Unraveling the Revenue Sourcing Rules for Sales and Use Taxes

The continued growth of digital goods and service offerings has proven to be far more than a temporary pandemic accommodation. Now, companies and states are struggling to determine which goods and services are subject to tax and how to source these sales for both sales and use and income tax purposes.

Taxation of Services

Sales and use tax collections represent the second-largest revenue source for state and local governments, surpassed only by property tax collections. Central to a state’s sales tax provisions was the theme that sales tax is imposed on the “retail sale of tangible personal property,” or TPP.

As sales of digital goods and services has grown, states have been keen to expand their tax base to include such mixed service offerings. Some states have broadly included any service delivered via a computer as qualifying as a retail sale of tangible personal property. Others have merely expanded the list of enumerated services to include broad categories such as software, information services, data processing, and digitally delivered goods and services.

The list of states expanding their definition of taxable goods and services to include the sale of digital products illustrates the transformation by states to tax cyber transactions. For example, Maryland since 2021 has taxed all forms of digital products including digital downloads, electronic publications, sound and video content, subscriptions, and license to access content online or use of a software application. Pennsylvania in 2016 began applying the definition of TPP to canned software and any otherwise TPP product or service delivered electronically or digitally.

Many states tax data processing services, including Connecticut, New Jersey, Kentucky, and Texas. In 2019, Washington, D.C., added digital goods to the definition of retail sales subject to tax. This year, Kentucky significantly broadened taxable services to include marketing, telemarketing, lobbying, website hosting, and private investigation. In addition, prewritten software is now considered taxable.

The Kentucky legislation goes into effect Jan. 1, 2023. Ohio and Rhode Island recently ruled that access to web portals, mobile apps, and online responses for market research qualified as electronic information subject to tax. New York recently reached a different conclusion: Membership fees, which grants access to web portals, mobile apps and digital content, were not considered to be taxable.

Adding to the confusion, the states remain divided on the taxation of digitally provided services. For example, digital products are taxable in states including Michigan, Pennsylvania, New York, Texas, and Washington, regardless of method of delivery. In contrast, California, Colorado, Georgia, Florida, and New Jersey do not tax products that are transferred to a customer over the internet.

Today, the offering of bundled or mixed goods and services is commonplace, as is delivery of services via hosted websites. While there still is an expansive list of mixed goods and services that fall outside the tax net, 38 states tax the entire bundled price when the nontaxable component equals or exceeds 10% of the total consideration paid by the consumer. As such, it is not sufficient just to know on a state-by-state or local jurisdiction-by-jurisdiction basis which goods and services are taxable; one must also know exactly how the goods and services are billed to customers. And if bundled, that the entire transaction is likely subject to tax.

Which State Has Jurisdiction Over a Transaction?

Rules determining which state is entitled to receive sales tax can differ depending on the source, destination, and nature of the product or service offering. Essentially, there are three ways to determine which state or local tax is required to be collected:

  • Destination-based: Transactions are governed by rules applicable in the state and local jurisdiction where the goods and services are delivered. This is the rule followed by most states for interstate and intrastate sales of goods and services.
  • Origin-based: Rates and rules are based on the location of the seller. Arizona, Illinois, Missouri, New Mexico, Tennessee, Ohio, Pennsylvania, Utah, Texas, and Virginia all have rules requiring origin-based sourcing in specific situations. These rules typically apply to intrastate sales when both the buyer and seller are in the same state. In such instances, local tax is based on the location where inventory is shipped or selling activity.
  • Mixed sourcing: The rates and rules are mixed based on the rules in the state, including interstate and intrastate. California is one state that, while it generally sources sales on a destination basis, applies origin sourcing when the sale originates from a location in the state. In addition to the above rules, some states have specific provisions for the sourcing of services that may differ from TPP sales. For example, Connecticut taxes services based on where the benefit is derived, which can differ from where the buyer is located or where the services are delivered. New Jersey sources services to the location where the services are first used, which also can differ from buyer or seller’s primary location.

Income Tax Considerations

The rules for sourcing or apportionment of sales for income tax purposes can vary significantly from those applicable to sales and use taxes. Market-based sourcing is becoming the predominant method of apportioning revenue, versus the cost of performance method in which the receipts are apportioned to a state where the predominant cost is incurred in producing the revenue. Market-based sourcing permits sellers to apportion sales based on market information where the customers are located—and in the case of services or software sales, where the services are used. Companies should be careful not to rely on income tax guidelines for the sourcing of revenue for sales tax purposes.

Planning Considerations

Guidance for the sourcing of sales is complicated and can not only vary among the states but also can vary within a state depending on the nature of the sale. Some simple planning recommendations include:

  • Take an inventory of product and service locations, including those sold through a marketplace facilitator.
  • Use software to help in the mapping process. The rules are so diverse and detailed that both large and small companies need to rely on third-party software solutions to comply with the various state and local requirements. There are numerous software providers, all with different applications, benefits, and cost considerations. No one software solution is appropriate for each company.
  • Seek professional independent advice. For even the most sophisticated company, the nuances of determining how to properly charge sales tax based on the location of the seller, delivery, or use of the product or service requires careful analysis. And if products or services are not properly mapped, the potential underpayment of tax in the event of audit can be significant, with no assurance that the jurisdiction(s) to which the tax was remitted will refund the overpayment.
  • Periodically test the sourcing decision and mapping process. Once a company has subscribed to a third-party software solution, company-specific data typically must carefully be mapped and inputted so the correct tax can be computed and directed to the right state(s) and localities. Companies would be well advised to periodically run sample data files to ensure the transactions are properly characterized within the software.


There is little question that sourcing of revenue for state and local tax purposes is exceptionally confusing, and companies that offer products or services that have any digital content or accessed remotely are particularly susceptible to both over and underpayments of tax. There are many options and requirements to consider when properly implementing sourcing and taxability decisions. As such, they should seek professional advice based on the organization’s specific facts and circumstances.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Roberts Peters is managing director at the Chicago office of Kroll.

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