10A-6(b) indicates that for apportionment purposes, the numerator of the sales fraction includes ‘‘the receipts of the taxpayer . . . arising from . . . (4) services performed within the State.’’ Regulation section 18:7-8.10, the regulation currently interpreting that provision, generally reflects a performance-based approach.

The Director’s Authority to Adopt Regs Implementing Statutes Is Limited and Any Regs That Exceed That Authority Are Invalid

For the proposed regulatory changes to be a valid interpretation of N.J.S.A. 54:10A-6(b)(4), they must provide a method that is consistent with the statutory method. However, because N.J.S.A. 54:10A-6(b)(4) explicitly requires service receipts to be assigned to where performed and the regulatory changes explicitly require those receipts to be assigned to where the customer receives the benefit of the service, the regulatory changes (if formally enacted) would be invalid in many scenarios.3

Of course, the director has been granted broad authority to promulgate regulations implementing tax statutes. Still, under case law, a regulation that ‘‘is inconsistent with the statute it purports to interpret . . .will be invalidated.’’4 The New Jersey courts have repeatedly and uniformly held that ‘‘an agency may not under the guise of interpretation . . . give the statute any greater effect than its language allows.’’5

The explicit requirement provided in N.J.S.A. section 54:10A-6(b)(4) to assign receipts from services based on where performed must prevail over any administrative regulations taking a contrary approach. ‘‘Statutes, when they deal with a specific issue or matter, are the controlling authority as to the proper disposition of that issue or matter. Thus, any regulation or rule which contravenes a statute is of no force, and the statute will control.’’6

The New Jersey Tax Court has recognized that ‘‘an administrative interpretation which is inconsistent with the ordinary and primary meaning of the statutory language will be ignored.’’7 Thus, to the extent the proposed regulatory changes would assign receipts to New Jersey from services that were not performed in the state, the regulatory change would be invalid.

When the Service Is Performed Outside the State

The proposed regulatory changes would require service receipts to be assigned to where the customer receives the benefit of the service even when the service is performed outside the state. The proposed regulation provides a series of rules and a set of examples. Interestingly, the first assignment rule appears to be a catchall provision that states, ‘‘The numerator of the receipts fraction developed in accordance with this section includes receipts from services not otherwise apportioned if the service is performed within this State.’’8

Although that provision, which requires receipts to be assigned to where performed, is consistent with thestatute being interpreted, it implies that the rest of the regulation will not require receipts to be assigned to where performed. That implication in and of itself is troubling because it implies that other provisions will assign receipts to other than where performed.

The next section purports to assign receipts based on where the customer is located.9 Customer location can be contrary to the underlying statute’s performance-based method. The regulation further indicates that receipts are derived from a customer in New Jersey if that customer has a regular place of business in the state (regardless of whether the service is received there) or if the customer has a billing address in New Jersey.10

In other words, imagine a Pennsylvania company providing services to a customer in Pennsylvania. Further imagine that the customer happens to maintain a warehouse in New Jersey. Even if the service has absolutely nothing to do with the New Jersey warehouse, the proposed regulation seems to require that the receipt be assigned to New Jersey. That result is inconsistent with the underlying statute (N.J.S.A. 54:10A-6(b)(4), which would have sourced that receipt to Pennsylvania) and raises significant commerce clause and due process clause apportionment concerns. Moreover, that provision creates an unreasonable compliance burden in that it would require sellers to know whether each of their customers has any place of business in New Jersey, even if the transaction occurs entirely outside the state.11

The next section of the proposed regulation assigns receipts for services that are received by a customer for use in multiple states.12 The section looks to where the relative portion of the benefit is received and even contemplates allowing a taxpayer to look to the relative New Jersey population as a proxy for where the benefit is received. (This subsection bears a markedly strong resemblance to California’s new market-based sourcing rules embodied in Cal. Code Regs. tit. 18 section 25136-2, which clearly depart from performance-based sourcing in favor of market-based sourcing.) It is difficult to understand how using the relative New Jersey population is a reasonable proxy for determining where a seller has performed its services as is required by the underlying statute.

The division provides 10 examples illustrating the rules described above. A few of them contain language contradicting the underlying statute’s requirement that receipts be assigned to where performed. For example, Example 2 indicates that some of the engineering service at issue is performed in New Jersey and some is performed in another state, yet all of the receipts are assigned to New Jersey because the benefit was received in New Jersey.

Thus, while the underlying statute limits New Jersey’s share to the receipts received for services performed in New Jersey, the regulation’s reach is greater. (Note that under current N.J.A.C. 18:7-8.10, the receipt would have been assigned proportionately to New Jersey and to the other state based on the relative costs of performance.)

Example 3 indicates that the entire service of developing custom software occurs in another state, but because the customer will use the software only in New Jersey, the entire receipt is assigned to New Jersey. Again, that appears to conflict with the statute, which would have assigned the receipt to the state where performed.

Many of the remaining examples also reach results that appear inconsistent with the underlying statute’s performance-based approach. The proposed regulation also provides new rules for assigning receipts from airline and trucking revenue, as well as asset management services.

The Portion of the Statute Being Interpreted Has Not Been Amended, So Why Is a Regulatory Change Needed?

New Jersey statute section 54:10A-6(b)(4) has not recently been amended by the Legislature. However, in 2011 the Legislature amended other portions of N.J.S.A. 54:10A-6 to phase out New Jersey’s threefactor apportionment formula in favor of a singlesales-factor formula. Some policymakers, including the Division of Taxation, apparently,13 take the position that customer-based assignment of receipts is consistent with the policy rationale underlying a single-sales-factor apportionment formula. After all, a traditional three-factor formula measures the capital (that is, property) and labor (that is, payroll) used to create a company’s market (that is, receipts); one could certainly argue that if a state eliminates its property and payroll factors to focus purely on receipts, those receipts should exclusively measure the company’s market.14

On the other hand, there is no inherent conflict in using a performance-based apportionment method in an apportionment formula that focuses on receipts. In fact, before its phaseout of three-factor apportionment, New Jersey used a double-weighted three-factor formula that counted receipts twice and property and payroll each only once. That formula, like a single-sales-factor formula, placed a greater emphasis on a company’s receipts than on its other factors. Yet the division was comfortable using (or felt compelled by the terms of its statute to use) performance-based sourcing in that regime.

Of course, New Jersey could require market-based sourcing. But it can only do so through a legislative amendment.

Of course, New Jersey could require marketbased sourcing. But it can only do so through alegislative amendment to N.J.S.A. 54:10A-6(b). The Division of Taxation lacks the power to enforce a regulation that directly conflicts with the law. As with all regulatory changes, the public is invited to comment on the proposed regulation. Comments must be submitted to the division by June 14, 2013.

1 See 45 N.J.R. 886(a).

2 See N.J.S.A. 54:10A-6(b)(4).

3 At times the location where a service is performed and the location where the customer receives the benefit of that service would be the same location. In those scenarios, the regulatory changes would reach a result that is consistent with the statute.

4 New Jersey Society for the Prevention of Cruelty to Animals v. New Jersey Department of Agriculture, 196 N.J. 366, 385-386 (2008); Equipment Leasing & Finance Assoc. v. Director, Division of Taxation, 24 N.J. Tax 527, 534 (Tax 2009).

5 Society for the Prevention of Cruelty, 196 N.J. at 386; Equipment Leasing, 24 N.J. Tax at 534.

6 L. Feriozzi Concrete Co., Inc. v. Casino Reinvestment Dev. Auth., 342 N.J. Super. 237, 251 (App. Div. 2001) (internalcitation omitted).

7 Smith v. Director, Division of Taxation, 7 N.J. Tax 187,195 (Tax 1984), aff’d, 8 N.J. Tax 319 (App. Div. 1986), aff’d 108 N.J. 19 (1987); see also Matter of Adoption of Amendments to N.J.A.C. 6:28-2.10, 3.6 and 4.3, 305 N.J. Super. 389, 401-2 (App. Div. 1997) (reiterating that an administrative interpretation will be set aside if it ‘‘plainly transgresses the statute it purports to effectuate or if it alters the terms of the statute or frustrates the policy embodied in it’’ (internal citations omitted)).

8 N.J.A.C. Proposed 18:7-8.10A(a)(1).

9 N.J.A.C. Proposed 18:7-8.10A(a)(2).

10 Note, however, that the proposed regulation’s Example 7 reaches a different result.

11 To make matters worse, New Jersey treats some partnerships’ and limited liability companies’ places of business as the places of business of their unitary partners or members. Thus, a seller would have to maintain records regarding its customers’ entity types and the places of business that could be deemed their places of business.

12 N.J.A.C. Proposed 18:7-8.10A(a)(3)

13 See the summary supporting proposed amendments in 45 N.J.R. 886(a).

14 In fact, many practitioners believe that because a singlesales-factor formula ignores capital and labor (that is, the activities that generate revenue), those formulas violate the U.S. Constitution’s requirement for fair apportionment.

© 2022 McDermott Will & EmeryNational Law Review, Volume III, Number 140

About this Author

In 1934 E.H. McDermott opened a law practice that focused exclusively on taxes. As chief counsel to the Joint Committee on Taxation of the United States Congress, McDermott observed firsthand how the rapidly expanding federal tax laws were affecting businesses and individuals. He recognized the need for a law firm to assist people and their businesses to understand and comply with their changing tax obligations.

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