Does an intercompany service charge to an affiliate in a separate-entity market state create apportionment for the provider?

Two features that put the fee in the numerator

The first feature is separate-entity reporting. Tennessee states the rule in its own words: "each taxpayer is considered a separate and single business entity and must file individual tax returns," and entities other than unitary groups of financial institutions and captive REIT affiliated groups "are not permitted to file a consolidated or combined franchise and excise return" (Franchise and Excise Tax Manual (June 2026), pages 17 to 18, citing Tenn. Code Ann. section 67-4-2007(e)(1)). The manual draws the consequence for affiliates: "intercompany transactions between affiliated entities will not be eliminated" (page 66). Pennsylvania's Corporate Net Income Tax is likewise levied "on a separate company basis with Pennsylvania modifications," and consolidated reporting is not permitted for Commonwealth purposes (Pennsylvania Department of Revenue, Corporate Net Income Tax Audit Manual (published October 7, 2025), Sections I and III).

A combined reporting state treats the same fee differently. California, for example, disregards intercompany transactions among members of a combined report for purposes of the sales factor (FTB Publication 1061, Guidelines for Corporations Filing a Combined Report (2025), applying Cal. Code Regs., tit. 18, section 25106.5-1). A fee that disappears from the factor in a combined state's return for a unitary group stays in the provider's factor in a separate-entity state, and it stays even in a combined state where the provider and the payer are not part of one unitary business, the threshold question the library's article on the unitary business principle addresses.

The second feature is market sourcing. In Tennessee, sales other than sales of tangible personal property are in the state "if the taxpayer's market for the sale is in this state," and for a service the market is in Tennessee "if and to the extent the service is delivered to a location in this state" (Tenn. Code Ann. section 67-4-2012(i)(1), (i)(1)(C)). In Pennsylvania, for tax years after 2013, sales from a service are in the Commonwealth if the service is delivered to a location there, and a service delivered both inside and outside the state is assigned by the percentage of its total value delivered to a location in the state (72 P.S. section 7401(3)2.(a)(16.1)(C), as restated in Information Notice Corporation Taxes 2014-01 (December 12, 2014); Synthes USA HQ, Inc. v. Commonwealth, No. 11 MAP 2021 (Pa. Feb. 22, 2023)). Neither rule asks where the provider's employees perform the work. Under the older cost-of-performance rule, a provider whose staff and costs sit entirely in another state assigned none of the fee to the state where its customer operates; the library's article on cost of performance versus market sourcing explains that rule and why most states left it. The zero percent habit is a holdover from it.

The formula gives the sourcing answer its full weight. For tax years ending on or after December 31, 2025, Tennessee apportions net earnings "by the receipts factor only" (Tenn. Code Ann. section 67-4-2012(a)(5)), a fraction of the taxpayer's total receipts in Tennessee over its total receipts everywhere (section 67-4-2012(g)). Pennsylvania has apportioned by a single sales factor for tax years beginning on or after January 1, 2013, as the Department's audit manual describes (Section VII).

Nexus: the fee alone can make the provider a taxpayer

Tennessee taxes persons that are doing business in the state and have substantial nexus there. Doing business is defined broadly as "any activity purposefully engaged in within Tennessee, by a person with the object of gain, benefit, or advantage," to the extent the federal and state constitutions permit (Franchise and Excise Tax Manual (June 2026), page 49). Substantial nexus includes bright-line presence, which a taxpayer has if its "total receipts in this state during the tax period, as determined under Tenn. Code Ann. § 67-4-2012, exceed the lesser of $500,000 or 25% of the taxpayer's total receipts everywhere during the tax period" (Tenn. Code Ann. section 67-4-2004(47), as restated in the manual at page 51). The manual adds that "physical presence is not required" (page 52). Because the bright-line test counts receipts as the apportionment statute sources them, the sourcing analysis and the nexus analysis are one computation. The 25 percent prong matters for a captive provider: a services company whose affiliates are its only customers can cross it with Tennessee receipts well below $500,000.

Pennsylvania reaches the same place by presumption. Beginning with tax periods starting on or after January 1, 2020, the Department treats "corporations without physical presence in the state, but having $500,000 or more of gross receipts sourced to Pennsylvania per year pursuant to the sales factor rules contained in 72 P.S. § 7401," as having a Corporate Net Income Tax filing requirement, and a taxpayer above that amount that claims no nexus is expected to file a report with information supporting its position (Corporation Tax Bulletin 2019-04, Nexus for Corporate Net Income Tax Purposes (issued September 30, 2019, revised August 6, 2020)).

Federal law offers no shelter. Public Law 86-272 bars a state net income tax only where the taxpayer's in-state activity is limited to soliciting orders "for sales of tangible personal property" that are approved and shipped from outside the state (15 U.S.C. section 381(a), as quoted in the Franchise and Excise Tax Manual (June 2026), page 59). A fee for services is outside it. Once nexus exists in Tennessee, the provider owes the excise tax of 6.5 percent on apportioned net earnings and the franchise tax of 25 cents per $100 of apportioned net worth, with a $100 minimum franchise tax (manual, page 18).

Where an affiliate receives a service

Market sourcing moves the question from the provider to the affiliate, and the two states answer it differently.

Tennessee sorts services into categories, and most intercompany charges fall in one. Its rule defines professional services as services "that require specialized knowledge," and lists among them "management services," "tax preparation, payroll and accounting services," "legal services," "consulting services," and "engineering services" (Tenn. Comp. R. & Regs. 1320-06-01-.42(4)(d)1). A professional service of "an intellectual or intangible nature" stays in that category even when it involves some in-person contact, and electronic delivery of documents does not move it into another category (Rule 1320-06-01-.42(4)(d)2(i) and (ii)). Charges for other services delivered to the customer fall under a separate category and are assigned "if and to the extent that the service is delivered in Tennessee" (Rule 1320-06-01-.42(4)(c)1).

For a professional service sold to a business customer, the rule does not look to where the customer's operations are. The sale is assigned "first, by assigning the receipts to the state where the contract of sale is principally managed by the customer; second, if such place of customer management is not reasonably determinable, to the customer's place of order; and third, if such customer's place of order is not reasonably determinable, to the customer's billing address" (Rule 1320-06-01-.42(4)(d)3(i)(II)). Where the taxpayer "derives more than 5% of its sales of services from a customer," it must identify the state of contract management (same paragraph), which rules out the billing-address shortcut for nearly every intercompany relationship. The state of contract management is "the primary location at which an employee or other representative of a customer serves as the primary contact person for the taxpayer with respect to the implementation and day-to-day execution of a contract entered into by the taxpayer with the customer" (Rule 1320-06-01-.42(1)(c)10). And the customer is "the person who contracts for such service, irrespective of whether another person pays for or also benefits from the taxpayer's services" (Rule 1320-06-01-.42(4)(d)3).

Three consequences follow. First, an affiliate whose services agreement is administered day to day by its own controller at its Tennessee plant generates Tennessee receipts for the provider. Second, an affiliate with every plant in Tennessee whose agreement is administered by a group treasury officer in another state can generate none, because the rule follows the contact, not the operations. Third, where one master agreement is signed by a parent for the benefit of several subsidiaries, the contracting party, not the benefited subsidiaries, is the customer under the rule's own definition.

Pennsylvania's text points elsewhere. Its statute asks where the service is delivered and, for a customer that is not an individual, falls back to "the location from which the services were ordered in the customer's regular course of operations," then to the billing address (Information Notice Corporation Taxes 2014-01, Section 2.0). The same notice states that services used by a trade or business "are delivered to the business location(s) containing the actual customers for the service" (Section 4.2.1). That reading looks to where the affiliate's people use the service, not to who manages the contract.

The Department's proposed regulation would make the point explicit for affiliates. Regulation #15-464, proposed 61 Pa. Code section 153.26a, was published as a proposed rulemaking in the Pennsylvania Bulletin on July 25, 2026; the comment period closed August 24, 2026, and the Independent Regulatory Review Commission's site showed no final-form regulation submitted as of October 14, 2026. Its definition of professional services includes management, payroll and accounting, data processing, legal and consulting services. For ordinary business customers it would adopt a contract-management, place-of-order, billing-address sequence much like Tennessee's (proposed section 153.26a(d)(17)(iii)). But where a professional service "is sold to an affiliated entity other than an individual person," it would set that sequence aside and source the service to "the location where the affiliated entity received the service" (proposed section 153.26a(d)(17)(vii)). Where that location must be approximated, a service that "primarily relates to specific operations or activities" of the affiliate would be assigned to the states of those operations "in proportion to the affiliated entity's payroll at the locations to which the service relates," and a service that relates to the affiliate's operations generally would be assigned to the states where the affiliate has employees, in proportion to its payroll there (proposed section 153.26a(d)(17)(vii)(A) and (B)). Until a final-form regulation is published, the proposal states the Department's view of the statute rather than binding law, but it indicates how the Department reads the delivery test for intercompany fees.

The same fee can therefore land differently in the two states. Tennessee follows the affiliate's contract manager; Pennsylvania, on its proposed rule, follows the affiliate's payroll.

Which part of the charge is a receipt

The form of the charge matters in at least one state. Pennsylvania's audit manual lists "management fees or intercompany sales/revenue that include a related markup" among receipts generally included in the sales factor, and "intercompany reimbursements or cost allocations for expenses" among items generally not included (Corporate Net Income Tax Audit Manual, Section VII). The manual states of itself that it "is not authoritative and may neither be cited to support an audit position nor relied on by the taxpayer," so it describes audit practice rather than law, but the distinction it draws is the one an examiner applies. An arrangement that bills a fee for services, even one priced at cost plus a markup, produces receipts; one that passes through specific third-party costs at no markup may be treated as a reimbursement.

Tennessee's statute counts the taxpayer's total receipts in the state (Tenn. Code Ann. section 67-4-2012(g)), and the Department reads "gross receipts" as "all receipts from whatever sources derived before any deductions" (Tenn. Code Ann. section 67-4-2004(20), as quoted in the manual at page 39). No published Tennessee guidance among the sources reviewed separates a pass-through reimbursement from a service fee for the receipts factor, so that line is unsettled there.

Tennessee's consolidated net worth election changes one of the two computations. An affiliated group may elect, by registration with the Department, to compute franchise tax net worth on a consolidated basis; the election binds all members for at least five years (manual, page 162). Under it, "all intercompany transactions and holdings between affiliated group members" are "excluded from the consolidated net worth apportionment ratio but are included in the excise tax apportionment ratio" (manual, page 173). For an electing group the intercompany fee drops out of the franchise tax ratio and remains in the excise tax ratio.

A worked example

A services company has all of its employees in State H, a combined reporting state. It provides accounting, payroll, procurement and legal support to three affiliates under separate written agreements and bills each a fee equal to its cost plus a markup. In a tax year ending December 31, 2026, it bills a manufacturing affiliate with its only plant in Tennessee $3.0 million, a distribution affiliate with warehouses in Pennsylvania $1.5 million, and a retail affiliate in State H $1.5 million. Its total receipts are $6.0 million and its net earnings $300,000.

In Tennessee, the result turns on who administers the manufacturing affiliate's agreement. If its plant controller in Tennessee is the provider's primary contact for day-to-day execution, the $3.0 million is a Tennessee receipt, the provider has bright-line presence, and its receipts factor is 50 percent: $150,000 of net earnings bear excise tax of $9,750, and its franchise tax is computed on its apportioned net worth. If the agreement is administered by the group's chief financial officer in State H, the Tennessee numerator is zero and, with no other contact, so is the bright-line computation.

In Pennsylvania, the $1.5 million exceeds the $500,000 presumption if it is sourced there. Under the proposed affiliate rule, services that relate to the distribution affiliate's warehouse operations are assigned in proportion to its payroll at the warehouses served; if all of that payroll is in Pennsylvania, the provider's Pennsylvania factor is 25 percent. The statute's delivery test, read with the 2014 notice, points to the same business locations.

In State H, if all four companies form one unitary combined group, the intercompany fees are disregarded in the group's factor, and the provider's income enters the group's apportionable base without its own receipts in the factor. The separate-entity states and the combined state do not coordinate, so the provider's earnings can be apportioned in a total above 100 percent, and none of the states is misapplying its own rule.

The open questions

Four points remain unsettled. First, Tennessee's contact-person test assumes that the customer has its own representative. In intercompany arrangements the provider's employees often run the function they bill for; whether a provider employee who serves as the affiliate's officer is a "representative of a customer" under Rule 1320-06-01-.42(1)(c)10 is a question the rule does not answer. Second, no Tennessee guidance among the sources reviewed separates cost reimbursements from service receipts. Third, Pennsylvania's affiliate rule is a proposal; open years are governed by the statute and the 2014 notice, under which an examiner and a taxpayer can reasonably disagree about whether the place of delivery is where the affiliate's employees use the service or where its order originates. Fourth, the price itself is open to challenge. Tennessee's variance authority may be invoked by the Department as well as the taxpayer where the standard formula does not fairly represent in-state activity (Franchise and Excise Tax Manual (June 2026), pages 384 to 385, citing Tenn. Code Ann. sections 67-4-2014 and 67-4-2112), and the Commissioner "may require combined reports utilizing a common apportionment formula covering members of an affiliated group" where intercompany activity calls for it (Tenn. Code Ann. section 67-4-2014(c)(1)). A markup well below what the services would command between unrelated parties invites that review.

Practice notes

The analysis begins with the agreement, not the return. A written intercompany services agreement that identifies the services by function, states whether any component is a pass-through of third-party cost, and names the affiliate's contact for day-to-day execution supplies the facts Tennessee's rule tests and the record Pennsylvania's delivery test needs. For each separate-entity market state where an affiliate operates, the working schedule shows the fee by affiliate, the sourcing category, the state assigned and the basis for it, and then compares the result to that state's nexus threshold, because the same figure drives both. Affiliate payroll by location, kept in the same schedule, supports the approximation Pennsylvania's proposed rule describes. A provider that has filed nowhere but its home state, on the view that its work is performed there, has exposure in each market state where its fees cross the threshold, and the years at issue run from the first year the threshold was met; a voluntary disclosure is usually a better route than an examination, which can begin from the deduction on the affiliate's own return. Where the group's home state combines and the market states do not, the overlap is a cost of the structure, and the responses available are agreements that reflect where each contract is in fact administered, pricing that holds up as arm's length, and a variance petition where the formula produces an unusual result. G&G State Tax Group provides intercompany service sourcing and nexus reviews for multistate groups alongside its state and local tax practice.