Press Room: Tax Release
California Franchise Tax Board Proposes Significant Changes to Market-Based Sourcing Rules
California’s Franchise Tax Board (FTB) held its third Interested Parties Meeting (IPM) on May 18, 2018, to discuss proposed changes to California Code of Regulations Title 18 Sec. 25136-2, which enumerates the state’s market-based sourcing rules for sales other than sales of tangible personal property. If adopted, these additional proposed amendments would significantly impact the way California sources services to businesses generally, as well as sourcing of government contract revenues, asset management services fees, and assignment of receipts derived from the sale of pass-through entity interests and corporate stock, dividends, and goodwill.
Sales From Services
Presently, California sources sales from the receipt of services to the state in which the customer receives the benefit of the service. FTB’s proposed changes are intended to simplify existing rules by creating rebuttable presumptions. To this end, FTB will presume the customer is receiving the benefit in the state and will assign sales to the state where the:
- associated real property is located,
- tangible personal property is located at the time the service is rendered,
- associated intangible property is used,
- business receives a service related to its in-state business, or
- individual is physically located when the service is performed.
These presumptions may be rebutted by showing, by a preponderance of the evidence, that the benefit of the service is not received in California.
Notably, a reasonable approximation may be used if the contract or books/records do not show where the benefit of the service was received under the above rules, or the rebuttable presumption is overcome. If reasonable approximation is not applicable, then the service is presumed to be received in California if the customer placed the order for the service in California. Finally, if the location of the benefit of the service is still undeterminable, the location shall be the customer’s billing address.
U.S. Government Contracts
Prior to the proposed changes, the regulations provided no guidance for government contractors. This area presents unique challenges where the benefit derived by the United States (U.S.) government may be difficult to discern, and in the case of classified contracts impossible to determine. Under the proposed regulation, if the taxpayer provides services to the U.S. government and the location where the service is being provided is not stated in the contract or book/records, or cannot be disclosed, and the location cannot be reasonably approximated by using another method, then the taxpayer may use the ratio of California population over U.S. population as a reasonable approximation. FTB reasons that services provided to the U.S. government are intended to benefit U.S. citizens, and therefore California population over U.S. population is the most reasonable way to source the amount of benefit received in California. These proposed changes would disregard that the benefit of these services may cover territories outside the U.S., and in some cases may benefit countries or regions wholly outside the U.S. The rule limits the use of foreign population except when the taxpayer can substantiate that it had sales in those specific geographic areas.
Asset Management Fees
FTB’s proposed changes also provide cascading rules to determine where the benefit of asset management services is received. First, if the shareholder’s, beneficial owner’s, or investor’s domicile is known, receipts are assigned to the state of domicile. Second, if the domicile of the shareholder, beneficial owner, or investor is unknown, receipts are assigned to the state that can reasonably be approximated. Third, if the above is inapplicable, receipts are assigned to California based upon the ratio of California population over U.S. population.
The shareholder’s, investor’s, or customer’s domicile is presumed to be the billing address in the taxpayer’s records, unless the taxpayer knows the principle place of business is different than the billing address. The beneficial owner’s domicile is presumed to be the beneficial owner’s billing address in the records of the service recipient or asset manager; unless either knows the beneficial owner’s primary residence or principle place of business is different.
The proposed changes define beneficial owner to mean, a person or entity who has an interest in a property that is distinct from the title ownership, is the owner of the income derived from the property for tax purposes, and for whose ultimate benefit the title holder maintains the property.
Assignment of Receipts From Sales of Pass-Through Interests and Corporate Stock, Dividends, and Goodwill
Currently, the regulations provide that if 50% or more of an underlying corporation or pass-through entity is comprised of tangible property or real property, then the sale is assigned based on the average of the payroll and property factors of the underlying entity. If more than 50% of the underlying corporation or pass-through entity is composed of intangible property, then sales are assigned based on the sales factor of the underlying entity. If a taxpayer does not have the above information, the proposed changes would assign the sale to the payor’s domicile.
FTB’s amendments propose to eliminate a provision that established 5% or less of total sales as de minimis and therefore not considered for determining where to assign sales from marketing intangibles to a particular state. The amendments also incorporate an additional example related to research and development (R&D) that provides assignment rules for an R&D company in California that contracts with an out-of-state pharmaceutical company to develop pharmaceuticals. The pharmaceutical company pays the R&D company an upfront, lump-sum payment for licensing rights of specified compounds that are used in California for continuing R&D, and in the example the lump-sum payment is sourced to the state in which the R&D company conducted the R&D (California) even though the pharmaceutical company was outside the state.
Finally, in the proposed changes FTB lowers the burden for it to successfully challenge a taxpayer’s reasonable approximation from clear and convincing to a preponderance of the evidence.
As of September 6, 2018, the proposed changes are pending further action by FTB and the Office of Administrative Law. If adopted, the proposed changes would have a significant impact on California’s market-based sourcing rules. While we are uncertain whether the proposed language will be adopted as currently presented, there was considerable interest and significant comments were received from representatives who attended the IPM. FTB intends to consider all questions and comments posed at the IPM as well as any written comments received (written comments were accepted until July 19, 2018), and indicated there will be at least one other IPM, although the timing for this fourth IPM is uncertain. FTB continues to update its website with draft language, explanation and background documents, and IPM information.
In addition to any potential changes to the sourcing rules, another open item is the tax period to which any new amendments may be operative. FTB indicated during the IPM that the operative date is an open question as it expects additional language changes – possibly owing to comments surrounding the language of the proposed amendments as well as the operative date for the new provisions.
Andersen Tax remains poised to assist clients with their compliance obligations and to help assess the potential impact to existing operations.