Press Room: Tax Release
Californians Vote to Require a Market-Based Single-Sales Factor
On November 6, 2012, Californians passed Proposition 39, which requires most multistate businesses to use a mandatory single-sales factor apportionment formula for tax years beginning on or after January 1, 2013. In addition, under the law taxpayers are required to source sales, other than sales of tangible personal property based on a market approach rather than identifying where the taxpayer incurs the greater cost of performing the income producing activity. Proposition 39 is estimated to generate an additional $1.1 billion annually in state revenue for the next five years.
Prior to the passage of Proposition 39, most taxpayers had three options when apportioning business income to California.
Under California Revenue and Taxation Code (CRTC) section 25128, taxpayers with income from sources both within and outside of California were required to use a formula that consisted of property, payroll, and double-weighted sales factors. Certain excluded taxpayers, which include businesses primarily in the agricultural, natural resource extraction or financial industries, were required to use an evenly-weighted property, payroll, and sales factor apportionment formula.
For tax years beginning on or after January 1, 2011, under CRTC section 25128.5, taxpayers other than excluded taxpayers could irrevocably elect each year to use a single-sales factor apportionment formula with market-based sourcing for sales other than the sales of tangible personal property.
Depending on the final outcome of Gillette v. Franchise Tax Board1, taxpayers also could have elected to use the Multistate Tax Compact’s (MTC) evenly-weighted three-factor formula since 1993, the year California became a full compact member of the MTC. In Gillette, the California Court of Appeals found that the imposition of a double-weighted sales factor did not supersede the single-weighted factor included in the MTC. The decision provides that the California law and the MTC provision exist concurrently, providing taxpayers an option to elect under either method.
The California legislature by majority vote on June 27, 2012, withdrew California from the MTC. While the intent of this withdrawal is to take away the MTC formula option, a law that would raise taxes on any taxpayer requires a two-thirds vote of the legislature. California intends that the withdrawal is effective on June 27, 2012, and any election of the MTC option made after that date is ineffective. Should Gillette survive on appeal, we expect the majority vote withdrawal from the MTC to be challenged in future litigation. Accordingly, taxpayers may have an opportunity to elect the MTC formula until a valid repeal is enacted.
Proposition 39 does not expressly withdraw California from the MTC, leaving open a potential MTC election. Accordingly, the only certainty provided by Proposition 39 is that the California formula with double-weighted sales is not an option for years beginning on or after January 1, 2013.
In addition to a mandatory single-sales factor, Proposition 39 requires taxpayers to use market-based sourcing rules for sales other than sales of tangible personal property instead of the cost of performance approach. Under these rules, sales of services are considered California sales to the extent the purchaser of the services received the benefit of the services in California. Sales from intangible property are considered California sales to the extent the property is used in California. In the case of marketable securities, sales are attributed to California if the customer is located in California. Sales from both real property and the rental, lease, and licensing of tangible personal property are considered California sales if the property is located in California. California Code of Regulations section 25136-2 provides a cascading set of methodologies presumed to reflect a taxpayer’s market for different revenue categories.
The Impact of Proposition 39
Proposition 39 aims to even the tax playing field for California businesses and out-of-state businesses doing business in California. While out-of-state businesses using a three-factor apportionment formula may see an increase in their California tax liability because property and payroll would not be included in the apportionment computation, all California taxpayers may be impacted. Deferred tax assets may be reduced if reflected in financial statements using a method other than a single-sales factor. Tax credits, net operating losses, and other book-tax differences must be analyzed to determine the expected period of utilization. In addition, taxpayers must consider whether to compute estimated payments for the first quarter in 2013 using a single-sales factor approach or based upon an anticipated election made under the MTC formula. Should a taxpayer elect under the MTC formula, and either Gillette is overturned or the withdrawal from the MTC is found valid, taxpayers may be subject to underpayment penalties if the MTC formula is used for estimated tax purposes and/or reported on an originally filed tax return.
California’s shift to both a single-sales factor apportionment method and market-based sourcing may also increase exposure to double taxation, particularly where an apportioning taxpayer is also doing business in a state using cost of performance. Prior to California’s withdrawal from the MTC and passage of Proposition 39, apportioning taxpayers could choose an apportionment method that complimented the apportionment and sourcing rules of other states. Elimination of these options and shift to a mandatory market-based sourcing approach has the potential to increase the overall amount of state taxes paid by taxpayers operating in states with different sourcing rules.
While taking away the choice of apportionment formulas does not in and of itself create an opportunity for tax savings, critically reviewing the difference in state tax laws may uncover tax reduction opportunities. Consider a technology services company with most of its costs in California. The company’s sole customer is in State X, a state that follows the cost of performance approach. This taxpayer would source its receipts to State X for California purposes, but to California for State X purposes. The receipts would effectively be reported nowhere.
While Proposition 39 may have an undesirable impact on many taxpayers, there are options available for relief. Any apportioning trade or business may petition the California Franchise Tax Board to use an alternative apportionment method where the method required by California does not fairly reflect the extent of a taxpayer’s in-state business activities. While this avenue generally applies to limited and specific cases, it is an option available to use a methodology other than a single-sales factor formula with market-based sourcing. This provision operates as a “relief valve” when the apportionment formula distorts the percentage of activity a taxpayer is conducting in California.
1 The Gillette Company, et. al. v. California Franchise Tax Board, No. A130803 (Cal. Ct. App. Oct. 2, 2012). This decision is available at: http://www.courts.ca.gov/opinions/documents/A130803A.PDF