The Indiana Tax Court recently ruled in favor of The University of Phoenix, Inc. (“University of Phoenix”) on an important issue of first impression involving the sourcing of service revenue for purposes of computing Indiana’s corporate income tax apportionment factor.   The University of Phoenix, Inc. v. Indiana Dep’t of State Revenue, Cause No. 49T10-1411-TA-00065 (Ind. Tax Ct. 2017).  Baker & McKenzie LLP represented the University of Phoenix in the case.  The Tax Court held that in sourcing service revenue, Indiana law requires a taxpayer activity/cost-based analysis and rejected the market/customer-based analysis historically advanced by the Indiana Department of State Revenue (“Department”). 

The University of Phoenix provides students educational services through one of two separate modalities—brick-and-mortar ground campus locations (“Ground Campus”) and an online platform (“Online Campus”). Indiana statutorily sources receipts from services using the costs of performance sourcing method, which requires taxpayers to source receipts from services to Indiana only if a greater proportion of the income-producing activity generating the receipts is performed in Indiana than in any other state as determined based on costs of performance.  Ind. Code § 6-3-2-2(f).  Employing a cost-based methodology on its originally filed returns, the University of Phoenix sourced 100% of its receipts attributable to its Indiana Ground Campus locations to Indiana.  Further, given that the Online Campus operations and associated costs are based principally in Arizona, none of the University of Phoenix’s Online Campus receipts were sourced to Indiana.  On audit, the Department asserted a market-based analysis and sought to source receipts from the University of Phoenix’s Online Campus students with an Indiana billing address to Indiana.

The University of Phoenix’s original return position was based upon and supported by a cost study detailing its relevant income-producing activities, associated costs and the respective geographic locations where such costs were incurred. The Department did not prepare its own cost study.  Rather, the Department argued that student location sourcing was appropriate because the relevant income-producing activity was the University of Phoenix providing a student the opportunity to attend an online class in return for payment and an Indiana resident agreeing to do so.  In other words, the Department attempted to interpret and apply Indiana’s costs of performance statute so as to achieve a market-based sourcing result.  The Tax Court rejected the Department’s interpretation and application of Indiana’s costs of performance sourcing rule, holding that both Indiana law and the Department’s regulation require the sourcing of receipts based on the activities of the seller, not the customer.

Further, the Tax Court rejected the Department’s argument that Indiana required a “transactional” as opposed to an “operational” or “aggregate” approach when evaluating a taxpayer’s income-producing activities and associated costs. In comparing the relevant authorities, the Tax Court determined that, unlike some other states, e.g., Oregon and Idaho, Indiana’s regulation does not require a “transactional” approach or analysis.  As such, the Tax Court held that the University of Phoenix appropriately sourced its Online Campus revenue for Indiana tax purposes.

Impact of Decision

The Department has historically assessed out-of-state taxpayers under a market-based or customer-based sourcing approach. By rejecting the Department’s market/customer-based approach, the Tax Court decision provides a straight-forward and much needed confirmation of Indiana law.

The Department has until January 2, 2018 to appeal the decision by either requesting a Petition for Rehearing with the Indiana Tax Court or filing a Notice of Intent to Petition for Review with the Indiana Supreme Court.

Indiana taxpayers who filed or were previously assessed on a customer/market-based approach should determine whether refund claims are warranted under the operational cost-based approach affirmed by the Tax Court.

Contact the Authors: Ted Bots and Roman Patzner