When it comes to the sourcing of receipts for apportionment, companies whose business includes the provision of services are often faced with the question of determining where the service or its benefit is received. This question is crucial for both income taxes, which are often apportioned based on a single sales factor, and gross receipts taxes, for which the receipts need to be properly sitused under state law. To perform a sales factor analysis, the service provided needs to be carefully defined, and the party receiving the service, and the location of that receipt, may present thorny questions. While a taxpayer will generally want to answer these questions in the manner most favorable to itself (e.g., lowest taxes, fewest filing obligations, easiest data gathering), there is always the risk that a jurisdiction will disagree upon audit. Such was the case with Express Scripts and the state of Maine, as adjudicated recently in Express Scripts Inc. et al. v. State Tax Assessor, 2023 ME 68, Docket: BCD-22-331 (Nov. 7, 2023).
The audit period covered by this case was 2011-2013, and the revenue whose sourcing was at issue was from claims adjudication and other pharmacy benefit manager (“PBM”) services performed by Express Scripts, Inc. and its unitary affiliates (collectively, “Express Scripts”). The PBM services included the negotiation of prices at which individuals who were members of various medical plans that were clients of Express Scripts could purchase prescription drugs from retail pharmacies, as well as the management of networks responsive to those clients’ preferences. Express Scripts at ¶ 4. The related service of claims adjudication involved the processing of these members’ claims in real time as they made purchases at retail pharmacies. This process included confirming the member’s eligibility, performing a concurrent drug interaction/utilization review, confirming to the pharmacy that it would receive payment from Express Scripts pursuant to their contracts, and informing the pharmacy of the member’s co-pay amount. Express Scripts at ¶ 5.
Beginning with its 2012 tax return, Express Scripts began sourcing the receipts from the PBM/claims adjudication services based on the location of the primary commercial and administrative headquarters of its clients, who were a combination of health insurers, health maintenance organizations, employers, governmental health programs, and union-sponsored benefits plans. Express Scripts at ¶ 4 and fn.5. During 2015, the same year the audit began, Express Scripts filed an amended return to use the new method for 2011 as well, which generated a refund claim. The refund claim was denied and Express Scripts was assessed for the difference in tax resulting from the use of this sourcing method in 2012 and 2013 rather than its previous sourcing method, which resulted in a higher factor.
The Maine Supreme Judicial Court (“Court”), the highest court in Maine, refers to the sourcing method favored by Express Scripts as the “market client basis” because Express Scripts’ clients’ locations form the basis for the sourcing. The previous sourcing method, asserted to be the correct method by the Maine Revenue Service (”MRS”), is referred to as the “market member basis.” As its name suggests, this latter method uses the location in which the prescription drug is dispensed to plan members as the basis for apportioning revenue from the PBM/claims adjudication services. The relevant code section, Maine Revised Statutes § 5211(16-A)(A), provides that “receipts from the performance of services must be attributed to the state where the services are received.” Under this wording, both methods would appear to have some justification. As Express Scripts argued, the services were received at its clients’ commercial and administrative headquarters because it contracts with, and ultimately bills, its clients, not the clients’ individual members. In opposition, the MRS argued that the services are received at the retail pharmacies because the individual members receive the services at issue when they fill prescriptions at retail pharmacies and Express Scripts provides claims processing services.
The Court reviewed this case because Express Scripts appealed the granting of a motion for summary judgment. In order to prevail, Express Scripts needed to demonstrate that there was a genuine issue of material fact regarding the location of the services provided. Bearing the burden of proof on appeal, Express Scripts needed to “present evidence sufficient to establish a prima facie case that its services were received at the commercial and administrative headquarters of its clients and . . . that the record affirmatively indicates that this fact remains in dispute.” Express Scripts at ¶ 29. The Court found that Express Scripts failed to do so. The Court refers to statements from Express Scripts’ Form 10-K filings, as well as contracts in the record that support the position that the services in question were provided to its clients’ members rather than the clients themselves. “Most notably,” the Court states, “Express Scripts’ Form 10-K for 2011 states explicitly: ‘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.’” Express Scripts at ¶ 33 (Emphasis added by the Court).
Regarding whether the fact of the location of services remains in dispute, the Court points to the summary judgment record containing support for the position that the PBM services include processing member claims at retail pharmacies, and nothing else. In this part of the discussion, the Court does not mention price negotiation or network management; the Court found no support in the summary judgment record to “support the contention that the receipts at issue include charges for PBM services other than processing member claims at retail pharmacies.” Express Scripts at ¶ 34. According to the Court’s reading of the PBM agreements, “the receipts in question were provided in response to invoices Express Scripts generated each week seeking reimbursement for processing members’ claims.” Express Scripts at ¶ 34. That processing service resulted from members going to pharmacies to fill their prescriptions. Because the Court found there was no genuine issue of material fact, summary judgment was rightfully granted by the trial court, and Express Scripts’ appeal failed.
ZHF Observation
Although it lost in court, Express Scripts’ sourcing position was not particularly aggressive. It is often difficult to determine the correct means of sourcing receipts from services when a statute provides a general rule such as “where the services are received.” It is not unreasonable to view one’s contracted clients as the parties receiving the services, and it is often much easier to determine the location of those clients than it is to perform a “look-through” analysis to determine the location of the clients’ members or customers, and the proportion of receipts stemming from each of those member or customer locations. When the correct sourcing method is uncertain, should a taxpayer take on a large data collection burden, compliance burden, and higher tax burden because the taxpayer suspects that some states might prefer a look-through method? Moreover, audit risk may work in both directions. While some states stand to gain from the look-through, the states housing the clients (or a taxpayer’s direct customers), probably stand to lose tax revenue when a taxpayer looks through to a more widely dispersed market base. The states are not uniform when it comes to look-through sourcing, and the determination should be sensitive to a taxpayer’s facts and circumstances.
An appropriate solution might be to request a tax commissioner opinion or ruling from the more material states. For instance, if the states housing a taxpayer’s major clients opine that the look-through method is correct, regardless of the states’ own loss of revenue, that would be a solid basis for using a look-through method. Of course, one cannot predict the outcome of such a request in advance. At least in Ohio, the Department of Taxation will provide informal feedback prior to issuing an adverse ruling and allow the taxpayer to withdraw the ruling request. The ruling request is only necessary where the state has neither regulations nor case law with sufficient detail and similarity to one’s own facts to give the taxpayer confidence in determining the answer from those sources. Oftentimes, making sure the facts are accurately stated and conveyed as part of the process can result in more favorable results.
ZHF attorneys are all experienced with such requests and ready to help.