How does Tennessee source a fulfillment affiliate's service fees under market-based sourcing?
Edvin Givargis Published 17 minute read
The short answer
By looking through the affiliate that pays the fee to the people who receive the deliveries. Tennessee sources a service receipt to the state "if and to the extent the service is delivered to a location in this state" (T.C.A. § 67-4-2012(i)(1)(C)), and the Department's rule construes "delivered" as the location of the taxpayer's market for the service, "not to be construed by reference to the location of the property or payroll of the taxpayer" (Tenn. Comp. R. & Regs. 1320-06-01-.42(4)(a)). The same rule names fulfillment services as the leading example of a service "delivered on behalf of" a customer and assigns such a receipt by where the third-party recipients are; in the rule's own example, a fulfillment company's fee is assigned to Tennessee "to the extent that" its deliveries on behalf of the seller are to recipients in Tennessee (Rule 1320-06-01-.42(4)(c)2(i)(III), Example 4). A Tennessee warehouse that fulfills orders for affiliated sellers based in other states therefore sources neither all of its fee to Tennessee, because the work happens there (unless it elects the pre-2016 rule for the year under section 67-4-2012(i)(4)), nor none of it, because the affiliates sit elsewhere. It sources the share that corresponds to shipments into Tennessee. Because the fulfillment entity files its own return with no intercompany elimination, and the receipts factor is now the entire apportionment formula, that share sets its Tennessee excise tax and its franchise tax receipts numerator, which is measured against the group's total receipts if the group has made the consolidated net worth election.
The fact pattern and the three readings
One affiliate holds the warehouse, the staff, the shipping contracts, and the customer-service desk in Tennessee. It stores inventory owned by affiliated selling entities, picks and packs their orders, hands the parcels to carriers, answers the sellers' customers by phone and email, and processes payments and returns. The selling affiliates are organized and managed in other states, and their customers are everywhere. The fulfillment affiliate bills each seller a fee, cost plus a markup or a per-order rate, and that fee is its only receipt. Three readings of the receipts factor compete.
The first reading assigns the entire fee to Tennessee because every activity that produces it occurs in Tennessee. This is the answer the pre-2016 statute gave, when Tennessee assigned receipts other than sales of goods to the state where the greater proportion of the earnings-producing activity was performed, based on costs of performance; the library's article on cost of performance versus market sourcing explains why that all-or-nothing rule produced a 100 percent factor for any provider concentrated in one state. Under current law the reading is not the default rule, because the rule states that "delivered" is not read by reference to the taxpayer's property or payroll (Rule 1320-06-01-.42(4)(a)). It survives as an election: for any tax year in which market sourcing produces a lower apportionment factor than the pre-2016 rule and the taxpayer has net earnings, the taxpayer may annually elect the pre-2016 rule (§ 67-4-2012(i)(4); § 67-4-2111(i)(4)). The statute says that the taxpayer may "annually elect" and nothing about mechanics; the Department's Franchise and Excise Tax Manual (June 2026) restates the election at page 345 without describing how it is made, and neither the manual nor the FAE 170 instructions prescribes a form, box, or schedule for it, so the election is made by applying the pre-2016 rule on the return with a statement that the taxpayer has elected it, and whether it can be made or withdrawn on an amended return is unaddressed. By contrast, the manual describes the parallel three-factor election under section 67-4-2012(a)(6) as made annually by checking the box on the first page of the return and completing Schedule N1, and gives its purpose, which applies equally to subdivision (i)(4): a taxpayer with accumulated Tennessee net operating losses or credits may want a higher apportioned base to use them against (Franchise and Excise Tax Manual (June 2026), page 307). The election belongs to the taxpayer and can only raise the Tennessee factor, so the 100 percent reading remains a position a taxpayer may adopt by election, not one the Department can impose on a return that did not elect it; for a fulfillment affiliate concentrated in Tennessee, electing it only raises Tennessee tax.
The second reading assigns none of the fee to Tennessee because the customer, the affiliate that contracts and pays for the service, is located outside Tennessee, and a service is "delivered to a location" where the customer is. The statute alone does not resolve it: section 67-4-2012(i)(1)(C) says "delivered to a location in this state" and says nothing about whose location. The Department's rule does. It sorts services into categories, and the category for a service the customer buys but someone else receives is assigned by the recipient's location, not the customer's, with fulfillment as the named example. The zero reading survives only if the fee is recharacterized as something other than a service delivered on behalf of the customer, which the rule's text makes difficult for pick-pack-ship.
The third reading assigns the fee in proportion to the sellers' own deliveries into Tennessee. If a seller's shipments handled by the Tennessee warehouse go 5 percent to Tennessee addresses and the fee is charged evenly per shipment, 5 percent of that seller's fee is a Tennessee receipt of the fulfillment affiliate. This is the reading the rule supports.
The statute and the rule
Tennessee moved to market-based sourcing for receipts other than sales of tangible personal property for tax years beginning on or after July 1, 2016, the effective date the Department states in its published guidance on the receipts factor. Under section 67-4-2012(i)(1), such sales "are in this 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" (§ 67-4-2012(i)(1)(C)). Where the state of assignment cannot be determined, the taxpayer must reasonably approximate it, and where it cannot, the receipt is excluded from numerator and denominator (§ 67-4-2012(i)(2) and (i)(3)). The franchise tax apportionment statute carries the same receipts factor and the same services rule in the same words (§ 67-4-2111(g) and (i)(1)(C)), so the excise tax answer carries to the net worth base.
The Department's rule, filed June 28, 2016 and effective September 26, 2016 (Rule 1320-06-01-.42, Administrative History), implements the statute. Paragraph (4)(a) restates the general rule and adds the construction that governs this article: "delivered" refers to the location of the taxpayer's market for the service and is not read by reference to the taxpayer's property or payroll. The rule then divides services into in-person services, services delivered to or on behalf of the customer, and professional services.
In-person services are services physically provided in person "where the customer or the customer's real or tangible property upon which the services are performed is in the same location as the service provider at the time the services are performed," assigned to the state where the customer receives them (Rule 1320-06-01-.42(4)(b)). Warehousing a seller's inventory resembles a service performed on the customer's property at the provider's location, but a fulfillment operation exists to move that property away to someone else, and the rule's fulfillment example would be surplusage if fulfillment were an in-person service.
The category that fits is services delivered to or on behalf of the customer. Where a service is neither in-person nor professional and "is delivered to or on behalf of the customer," the sale is in Tennessee "if and to the extent that the service is delivered in Tennessee," and the rule defines the on-behalf-of case: "A service that is delivered 'on behalf of' a customer is one in which a customer contracts for a service but one or more third parties, rather than the customer, is the recipient of the service, such as fulfillment services" or the delivery of advertising to the customer's intended audience (Rule 1320-06-01-.42(4)(c)1). For physical delivery, the taxpayer "must first attempt to determine the state or states where such services are delivered" and assign the sale to those states; if it cannot determine them but has enough information to approximate, it must reasonably approximate (Rule 1320-06-01-.42(4)(c)2(i)(I) and (II)).
Example 4 under subparagraph (4)(c)2(i)(III) is the fact pattern in mirror image: an out-of-state fulfillment company ships goods from its out-of-state warehouse to Tennessee purchasers on behalf of an out-of-state catalog and internet seller. The rule concludes: "The sale of the fulfillment services of Fulfillment Corp to Sales Corp is assigned to Tennessee to the extent that Fulfillment Corp's deliveries on behalf of Sales Corp are to recipients in Tennessee." With the example turned around, the warehouse in Tennessee and the recipients spread across the country, the same sentence assigns the fee to Tennessee by the recipients in Tennessee. The location of the warehouse plays no part in either direction, which is what paragraph (4)(a) says it should not.
Which reading each authority supports
The statute standing alone is consistent with the zero reading and with the look-through reading, and supports the 100 percent reading only through the taxpayer's annual election under subdivision (i)(4), because "the taxpayer's market for the sale" is a customer-side concept. The rule resolves the remaining choice in favor of look-through. The numerator is therefore neither zero nor the whole fee, and the denominator is the whole fee. Rule 1320-06-01-.42(1)(f) excludes from both a sale whose state of assignment the taxpayer cannot ascertain "using a reasonable amount of effort undertaken in good faith," but a provider that generates the shipping labels has the delivery addresses by definition, so the exclusion has little application to the core fee.
The contrast with the Department's treatment of goods sharpens the point. For sales of tangible personal property, the Department has ruled that it does not look through a purchaser to the purchaser's own customers; a manufacturer selling to wholesalers through a third-party distribution facility in Tennessee sources by the wholesalers' locations, not the end users' (Revenue Ruling #24-06, July 31, 2024). That position rests on section 67-4-2012(h) and Rule 1320-06-01-.33, which govern goods; the services rule adopts the opposite structure for the on-behalf-of category, and carrying the goods ruling over to a fulfillment fee reaches the zero reading by analogy to a rule written for a different kind of receipt.
The hard cases inside the fee
The look-through reading is easy to state for parcels and harder to apply to the rest of the fee; the Department has not addressed the composite fee in any published ruling. Four questions recur.
The first is unbundling. A single monthly fee often covers storage, pick-and-pack, shipping coordination, customer-service contacts, payment processing, and returns handling. The rule assigns a service by its category and does not address a single fee that covers several services. Pick-and-pack and shipping coordination are part of the delivery the rule's fulfillment example describes. Storage is the weak point: in-person services include services performed at a location the service provider operates while the customer's tangible property is there, assigned where the service is received (Rule 1320-06-01-.42(4)(b)), and a separately priced storage charge for inventory held in a Tennessee warehouse invites that reading. Unbundling can therefore raise the Tennessee share as well as lower it.
The second is customer service delivered by phone and email to the sellers' customers. The rule addresses the closest case directly. In its call-center example, a company that answers telephone calls from a catalog retailer's customers is delivering a service electronically to those customers on behalf of the retailer and must assign the proceeds to the state or states from which the calls are placed (Rule 1320-06-01-.42(4)(c)2(iii)(IV), Example 2). The governing sentence assigns such a service to Tennessee "if and to the extent that the end users or other third-party recipients are in Tennessee" (Rule 1320-06-01-.42(4)(c)2(iii)(I)), and email to the same customers falls in the same category. The example involves order-taking calls, but its reasoning, that the calls are a service delivered to the retailer's customers on the retailer's behalf, applies equally to post-sale calls. Where call and email records do not show the customer's state, the rule calls for a reasonable approximation (Rule 1320-06-01-.42(4)(c)2(iii)(II)), and the shipment ratio for the same customers is one available approximation.
The third is returns, processed, restocked, and refunded at the Tennessee warehouse. One view treats the service as delivered to the seller, which receives the restocked inventory and the refund accounting, placing the component outside Tennessee; another treats the customer who ships the return and receives the refund as the third-party recipient, placing it with the shipment ratio. The rule does not answer the question, and the position is usually decided by consistency with the method used for the outbound fee.
The fourth is the seller's own address, which under the look-through reading does not matter in either direction: a seller organized elsewhere whose shipments go largely to Tennessee addresses generates a largely Tennessee fee, and the reverse holds. The sellers also have their own Tennessee analysis, since each owns inventory in a Tennessee warehouse and delivers goods to Tennessee customers, sourced by destination under section 67-4-2012(h); the ship-to data behind the fulfillment fee ratio also supports the sellers' own destination sourcing, although the sellers weight it by sales dollars and the fulfillment affiliate by the fee attributable to each delivery.
Why the answer decides the tax
Tennessee taxes the fulfillment affiliate on its own. Section 67-4-2007(e)(1) provides that, outside the financial institution and captive REIT combined groups and any variance under section 67-4-2014, "each taxpayer shall be considered a separate and single business entity for Tennessee excise tax purposes and shall file its Tennessee excise tax return on a separate entity basis reflecting only its own business activities." The intercompany fee is therefore not eliminated. It is the fulfillment affiliate's gross receipt, the markup on it is its net earnings, and the sellers deduct it. The consolidated net worth election under section 67-4-2103(d) does not consolidate the excise tax, but it does change the franchise tax receipts factor: an electing taxpayer's numerator is still its own Tennessee receipts, while the denominator becomes the group's total receipts (§ 67-4-2111(g)(2)), so the fulfillment affiliate's sourcing position is measured against the whole group's receipts rather than its own fee. The variance authority of section 67-4-2014(a), and of section 67-4-2112(a) for the franchise tax, which permits separate accounting, added or excluded factors, or another method where the standard formula does not "fairly represent the extent of the taxpayer's business activity in this state," is the route by which the group's overall footprint enters the apportionment computation. Separately, section 67-4-2014(c) allows the Department to allocate income among commonly controlled businesses, with federal section 482 guidance, so the markup itself is open to examination. The Department's variance rule requires a written petition on or before the statutory due date of the return and "clear and cogent evidence that peculiar or unusual circumstances exist which would cause application of the said statutory provisions to work a hardship or injustice" (Rule 1320-06-01-.35(3)).
The apportionment formula makes the receipts factor decisive. Public Chapter 377 (2023), the Tennessee Works Tax Act, phased Tennessee to a single sales factor: for tax years ending on or after December 31, 2023, the receipts factor is weighted five times over a denominator of seven; for tax years ending on or after December 31, 2024, eleven times over thirteen; and for tax years ending on or after December 31, 2025, net earnings are apportioned by the receipts factor alone (§ 67-4-2012(a); Notice #23-11), except that a qualified member of a qualified group, a category limited to large telecommunications, internet access, and video service providers (§ 67-4-2012(j)), stays on the property, payroll, and triple-weighted receipts formula (§ 67-4-2012(a)(7)). Section 67-4-2111 carries the same schedule and the same exception for net worth.
The three readings diverge sharply in a full single sales factor year for a fulfillment affiliate whose property and payroll are entirely in Tennessee. Under the 100 percent reading, all of its net earnings bear the excise tax at 6.5 percent (§ 67-4-2007(a)) and all of its net worth bears the franchise tax at 25 cents per $100 (§ 67-4-2106). Under the zero reading, its ratio is zero, the excise tax is zero, and the franchise tax is the $100 minimum (§ 67-4-2119). Under the look-through reading, the ratio is the Tennessee share of the shipments it handled, for many national sellers a low single-digit or low double-digit percentage. In the transition years the property and payroll factors, both 100 percent for this taxpayer, still carry two-sevenths and then two-thirteenths of the formula, a floor that disappears for tax years ending on or after December 31, 2025, unless the taxpayer elects the prior formula under section 67-4-2012(a)(6), an election available only where it raises the ratio and the taxpayer has net earnings.
The exposure is not symmetric. A return filed on the zero reading understates the fulfillment affiliate's Tennessee tax in every market-sourcing year, and under a full single sales factor it reports a Tennessee-based operating company with an excise tax of zero, which an auditor will test first. A return filed on the 100 percent reading overstates it unless it reflects the annual election under section 67-4-2012(i)(4); without that election, the overstatement is a refund claim for any open year.
Practice notes
The working document is a shipment schedule by ship-to state, by selling affiliate, by tax year, drawn from the fulfillment system's own label data; it supports the fulfillment affiliate's receipts factor and the sellers' destination sourcing at the same time. Where the fee covers several functions, the schedule should note which components track shipments and which, such as returns, rest on a stated position, so the method is consistent across years and affiliates. Open years filed on either the 100 percent or the zero reading deserve a second look, the first for refund unless the filing reflected an (i)(4) election and the second for exposure that grows as the receipts factor reaches full weight. For tax years ending before January 1, 2024, the franchise tax also carried a minimum measure based on Tennessee real and tangible property, since repealed (Public Chapter 950 (2024)), so the zero reading did not reduce the franchise tax of a Tennessee warehouse operator to the minimum in those years. Intercompany agreements should describe the services by function and state whether storage is priced separately, since the sourcing category for each component follows what the contract says the affiliate does. G&G State Tax Group provides Tennessee receipts factor and intercompany service sourcing analysis alongside its state and local tax practice.
This article states the law as of October 5, 2026
Statutes, rates, thresholds, and agency practice change, and a different set of facts can change the answer. Before acting on anything discussed above, contact G&G State Tax Group, or another state and local tax adviser, to confirm what has changed since this was written and how the rules apply to a specific situation.
This publication is informational in nature and is not, and should not be considered, legal, accounting, tax, or other professional advice for any person or situation. Correct application of tax law depends heavily on the facts and circumstances in each case, and G&G State Tax Group, LLC assumes no liability in connection with the use of this information, and is not obligated to inform any reader of changes in the law or other factors that could affect the information contained herein.