Maine Determines that Taxpayer Must Source Service Revenue to Location of its Customer’s Customer

By: Jeff Glickman, SALT Partner

At a glance

• The main takeaway: In states that use market-based rules to source service revenue for state income tax purposes, is the market based on the location of your customer or the location of your customer’s customer?
• Assess the impact: The “customer versus customer’s customer” sourcing argument has been at the center of many service revenue sourcing disputes, and it is misplaced to assume that a taxpayer need only look to the location of its contractual customer.
• Take the next step: Aprio’s State and Local Tax (SALT) team can analyze and provide interpretive guidance to help your business determine the source of its service revenues for state apportionment purposes. 

Schedule a free consultation today to learn more!

The full story:

On November 7, 2023, the Maine Supreme Judicial Court (Court) delivered an opinion on an issue that service providers grapple with constantly — How should service revenues be sourced in states that use market-based sourcing rules?¹

A closer look at the case

Express Scripts Inc. (ESI or the Taxpayer) sold pharmacy benefit management (PBM) services throughout the United States, including in Maine. Its clients included health insurers, health maintenance organizations, employers, governmental    health programs, and union-sponsored benefits plans, and that its clients’ members were the primary recipients ESI’s PBM services.

When a member presented his or her ESI card at a retail pharmacy, ESI communicated in real-time with the pharmacy to process prescription drug claims at the point of sale. The pharmacist sent the member’s prescription information to ESI through its computer system, and ESI processed the claim and responded back to the pharmacist in real-time. This process is referred to as the “adjudication of claims.” The claims-adjudication process included:

1. Confirming the member’s eligibility to the pharmacist;
2. Performing a concurrent drug interaction/utilization review;
3. Confirming to the retail pharmacy that it would receive payment from ESI pursuant to their agreements, if the claim was accepted; and
4. Informing the retail pharmacy of the co-payment amount to be collected from the member.

Unpacking the Court’s ruling

For tax years 2011 through 2013, ESI sourced its receipts from PBM services under two different sourcing rules. On its original 2011 Maine income tax return, ESI sourced its PBM service revenues based on what it referred to as a “market member basis,” which looks to the state in which the prescription drug is dispensed to members by the retail pharmacies. However, on its 2012 and 2013 returns, ESI sourced its PBM service revenues based on what it referred to as a “market client basis,” which looks to the location of the primary commercial and administrative headquarters of clients.

The Taxpayer was audited by Maine for those years, and early on during the audit, the Taxpayer amended its 2011 return to source its PBM services revenues on a market client basis, which resulted in a refund. That refund was denied, and Maine assessed ESI for additional taxes for the 2012 and 2013 tax years.

Maine’s corporate income tax apportionment rules provide specific sourcing rules under its sales factor.  Specifically regarding services, the statute provides that:

[R]eceipts from the performance of services must be attributed to the state where the services are received. If the state where the services are received is not readily determinable, the services are deemed to be received at the home of the customer or, in the case of a business, the office of the customer from which the services were ordered in the regular course of the customer’s trade or business. If the ordering location cannot be determined, the services are deemed to be received at the home or office of the customer to which the services are billed.²

In this case, ESI argued that the market client basis was more appropriate because it contracts only with its clients and not the individual members, and therefore the ultimate recipient of the service is the client.  The Court disagreed, noting that there were numerous places in the record indicating that the members received the PBM services. For example, in ESI’s Form 10-K for the years at issue, ESI explained that pursuant to its contract with one client, ESI “provides PBM services to members of the affiliated health plans of [its clients].” The 2011 filing also states: “Although we contract with health plans and employers, the ultimate recipients of many of our services are the members and employees of these health plans and employers.” Therefore, the Court upheld the assessment against ESI.

The bottom line

The “customer versus customer’s customer” sourcing argument is one that has been at the center of many service revenue sourcing disputes, and it is misplaced to assume that the taxpayer need only look to the location of its contractual customer. In our May 2022 SALT Newsletter, we wrote an article summarizing a California legal ruling that addressed sourcing of services.³ In particular, situation two of that ruling concerned a company that administers drug benefit programs pursuant to contracts with health plan providers, similar to the arrangement in this case. Like the Maine Court, California concluded that the services should be sourced to the location of the health plans’ members.Aprio’s SALT team has experience analyzing the rules in each state and the interpretive guidance and can assist your business to determine the source of its service revenues for state tax apportionment purposes. In some cases, it might make sense to obtain private letter rulings from each state and Aprio can draft and submit those on your behalf. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.  

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¹ Express Scripts Inc. et al., v. State Tax Assessor, 2023 ME 68, Docket No. BCD-22-331, (Me. Sup. Jud. Ct., Nov. 7, 2023).

² 36 Me. Rev. Stat. § 5211(16-A)(A). For sales of services to the Federal Government, a different method applies.

³ State of California Franchise Tax Board, Legal Ruling 2022-01 (3/25/2022).