Business entities that report income from securities and other types of intangible property (e.g., interest, dividends and gains or losses) for the 2015 year but have not filed California returns may need to take action before October 17, 2016. As such, your immediate attention is required.

On September 15, 2016, the California Office of Administrative Law approved amendments proposed by the California Franchise Tax Board (FTB) to Cal. Code Regs. (CCR) tit. 18, Section 25136-2 (the Amendments) relating to the sourcing of revenues from sales other than sales of tangible personal property. The Amendments change the state to which revenues derived from dividends, interest, securities and other intangible property are assigned for purposes of determining the California sales factor. Coupled with California's bright-line nexus standards,¹ companies that are not currently filing tax returns in California may now be subject to California taxation, including the state's $800 minimum tax. (As of January 1, 2015, any taxpayer with more than $536,446 of revenues assigned to the state (with such sales assigned based upon California's own market-based sourcing regulations) is deemed to be "doing business" in California and is obligated to file a corporate franchise tax return.) These nexus provisions apply not only to corporations, but also to all other types of legal entities.² Moreover, since California is not bound by international tax treaties and does not recognize the concept of "permanent establishment," foreign taxpayers that believe they are protected from all US taxation under their nation's tax treaties with the US may find that the new rules subject them to California taxation.

The Amendments are retroactive to tax years beginning on or after January 1, 2015 (although taxpayers can elect to apply those changes to all open years for which market-based sourcing was required).³

Taxpayers that already file returns in California may see little effect from the Amendments, other than adjustments in their sales factor numerators that may reduce or increase their California sales factor and accordingly, their California tax liability. Such California taxpayers may be required to amend their California tax returns to reflect the effect of these new sourcing rules.

The bigger question, though, is the effect the Amendments will have on business entities that are not intending to or have not previously filed in California. Under the new sourcing rules, business entities that merely receive income from securities and intangible property may have a filing requirement in California.⁴ Nothing in the new rules changes the filing calculus for certain limited partners of Qualified Investment Partnerships or certain alien corporations that limit their activities to those permitted under CRTC Section 17955 or 23040.1. For example, income attributable to sources within California generally does not include the income a non-US corporation receives from trading property for its own account within the meaning of IRC Section 864(b)(2)(A)(ii).

The Amendments may create a filing requirement for a business entity that was previously determined to not have a filing requirement.

For tax years beginning on or after January 1, 2011, California adopted "bright-line" or economic nexus standards. (See Tax Alert 2009-343) Under these rules, California deems any company whose California sales in a given year exceed a certain numerical threshold to be doing business in California and, therefore, subject to California income taxation.⁵ The current threshold is the lesser of $536,446 or 25% of the business's total sales sourced to California⁶ for tax years beginning in 2015 (the bright-line nexus standard).⁷

To determine the amount of California sales for bright-line nexus purposes, the statute expressly states that California's sourcing rules must be used.⁸ The sourcing rules referenced are the rules a taxpayer would follow to compute the numerator of its California sales factor. Essentially, every business entity must compute its California sales factor numerator to determine if it has a filing requirement. A business entity that never had a California filing requirement may have one as result of receiving interest, dividends, etc. that are attributed to California (included in the numerator of the sales factor) under the Amendments.

Specific changes to the Regulation

The Amendments provide guidance interpreting CRTC Section 25136(a)(2), which states that "[s]ales from intangible property are in [California] to the extent the property is used in this state." To the contrary, receipts from sales of marketable securities are assigned based on the location of the customer. The Amendments include a definition of the term "marketable securities" (two definitions, in fact) and rules that attribute to California items such as interest, dividends, goodwill and receipts from marketable securities.

I. Sourcing of interest or dividends

Regulation Section 25136-2(d) addresses the assignment of receipts from certain types of property, including sales of shares of stock and partnership interests (that are not treated as marketable securities). The regulation assigns such sales to California based on the apportionment factor of the legal entity that was sold. The Amendments provide that dividend and goodwill receipts are treated the same as receipts from sales of stock and partnership interests. It would seem that dividends would be attributed to the California sales factor numerator based on the apportionment factor of the corporation that paid the dividend. ⁹

Regulation Section 25136-2(d)(1)(A)(2) addresses the sourcing of interest. Interest from loans secured by real estate is assigned to the location of the real estate serving as security for the loan. Interest from loans that are unsecured or are secured by personal property is assigned to the location of the borrower. The location of the borrower is not defined in the Amendments or in the regulation.¹⁰

All other interest (for example, interest on a bank account) is assigned to the recipient's sales factor numerator based on the location where the investment is managed.¹¹

II. Receipts from marketable securities

The Amendments set forth two new definitions of "marketable securities" — one that is important for most taxpayers while the other is specifically applicable only to securities or commodities dealers.

The first definition (found in new Regulation Section 25136-2(b)(1)(5)) provides that "marketable securities" means any security that is actively traded in an established stock or securities market and is regularly quoted by brokers or dealers in making a market. An "established stock or securities market" is specifically defined.¹²

The second definition (found in new Regulation Section 25136-2(b)(1)(6)) applies to a "securities dealer" under IRC Section 475 (c)(1)or a "commodities dealer" that has made an election under IRC Section 475(e) (hereinafter referred to as a securities dealer). For a securities dealer, "marketable securities" means any security that is defined in IRC Section 475(c)(2) or 475(e)(2)(B), (C), or (D), and any contract to which IRC Section 1256(a) applies, that has not been excepted under IRC Section 475(b). The application of this second definition would appear to be broader, because the security does not have to be sold on an established stock or securities market. This second definition also provides that "[r]eceipts from marketable securities under this subsection include any interest and dividends associated with such marketable securities."¹³ Both definitions clearly exclude gross receipts that are excluded from apportionment under CRTC Section 25120(f)(2) (e.g., principal payments on certain securities, tax refunds, pension reversions).

Under the Amendments, sales of marketable securities are assigned to the location of the customer as follows:

(1) If the customer is an individual, the sale is assigned to California if the customer's billing address is in California.

(2) If the customer is a corporation or other business entity, the sale is assigned to California if the customer's commercial domicile is California.

Subject to rebuttable presumptions, the commercial domicile of the corporation or business entity is determined by the taxpayer's books and records kept in the normal course of business or other credible documentation. If the customer's billing address cannot be determined under subsection (1) or the customer's commercial domicile cannot be determined under subsection (2), then the location of the customer may be reasonably approximated. The regulation provides an example of reasonable approximation using the billing address where a business customer's commercial domicile cannot be established.

The FTB has not specifically defined who the customer is when interest or a dividend is paid on a marketable security. Therefore, for most taxpayers, it would appear that a dividend received from a company whose commercial domicile is in California would be assigned to California for sales factor apportionment purposes.

III. Sourcing of interest and dividends from marketable securities held by any person that is not a securities dealer or commodity dealer.

It was noted previously that a securities dealer's receipts from marketable securities includes interest and dividends from marketable securities and are assigned based on the location of the customer. At this time, it is not clear how other taxpayers that earn interest and dividends from marketable securities attribute such receipts. It is likely that a different amount of revenue will be assigned to California depending on whether the sourcing rule in Paragraph 1 applies (i.e., basing dividend income on the activities of the company being sold) or the rule in Paragraph II.It could be argued that dividends or interest received from holding a marketable security should be assigned under the rule set forth in Paragraph II, regardless of whether the holder is a securities dealer. Accordingly, it is important to consider which rule applies and monitor future developments

For example, a corporation with a commercial domicile in California (let's call it Corporation CA) and a corporation with a commercial domicile outside of California (let's call it Corporation XYZ) each have a 4% California apportionment factor.¹⁴ Assume that an Illinois headquartered corporation (IllinoisCo) receives $1,000 in dividends from each of Corporation CA and Corporation XYZ. Finally, assume in this case that the dividends are not thrown-out of the sales factor under CRTC Section 25120 (because they would constitute an "occasional sale").

— Applying the rule described in Paragraph I (i.e., assignment to California based upon the extent of California activities of the company making the dividend payment), IllinoisCo will assign $80 of dividend revenue to California (i.e., $1,000 x 4% from each payor).

— Under the rule described in Paragraph II (i.e., assignment based upon the commercial domicile of company making the payment), IllinoisCo will source $1,000 of dividend revenue to California (only the $1,000 dividend received from Corporation CA (since Corporation CA is headquartered in California). None of the dividend received from Corporation XYZ would be assigned to California.

The market-based sourcing rules in Regulation Section 25136-2 govern for purposes of determining California's Bright-Line or Economic Nexus

The Amendments to the sales factor sourcing rules will be used to determine if a company is subject to California business taxes. Theoretically, a business with no office or employees in California and that only has California source receipts from activities such as selling marketable securities through an exchange, owning stock or receiving interest income from loans to a California-based business entity can be "doing business" in California if its California sales exceed the doing business sales factor threshold (i.e., are more than $536,466). If so, the business may have a filing requirement in California under the statutory scheme. Potentially, there are US constitutional issues under both the Commerce Clause and the Due Process clause raised by the application of the rules in this manner. Regardless, this is an extremely controversial and unsettled area of the law and, at a bare minimum, affected taxpayers should understand these issues.

Implications

The above is a brief summary of the Amendments and their effect on the bright-line nexus provisions adopted by California. As this Alert suggests, there are many uncertainties that will affect each business differently. Business entities will need to review their revenue streams and determine if a California filing requirement exists. We list below some of the technical issues to consider in applying the Amendments:

— The Amendments affecting the sourcing of revenues from sales of marketable securities do not address transactions effectuated through an exchange or other instances when the seller cannot identify the location of the customer. The business entity may have internal information that allows a reasonable approximation. Otherwise, it may be possible to consider external factors such as California's share of the population to approximate the California portion of these receipts.

— When attributing interest income from loans for financial institutions, the FTB does not distinguish between taxpayers that originate debt and taxpayers that acquire originated debt. This is true under the Amendments.

— It is not clear under the Amendments whether certain recipients of interest or dividends from marketable securities fall under the new sourcing rules outlined in Paragraph II above (i.e., based on the commercial domicile of the business entity making the payment). Under the statute (CRTC Section 25136(a)(2)), it appears reasonable to apply the rules described in Paragraph II to dividends and interest from marketable securities regardless of whether the recipient is a securities dealer.

— Under the Amendments affecting the sourcing of revenues from marketable securities, it appears that the customer is the one paying the interest or dividends. As it may be difficult to determine the location of the customer for certain securities, falling through the cascade of the hierarchy established under Regulation Section 25136-2, a taxpayer could use a "reasonable approximation" method to assign the dividends if its books and records do not contain the appropriate information to make a different determination.

— Arguably, under a long line of US Supreme Court cases, affected businesses might successfully assert that, under the US Constitution, merely holding stock in a public company is not sufficient to bring an entity into California's taxing jurisdiction. Analysis of the strength of such a positon is beyond the scope of this Alert. In addition, any business entity wishing to take a non-filing position, must factor in penalty risk as well as the cost of potential audit defense.

— An alien corporation (i.e., one that is not incorporated in the US) should considering filing a California tax return prior to the extended due date (October 17, 2016 for 2015 calendar year filers) simply to make a water's edge election. If the corporation does not file a return making a water's edge election and the FTB successfully asserts that a tax return is due as a result of applying these new dividend sourcing rules, the corporation would be precluded from making a water's edge election for the year, opening up the entire worldwide group of the corporation to a filing requirement in California. Even if the foreign dividend recipient's income and apportionment factors themselves wouldn't be excluded from a water's edge return,¹⁵ the water's edge election could prevent the income and apportionment factors of other unitary corporations from being pulled into California's tax web. Consequently, a properly prepared and filed protective water's edge election might serve as an inexpensive insurance policy against a future FTB assertion of nexus even if the corporation is relatively confident that it would prevail in any underlying controversy.

— It is not clear whether a taxpayer electing to apply the Amendments early must elect to apply all of the amendments or may elect to apply certain of the changes. It is also not clear whether the taxpayer must make the early adoption election for all eligible open years or certain years.

— The statute of limitations for filing refund claims in California is generally four years after the date the return was filed. While the regulations do not, by their terms, allow a taxpayer to elect to apply them to a return for a year prior to one beginning on or after January 1, 2012, these regulations must interpret the statute. Consequently, to the extent a position applies in 2012, there may be a basis to argue that it applies earlier, notwithstanding the effective date language in the regulation. If electing to apply the theory of the Amendments to an earlier year return results in a refund claim, the normal statute of limitations for calendar year 2011 returns that haven't already expired will be expiring between now and October 17, 2016. If a company can benefit from a change in these rules for 2011, immediate action is required.

— Returns that have been filed for 2015 should be reviewed to determine whether application of the new rules may be detrimental and if so, amended as appropriate.

Filing requirements for entities classified as partnerships¹⁶ - A partnership (or LLC classified as a partnership) must file a California return if it has any amount of California-source income. ¹⁷ Hence, a partnership with income from securities and no other activity in the state may have a filing requirement if it has any sales that can be attributed to California. If the imposition of the rules results in even $1 of revenue being assigned to California, the FTB will expect to receive a partnership return and, failing to receive one, it can be expected to assert the "per partner/per month" filing penalty. Relative to any year's tax return, these penalties are capped at $261 per partner. But if a partnership has a large number of partners, these penalties can quickly add up to the thousands of dollars (e.g., a partnership with 1,000 partners could be penalized $261,000). Any partnership wishing to argue one of the defenses above in order to support a non-filing position, must factor in penalty risk as well as the cost of a potential audit defense.

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ENDNOTES

¹ Cal. Rev. & Tax Code (CRTC) Section 23101(a)(2) (originally $500,000, the threshold is adjusted annually for inflation.)

² The rules also may apply to those individuals who are doing business in California. A detailed analysis of how these rules affect individuals who directly invest in stocks and bonds is beyond the scope of this Alert.

³ Generally, taxpayers can make such an election for all tax years beginning on or after January 1, 2013. Taxpayers that made a timely filed election to use the single sales factor for tax years beginning on or after January 1, 2012, may also elect to apply the Amendments to those years as well.

⁴ Note that the previous version of the regulation addressed the sourcing of gains from the sales of securities and that those rules have not changed as a result of these Amendments.

⁵ CRTC Section 23101(b)(2).

⁶ Similar rules, but with lower thresholds, apply to business entities having only property or payroll in the state.

⁷ Note that corporations generating less revenue than is required to establish bright-line nexus could have a California income tax filing obligation as opposed to a franchise tax filing requirement. Discussion of that topic is beyond the scope of this Alert.

⁸ CRTC Section 23101(b)(2) ("For purposes of this paragraph [(b)(2)], sales in [California] shall be determined using the rules for assigning sales under [CRTC] Sections 25135 and subdivision (b) of 25136 and the regulations thereunder, as modified by regulations under Section 25137.") "The regulations thereunder" as used in this paragraph, refers to the FTB's regulations, including the Amendments.

⁹ The proceeds from occasional and substantial sales are thrown out of the sales factor. [CCR tit. 18, Section 25137(c)(1)(A).] Most sales of corporate stock or sales of goodwill will likely be both occasional and substantial under this regulation and, therefore, will be thrown out of the sales factor. Whether the throw-out rule applies for determining if an entity is doing business in California is an open question but we understand that the FTB will argue that it does not.

¹⁰ Arguably, the borrower's location is its commercial domicile. But equally arguable (and also in line with the general theory of the market-based sourcing scheme under which the Amendments were adopted), the borrower's location could be determined based upon the borrower's geographic footprint or apportionment factor.

¹¹ "Other interest" that is related to a business's treasury function may be excluded from the sales factor (thrown-out) under CRTC Section 25120(f)(2)(K).

¹² Regulation Section 25136-2(b) defines an "established stock or securities market" as " … (1) a national securities exchange that is registered under Section 78f of the Securities Exchange Act of 1934 (15 U.S.C. Section 78a to 78pp); or (2) a foreign securities exchange or board of trade that satisfies analogous regulatory requirements under the law of the jurisdiction in which it is organized (such as the International Stock Exchange of the United Kingdom and the Republic of Ireland, Limited; the Marche a Terme International de France; the Frankfurt Stock Exchange; and the Tokyo Stock Exchange.")

¹³ The FTB has not explained why the first definition of "marketable securities" in Regulation Section 25136-2(b)(1)(5) does not have a similar provision to that in the second to include interest and dividends.

¹⁴ Of course, this example points out a huge practical problem in applying the look-through aspect of the general dividend sourcing rule: How is the recipient of the dividend supposed to determine the apportionment factor of the dividend payor? (And that would likely be the case, regardless of whether the payor is a publicly traded company (with SEC filings) or a privately held company.)

¹⁵ For example, if 100% of its dividends are assigned to the US, it would fail California's 80/20 test and be fully included in the California water's edge combined reporting group.

¹⁶ Partnerships or LLCs treated as partnerships may wish to consider entering into the Voluntary Compliance Program or Filing Compliance program if there is a potential for prior year liability.

¹⁷ CRTC Section 18633; 18633.5.