June 21, 2017 California FTB holds second interested parties meeting to discuss next round of proposed amendments to its market-based sourcing rules On Friday, June 16, 2017, the California Franchise Tax Board (FTB) held its second Interested Parties Meeting (IPM) for the next round of proposed amendments to its market-based sourcing rules codified at California Code of Regulations tit. 18, (CCR) section 25136-2. The FTB released draft language for some of the proposed amendments including language that will impact asset managers, government contractors, and other industries. Below is a summary of the IPM. For a recap of what was discussed at the first IPM held on January 20, 2017, see Tax Alert 2017-148. Asset management fee issue The proposed draft language revised the asset management fee examples, which were discussed at the first IPM. The revised examples, which are set forth at CCR section 25136-2(c)(2)(A), are as follows: 13. 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 on the basis of the value of their interest. 14. Benefit of the Service — Business Entity, subsection (c)(2)(B). Same facts as Example 13 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. The noted changes to Example 13 are in the last sentence, which provides that the sale shall be assigned to the location of the shareholders, beneficial owners, or investors on the basis of the value of the interest. [Emphasis added.] During the IPM, there was a question as to how the value of the interest should be determined. The FTB hearing officers responded that they believed the assets in question would have a monetary value and that the valuation should occur at the end of the year. They did not indicate that this would serve as the only method for determining the value of the interest and it seems likely that further clarification will be needed on this point. In regard to Example 14, the FTB changed the prior example by eliminating the language at the end of the prior example, which provided that if the asset management corporation cannot reasonably approximate its receipts, then those receipts shall be disregarded for purposes of determining the sales factor. While no comment was made regarding the removal of this language, a commenter suggested that the "shall assign" language be changed to "permitted to assign" because some taxpayers may not be able to comply with the FTB's proposed method of assignment based upon zip codes or other statistical data. The FTB agreed this would be a helpful change. During the IPM, one commenter explained that the look-through approach, as applied to the asset management fee, is difficult to administer. The look-through approach assigns the asset management fee to the location of the shareholders, beneficial owners or investors. The commenter explained that the asset management corporation, which the commenter represented, provides services to a variety of clients. The commenter indicated that in order to obtain the location of each shareholder, beneficial owner or investor, the asset management corporation would have to have access to its customer's books and records, which it likely would not have. As such, determining the location of the shareholders, beneficial owners or investors, would be overly burdensome if not impossible to obtain. The commenter provided that, in those instances where records are difficult to obtain, it would be more appropriate to assign the sale to the location of its customer, which is the pension funds, retirement accounts or other investment accounts. The FTB hearing officers indicated they were aware that some asset managers have difficulty determining the location of the shareholders, beneficial owners or investors of the customer's they are providing services to and would take the comments into consideration. A comment was also received about the effective date of the asset management fee examples. Prior to the asset management fee examples being removed during the first set of amendments to the market-based sourcing rules, most observers believed that the asset management examples would have an effective date of January 1, 2015 (i.e., the initial retroactive date from the first round of amendments to the regulation), with a provision that a taxpayer could elect to apply the amendments retroactively to taxable years beginning on or after January 1, 2012, similar to the way other amendments to the market-based sourcing rules applied. When the asset management fee examples were removed from the prior amendments and then reintroduced during this second round of amendments, however, a common understanding was that the effective date would follow a similar pattern as the prior round of amendments, possibly as of the date the examples were reintroduced, for example as of January 1, 2017. During the IPM, the FTB hearing officers first indicated that because the asset management corporation examples had already been provided previously, the FTB intended them to be applied retroactively as if the asset management corporation examples had been included in the prior round of amendments. Following up on the FTB's statement, the same commenter indicated that the proposed asset management fee rules are already being applied by FTB auditors for years prior to 2015. The FTB representatives responded that the asset management corporation language was intended to provide examples of how to apply the market-based sourcing rules already in effect. The FTB hearing officers indicated that they would discuss the issue with the FTB audit leadership. The FTB representative's response did not provide certainty as to the issue of the retroactive application of the asset management corporation examples, however, the FTB hearing officers stated that they would provide an effective date for this next round of amendments in advance of the next interested parties meeting. Government contracts for services The FTB also included proposed examples dealing with the sourcing of the location of where the benefit is received as to government contracts. The FTB proposed to add CCR section 25136-2(b)(1)(E) which states that when a contractor provides field support in two states under a contract with an agency of the US Government, the receipts are assigned proportionally to the two states. The FTB elaborated on its reasoning for this amendment using the example of a large piece of equipment being used outside the US that has to be brought to California to be repaired before being put back in service at a location outside the US. In that case, according to the FTB the benefit of the service received would be at the location outside the US. If the equipment is used in two locations, the benefit received would be assigned proportionally to the two locations. The FTB asked whether clarification was needed for the term "field support" and comments indicated clarification would be helpful. Another comment was raised asking how the FTB intended to apply proportionality. The FTB hearing officers stated that either the contract will break out a dollar amount for each location or the taxpayer would have some other way to weight how the benefit was received between the two locations. Another comment requested that an example be added to illustrate where the benefit of the service is received when deliverable goods result from the service performed. The FTB hearing officers said they would consider the request. Another comment asked about whether the example could also apply to non-government contractors and the FTB said that it would make sense for the example to apply. The FTB asked for feedback on whether the example should be broader or whether it should include a second example. The audience seemed to favor having a general rule that would cover both government and non-government contractors. The other examples added related to government service contracts mainly focused on where the benefit of the service is received. The FTB included language stating that the appropriate measure for where the benefit of the service was received is the population of California over the US population. In short, the benefits of national security were limited to the US instead of the broader ratio of the population of California over worldwide population. The FTB emphasized that while this population spread was a reasonable approximation with respect to these two proposed government services examples, it did not intend for it to be the default rule for reasonable approximation. A commenter asked whether the FTB planned to deal with classified government contracts and suggested that the US population ratio may be appropriate, especially if the taxpayer could provide an affidavit stating that the classified services related to national defense. The FTB noted that the proposed Space Transportation regulation had a specific provision dealing with confidential contracts but would welcome feedback on whether this could be applicable. The same commenter said that US population seemed more reasonable than the proposed Space Transportation rule. Subcontractor example The FTB also included a general example that dealt with how to source services in which a subcontractor was hired to complete the service for the taxpayer. A commenter said that it may be more efficient for the regulation to include language confirming that subcontractors should be treated as the taxpayer's employees for purposes of sourcing, instead of including this example. The FTB said it would consider the comment. A commenter followed up stating that, as written, the example did not account for a scenario in which the end result was a deliverable sent to another state that was different from where the service was provided. The FTB again acknowledged the comment as something to consider. Proposed change in approximations based on population During the first IPM, the FTB suggested that in some cases including the population of a foreign country was not appropriate in determining the market. The proposed language would change the definition for "reasonably approximated" from the populations of "other countries" and replace it with "foreign jurisdictions or geographic areas". The example given by the FTB is that China and India have very large populations, however, not everyone in these countries may be benefitting from the use of marketing intangibles, for example, and so taxpayers need to consider whether a smaller geographic area, such as cities within a country, would be more accurate. The FTB confirmed that these terms were not defined and that it had not considered how to treat US territories. A comment was also received requesting an example of how to apply the use of a geographic area, which the FTB agreed would be helpful. Two comments by the FTB hearing officer that were not linked to proposed language The FTB announced that after previously discussing the possibility of looking to CCR section 25137-2 for guidance in sourcing long-term contracts for services, it decided not to do this. The FTB reasoned that CCR section 25137-2 dealt with what year to report income and the apportionment percentage to be used, which was not particularly helpful. CCR section 25137-2 relied on where the project was located based on costs incurred which also would not be applicable to forming market-based sourcing guidance. The FTB hearing officer also stated there would be no special rules for long term research and development (R&D) contracts because the normal rules were sufficient. The FTB hearing officer did note that the FTB provided a new proposed example related to R&D for additional guidance in CCR section 25136-2(c)(2)(E)(9). However, later in the session the FTB hearing officers asked whether the example in CCR section 25136-2(c)(2)(E)(9) was helpful and the general feedback indicated the example restated the sourcing general rules, without any guidance. The FTB said it would plan to remove the example from the next draft of proposed language. Dividends During the first IPM, the FTB indicated that it would take another look at the current rules for sourcing dividends. The prior amendments to CCR section 25136-2, in effect for tax years beginning on or after January 1, 2015, stated 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. During this second IPM, a commenter asked whether the FTB was going to propose any changes as to the sourcing of dividends. The FTB hearing officers said that the proposal to take another look at dividends was not well received based on the comments from the first IPM and, as a result, the FTB was no longer pursuing amendments with respect to the sourcing of dividends. As such, the rules related to dividends would remain as provided in the prior round of the market-based sourcing amendments. Reasonably approximated/reasonable approximation The FTB also proposed language to clarify that the taxpayer's reasonable approximation method shall be used unless the FTB shows "by clear and convincing evidence" that such method is not reasonable. During the IPM, however, the FTB announced that it planned to change the standard from "clear and convincing evidence" to "a preponderance of the evidence". Freight forwarder examples The proposed language also included examples for sourcing where the benefit of services from freight forwarding was received. The examples had been revised to take into consideration feedback from the first IPM. In addition to the FTB's longstanding informal sourcing rules provided in its Multistate Audit Technique Manual that provided for 50% of the benefit to be received at the point of origin and 50% received at the point of destination, the FTB also proposed an example that assigns the sales to the office of the customer which placed the order or the commercial domicile of the customer. A commenter noted that the additional example, which would allow for treatment other than a 50/50 rule based on point of origin/point of destination, was appreciated because the complex nature of the freight forwarding and logistics business was not always properly reflected by the 50/50 rule. Marketing intangibles The FTB put forth proposed language to apply a throw-out rule for sales of marketing intangibles, if such sales are assigned to jurisdictions where sales represent 5% or less of total sales. The example proposed indicates that such sales are viewed as de minimis. In a response to a question, the FTB clarified that the 5% threshold would apply to jurisdictions in the aggregate. The FTB explained that it would not throw out sales for jurisdictions that had less than 5% of the marketing intangible sales if, when added together, those de minimis jurisdictions exceeded the 5% threshold. The FTB also indicated that it was open to exploring a different de minimis threshold than 5% and would consider revising the proposed language based on the comments raised. Next IPM Finally, the FTB stated that a third IPM would be held in 90 to 120 days, and updated proposed language would be provided prior to this third IPM. The FTB requested that written comments be received by August 15, 2017, to be considered before the third IPM. Implications For the Asset Management industry, the June 16, 2017, IPM marks the continuation of the FTB's push to provide a "look-through" rule in assigning receipts for asset management fees. This second IPM, however, marks the first time comments were provided to attempt to revise the asset management examples provided by the FTB. The FTB appeared receptive to these comments and indicated a willingness to talk further in regard to the complexities and practicalities of applying the look-through approach. With the FTB's decision not to revisit the sourcing of dividends, the intersection of dividend sourcing and economic nexus could continue to create problems for taxpayers. Under the market-based sourcing rules, if an investor has a California sourced dividend that exceeds California's economic nexus, it could now have a California filing requirement. The proposed language also includes a narrowing of the reasonable approximation standard when the potential benefit of an intangible or service is received in a global market. Instead of including a foreign country's population to show where the benefit is received, the FTB proposes to limit the population to a specific geographic region within a country. While proposing this limitation, the FTB provides no guidance as to how taxpayers should determine when to apply a restricted geographic area. Even after the latest IPM, uncertainty continues to exist as to the effective date of this latest round of amendments, especially with respect to the asset management fee examples. The FTB plans to provide a proposed general effective date in advance of the next IPM but whether this language will address the asset management fee examples remains to be seen. We will continue to monitor the discussions and send alerts as the regulatory process continues. ———————————————
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