On June 4, 2018, Governor John Hickenlooper signed into law HB 1185 (the law) which, among other things, replaces Colorado's current cost-of-performance method of sourcing sales from intangible property and services for sales factor apportionment purposes with a market-based sourcing method. This provision will be effective for income tax years beginning on and after January 1, 2019. The new provisions are modeled after similar provisions in the Multistate Tax Commission's (MTC) model act.

The law defines key terms and, consistent with the MTC model act, replaces the terms "business income" and "nonbusiness income" with "apportionable income" and "nonapportionable income," respectively. Further, the term "receipts" is defined to mean "all gross receipts of the taxpayer that are not allocated … and that are received from transactions and activity occurring in the regular course of the taxpayer's trade or business" and excludes receipts from hedging and securities transactions. The law maintains the existing exclusion for foreign-source income that is included in taxable income from a taxpayer's Colorado receipts for purposes of apportioning apportionable income.

For purposes of sourcing receipts from sales of tangible personal property, the law continues to include a throwback rule (i.e., receipts from sales of tangible personal property are sourced to Colorado if the property is shipped from a place in Colorado and the taxpayer is not taxable in the shipped-to state). The law also provides clarification as to when a taxpayer is "not taxable" for purposes of applying the throwback rule.

Receipts from sales of non-tangible property and services are sourced to Colorado if the taxpayer's market for the sale is in the state. Sales of a service are in Colorado to the extent the service is delivered to a location within the state. Sales, rentals, leases or licenses of real/tangible personal property are in Colorado to the extent the real/tangible personal property is located in the state. Receipts from certain intangibles are sourced based on usage in Colorado. Intangibles enumerated for this purpose include intangibles utilized in marketing a good or service to a customer, intangibles that authorize a user to conduct a business activity in Colorado and intangibles that are contingent on the productivity, use or disposition of the intangible property. All other income from intangibles is excluded from the numerator and denominator of the apportionment factor. "Reasonable approximation" will be used to determine the state(s) of assignment when the state of assignment cannot be determined. Receipts are excluded from the denominator of the apportionment factor if the state of assignment cannot be determined or reasonably approximated.

Various items of "nonapportionable income" are allocated to Colorado as follows under the bill:

— Net rents and royalties from real property are allocated to Colorado if the property is located in the state

— Net rents and royalties from tangible personal property are allocated to Colorado if and to the extent the property is used in the state, or in its entirety if the taxpayer's commercial domicile is in Colorado and the taxpayer is not organized under the laws of, or its income is not taxable in, the state in which the property is utilized (the law provides guidance on determining the property's utilization in Colorado)

— Capital gains and losses from sales of real property are allocated to Colorado if the property is in the state

— Capital gains and losses from sales of tangible personal property are allocated to Colorado if the property has a situs in Colorado at the time of sale or the taxpayer's commercial domicile is in Colorado and the taxpayer's income is not taxable in the state in which the property had a situs

— Capital gains and losses from sales of intangible property are allocated to Colorado if the taxpayer's commercial domicile is in the state

— Interest and dividends are allocated to Colorado if the taxpayer's commercial domicile is in the state

— Income derived from the exploitation of patents and copyrights are allocated to Colorado if the patent or copyright is utilized by the payer in a state in which the taxpayer is not taxable and the taxpayer's commercial domicile is in Colorado (the law provides guidance on determining whether and to the extent the patent or the copyright is utilized in Colorado)

— Other nonapportionable income allocated under an above method, will be allocated to Colorado in a manner determined by the state (e.g., creation of industry-wide, transaction-wide, or activity-wide allocation and apportionment provisions)

Under the law, taxpayers can continue to elect to treat all income as apportionable income as under prior Colorado law. As was the case with respect to the election under prior law, any such election must be made by the extended due date of the return and is irrevocable for the tax year once made.

Provisions of the law make clear that the existing apportionment regulations for special industries of the Colorado Department of Revenue (Department) remain in effect and unchanged by the new statute. Such special industry apportionment regulations continue to apply to financial institutions, airlines, railroads, trucking companies, publishers, broadcasters and cable providers, mutual fund service providers, and telecommunication companies. In general, these special industry regulations already applied a market-sourcing method of apportionment.

Lastly, the law provides that, if the allocation and apportionment provisions do not fairly represent the extent of the taxpayer's business activities in Colorado, the taxpayer may petition for, or the Department may require, use of an alternative apportionment formula. With respect to such requests for alternative apportionment, the law sets forth new procedural rules related to the Department's authority, standards for evaluation of alternative apportionment, and places the burdens of proof on the party seeking alternative apportionment.

Implications

When Colorado adopted single sales factor apportionment in 2009, it failed to adopt a market-based sourcing rule for services and intangibles. This situation was unique to Colorado, which was one of few states that had adopted single sales factor, but not market-based sourcing. Policy makers proposing the law acknowledged that Colorado's cost-of-performance rule, coupled with single sales factor apportionment, was unfavorable from an economic development perspective.

In moving to market-based sourcing, the Legislature declared in the statute that, "(a)s the nation is moving to a more service-based economy it is important to align the income tax laws to current realities." Taxpayers should review this change and determine whether income from non-tangible property and services will now be apportioned or allocated to Colorado. Further taxpayers should consider whether treating all income as apportionable income would be beneficial and consider making the election provided by Colorado law.

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