For Tennessee franchise and excise tax, where does a manufacturer source drop-shipment sales — to the third-party merchant it bills, or to the end customer who receives the goods?

Plain-English summary

An out-of-state manufacturer sells specialty products to customers across the country, but — because of regulatory rules — it has to sell through third-party "merchants" that handle order intake, billing, and compliance. In practice, a customer orders from a merchant, the merchant relays the order to the manufacturer, the manufacturer validates it and ships the product directly to the customer (through a third-party Tennessee warehouse where goods sit for a few weeks before shipping). The manufacturer keeps title until the product reaches the customer; only then is a sale recorded from the manufacturer to the merchant, and a split second later from the merchant to the customer.

The question is a sourcing question for Tennessee's franchise and excise (F&E) tax: when the manufacturer apportions its income to Tennessee, does a sale count as a Tennessee sale based on the merchant it bills, or based on where the end customer is?

The Department advised: source the sale to the end customer's location. If the end customer is in Tennessee, the receipt goes in the Tennessee numerator of the receipts factor; if the customer is out of state, it doesn't. The reason is Tennessee's drop-shipment rule. Tennessee sources sales of goods to where they're delivered, and it treats the "ultimate recipient" as the purchaser when a buyer directs its supplier to ship straight to the buyer's own customer. Here the merchant (the manufacturer's buyer) directs the manufacturer to ship directly to the customer, so the customer is that ultimate recipient and the sale follows the goods to the customer.

A detail mattered: no sale to the merchant is recorded until after the customer places an order. That is what makes it a true drop shipment. The Department noted that if instead the merchant had bought the products and warehoused them in Tennessee until a customer ordered, the manufacturer's sale would terminate with the merchant (a Tennessee sale to the merchant), and the merchant's later sales to customers would be separate transactions sourced by the merchant.

What this means for you

Manufacturers and suppliers selling through intermediaries

For Tennessee F&E apportionment, a true drop shipment is sourced to the end customer who receives the goods — not to the middleman you invoice. Where your customer's customer is located drives your Tennessee receipts factor. Keep in mind this is about income-tax-style apportionment, not about who collects sales tax.

Why the timing of the sale matters

The result depends on the deal really being a drop shipment: the intermediary directs you to ship to its customer, and the sale to the intermediary isn't booked until the customer has ordered. If the intermediary instead buys and stocks inventory (in Tennessee) before any customer order, your sale ends with the intermediary in Tennessee, and the intermediary — not you — sources the downstream sales.

Companies warehousing goods in Tennessee

Routing goods through a Tennessee third-party warehouse on the way to out-of-state customers doesn't make those sales Tennessee receipts when the shipment ultimately terminates with an out-of-state customer. Delivery is judged by where the shipment ends up with the ultimate recipient.

Accountants and tax professionals

This applies the receipts-factor delivery rule in § 67-4-2012(h) and the ultimate-recipient drop-shipment regulation, Rule 1320-06-01-.33(1)(c) and (d), within Tennessee's weighted three-factor formula (§ 67-4-2012(a)(3), with the receipts factor at § 67-4-2012(g)). It is consistent with prior Revenue Ruling 04-12 and Letter Ruling 13-14. Remember a revenue ruling is advisory only.

Common questions

Q: For Tennessee F&E tax, do I source a drop-shipment sale to the distributor I bill or to the final customer?
A: To the final customer (the "ultimate recipient"). When your buyer directs you to ship directly to the buyer's customer, Tennessee treats that customer's location as the place of sale for your receipts factor.

Q: What makes this a "drop shipment" instead of a sale to the middleman?
A: The middleman directs you to ship to its customer, and your sale to the middleman isn't recorded until after the customer orders. If the middleman buys and warehouses inventory first, your sale ends with the middleman instead.

Q: We ship through a Tennessee warehouse — does that make the sales Tennessee sales?
A: Not by itself. Delivery is sourced to where the shipment ultimately terminates with the recipient. Goods that pass through a Tennessee warehouse on the way to an out-of-state customer are sourced out of state.

Q: Can I rely on this ruling?
A: No one can rely on it as binding. A Tennessee revenue ruling is advisory only and is not binding on the Department even as to the taxpayer who requested it. It shows the Department's reasoning on these facts; your facts may differ. (This is a franchise/excise apportionment question, separate from sales-tax collection.)

Citations and references

Statutes:
- Tenn. Code Ann. § 67-4-2007 (excise tax on net earnings) and § 67-4-2106 (franchise tax on net worth)
- Tenn. Code Ann. § 67-4-2010(a) (apportionment of net earnings) and § 67-4-2110(a) (apportionment of net worth)
- Tenn. Code Ann. § 67-4-2012(a)(3) (weighted three-factor apportionment formula)
- Tenn. Code Ann. § 67-4-2012(g) (receipts factor) and § 67-4-2012(h) (sales of TPP sourced to the Tennessee delivery location, regardless of F.O.B.)

Regulations and authorities:
- Tenn. Comp. R. & Regs. 1320-06-01-.33(1)(a), (1)(c) (delivery rule; shipment terminating in Tennessee) and 1320-06-01-.33(d) ("ultimate recipient" drop-shipment rule)
- Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977) (a state income tax must be fairly apportioned)
- Tenn. Dep't of Revenue Revenue Ruling 04-12 and Letter Ruling 13-14 (drop-shipment sourcing to the ultimate recipient)

Source

• Landing page: https://www.tn.gov/revenue/tax-resources/legal-resources/tax-rulings.html
• Original PDF: https://www.tn.gov/content/dam/tn/revenue/documents/rulings/fae/24-12fe.pdf

Original ruling text

Revenue rulings are not binding on the Department. This ruling is based on the particular facts
and circumstances presented, and is an interpretation of the law at a specific point in time.
The law may have changed since this ruling was issued, possibly rendering it obsolete. The
presentation of this ruling in a redacted form is provided solely for informational purposes,
and is not intended as a statement of Departmental policy. Taxpayers should consult with a
tax professional before relying on any aspect of this ruling.

The sourcing of drop shipment sales for Tennessee franchise and excise tax purposes.

Revenue Rulings are statements regarding the substantive application of law and statements of
procedure that affect the rights and duties of taxpayers and other members of the public. Revenue
Rulings are advisory in nature and are not binding on the Department.

The Taxpayer is a manufacturer that sells specialty products throughout the United States and the
world. The Taxpayer is not located in Tennessee. Due to regulatory requirements put in place by
various governing bodies, the Taxpayer is required to adhere to strict rules surrounding the
manufacturing and distribution of its specialty products. In accordance with these rules, the Taxpayer
is required to sell its specialty products (the “Products”) using third-party merchants (“Merchants”) to
end customers located throughout the United States, including Tennessee. The Taxpayer pays
Merchants a fee to perform various activities, including order intake, billing, adherence to regulatory
compliance and reporting. The Merchants have locations in Tennessee as well as in other states.
The end users submit orders for the Taxpayer’s Products to Merchants. The Merchants then
communicate orders for Products to the Taxpayer. Product orders are subject to review and approval
by the Taxpayer. Upon receipt of an order from Merchants, the Taxpayer contacts the end users to
validate the order. Once validated, the Taxpayer is responsible for fulfilling the order to the end user,
including packaging, labeling, and shipping.
Merchants do not take possession of the Taxpayer’s Products. Merchants also do not perform logistics
activities. The Taxpayer contracts with a third-party for logistics services and the use of a facility. The
facility is not related to the Taxpayer or Merchants. The Taxpayer pays the third-party a fee for its
services.
The third-party facility is a regulated temperature-controlled facility (the “Facility”) located in
Tennessee. The Facility receives Products from the Taxpayer’s manufacturing location and then
subsequently ships them to the end users. The Taxpayer is responsible for shipping activities and the
associated costs of delivering the Taxpayer’s Products from Facility to end users via common carrier.
The Taxpayer’s Products arrive at the Facility pre-packaged and pre-labeled for shipment to end users.
Products are held at Facility for a limited amount of time. The length of time a Product is held is

typically two to six weeks. Facility does not take title to Products; the Taxpayer retains title throughout
the process (i.e., through manufacturing until delivery to end users when title transfers upon delivery).
The Taxpayer satisfies orders to end users in accordance with the terms stated within governing
contracts. Consistent with contract terms, a sale is first recorded between the Taxpayer and
Merchants upon delivery to end users, and then a second sale is recorded (a moment in time later)
between Merchants and end users. Also, upon delivery of Products to end users, title and risk of loss
to the Taxpayer’s Products flashes from the Taxpayer to the Merchants, and then immediately
thereafter from the Merchants to the end users. End users receive goods, taking title to, and
possession of, the Taxpayer’s Products.
The Taxpayer knows the location of the end users of its Products. The Taxpayer consistently computes
its income tax liability in other states by using an apportionment formula that sources receipts from
sales of the Taxpayer’s Products to the location of the end users of its Products.
It is assumed the Taxpayer has substantial nexus with Tennessee for franchise and excise tax
purposes and the right to apportion.

Where should the Taxpayer source sales of Products to end users for purposes of Tennessee
franchise and excise taxes?
Ruling: When the end user is located in Tennessee, the Taxpayer should source the sale to
Tennessee, and when the end user is located out of state, the Taxpayer should source the sale
outside of Tennessee for Tennessee franchise and excise tax purposes.

TENN. CODE ANN. § 67-4-2007 (2022) imposes the excise tax on the privilege of doing business in
Tennessee based on 6.5% of a business’s net earnings. TENN. CODE ANN. § 67-4-2106 (2022) imposes
the franchise tax at a rate of twenty-five cents per $100 of the business’s net worth. In order to not
violate the Commerce Clause of the United States Constitution, a state tax on a business’s income
must be, among other things, fairly apportioned. 1
TENN. CODE ANN. § 67-4-2010(a) (2022) provides that a taxpayer that has business activities taxable both
inside and outside the state of Tennessee shall allocate or apportion its net earnings or losses for
Tennessee excise tax purposes. A similar provision applies for apportioning a business’s net worth for
Tennessee franchise tax purposes under TENN. CODE ANN. § 67-4-2110(a) (2022). Because the Taxpayer
has business activities both inside and outside Tennessee, it must apportion its net earnings and net
worth for purposes of the Tennessee franchise and excise taxes.
TENN. CODE ANN. § 67-4-2012(a)(3) (Supp. 2023) provides that net earnings are apportioned to
Tennessee by multiplying the earnings by a fraction, the numerator of which is the property factor

See Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977) (finding that a state tax on a business’s income (1) must be applied
to an activity with a substantial nexus with the taxing state; (2) must be fairly apportioned; (3) does not discriminate against
interstate commerce; and (4) is fairly related to the services provided by the state).
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plus the payroll factor plus five times the receipts factor, and the denominator of the fraction is seven. 2
The same apportionment formula applies for apportionment of net worth for Tennessee franchise
tax purposes.3
The factor relevant to this ruling is the receipts factor. The receipts factor is a fraction, the numerator
of which is the total receipts of the taxpayer in this state during the tax period, and the denominator
of which is the total receipts of the taxpayer everywhere during the tax period. 4
Pursuant to TENN. CODE ANN. § 67-4-2012(h), sales of tangible personal property are in Tennessee if the
property is delivered or shipped to a purchaser, other than the United States government, inside this
state regardless of the F.O.B. point or other conditions of the sale. Similarly, T ENN. COMP. R. & REGS.
1320-06-01-.33(1)(a) (2016) provides that sales of tangible personal property are in this state if the
property is shipped to a purchaser within this state regardless of the F.O.B. point or other conditions
of sales. TENN. COMP. R. & REGS. 1320-06-01-.33(1)(c) further provides that:
[p]roperty is delivered or shipped to a purchaser within this state if the shipment
terminates in this state, even though the property is subsequently transferred by the
purchaser to another state.
Example: The taxpayer makes a sale to a purchaser who maintains a central
warehouse in this state at which all merchandise purchases are received. The
purchaser reships the goods to its branch stores in other states for sale. All of
taxpayer’s products shipped to the purchaser’s warehouse in this state are property
“delivered or shipped to a purchaser within this state”.
Importantly, Tennessee allows sourcing to an “ultimate recipient” in a drop shipment transaction in
which the purchaser directs its supplier to ship merchandise ordered directly to the purchaser’s
customer.5 TENN. COMP. R. & REGS. 1320-06-01.33(d) states:
[t]he term “purchaser within this state” shall include the ultimate recipient of the
property if the taxpayer in this state, at the designation of the purchaser, delivers to
or has the property shipped to the ultimate recipient within this state.
Example: A taxpayer in this state sold merchandise to a purchaser in State A. Taxpayer
directed the manufacturer or supplier of the merchandise in State B to ship the
merchandise to the purchaser’s customer in this state pursuant to purchaser’s
instructions. The sale by the taxpayer is “in this state”.
The corollary to that rule would be that a drop shipment to an ultimate recipient outside of Tennessee
would not be a sale to a purchaser within this state.
In this ruling, the end user places an order with the Merchant. The Merchant then informs the
Taxpayer of the end user’s order. After being informed of an order from the end user, the Taxpayer
This formula is for tax years ending on or after Dec. 31, 2023, but before Dec. 31, 2024. Financial institutions, common carriers,
and manufacturers that have elected to use a single sales factor formula are not required to use the three-factor apportionment
formula.
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3

See TENN. CODE ANN. § 67-4-2111(a)(2) (Supp. 2023).

4

TENN. CODE ANN. §§ 67-4-2012(g) (Supp. 2023), 67-4-2111(g).

5

See, e.g., Tenn. Dept. Rev. Rev. Rul. 04-12 (April 26, 2004) and Tenn. Dept. Rev. Ltr. Rul. 13-14 (Oct. 11, 2013).

3

validates the order by contacting the end user. After the Taxpayer has contacted the end user, the
Taxpayer fulfills the order. Under this set of circumstances, the end user is an “ultimate recipient” in
a drop shipment transaction. The facts presented describe a “drop shipment” sales transaction in
which the purchaser (the Merchant) directs its supplier (the Taxpayer) to ship goods directly to the
purchaser’s customer (the end user). When the Merchant informs the Taxpayer of the order placed
by the end user, the Merchant is designating to whom and to where the Taxpayer should ship the
Product. The controlling factor in sourcing drop shipment sales for purposes of the seller’s
apportionment formula receipts factors is where the seller, at the direction of the purchaser, delivers
or ships the merchandise to the purchaser’s customer.
Vital to the end user being considered an ultimate recipient is the fact that a sale of the Product to the
Merchant is not recorded until after the order from the end user has been placed with the Taxpayer.
Had the Merchant purchased the Product and held it at the Facility until the Merchant received an
order from an end user, the sale from the Taxpayer would be considered a sale to the Merchant rather
than a drop shipment to an ultimate recipient. In that case, there would be no drop shipment because
the Taxpayer’s sale of the Product terminates with the Merchant. Subsequent sales by the Merchant
of the Product would be just that, subsequent transactions that would be sourced to the location of
the subsequent buyers for purposes of the Merchant’s franchise and excise tax.
Thus, for purposes of the franchise and excise taxes, drop shipments from the Taxpayer to end users
will be sourced to the location of the end user. In mechanical terms, drop shipments to end users in
Tennessee will be included in the numerator of the receipts factor, while drop shipments to end users
outside of Tennessee will not be included in the numerator.

APPROVED:

David Gerregano
Commissioner of Revenue

DATE:

December 19, 2024

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