The Cost-of-Performance Rule

The taxation of service revenue has long been a complex issue for states imposing corporate income tax. Traditionally, states followed the cost-of-performance (COP) rule, which sources revenue from services based on where the greatest proportion of the income-producing activity occurs. This method, derived from the Uniform Division of Income for Tax Purposes Act (UDITPA), seeks to allocate service revenue to the location where the work is performed rather than where the customer benefits from the service.

The rationale behind the COP rule is rooted in the principle that businesses should pay tax based on the location of their economic activities. This method was designed to prevent states from taxing revenue that was not earned within their jurisdiction. COP sourcing aligns with fundamental tax concepts that tie taxation to physical presence, operational costs, and business investment within a state.

The historical reliance on COP sourcing was particularly beneficial for industries that required significant infrastructure, human capital, or technical resources concentrated in specific locations. Professional service firms, consulting businesses, financial institutions, and technology companies relied on this methodology as it clearly reflected where their core business functions were executed.

Challenges with the Cost-of-Performance Method

While the COP approach has long been a cornerstone of state tax policy, it has encountered significant challenges in the modern economy. The rapid growth of remote work, digital services, and cloud-based platforms has complicated the ability of tax authorities to determine where income-producing activity truly takes place.

Some key issues with COP include:

• Lack of Uniformity: The interpretation of “cost of performance” varies across jurisdictions. Some states focus on payroll expenses, others on operational expenditures, and some use a mix of factors.

• Difficulties in Auditing: States often struggle to verify where services are performed, especially when companies operate in multiple locations and do not neatly track expenses per jurisdiction.

• Incentives for Tax Planning: Because states apply COP differently, businesses can engage in strategic tax planning by locating key service functions in states with favorable tax regimes.

• Misalignment with Economic Reality: COP sourcing does not always reflect where the economic benefit of a service is realized, leading states to argue that they are losing tax revenue to jurisdictions where businesses physically operate but do not sell their services.

The Shift Toward Market-Based Sourcing

To address the perceived shortcomings of the COP approach, many states have transitioned to market-based sourcing, which attributes service revenue to the location where the customer receives the benefit. The rationale behind this shift is that businesses derive income from the markets they serve rather than from the locations where they perform their work.

The move toward market-based sourcing has been driven by several factors:

• Expansion of Digital Services: Companies providing digital content, streaming services, and SaaS platforms often have little to no physical presence where their customers reside, making COP sourcing less applicable.

• Revenue Protection for States: States argue that taxing businesses based on customer location ensures they collect revenue from out-of-state businesses that benefit from their economic infrastructure.

• Simplification of Tax Administration: Market-based sourcing, in theory, provides a more straightforward method of assigning revenue by looking at customer billing addresses, locations of service consumption, or contractual terms.

Despite these perceived advantages, market-based sourcing has introduced new compliance burdens for businesses. Companies operating across multiple states now must track customer locations accurately, navigate conflicting rules, and deal with states that may impose aggressive assessments.

How Florida Compares to Other States

Florida is at a crossroads with its COP Rule. The Florida Department of Revenue has begun interpreting the COP rule as if it does not exist and marketplace sourcing is the law. Meanwhile, service providers are filing case after case in Leon County fighting the change. While Florida case law appears committed to COP, something doesn’t sit right about tech companies, which are largely located outside of Florida, paying no (or very little) income tax to the state. 

Pennsylvania: Judicial Interpretation Supporting Market-Based Sourcing

Pennsylvania’s shift toward market-based sourcing was largely a result of judicial interpretation rather than explicit legislative change.

• In Synthes USA HQ Inc. v. Commonwealth, the Pennsylvania Supreme Court upheld the Department of Revenue’s interpretation that service revenue should be sourced based on where the customer receives the benefit, effectively producing a market-based sourcing result.

• The ruling emphasized that Pennsylvania’s later statutory amendment adopting explicit market-based sourcing (effective in 2014) was merely a clarification rather than a substantive policy shift.

• Comparison to Florida: Whereas Pennsylvania’s courts have supported the Department of Revenue’s move toward market-based sourcing, Florida’s courts have consistently reinforced the statutory COP requirement, rejecting administrative efforts to circumvent it.

Texas: Recent Case Law Reinforcing Cost-of-Performance

Texas, like Florida, follows a cost-of-performance methodology, but its courts have taken a more detailed approach to defining where service revenue is earned.

• In Sirius XM Radio Inc. v. Hegar, the Texas Supreme Court ruled that Sirius XM’s service revenue should be sourced to the state where the service was performed, rather than where its customers received the signal.

• The court rejected the Texas Comptroller’s argument that the relevant income-producing activity was the transmission of the satellite signal to customers in Texas. Instead, it determined that the service was performed primarily outside Texas, aligning with a strict COP approach.

• Comparison to Florida: While Texas and Florida both formally adhere to COP sourcing, Texas courts have engaged in more detailed fact-finding to determine the proper sourcing location, whereas Florida courts have largely limited their role to rejecting the DOR’s market-based interpretations.

New York and California: Hybrid and Ordering Rules

New York and California both apply market-based sourcing, but they introduce additional complexities through hybrid models and tiered ordering rules:

• New York: Services are generally sourced where the benefit is received, but if that location is unclear, secondary methodologies apply, including the delivery destination of the service.

• California: The state applies an ordering rule that first attempts to determine where the benefit of the service is received. If that cannot be determined, alternative factors such as customer billing address are considered.

• Comparison to Florida: While Florida applies a singular, rigid COP rule, New York and California use multi-step approaches that provide flexibility in determining market-based sourcing.

Minnesota, Iowa, and Georgia: Unique Market-Based Sourcing Approaches

Several other states have also developed distinct market-based sourcing methods:

• Minnesota sources receipts to where “the services are received.”

• Iowa apportions receipts “in proportion to the extent the recipient receives the benefit of the service in Iowa.”

• Georgia deems service receipts as in-state if they are “derived from customers within the state” or “otherwise attributable to this state’s marketplace.”

• Comparison to Florida: Unlike Florida’s COP Rule, which strictly follows the physical location of service performance, these states focus on customer location but still apply unique criteria that differ from standard market-based sourcing rules.

Given the recent surge in litigation in Florida—including the numerous cases in Leon County that are currently challenging the DOR’s decisions—it is clear that businesses are pushing back against what they see as an overreach by the Department. These cases will set crucial precedents that may determine whether Florida remains an outlier in its adherence to COP or if legislative or judicial pressure will force the state toward market-based sourcing.