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) tit. 18, Section 25136-2 (Section 25136-2 regulations). The forthcoming proposed amendments will affect asset managers, government contractors and other industries.

A summary follows of issues from the IPM that are most relevant to the asset management industry.

Asset management fee issue

Before finalizing the latest round of amendments to the Section 25136-2 regulations, the FTB removed the examples shown below from the draft regulation in response to financial services 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 these examples in a discussion paper released prior to the IPM, and indicated that it planned to include them in the next round of amendments to the regulation. The FTB asked for comments on the language, but none were 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 the Section 25136-2 regulation, in effect for tax years beginning on or after January 1, 2015, state that gross receipts from dividends must be sourced in the same way as sales of shares of corporate stock or sales of pass-through ownership interests. The FTB representatives 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 tit. 18, 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 the sourcing of revenues from 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) and 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. No comments were provided during the meeting in regard to this issue. One question was raised regarding the 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 of the regulations 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 subsection (b)(5) of the Section 25136-2 regulation. 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 about 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 the California Supreme Court's ruling in 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 held that the challenging party had the burden of proof but, once it was met, the FTB could impose its own method. A commentator suggested including the burden-of-proof rules in the Section 25136-2 regulation itself. The FTB appeared amenable to this suggestion. The hearing officers also raised questions about the provision in the regulation requiring the 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 US. 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.

Implications

For the asset management industry, the IPM held on January 20, 2017, marks the continuation of the FTB's push to provide a "look-through" rule in assigning receipts for asset managers. The FTB provided clear indications that it will be including these examples in the new draft regulation. As such, taxpayers should consider using the "look-through" rule in determining nexus and/or making estimated payments.

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. It is more likely, however, that the FTB would follow a similar effective date as with the first round of changes, which was an effective date for tax years beginning on or after January 1, 2015, or for elective single sales factor prior to 2015, effective retroactively to January 1, 2012.

One recurring theme from the meeting is the FTB's interest in reviewing other states' guidance, especially the prolific regulations issued by the state of Massachusetts. It does not appear, however, that this will change the FTB's thoughts on sourcing investment management and advisory fees. In this area, it seems that the FTB wants to treat advisors to regulated investment companies (RICs) and alternative asset managers in a similar fashion. The FTB's hearing officers 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.

Coupled with California's bright-line nexus rules (currently holding that sourcing $547,711 of revenues to California is enough to be deemed to be doing business in the state),¹ these new sourcing regulations could present many asset managers with the possibility of having tax filing obligations in the state that they may not have otherwise expected.

While a specific date was not given, the FTB indicated the next interested parties meeting would be held in about six months. In the interim, the FTB will accept written comments from the industry through this regulatory process. If a taxpayer chooses to make a written submission, the contacts below can assist with directing its comments to the appropriate parties at the FTB.

For additional information regarding this IPM, including implications to other industries, refer to Tax Alert 2017-148.

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ENDNOTES

¹ The FTB annually publishes the "doing business in California" thresholds on its website (last accessed on January 26, 2017).