On June 25, 2024, the South Carolina Administrative Law Court (ALC) issued a decision in U.S. Bank N.A. v. S.C. Department of Revenue, affirming the South Carolina Department of Revenue’s (Department) assessment of over $4.75 million in tax and related interest.1 The decision addressed the sales factor sourcing for several of U.S. Bank’s income streams, including the sourcing of mortgage loan interest and servicing fees, as well as credit card interest and fees. The decision appears to be both a shift in South Carolina’s approach to sourcing these income streams as income from intangible assets and an extension of how the Department defines the “income-producing activity” related to sourcing receipts from services to South Carolina in what amounts to a market-based sourcing approach.
South Carolina is unique in that the Department and courts have stated that the state is neither a market-based state nor a cost of performance state.2 Instead, South Carolina sources income from services to South Carolina, “to the extent the income-producing activity is performed within [South Carolina].”3 The state has not adopted the Uniform Division of Income for Tax Purposes Act’s (UDITPA) cost of performance statutory language. South Carolina does not have a statutory definition of “income-producing activity,” and as a result, the meaning of the term has been left to the courts to discern.
Recent cases have seen a shift in the treatment of “income-producing activity” from a more traditional pro rata cost of performance-related metric to something much more akin to a market-based sourcing approach, albeit seemingly limited to certain industries.4 The decision in U.S. Bank extends this trend, expanding market-based sourcing principles to the banking industry, if not more broadly.
In U.S Bank, the ALC looked at three separate revenue streams for the bank—mortgage interest and servicing fees, servicing fees related to mortgages sold to a government-sponsored entity (GSE), and revenue from credit card fees and credit card interest.
Revenue Streams as Intangible Property
The first theory used by the ALC to source U.S. Bank’s revenue streams described above was that each of the items was intangible property. Under S.C. Code Ann. §12-6-2295(A)(3), receipts from the use of intangible property are sourced to South Carolina to the extent the property is used in the state.
The ALC found that mortgages, as “evidences of debt,” are intangible property, and the income from a mortgage should be sourced based on where the mortgage is used. The court found that a mortgage is used at the location of real property securing the loan and that the location of a borrower could serve as a reasonable proxy for the location of real property. Of note, the court also concluded that mortgages sold to GSEs should be sourced based on the location of the real property securing such mortgages, not based on the location of the GSE.
Likewise, the ALC characterized the extension of credit through credit cards as the creation of accounts receivable. Accounts receivables are considered intangible property; therefore, the court determined that credit card interest and fees should be sourced pursuant to S.C. Code Ann. § 12-6-2295(A)(3). Accordingly, the court agreed with the Department that interest and fees from credit cards held by South Carolina cardholders should be sourced to the state.
Revenue Streams as Services
Under the second alternative theory, the ALC found that even if the mortgages were considered services (as opposed to intangible property), the interest and fees would be sourced based on the location of the borrowers. Similar to the logic employed by the South Carolina Court of Appeals in DIRECTV, Inc. & Subsidiaries v. S.C. Department of Revenue, the income-producing activity of the services would be the issuance of the mortgage loans as opposed to the preparatory or income-anticipatory activities leading up to the issuance. The court cited extensively from the DIRECTV decision, seemingly drawing no distinctions between the industries or revenue streams at issue.
The court applied the same approach to sourcing credit card interest and fees as it did to mortgage interest and servicing fees. The court clarified that even if the extension of credit was considered a service, the income would be sourced based on the income-producing activity of loaning the money to credit card holders in South Carolina as opposed to the preparatory or income anticipatory activities performed by U.S. Bank.
In addition, the court found that interchange or merchant fees were from the performance of a service, and the income-producing activity for such fees was the actual approval or disapproval of transactions. Accordingly, the court found that interchange or merchant fees should be sourced to South Carolina if the merchant was located in the state.
Impact
While this decision is only a trial court decision and may very well be appealed, it still indicates a shift in the Department’s approach to the sourcing of income for the banking industry.5 Thus, clients doing business in South Carolina, but with substantial operations outside of South Carolina, should consider the impact of a change to a market-based sourcing approach for income from mortgages, credit card fees, and similar products or services for financial statement reserves and/or tax return filing positions.
However, this decision should also be taken into account by non-financial institutions. While nominally discussing the impact of South Carolina’s unique sourcing rule for services, the ALC’s methodology for determining the location of the income-producing activity made no firm distinction between services provided by financial institutions or non-financial institutions. As such, all taxpayers that have some element of service revenue should follow the proceedings in this case and evaluate their sourcing methodology in South Carolina.
- 1Docket No. 20-ALJ-17-0168-CC (June 25, 2024).
- 2DISH DBS Co. v. S.C. Department. of Revenue., No. 2016-001642, 2018 BL 401605 (S.C. Ct. App. Oct. 31, 2018) (unpublished opinion).
- 3S.C. Code Ann. Section 12-6-2295(A)(5).
- 4DIRECTV, Inc. & Subsidiaries v. S.C. Department of Revenue, 421 S.C. 59 , 71 , 804 S.E.2d 633 , 639 (S.C. Ct. App. 2017).
- 5Pursuant to Rule 203(b)(6) SCACR, appellants typically have 30 days to appeal the decision of an administrative tribunal.