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On Friday, January 20, 2017, the California Franchise Tax Board (FTB) held its first Interested Parties Meeting (IPM) for the next round of proposed amendments to its market-based sourcing rules under California Code of Regulations (CCR) Section 25136-2. The forthcoming proposed amendments will affect asset managers, government contractors and other industries.

Below is a summary of the IPM.

Asset management fee issue

Before finalizing the last round of amendments to the Section 25136-2 regulations, the FTB removed the examples shown below from the draft regulation due to industry feedback that the proposed examples had not yet been fully examined by the industry:

Example 1

Benefit of the Service — Business entity, subsection (c)(2)(A). Asset Management Corp, which is not subject to California Code of Regulations Section 25137-14 because the taxpayer is not providing services to at least one Regulated Investment Company, provides administration, distribution and management services for pension plans, retirement accounts, or other investment accounts, by contracting with third party entities to provide these services on behalf of shareholders, beneficial owners, or investors of the pension plans, retirement accounts or other investment accounts. Since the benefit of the services is received by the shareholders, beneficial owners, or investors, the sale of these services shall be assigned to the location of the shareholders, beneficial owners, or investors.

Example 2

Benefit of the Service — Business Entity, subsection (c)(2)(B). Same facts as Example 5 except that Asset Management Corp cannot determine through its books and records kept in the normal course of business the domicile of the shareholders, beneficial owners, or investors. Asset Management Corp shall assign the sales by reasonably approximating the domicile of the shareholder, beneficial owner, or investor by utilizing information based on zip codes or other statistical data. If Asset Management Corp cannot reasonably approximate a method for determining the domicile of the shareholders, beneficial owners, or investors, then those receipts shall be disregarded for purposes of the sales factor.

The FTB included the above examples in a discussion paper released before the IPM, and indicated that it planned on including them in the next round of amendments to the regulation. The FTB asked for comments on the language, but there were none stated at the meeting.

Dividends and interest

During the meeting, the FTB indicated that it was taking another look at the current rules for sourcing dividends and interest. The prior amendments to CCR Section 25136-2, in effect for tax years beginning on or after January 1, 2015, state that gross receipts from dividends are to be sourced in the same way as sales of shares of corporate stock or sales of pass-through ownership interests. The FTB stated that it could be conceptually difficult to think of dividends and interest as having a "market" and suggested that perhaps these items should be excluded from the sales factor. The hearing officers referenced subsections of CCR Section 25137 that provide for inconsequential buckets of receipts to be thrown out of the sales factor as a way to resolve any uncertainty in sourcing dividends or interest.

Comments were made that such an approach seemed inconsistent with the definition of "sales" contained in the California Revenue and Tax Code (CRTC). Additionally, comments were made on whether such an approach would require a statutory amendment. Commentators also suggested that assigning dividends to commercial domicile could be a viable approach.

The FTB asked for input regarding the assignment of interest for business entity borrowers. There were no comments provided during the meeting in regard to this issue. There also was a question regarding effective dates for any changes in the dividend and interest assignment rules. It was pointed out that, by raising dividends and interest as topics for discussion, the FTB has created uncertainty as to when any changes to the sourcing rules for dividend and interest income would become effective — if they would be applied retroactively and if there would be a final amendment effective with enough time to amend prior returns. The hearing officer agreed that these issues should be addressed.

Reasonably approximated/reasonable approximation

The FTB discussed the term "reasonable approximation," as defined in CCR Section 25136-2(b)(5). The FTB clarified that it would not challenge a taxpayer's method of assigning sales under the reasonable approximation rule with a method it determines to be more reasonable, unless the taxpayer's method is found to be unreasonable. A question arose from a commentator as to which party would have the burden of proof when there is an assertion that the reasonable approximation method employed by the taxpayer was unreasonable. Another commentator indicated that the burden of proof should rest with the party challenging the reasonable approximation method. The FTB appeared open to this suggestion, as it referenced Microsoft v. FTB (2006)39 Cal. 4th 750, and indicated that a similar burden of proof standard could be used for the reasonable approximation rule. In Microsoft, the court provided that the challenging party had the burden of proof; however, upon being met, the FTB could impose its own method. A commentator suggested including the burden of proof rules in the regulation. The FTB appeared amenable to this suggestion. The hearing officers also raised questions about the provision in the regulation that requires use of the US population as the metric when using population as a reasonable approximation, unless it can be shown that the benefit of the service or the benefit of use occurs outside the United States. The FTB noted that it was reviewing whether the US population should be the default standard, or whether the area of the benefit of the service or use of the intangible, perhaps at a subnational level, should be the default metric.

Benefit of the service received

The FTB asked for guidance in regard to "benefit of a service received." Specifically, the FTB asked for input on whether there is a distinction between the immediate benefit of a service and the ultimate benefit that would alter the timing of the sale. There were no comments on this topic during the meeting.

The FTB also requested input regarding the assignment of receipts from government services contracts. The FTB indicated that it would include a special subsection within the proposed amendments to CCR Section 25136-2 to address government contracts. This is a significant change from the FTB's previous public comments that it would only add examples of how to source government contracts. The FTB confirmed that while it would look to CCR Section 25136-2's cascading rules for creating the special subsection, there also is the possibility that it will "go off the track" for sourcing government contracts. The FTB raised the idea of looking to CRTC Section 25135's origin sales rule for tangible personal property (TPP) sales to the US government and applying a throwback rule for government contract services and intangibles. A question was raised about classified or top secret revenue streams of defense contractors. The FTB suggested using an agreed upon "deemed numerator" to address these kinds of contracts. No specifics were provided on how this approach would work in practice.

In addition, the FTB discussed the treatment of research and development contracts. The FTB indicated that it was looking into assigning these sales in a manner similar to that contained in the special regulation for long-term construction contracts under CCR Section 25137-2. A comment arose in regard to how milestone payments should be treated, if such payment is made before a product is marketed. The FTB said that the assignment of the sale should be determined at the time of payment, and that the market should be determined with reference to the party paying for the research and development, and not the potential market for any eventual product that was developed. A commentator noted that the milestone payment may be made in reference to future markets. In this case, the FTB agreed that it would look at the contract. The FTB also considered the possibility that these sales would "fall through" the reasonable approximation layer of the cascading rules for assignment and could be assigned by reference to the location where the customer placed the order for service or the customer's billing address.

The FTB asked for comment in regard to the sale of patents when the taxpayer has little information on how the patent will be used after the sale. This sale is covered by CCR Section 25136-2(d)(1)(A). The FTB acknowledged the confusion as to how the section is currently worded. The FTB indicated the intent of the provision is for the sale to be assigned to where it is used by the buyer, and if not known, then assigned based on where it was used in the 12 months before the date of the sale.

Freight forwarder examples

The agenda included freight forwarding examples, which the FTB introduced by explaining that the examples were not intended to change the FTB's longstanding informal sourcing rules provided in its Multistate Audit Technique Manual (MATM), but instead would provide the same methodology as the MATM but now as examples in the proposed Section 25136-2 amendments. There was a comment as to whether the examples captured the nuances of the freight forwarding industry and the distinction between the services provided by a broker and a carrier. Another comment asked whether the examples actually addressed where the benefit of the service is received. The FTB said it would take these comments into consideration.

Marketing intangibles

Lastly, the FTB discussed whether a marketing intangible must be "well known" in a location in order to assign the sales upon such marketing intangible to that location. A comment was made that the regulation should not distinguish as to whether the marketing intangible is "well known" or not. The FTB raised an example questioning whether a marketing intangible well-known in the United States was equally well-known elsewhere. This example signaled the FTB's reluctance to consider equal treatment of all marketing intangibles.

Implications

For the Asset Management industry, the January 20 IPM marks the continuation of the FTB's push to provide a "look through" rule in assigning receipts for Asset Managers. The FTB gave a clear indication that it will be including these examples in the new draft regulation.

Regarding the dividend issue, it appears that the FTB is re-thinking the rules it recently promulgated and may move away from the current approach. It remains unknown whether any amendments made in this round will be applied with retroactive effect.

There is a question of how this latest round of amendments would be applied retroactively. The FTB did not provide clear guidance as to the retroactivity of such amendments.

For taxpayers with government contracts for services and intangibles, the IPM marks the start of the FTB's focus in this area with a strong statement that there is a need for a special subsection within the regulation to deal with government contracts.

One recurring theme from the meeting is the FTB's willingness to look at other states' guidance, especially the prolific regulations issued by the state of Massachusetts. The FTB also noted that it was revising its 50-state analysis to include more recent market based sourcing regulations and potential guidance from the Multistate Tax Commission. The revised 50-state analysis would be available to taxpayers on the FTB's website.

While a specific date was not given, the FTB indicated the next interested parties meeting would be held in about six months. We will continue to monitor the discussions and send alerts as the regulatory process continues.

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