My company's cost-tracking system can't reliably show where subcontracted work was actually performed or controlled -- can I use payroll apportionment instead, and how do I calculate the out-of-state deduction if so?

Plain-English summary

A company providing professional and information technology services, primarily to the U.S. government, sought a five-year BPOL refund from a Virginia city, arguing its original method of situsing gross receipts to the city was wrong and that it should instead use PAYROLL APPORTIONMENT plus the OUT-OF-STATE DEDUCTION. The company's original approach used a cost-tracking system that assigned direct labor costs, subcontractor costs, and other costs to location codes, then allocated gross receipts based on those cost assignments. The company explained that while direct labor was probably assigned accurately, subcontractor costs were tracked inconsistently -- sometimes by the project manager's location, sometimes by the purchaser's location, sometimes another way entirely -- because the company often didn't even know where its subcontractors were physically doing the work. Fixed-price contracts compounded the problem: they were often performed across multiple states with several different points of control, none of which the cost system could reliably capture. Altogether, subcontractor and fixed-price-contract revenue accounted for roughly two-thirds of the company's total revenue.

The city denied the refund, arguing the company's own system PROVED it could directly situs its receipts (why else have the system?), and that removing subcontractor-linked location codes was itself evidence of an ability to situs directly. The Tax Commissioner rejected both arguments. Virginia's BPOL situs rules for services follow a strict hierarchy: performed-at, then directed/controlled-from, and only as a last resort, payroll apportionment. The city over-relied on the DIRECT LABOR portion of the company's system, but the statutory method is fundamentally REVENUE-based, not cost-based -- a direct-labor cost assignment is only useful to the extent the labor cost is CLEARLY connected to the specific revenue it helped generate. Here, while direct labor assignments looked accurate, the company's genuine inability to determine where SUBCONTRACTED work was performed or controlled (and the multi-location, multi-point-of-control nature of its fixed-price contracts) created real doubt about whether receipts could be reliably sitused under the general method at all. Given the sheer complexity of the company's multi-state, multi-contractor operations, the Commissioner found payroll apportionment justified -- consistent with the Virginia Supreme Court's decision in Ford Motor Credit Co. v. Chesterfield County (2011), which held that a company's own internal accounting system assigning revenue to a local office doesn't establish proper BPOL situs there if the system ignores where the underlying work actually happened across many other locations.

On the OUT-OF-STATE DEDUCTION (which lets a business deduct receipts attributable to business conducted in another state where it's liable for an income-like tax and files a return), the Department explained the three-step process that applies when payroll apportionment is used to situs receipts: (1) determine whether employees from the Virginia office earn or help earn receipts attributable to customers in other states where the company files an income tax return; (2) determine which receipts are eligible for the deduction; and (3) multiply those eligible receipts by the SAME payroll factor used to situs the gross receipts in the first place. Because the city conceded the company might be eligible for the deduction but wasn't satisfied with the documentation provided, the case was returned to the city so the two sides could work through the deduction calculation together, with a 90-day appeal window preserved if a dispute remains after the city's next final determination.

What this means for you

Multi-state service businesses (especially government contractors) with heavy subcontractor use

If your accounting system can't reliably show WHERE subcontracted or multi-location fixed-price work was actually performed or controlled -- not just where it was billed or which project manager oversaw it -- that's a real basis for using payroll apportionment instead of the general statutory (performed-at/directed-from) situs method, even if some portion of your revenue (like direct labor) looks precisely trackable.

Businesses whose own internal accounting/cost-tracking system gets cited against them by a locality

A locality pointing to your own system as "proof" you can directly situs receipts isn't automatically right -- if the system's assignments (especially for subcontracted or multi-location work) don't reliably reflect where the underlying licensable activity actually happened, that's a legal problem for the locality's position, not evidence against you. Ford Motor Credit is the controlling precedent here.

Businesses claiming the out-of-state deduction alongside payroll apportionment

Use the Department's three-step process: confirm your Virginia-office employees actually earn/participate in earning revenue from customers in states where you file an income tax return, identify which receipts qualify, and then multiply those receipts by the SAME payroll factor used for your situs calculation -- not a separately-derived percentage.

Common questions

Q: If my company's own cost-tracking system assigns revenue to a location, does that prove BPOL situs there?
A: Not necessarily. Under Ford Motor Credit Co. v. Chesterfield County, an internal system that assigns revenue to one office without reliably capturing where the underlying work was ACTUALLY performed (especially for subcontracted or geographically dispersed work) doesn't establish valid situs there.

Q: When is payroll apportionment justified instead of the general statutory situs method?
A: When it's impossible or impractical to determine where services were performed or directed/controlled -- which can be the case for businesses whose operations span many states and involve subcontractors or fixed-price contracts with multiple points of control that a cost-tracking system can't reliably assign.

Q: How do I calculate the out-of-state deduction when payroll apportionment is used to situs my gross receipts?
A: Follow the Department's three-step process: (1) confirm employees from your Virginia definite place of business earn or participate in earning receipts from customers in states where you file an income tax return; (2) identify the receipts eligible for the deduction; (3) multiply those eligible receipts by the SAME payroll factor used to situs your gross receipts.

Citations and references

• P.D. 99-252 (9/24/1999) (when payroll apportionment applies, the apportionment percentage is applied to the ENTIRE pool of taxable gross receipts, including receipts attributable to subcontractor-performed work)
• P.D. 18-168 (9/26/2018) (the direct labor method can sometimes better approximate the general statutory situs method, but only to the extent labor costs are clearly and directly tied to the revenue they helped generate)
• P.D. 10-229 (9/29/2010) (out-of-state deduction computed by multiplying out-of-state gross receipts by the same payroll factor used for situs)
• P.D. 12-89 (5/31/2012) (established the three-step process for computing the out-of-state deduction under payroll apportionment)
• Ford Motor Credit Co. v. Chesterfield County, 281 Va. 321, 707 S.E.2d 311 (2011) (an internal accounting system assigning revenue to a local branch doesn't establish proper BPOL situs there if it ignores where the underlying work was actually performed elsewhere)
• Nielsen Co. (US), LLC v. County Bd. of Arlington Cty., 289 Va. 79, 767 S.E.2d 1 (2015) (upheld the Department's out-of-state-deduction computation methodology)

Subject

Situs : Services - Payroll Apportionment; Deduction- Out of State

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 21-111

Original ruling text

August 24, 2021

Re: Appeal of Final Local Determination

Taxpayer: *

Locality: *

Business, Professional and Occupational License Tax

Dear *:

This final state determination is issued upon the application for correction filed by you on behalf of * (the “Taxpayer”), with the Department of Taxation. You appeal the denial of refunds of Business, Professional and Occupational License (BPOL) tax by *** (the “City”) for the 2013 through 2017 tax years.

The BPOL tax is imposed and administered by local officials. Virginia Code § 58.1-3703.1 authorizes the Department to issue determinations on taxpayer appeals of BPOL tax assessments. On appeal, a BPOL tax assessment is deemed prima facie correct, i.e ., the local assessment will stand unless the taxpayer proves that it is incorrect.

The following determination is based on the facts presented to the Department summarized below. The Code of Virginia sections, regulation and public documents cited are available on-line at www.tax.virginia.gov in the Laws, Rules and Decisions section of the Department’s web site.

FACTS

The Taxpayer was a provider of professional and information technology services primarily for the United States government. The Taxpayer filed for a refund of BPOL taxes paid to the City for the 2013 through 2017 tax years. The refund was based on changing the situsing of gross receipts to the City by using payroll apportionment and claiming the out-of-state deduction. The City denied the refund, and the Taxpayer filed an appeal with the City. In its final determination, the City concluded that the Taxpayer’s original method of situsing gross receipts was in accordance with the general statutory methods and that the Taxpayer had not provided sufficient information to substantiate the out-of-state deduction. The Taxpayer appealed to the Department, contending that its cost tracking system did not accurately situs gross receipts and that it was not otherwise possible or practical to situs gross receipts using the general methods. The Taxpayer also contends that the out-of-state deduction should be computed using the method applicable to payroll apportionment.

ANALYSIS

Situs

The general rule for establishing situs for the BPOL tax is that whenever the tax is measured by gross receipts, “the gross receipts included in the taxable measure shall be only those gross receipts attributed to the exercise of a privilege subject to licensure at a definite place of business within [the] jurisdiction.” See Virginia Code § 58.1-3703.1 A 3 a. In determining the situs of gross receipts, Virginia Code §§ 58.1-3703.1 A 3 a 4 and 58.1-3703.1 A 3 b state that receipts from services are to be taxed based on (in order): (i) the definite place of business at which the service is performed, or if not performed at any definite place of business, (ii) the definite place of business from which the service is directed or controlled; or as a last resort (iii) when it is impossible or impractical to determine where the service is performed or from where the service is directed or controlled, by payroll apportionment between definite places of business.

The Taxpayer used a cost tracking system to estimate its gross receipts attributable to the City. The system captured direct labor costs, subcontractor costs and other direct costs. Then, the Taxpayer allocated gross receipts based on costs as they were assigned to various location codes. The Taxpayer concedes that the cost tracking system may have correctly allocated direct labor costs but explains that subcontractor costs were assigned in various ways, such as the location of the project manager, the location of the purchaser or some other location. The Taxpayer states that it did not often know where subcontractors were performing their work. The Taxpayer concedes that under such circumstances, the gross receipts should be sitused to where the activity was directed or controlled, but asserts that this was not usually discernable from the language of the contract or captured in a report.

The Taxpayer also explains that services under fixed price contracts were usually performed in multiple locations, often in more than one state, and there may have been several points of control for each contract. The Taxpayer states that its cost tracking system could not account for where parts of the contract were performed or from where they were directed or controlled. The Taxpayer explains that usually the fixed price contract revenue was assigned to the place of the project manager, which may or may not have been the location where the services were performed or from where they were directed or controlled. The Taxpayer claims the resulting mismatches between revenue and costs were significant because non-payroll costs and fixed price contracts accounted for approximately two-thirds of the ultimate revenue assignment.

In its final determination, the City argues that the Taxpayer stated that revenue from work performed by subcontractors outside of a definite place of business was attributed to the site where the work was directed or controlled. The City later concedes that the Taxpayer’s system distorted the location of gross receipts where subcontractors had been used but concluded the inclusion of gross receipts for subcontracted labor did not materially distort the revenue estimation.

The Taxpayer argues that gross receipts attributable to subcontractor work could not be practically sitused under the general rule, not that they should have been excluded from the pool of gross receipts. Second, if payroll apportionment is applied as the Taxpayer requests, the apportionment percentage would be applied to the entire pool of taxable gross receipts, which would also include receipts attributable to services performed by subcontractors. See Public Document (P.D.) 99-252 (9/24/1999).

Finally, the City simply says that all of the information provided indicates that the Taxpayer has been able to directly situs gross receipts and that the explanation of the method from the Taxpayer indicates the direct situs of gross receipts. On the contrary, the Taxpayer explained to the City the shortcomings of its original methodology, shortcomings that would in fact result in inaccurate situsing of the gross receipts. With regard to the Taxpayer’s business decision to eliminate the organization and location codes, the City claims this change was proof that the Taxpayer had the ability to directly situs gross receipts. Again, this claim ignores the shortcomings with the system that the Taxpayer had already pointed out to the City. Finally, the City complains that the removal of the location codes would exclude receipts for work performed by subcontractors, which has already been shown to be incorrect above, and result in a payroll methodology that results in an easier methodology for purposes of calculating the out-of-state deduction under Virginia Code § 58.1-3732 B2. These arguments, however, ignore the substantive question whether payroll apportionment should be used based on the facts and circumstances in the case.

The Department shares the City’s concerns about changes to the Taxpayer’s accounting systems. Could a business that is unable to accurately track its contract costs effectively manage its operations? Still, for the purposes of this assessment, the law must be applied to circumstances as they are, not as they should be.

Ultimately, the City relied too heavily on the direct labor method, which can sometimes be a more accurate representation of the general statutory method without resort to payroll apportionment. See P.D. 18-168 (9/26/2018). Taxpayers and localities should remember, however, that the statutory situsing method is a revenue rather than cost-based method. Therefore, the direct labor method is only applicable to the extent is accurately reflects the assignment of revenue. As such, the labor costs must be directly associated with the receipt of the revenue, i.e., the taxpayer’s employees must perform services for which the employees are paid and for which the customers pay, and this relationship and the associated cost and revenue connection must be clearly discernable. While the assignment of direct labor costs appeared to be accurate, the inability of the Taxpayer to accurately identify where services performed by subcontractors were directed or controlled raises sufficient doubts as to whether receipts can be sitused under the statutory method. The reliance on the direct labor method also does not address the issues, described above, related to the situsing of the Taxpayer’s fixed price contracts.

It is clear from the information provided that the Taxpayer’s business operations were highly complex and spanned a number of states and countries in the performance of many contracts carried out by great number of employees and contractors. It is also clear that the allocation of gross receipts to definite places of business under the first two statutory methods would be very difficult in this case, if it were even possible at all. Accordingly, the Department believes the use of payroll apportionment in this case is justified under the circumstances.

In the Department’s opinion, this outcome is consistent with that of Ford Motor Credit Co. v. Chesterfield County , 281 Va. 321, 707 S.E.2d 311 (2011). In that case, the taxpayer had an internal accounting system which the locality relied on to justify its attribution of gross receipts to the local branch office. The system, however, did not attribute revenue based on all the various activities that went into the contract, many of which were performed at other definite places of business besides the one in the locality. Therefore, the fact that the accounting system assigned revenue to the local branch did not mean the gross receipts were properly sitused there under the general rule. See id . at 281 Va. 321, 342, 707 S.E.2d 311, 322. In the Court’s view, it was at least impractical for the taxpayer to have to determine how gross receipts from each of the thousands of loans that the local branch handled should be apportioned. Accordingly, the Court concluded that payroll apportionment was the proper situsing method. See id .

Out-of-State Deduction

Virginia Code § 58.1-3732 B 2 provides a deduction from gross receipts otherwise taxable for any receipts “attributable to business conducted in another state or foreign country in which the taxpayer . . . is liable for an income or other tax based upon income.” Title 23 of the Virginia Administrative Code (VAC) 10-500-80 A 2 further explains that a taxpayer must be liable for an income or an income-like tax in the other state and file a return in that state to take advantage of the deduction.

The statutory language allowing the deduction is best analyzed as consisting of three requirements:

“any receipts” includes receipts that have already been assigned to the definite place of business for BPOL taxation purposes. A business cannot deduct receipts that have already been excluded by the situsing rules.

“attributable to business conducted in another state or foreign country” conveys that some portion of the receipts assigned to the definite place of business must be attributable to business activity in another state. To ascertain if such gross receipts exist, a business must analyze whether employees from the Virginia definite place of business earn, or participate in earning receipts attributable to customers in other states.

“in which the taxpayer (or its shareholders, partners or members in lieu of the taxpayer) is liable for an income or other tax based upon income” denoting that a business must be liable for income tax to the state in which occurred the business activity considered in the second requirement.

When gross receipts are apportioned by using the general payroll apportionment formula, the amount of the out-of-state deduction would be determined by multiplying the total out-of-state gross receipts by the same payroll factor used to determine the situs of gross receipts. See P.D. 10-229 (9/29/2010).

Subsequently, in P.D. 12-89 (5/31/2012), the Department established a three-step process for computing the out-of-state deduction when payroll apportionment is used to situs gross receipts. These steps are as follows:

Determine if employees from the definite place of business earn, or participate in earning receipts attributable to customers in other states where a taxpayer filed an income tax return;

Determine the receipts that are eligible for deduction; and

Multiply the receipts eligible for the deduction by the same payroll factor used to determine the situs of gross receipts.

The Department’s methodology was upheld in Nielsen Company (US), LLC v. County Board of Arlington County , 289 Va. 79, 767 S.E.2d 1 (2015). In this case, the City conceded that the Taxpayer might be eligible for the deduction but declined to allow the deduction because the Nielsen methodology for computing the deduction was unavailable and because the Taxpayer had not provided sufficient information.

DETERMINATION

Under the facts and circumstances presented, the Department finds that the Taxpayer was eligible to use payroll apportionment to apportion gross receipts. In light of that conclusion, the case is being returned to the City to determine to what extent, if at all, the Taxpayer was eligible to claim the out-of-state deduction under the process used when payroll apportionment is used to situs gross receipts. The City concedes that the Taxpayer may be eligible for the deduction, but the City was not satisfied with the information provided. The Taxpayer, however, states that it can provide more information to substantiate the deduction upon request.

Accordingly, the Taxpayer and the City are instructed to work together to resolve the out-of-state deduction issue. The Taxpayer must respond to any further information requests from the City in a timely fashion. Once the City has had an opportunity to re-examine the out-of-state deduction issue, the City is instructed to issue a final determination as to that issue to the Taxpayer in writing, thoroughly analyzing the facts and circumstances in light of the applicable laws and policies. If the Taxpayer wishes to dispute that final determination, it may appeal to the Department within 90 days as provided under Virginia Code § 58.1-3703.1.

If you have any questions regarding this determination, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/3533.M

Related Documents

99-252

10-229

18-168