Washington State Rulings Highlight Thorny Business Tax Questions

A pair of recent precedential decisions from Washington state appeals courts ties into two hot topics in state and local taxation: market-based sourcing of services and taxing interchange fees for credit or debit card transactions.

In Betts Patterson & Mines v. Department of Revenue, the Division One appellate court disagreed with an insurance defense law firm that the location of insurance companies’ legal departments received the benefit of its litigation services. The court, affirming the Department of Revenue’s denial of most of the firm’s refund request, held that the benefit was received where the litigation occurred—in Washington state.

Where a customer actually receives the “benefit” of a service for apportioning gross income for Washington business and occupation, or B&O, tax has been a matter of frequent dispute. A related question—what qualifies as gross income in the first place—was addressed in the second decision. That case offers another planning lesson: Transaction fees should be excluded from taxable gross income if the taxpayer has no legal right to receive the fees and doesn’t actually receive them.

In First Data Merchant Services v. Department of Revenue, the state’s Division Three appellate court addressed whether a payment-card transaction processor must pay B&O tax on interchange fees that banks issuing credit cards charge and deduct before sending funds through the processor to the merchants.

The “interchange fee” is taken by the bank before they send the money to the payment processor. While the processor’s contract with the merchants in this case authorized the processor to charge the interchange fee, the processor wasn’t entitled to receive the interchange fee, which is taken by the bank before any funds are sent out.

The bank, a separate legal entity from the processor, charges the fee for the separate and distinct service that the bank provides: checking the customer’s credit and funding the transaction. The B&O tax simply couldn’t apply to fees that the processor didn’t receive for services separately provided by a distinct legal entity.

Together, these two decisions underscore the continuing importance of carefully analyzing the economic substance of transactions when determining tax obligations.

For market-based sourcing, the question is where the tangible benefit of a service is actually realized—an analysis that can be far from straightforward. For example, the law firm in Betts simply wanted to use client billing addresses for sourcing, as that was what was least burdensome for tracking sourcing of receipts for B&O tax purposes.

The court rejected that approach, even though the Department of Revenue’s rule on sourcing says a law firm that shows it’s “not commercially reasonable” to track each charge to each client can assume the benefits of the legal services are received at the location of the billing address.

But here, the court noted, the insurance defense law firm provided no evidence of why tracking the charges of its litigation services would have been commercially unreasonable.

If a taxpayer plans to rely on any rule where the outcome depends on a reasonableness showing, the only course to obtain certainty would be to obtain a ruling based on thoroughly accurate facts. Otherwise, the best taxpayers can do is to try to ascertain where the “helpful or useful effect” of the client’s services are realized. That requires a careful understanding of the particular service and review of the many potentially applicable examples in the sourcing rule.

If such an analysis creates an outcome that’s overly burdensome to track, then the taxpayer should document what the actual costs would be for complying with that sourcing outcome, as those costs in themselves could become part of the sourcing analysis.

Meanwhile, First Data clarifies that a taxpayer can’t be assessed B&O tax on amounts or value that never “actually accrue” to the taxpayer. The result turns on what fees the taxpayer is “actually entitled to receive” as a legal matter.

It was pivotal that the parties in First Data were “separate legal entities that provided separate and distinct services.” This is different from the relationship between, say, a pepperoni maker and a pepperoni pizza maker, where the pizza maker must pay tax on all the pizza toppings—an example the Department of Revenue unsuccessfully argued in the case.

The difference, the court explained, is that the pizza maker receives the full price for the pizza, including the toppings, whereas First Data didn’t receive the full price inclusive of the interchange fees.

Betts and First Data show that businesses should carefully analyze the economic substance of their transactions to ascertain the correct tax treatment.

For market-based sourcing, this means truly understanding where the customer receives the useful effect of the service and the actual cost of tracking this. For determining what should be included in taxable gross income, this means structuring contractual arrangements and payment flows to ensure that fees retained by third parties are clearly delineated as amounts the taxpayer is neither entitled to nor actually receives.

But these rulings likely won’t be the last word on the thorny topic of where customers receive the benefit of taxable services or what constitutes taxable income.

The cases are Betts Patterson & Mines PS v. Wash. Dep’t of Revenue, Wash. Ct. App., Div. 1, No. 86756-3-I, opinion filed 11/3/25; and First Data Merchant Servs. LLC v. Wash. Dep’t of Revenue, Wash. Ct. App., Div. 3, No. 40584-2-III, opinion filed 1/29/26.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Michelle DeLappe is a partner at Fox Rothschild in Seattle focused on state and local tax matters.

Ariel Lynn Cook is a state and local tax associate at Fox Rothschild in Seattle.

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