District of Columbia Adopts Single Sales Factor Apportionment, Market-Based Sourcing, and a Throwout Rule, Expands the List of Services Subject to Sales Tax, and Reduces the Corporation and Unincorporated Business Franchise Tax Rates
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On February 26, 2015, the District of Columbia (the “District”) enacted the Fiscal Year 2015 Budget Support Act of 2014 (the “Budget Support Act”) the result of which is, effective for taxable years beginning after 2014, the adoption of single sales factor apportionment, market-based sourcing, a “throwout” rule for receipts from sales of other than tangible personal property, and a reduced 9.4% tax rate for corporations and unincorporated entities. The Budget Support Act also expands the scope of services subject to sales tax to include such services as car washing, bottled water delivery services, and health-club services. Lastly, the Budget Support Act clarifies the definition of Qualified High Technology Company (“QHTC”) used for purposes of tax credits, the exemption from Unincorporated Business Tax, and the special 6% tax.
Adoption of Single Sales Factor, Market-Based Sourcing and Throwout
Currently, the District requires Corporation and Unincorporated Business Franchise Tax taxpayers to apportion income using a three factor formula comprised of property, payroll and double-weighted sales, where, for sales factor purposes, receipts from sales of other than tangible property are sourced using an income-producing activity/costs of performance approach. Effective for taxable years beginning after December 31, 2014, these taxpayers will be required to apportion income using a single sales factor and assign receipts from the sale of other than tangible personal property using a market-based approach.
||Source to District of Columbia If...
|… Sale, rental, lease or license of real property
||… To the extent the real property is located in District of Columbia
|… Rental, lease or license of tangible personal property
||… To the extent the tangible personal property is located in District of Columbia
|… Sale of a service
||… Service is delivered to a location in District of Columbia
|… Rented, leased, or licensed non-marketing intangible
||… To the extent the intangible property is used in District of Columbia
|… Rented, leased, or licensed marketing intangible
||… The underlying good or service is purchased by a consumer in District of Columbia
|… Sale of intangible property - contract right, government license, or similar intangible that authorizes the holder to conduct a business activity in a specific geographic area
||… The geographic area includes all or part of District of Columbia
|… Sale of intangible property - sales contingent on productivity, use, or disposition of the intangible property
||… Treat as a receipt from the rental, lease or license of such intangible property
Under these market-based sourcing rules, the District allows for reasonable approximation where the state of assignment cannot be determined. In addition, the District requires “throwout” (i.e., exclusion from numerator and denominator of the sales factor) with respect to receipts from sales of other than tangible personal property where: (1) no assignment rule is provided; (2) the taxpayer is not subject to tax in the state of assignment; or (3) the state of assignment cannot be reasonably approximated.
Reduced Corporation and Unincorporated Business Franchise Tax Rates
Effective for taxable years beginning after December 31, 2014, the rate of tax imposed on corporations and unincorporated businesses will be reduced to 9.4% from the current rate of 9.975%. Subject to available funding and inclusion in subsequent budgets, the tax rate may be further reduced incrementally to as low as 8.25%.
Additional Unincorporated Business Tax Exemption
Currently, the District exempts certain businesses from the Unincorporated Business Tax, including: (1) a trade or a business which by law, customs, or ethics cannot be incorporated; (2) a corporation that is required to incorporate under the Professional Corporation laws; (3) a trade or business in which 80% or more of the gross income is derived from personal services rendered by partners or members of the business; and (4) a QHTC. For taxable years beginning after December 31, 2014, a business “that arises solely by reason of the purchase, holding, or sale of, or the entering, maintaining, or terminating positions in stocks, securities, or commodities for the taxpayer’s own account” will also be exempt from the tax provided that the business does not: (1) hold property, or maintain positions, as stock in trade, inventory, or for sale to customers in the ordinary course business; (2) acquire debt instruments in the ordinary course of business for funds loaned or services rendered; or (3) hold stock in a real estate investment trust or partnership interest that is not traded on an established securities market.
Qualified High Technology Company (“QHTC”) Definition Clarification
In addition to the Unincorporated Business Tax exemption for unincorporated businesses that meet the QHTC definition, the District applies a special 6% tax and offers certain tax credits to a corporation that meets the definition as well. In BAE Systems Enterprise Systems Inc. v. District of Columbia Office of Tax and Revenue
, 56 A.3d 477 (D.C. 2012), the District Court of Appeals affirmed the Office of Administrative Hearings and held that the historic QHTC definition did not require property ownership or the payment of rent or the exercise of predominant authority, dominion, or control over an office or base of operations in the District. In an attempt to overturn that decision, the Budget Support Act clarifies that QHTC status applies only to a company that owns or leases an office in the District and meets the employment requirement. In addition, the Budget Act excludes an online or brick and mortar retail store and a building or construction company from the QHTC definition. These changes to the QHTC definition appear to be effective October 1, 2014, because no particular effective date is provided for these changes and the general applicability date of the Budget Support Act is October 1, 2014.
Sales Tax on Additional Services
Effective as of October 1, 2014, the District will impose sales tax on the sale or charge for the following: (1) bottled water by the gallon delivered via a bottled water delivery service; (2) household goods storage services; (3) carpet and upholstery cleaning and dyeing and rug repair; (4) health-club services or a tanning studio; (5) car washing, not including self-service carwashes; and (6) a bowling alley or a billiard parlor.
- With the adoption of single sales factor apportionment and market-based sourcing, the District joins the ranks of many other states that have transitioned from three factor apportionment and the use of an income-producing activity/costs of performance approach for sourcing receipts from sales of other than tangible personal property.
- Service based business, especially those that provide services to the federal government, should evaluate the potential impact of the new single sales factor and market-based sourcing rules. The risk is that apportionment to the District could substantially increase under this new market-based sourcing regime, and, thus, subject more income of incorporated and unincorporated businesses to the still relatively high 9.4% District tax rate. Special attention should be paid by S Corporations, since the District franchise tax applies at the entity-level, regardless of federal income tax treatment. Regulations to clarify the applicability of the new adopted sourcing rules are currently being drafted. However, the expected issuance of the regulations late in the tax year could leave certain taxpayers with underpaid estimated taxes and a surprise District tax bill.
- Many businesses will welcome the tax rate reductions under the Budget Support Act. However, a business that does not own or lease an office in the District but relied on or anticipated relying on the decision in BAE Systems Enterprise Systems Inc. for a more inclusive QHTC definition may now be subject to the Unincorporated Business Tax, the higher Corporation Franchise Tax, or may no longer benefit from the tax credits it once enjoyed.
- Businesses that provide a bottled water delivery service, household goods storage service, carpet and upholstery cleaning and dyeing or rug repair services, health-club services, or car washing services, or operate a tanning studio, bowling alley, or a billiard parlor, will effective October 1, 2014, have to concern themselves with collecting, reporting, and remitting sales tax on the sales of such services.
For more information, please contact one of the following regional practice leaders: