For the past 20 years at least and for good reason, the predominant focus on state income apportionment has been on the sales factor and market-based sourcing of receipts from sales of services and licenses/sales of intangibles. However, manufacturing and distribution of goods (tangible personal property, or “TPP”) remains a large and important component of the national and many state economies. Taxpayers that are manufacturers and sellers utilizing distribution intermediaries should review the state rulings discussed in this article and their current sales factor sourcing practices.
Recent rulings from departments of revenue in Colorado, Illinois, New Mexico, Tennessee, and a tax tribunal decision from Michigan demonstrate that the sourcing of receipts from sales of TPP for the sales factor cannot be taken for granted. Especially when sales by the manufacturer/seller are made using related or unrelated distribution intermediaries, state taxing authorities and taxpayers may disagree on the appropriate state for destination-sourcing of these sales.
Destination Sourcing of Sales of TPP—An Overview
For sales factor sourcing of sales of TPP, most states have adopted a version of the Uniform Division of Income for Tax Purposes Act (UDITPA) or Multistate Tax Compact (MTC) that provides:
“Receipts from the sale of tangible personal property are in this State if: (a) the property is delivered or shipped to a purchaser, other than the United States Government, within this State regardless of the f.o.b. point or other conditions of the sale …"
MTC Compact Art. IV., §16(a). See also Cal. Rev. & Tax Code §25135(a); 35 I.L.C.S. §5/304(a)(3)(B)(i); Tenn. Code Ann. §67-4-2012(h).
Other states adopt a variation of statutory language, but also generally source receipts from sales of TPP to the customer’s destination. Just as with the market sourcing of receipts from sales of services, taxpayers cannot simply rely on customer billing addresses or “ship to” addresses for sourcing sales of TPP. Roughly less than half of the states that impose a corporate income tax apply a sales factor “throwback rule” that sources receipts from sales of TPP to customers in states where the seller is not taxable to the seller’s state of shipment. In addition, most states source sales of TPP to the US government to the state of shipment.
States have commonly adopted an MTC model apportionment regulation which provides: “Property is delivered or shipped to a purchaser within this state if the shipment terminates in this state, even though the property is subsequently transferred by the purchaser to another state.” 18 Cal. Code Regs. §25135(a)(3); Colo. Regs. §39-22-303.6-6(3); Ill. Admin. Code tit. 86, §100.3370(c)(1)(C); N.M. Regs. §3.5.17.8.C.; Tenn. Comp. R. & Regs. §1320-06-01-.33(1)(c).
Historically, issues have arisen for sourcing “dock” sales of TPP—when the customer has sent its vehicles or arranged for a common carrier to pick up the purchased TPP at the seller’s location or “dock.” Likewise, similar issues have arisen for “drop shipment” sales—a three-party transaction involving a shipper, retailer, and customer where the retailer directs the shipper to ship the TPP directly to the customer. For drop shipment sales, title to the TPP may pass from the shipper to the retailer and then to the customer at the shipper’s dock or at the customer’s destination. States have sought to source dock sales and drop shipment sales to the shipment location but have generally not met with success. See, e.g., Gilmour Mfg. Co. v. Commonwealth, 822 A. 2d 676 (2003) (destination sourcing of dock sales); Stryker Corp. v. Director, Div. of Taxation, 18 N.J. Tax 270 (1999), aff’d, 775 A.2d 1200 (App. Div. 2000), aff’d, 773 A. 2d 674 (N.J. 2001) (destination sourcing of drop shipment sales). In general, state courts have interpreted the language of the sales factor sourcing statute and specifically the words “within this state” as modifying the word “purchaser.”
In McDonnell Douglas Corp. v. Franchise Tax Board, the taxpayer manufactured aircraft in California and sold them to American and international buyers. 26 Cal. App. 4th 1789 (1994). Most of its commercial aircraft were delivered to buyers in either California or Arizona. The buyers then arranged for transportation of the aircraft out of either state. For sales of aircraft delivered in California, the Franchise Tax Board (FTB) relied on a prior legal ruling that concluded “delivered” to the buyer meant the place at which the buyer took possession and control of the TPP. For sales of aircraft delivered in California, the FTB contended those sales were sourced to the taxpayer’s California sales factor numerator because the buyers took possession and control of the aircraft in California. The court of appeal disagreed and pointed out that sourcing sales of TPP is based on a destination rule, not a place of delivery rule. See also Revenue Cabinet v. Rohm and Haas Kentucky, Inc., 929 S.W. 2d 741 (Ky. Ct. App. 1996). Further, the place where title to the TPP passed was not mentioned by the court—most likely because sales of TPP are sourced based on their destination “regardless of the F.O.B. point…"
But what if a seller of TPP uses distribution intermediaries to ship or deliver TPP to ultimate customers? Often, the seller may ship or deliver its TPP to the distributor, title to the TPP may pass to the distributor, and the TPP may be warehoused by the distributor for weeks before being shipped or delivered by the distributor to the ultimate customer. The distributor’s warehouse may be in the same state as the seller or in a different state. In addition, at the time the seller ships its TPP to the distributor’s warehouse, a sale to the ultimate customer may or may not have been made. When sales are not made using a distribution intermediary, the shipment may be diverted to the buyer’s or another party’s warehouse in the seller’s state due to weather or other circumstances. Alternatively, the buyer may temporarily store the TPP in the seller’s state for purposes of investigation, quality control testing, or for further assembly. See, e.g., Appeal of Mazda Motors of America (Central), Inc., No. 94-SBE-009 (Cal. State Bd. of Equal., Nov. 29, 1994).
Destination state sourcing of sales of TPP is not always cut and dried, especially when the shipment or delivery of the TPP involves a distribution intermediary. Sales factor sourcing of these sales can be a fact-intensive exercise and, like much in state income taxation, the results can vary by state.
Colorado
For tax years beginning on or after January 1, 2019, Colorado no longer treats sales to the US government shipped from Colorado in the numerator of the sales factor. Col. Rev. Stat. §39-22-303.6(5)(b). (Effective for tax years beginning on or after January 1, 2021, Alabama also repealed its similar “throwback rule” for sales to the US government.) Thus, the US government is now treated the same as any other purchaser. In Colorado PLR 24-003 (Aug. 21, 2024), the taxpayer manufactured its products in Colorado and one of its principal customers was the US government. Because US government facilities were often not ready to receive the products after the sale, the contract of sale required the taxpayer to store the products in Colorado. While stored in Colorado, the US government performed a final inspection at which time “unconditional acceptance” occurred (and passage of title to the government occurred). Afterwards, the products were required to remain in storage in Colorado for 30 days. While in storage the US government paid the taxpayer for the storage and maintenance. When the government determined the delivery destination for the products, the taxpayer shipped the products to the designated destination.
Because the Colorado sourcing statute, like those of many other states, disregards passage of title, i.e., “F.O.B. point”, the Colorado Department of Revenue (“Department”) ruled that the government’s “final inspection” when title passed to the US government in Colorado was not determinative of destination. Likewise, storage of the products in Colorado was also not determinative. The Department relied on Lone Star Steel Co. v. Dolan, 668 P. 2d 916 (Colo. 1983) (transfer of steel pipe to a third-party service provider in Colorado prior to delivery by common carrier to the out-of-state purchaser did not result in sourcing the sales to Colorado.) As a result, the Department ruled that the sales to the US government were not sourced to the Colorado sales factor numerator.
Illinois
In Illinois PLR IT 24-0001 (Aug. 22, 2024), the taxpayer was a cross-platform global games company with a focus on content and digital markets whose customers were licensed gaming companies. Its products were manufactured outside Illinois. All products were shipped from outside Illinois, but the taxpayer used a third-party distribution center located in Illinois. No inventory was stored at the distribution center, as the taxpayer’s products had already been sold to customers at the time of shipment prior to arrival at the Illinois distribution center. After arrival at the distribution center, no further modifications, product changes, or alterations to the products occurred. Upon arrival by motor carrier, the trucks were unsealed, and their contents were moved to different trucks depending upon the destination of the products. The products remained at the Illinois distribution center from a few hours to up to seven days.
The Illinois Department of Revenue concluded that the taxpayer’s shipments did not terminate in Illinois. The Department emphasized that only the taxpayer, and not its customers, used the Illinois distribution center. Because the distribution center was not customer-owned or leased and customers did not authorize shipment to the Illinois distribution center or accept the products upon arrival there, the Department ruled that the taxpayer’s shipments did not terminate in Illinois. In addition, the ruling also concluded that because the taxpayer’s sales did not originate or terminate in Illinois, the Illinois sales factor throwback rule was inapplicable.
Michigan
Electricity is treated as TPP by most states for sales factor purposes. See, e.g., Powerex Corp. v. Dept. of Revenue, 346 P. 3d 476 (Ore. 2015). The electric industry involves generation, transmission, and distribution. Generation is the process of converting energy into electricity. Transmission is the transportation of electricity. Distribution is the transfer of electricity to homes and businesses. The “electric grid” is the transmission and distribution infrastructure. Electricity generators inject the electricity they generate into the electric grid at a substation known as a “point of receipt,” “interconnection point,” or “physical node.” Under federal law and regulations, an electricity generator is required to sell its electricity to an Independent System Operator (ISO), which operates the transmission system. The ISO does not own the transmission system, but it does dictate how much electricity is injected into and withdrawn from the system. ISOs are nonprofit, membership organizations. Entities that wish to participate in the electric grid register with an ISO as a “market participant.” Market participants are transmission system owners, buyers who withdraw electricity from the grid for resale to customers (known as load-serving entities), and electric generators who inject electricity into the grid.
A recent Michigan Tax Tribunal decision, CMS Energy Corp. v. Dept. of Treasury (Decision No. 19-003783 (Feb. 13, 2025)), addresses the sourcing of sales of electricity by a generator to an ISO for transmission to customers. In a lengthy opinion that went into considerable detail about the electric industry, the parties’ arguments, and the applicable Michigan law and authorities, the Michigan Tax Tribunal ruled that the ultimate destination of the taxpayer electricity generator’s sales of electricity was not the location of the business and individual customers who used the electricity. (Michigan adopts the UDITPA/MTC Compact destination sourcing statute for sales of TPP; however, “in the case of [sourcing sales to Michigan of] electricity and gas, the contract requires the property to be shipped or delivered, to any purchaser within this state.” Mich. Comp. Laws §206.665(1)(a)). Rather, the destination for the generator-taxpayer was the place where title to the electricity transferred to the ISO. The tribunal concluded that separate sales transactions occurred, first from the taxpayer-generator to the ISO and then a resale from the ISO to the other market participants. Accordingly, the tribunal rejected the taxpayer-generator’s argument that ultimate destination is the place where the first beneficial use of the sale of TPP occurs. (The tribunal rejected the taxpayer-generator’s reliance on a Minnesota sales tax case, Sellner Mfg. Co. v. Commissioner of Revenue, 202 N.W. 2d 886 (Minn. 1972), in favor of another Minnesota dock sales case, Olympia Brewing Co. v. Commissioner of Revenue, 326 N.W. 2d 642 (Minn. 1982). Olympia Brewing did not involve two separate sales transactions.)
New Mexico
In New Mexico Ruling 210-25-1 (Feb. 13, 2025), operating subsidiaries (“OCs”) of a parent corporation manufactured, purchased, and imported various products. Another affiliate managed the distribution of the products. The OCs’ products were sold to distributor-wholesalers located inside and outside of New Mexico for further sale to purchasers also located inside and outside New Mexico.
The affiliate used two methods to distribute the OCs’ products:
1. Under the first method, the products were shipped by common carrier to a third-party warehouse. The products had not yet been sold, but were stored at the warehouse until unrelated distributor-wholesalers placed an order. When an order was placed, title to the products passed to the distributor-wholesalers at the warehouse location and shipped to the distributor-wholesalers who were in New Mexico. The distributor-wholesalers would then ship the products to customers within or outside New Mexico.
2. Under the second method, the products were shipped by the affiliate to a distribution center that it owned, known as a “regional hub.” All regional hubs were located outside of New Mexico. The products remained at the regional hub until a distributor-wholesaler placed an order. Title to the products passed to the distributor-wholesalers prior to arrival at their warehouses. The distributor-wholesalers then distributed the products to other distributors or retailers located inside or outside New Mexico.
The New Mexico Department of Taxation and Revenue’s ruling as to the first method of distribution is not surprising. This method involved two separate sales transactions—the first from the OCs’ to the distributor-wholesalers with shipments terminating in New Mexico at the distributor-wholesalers’ New Mexico warehouses. The distributor-wholesalers were the purchasers of the OCs’ products. These were New Mexico-sourced sales by the OCs. As to the second method of distribution, the sales to the distributor-wholesalers were not only shipped from regional hubs outside New Mexico, they were delivered to purchasers inside or outside New Mexico. Two separate sales transactions again occurred—first to the distributor-wholesalers and then to the distributor-wholesalers’ customers. The fact that some of the distributor-wholesalers’ customers were in New Mexico did not change the sourcing of the OCs’ sales to the distributor-wholesalers delivered outside New Mexico as non-New Mexico destinations.
Tennessee
Two rulings issued by the Tennessee Department of Revenue in 2024 also involved sales of manufactured products shipped to and temporarily stored at third-party distribution centers in Tennessee, but the rulings arrived at different conclusions based on subtle factual differences. Like the other states discussed, Tennessee’s destination sourcing statute for sales of TPP disregards “F.O.B. point and other conditions of sale” and Tennessee’s administrative rule adopts the same termination of shipment in-state provision. 18 Cal. Code Regs. §25135(a)(3); Colo. Regs. §39-22-303.6-6(3); 86 Ill. Admin. Code §100.3370(c)(1)(C); N.M. Regs. §3.5.17.8.C.; Tenn. Comp. R. & Regs. §1320-06-01-.33(1)(c).
In Tennesee Revenue Ruling 24-06 (July 31, 2024), the taxpayer sold its products to wholesale distributors, which in turn sold the products to end-users. Title to the taxpayer’s products passed to the wholesale distributors upon arrival at the distributors’ warehouses. The products remained at the warehouses from 14 to 25 days, were not repackaged or altered, and were then transported to the end-users. The taxpayer was in contact with the end-users during the entire ordering and shipping process, including before and after passage of title to the distributors. Importantly, orders by end-user customers were placed with the wholesale-distributors after products arrived at their warehouses. The Department concluded that the sales to the wholesale distributors shipped to a Tennessee warehouse were sourced to the taxpayer-seller’s Tennessee sales factor numerator. The taxpayer’s sales to the wholesalers and the wholesalers’ sales to the end-users were two separate transactions. As a result, the Department distinguished the facts of its ruling from McDonnell Douglas, Rohm and Haas, Lone Star Steel, and other cases argued by the taxpayer to apply a strict “ultimate destination” principle. In short, those cases did not involve separate sales transactions between a manufacturer/seller, wholesaler-distributor, and end-user customers (who were customers of the distributor).
Conversely, Tennessee Revenue Ruling 24-12 (Dec. 19, 2024) addressed a drop shipment fact pattern. The taxpayer was a manufacturer and seller of specialty products. When a merchant received an order for one of the taxpayer’s products, the taxpayer fulfilled the order by contracting with a third-party logistics company. The products arrived at the third party’s climate-controlled distribution center, were not repackaged or altered, remained for two to six weeks, and then were shipped to the end-user. Title did not transfer until the products were received by the end-user. While there are some similarities between the facts of Tennessee Revenue Ruling 24-12 and Tennessee Revenue Ruling 24-06, i.e., both involved the use of distribution intermediaries where the products were temporarily stored prior to on-shipment to the ultimate customer, the Department distinguished the former ruling from the latter. Largely because Tennessee Revenue Ruling 24-12 dealt with drop shipments and title did not pass until the taxpayer’s products were delivered to the end-user, the Department ruled that sales delivered to non-Tennessee end-users were not sourced to Tennessee even though the product passed through and was temporarily held in a Tennessee distribution center.
While the result in Tennesee Revenue Ruling 24-12 was favorable for that taxpayer, the Department may have introduced additional formalities into the determination of sourcing drop shipment sales (and possibly dock sales, as well) that may not be supported by the applicable Tennessee statute. For example, the Department’s emphasis on where title passed should not be determinative of sourcing and is not only inconsistent with the statute, but also the Department’s prior rulings. See, e.g., Tennessee Letter Ruling 13-14 (Oct. 11, 2013); Tennessee Revenue Ruling 04-12 (Apr. 26, 2004). Further, the Department concluded that it was "[v]ital” that the sale by the taxpayer to the merchant was not recorded until after the end-user placed their order with the merchant. Again, a formality that isn’t supported by the statute.
Whether a manufacturer/seller is based in Tennessee or shipping into Tennessee and whether sales transactions involve distribution intermediaries, drop shipments, dock sales, or direct shipments, the facts of these transactions need to be closely scrutinized.
Conclusion
Market-based sourcing of sales of services and licenses/sales of intangibles have rightly received the bulk of the attention over the past decades by taxpayers and income tax practitioners. However, manufacturing and sales of TPP remain a large component of the US economy (and recent global events indicate an intent to “re-shore” manufacturing). Taxpayers that are manufacturers and sellers utilizing distribution intermediaries are encouraged to take notice of the state rulings discussed in this article and review their current sales factor sourcing practices.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
Scott D. Smith is the Managing Director of the State and Local Taxes practice at Forvis Mazars, LLP.
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