On Friday, May 18, 2018, the California Franchise Tax Board (FTB) is scheduled to hold its third Interested Parties Meeting (IPM) to continue ongoing discussions for the next round of proposed amendments to its market-based sourcing rules promulgated under California Code of Regulations, title 18, (CCR) section 25136-2. In anticipation of this meeting, the FTB released draft language (and a corresponding explanation) of the proposed amendments, including language that will affect asset managers, government contractors, research and development companies, and numerous other industries.

This Alert summarizes the draft language that will facilitate discussion at this third IPM.¹ The proposed regulatory changes arguably represent the FTB's most sweeping and far-reaching changes to date affecting general market-based sourcing assignment rules, definitions, illustrative examples, and overall structure and organization of CCR section 25136-2. Indeed, many of the changes are entirely new, making this is the first time taxpayers and practitioners have seen them. Affected taxpayers should consider submitting written comments by the July 19, 2018 deadline and/or attending the meeting to provide input.

For a recap of what was discussed at the first IPM held on January 20, 2017, see Tax Alert 2017-0148. For a recap of what was discussed at the second IPM held on June 16, 2017, see Tax Alert 2017-0992.

General definitions

Amendments were proposed to the general definitions section of the regulation. A section would be added to define "beneficial owner," which is a term used in the newly-added rules for asset management fees, discussed later. Beneficial owner "means 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." According to the FTB, this definition is derived from general legal and federal use of the term.

In addition, a section would be added to define "domicile." The domicile of the shareholder, investor or customer is presumed to be the billing address on the taxpayer's records. If, however, the taxpayer had knowledge of the actual domicile, then the presumption would not control. The FTB would also add a definition of what is meant by "domicile" in the context of a "beneficial owner" for its new asset management assignation rules. Similar to the general domicile rule, the domicile of a beneficial owner of assets managed by an asset manager is presumed to be the beneficial owner's billing address on the records of the entity for whom the asset management services are rendered, or on the records of the asset manager.² If, however, the entity for whom the asset management services were rendered, or the asset manager, had actual knowledge that the beneficial owner's primary residence or principal place of business differs from the beneficial owner's billing address, the presumption would not control.

The reasonable approximation section would be amended to address the population percentage. There are situations when a population percentage is required as a reasonable approximation. The general rule provides that the US population should be included in the denominator of the population percentage. If it can be shown that the benefits from the service are received, or the intangible property is used, outside of the US, then the population of those foreign jurisdictions or geographical areas may be added to the denominator of the population percentage. Previously, the regulation referenced "foreign country," but it would be changed to reflect "foreign jurisdiction or geographical area." FTB is concerned that taxpayers will include the total population of countries such as India or China in the denominator of the population percentage in order to dilute the ratio. For example, if taxpayer only does business in Shandong, China, then only the population of Shandong would be included in the denominator and not the total population of China. In order to include the population of a foreign jurisdiction in the denominator of the population ratio, taxpayer must provide substantiation that it had sales or services in those specific geographical areas. If taxpayer cannot provide substantiation that it has sales or services in those specific foreign jurisdictions, then the denominator of the population percentage would be limited to the US population.

Simplifying rules for assignment of sales of services to businesses and government entities

The FTB revamped its rules for assignment of sales of services to businesses and government entities by including what the FTB is calling "simplifying rules." Unlike some of the other proposed changes, these were not discussed at the prior IPMs. Given the sweeping nature of the proposed changes, this may catch taxpayers by surprise. Notably, however, simplifying rules were not added to sales of services to individuals, as those rules were kept intact.

According to the FTB, taxpayers and staff have faced challenges trying to assign sales of services and determining the location where the "benefit of a service is received."³ As a result, the FTB is proposing to add simplifying rules similar to those contained in other states, such as Wisconsin and Utah. These rules provide for a rebuttable presumption.

The following are the five general presumptions.

1. Services that are directly related to real property will be sourced to the location of the real property.

2. Services that are directly related to tangible personal property (TPP) will be sourced to the location of the TPP at the time the service was performed.

3. Services that are directly related to intangible property will be sourced to the location where the intangible property was used.

4. Services related to individuals will be sourced to the location of the individual at the time the services are performed.

5. Services that are related to a business entity will be sourced to the location of the business entity at the time the services are performed. This does not necessarily mean that the services will be sourced to the headquarters or commercial domicile of the business entity. If the services relate to a branch office, then the services will be sourced to the location of the branch office.

To the extent the taxpayer receives one fee for a service that relates to more than one of the simplifying rules, the service shall be characterized by the simplifying rule to which the service predominantly relates.

The FTB recognizes that some services cannot be sourced accurately by using the simplifying rules. Therefore, a rule would be added that would allow the FTB or the taxpayer to overcome the simplifying rule presumption by showing, based on a preponderance of the evidence, that the benefit of the service is received at a location other than that provided under the simplifying rules.

The FTB would also incorporate existing cascading rules for assignment of sales to businesses or government entities for purposes of determining the location of where the benefit is received under the simplifying rules. Further, additional language would be added in these cascading rules to provide that, if the taxpayer's services are provided under a US government contract, and the location where the benefit of the service was received cannot be determined by contract or books and records, or if the contract cannot be disclosed, and the location cannot be reasonably approximated by any other method, the taxpayer may reasonably approximate the location by using the ratio of California over US population. According to the FTB, the rationale for this proposed addition is that US government services are predominantly intended to benefit the interests of US citizens.

Most of the changes in the regulation come from numerous proposed revisions to the examples with respect to service receipts derived from businesses and government entities for purposes of showing how the simplifying rules would work to assign such receipts. Industries affected include government contractors, logistics companies, research and development companies, call center subcontractor companies, and payroll service companies. For instance, the FTB has inserted the following non-exhaustive list of examples:

— Contractor Corp provides military field support services, repair services for tanks and other heavy equipment, to an agency of the US government. A tank becomes inoperable in a foreign geographic area. That tank is delivered to and repaired by Contractor Corp in this state. Upon completion of the repairs, the tank returns to public service in a foreign geographic area. The benefit of the service is received in California because the service relates to tangible personal property that was located in California at the time the service was received.

— Contractor Corp provides military field support services to an agency of the US government. Contractor Corp maintains software for a military computer network. Contractor Corp is unable to disclose or does not know the location where the software is used by military personnel. A reasonable approximation of the location where the benefit of the software maintenance is received shall be based upon the ratio of the population in this state compared to the population of the US.

— For a flat fee, Logistics Corp contracts with Customer Corp to arrange for the pick-up and delivery of Customer Corp's goods between State A and State B. The sales from Logistics Corp's services to Customer Corp shall be assigned to where the goods are located when the service is received. The benefit of the service received is determined by the ratio of miles in this state to total miles between State A and State B. This example appears to differ from 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, or the FTB's prior proposed example, which has been deleted, that assigned the sales to the office of the customer placing the order or the commercial domicile of the customer.

— Call Center Corp, located in this state, provides call center services for business customers. Fly Fishing Corp, located in State A, sells equipment, training services, and travel services to its customers. It also provides call center services to those customers. Fly Fishing Corp subcontracts its call center operations to Call Center Corp. Call Center Corp maintains records regarding the location from which customer calls originate. The location of the receipt of the benefit of the service is in this state to the extent Fly Fishing Corp's customers are physically present in this state at the time the call center service is received.

— R&D Corp located in this state enters into an agreement with Pharmaceutical Corp located in State A for development of pharmaceuticals. R&D Corp will receive milestone payments for clinical tests to be performed in States A and B. The milestone payments from Pharmaceutical Corp to R&D Corp are assigned to States A and B because the clinical tests to be performed by R&D Corp are a service related to an intangible used in States A and B.

In addition, the FTB has deleted numerous examples from the prior proposed regulatory draft that interested parties felt were not helpful, such as those pertaining to companies in the internet advertising (reasonable approximation example), painting, government contractor, R&D, window washing, freight forwarding and asset management industries.

Mixed sales contracts

The FTB is proposing to add rules and an example addressing when a contract includes both the sale of a service and the sale of tangible or intangible property. Like the simplifying rules previously discussed, these extensive and material changes were never discussed at any prior IPM, and therefore represent the first time taxpayers will have a chance to comment on them. These new rules are found under new subsection (c)(3) and thus fall under the regulation's broad service revenue assignment category.

Under these new rules, if the sale of the service and the sale of the property were separately stated in the contract, they would be assigned according to the separate statements. If, however, they were not separately stated, and the property portion of the sale were incidental to the service portion of the sale, the total gross receipts would be assigned as a service. If the service portion of the sale were incidental to the property portion of the sale, then the total gross receipts would be assigned as a sale of property.

An example would be added to the regulation to help explain how this new rule applies. The example deals with a corporation purchasing computers from a computer seller. Two hours of information technology support service are included in the purchase price. The price for the computer and the price for the information technology support service are not separately stated in the contract. Because the sale of the information technology support service is incidental to the sale of the computers, the sale is characterized as a sale of tangible personal property.

Asset management fees

For asset management fees, the FTB deleted the proposed examples entirely and instead determined that assignment rules would be more appropriate. The new assignment rules are patterned after CCR section 25137-14, the special industry regulation for mutual fund and asset management service providers.

Under these new provisions, the benefit of the asset management services is received by the shareholders or investors of the assets unless the shareholder or investor is holding title for a "beneficial owner," as previously defined. If the shareholder or investor is holding the asset for a beneficial owner, the benefit is received by the beneficial owner of the asset. The location of the receipt of the benefit of the service is determined under the following cascading rules:

(A) If the taxpayer knows the "domicile"⁴ of the shareholders, beneficial owners, or investors, then the receipts from the asset management services shall be assigned to California to the extent the domicile of the shareholders, beneficial owners or investors is in California.

(B) If the taxpayer does not know the domicile of the shareholders, beneficial owners or investors, the receipts shall be assigned to California to the extent the domicile of the shareholders, beneficial owners, or investors can be reasonably approximated to be in California.

(C) If the taxpayer does not know the domicile of the shareholders, beneficial owners or investors, and their domicile cannot be reasonably approximated, sales to California shall be based upon the ratio of the population in this state compared to the population of the US.

In its explanations of its rationale to the reasonable approximation amendments, the FTB states the following: "Commentators have requested adoption of the reasonable approximation method of assigning the sale to the first tier entity below the asset managers in situations where the shareholders or investors appear in multi-layers below the first tier and are not known to the asset managers. Assigning the asset management fees to the first tier would, in most cases, not represent the market of asset managers because the shareholders or investors who received the benefit of the asset management service are not located in, and in many cases are far removed from, that first tier. Staff believes that a ratio of California over U.S. population reasonable approximation method is a fairer reflection of the market."

Accordingly, the FTB abandoned one prior proposed example that would have assigned sales on the basis of the value of the interest held by shareholders, beneficial owners or investors. But, with the FTB's adoption of a US population assignment rule, if the first two cascading rules do not apply, it generally kept the spirit of the other prior proposed example that would have assigned the sales by reasonably approximating the domicile of the shareholder, beneficial owner, or investor utilizing information based on zip codes or other statistical data. Indeed, as shown by its proposed rules for this industry and its comments, the FTB believes an overall "look-through" methodology for assigning asset management fees is the most appropriate approach for the market regulation, despite concerns expressed by taxpayers in the prior IPM that they generally do not have access to their customers' books and records.

Receipts from the sale of stock or a partnership interest, dividends and goodwill

In general, these rules provide that, if more than 50% of the assets of the underlying corporation consist of tangible/real property, then the receipts are assigned based on the average of the payroll and property factors of that corporation/partnership. If more than 50% of the assets of the underlying corporation/partnership consist of intangible property, then the sales factor of the underlying corporation/partnership is used to assign the sale of stock.

At the prior IPM, commenters expressed concern that, if a taxpayer sold a minority interest in a corporation/partnership, it would be unable to source that sale because it generally would not have the factor information of that underlying corporation/partnership. Accordingly, the FTB would add a new provision that, if a taxpayer does not have access to information to enable it to assign the sale under the corporation's/partnership's factors, then the sale is assigned to the domicile of the "payor."

It is unclear however, what "payor" means, as it is not a defined termed in the regulation. In other words, does "payor" mean the actual buyer, does it mean the underlying corporation/partnership whose interest was sold, or a combination of both depending on whether the gross receipt is derived from the sale of stock/partnership interest (in which case it could be the actual buyer) or derived from goodwill/dividends (in which case it could be the underlying corporation/partnership)? In at least one state (Texas), it means the state of incorporation of a corporation. Does California intend to follow that rule? This will need to be clarified at the IPM.

Perhaps most importantly, this proposed change may affect whether companies may be subject to nexus and a filing requirement due the intersection of California's bright-line, economic nexus and market-based sourcing provisions.

Sale of intangible assets

The receipts from the sale of intangible property would be assigned to the location where the intangible property is used. The amendments clarify that the receipts should be sourced to the location where the intangible property will be used by the purchaser. Before this amendment, it was unclear if the receipts should be assigned to the location where the taxpayer used the intangible property or where the purchaser will use the intangible property. This amendment clarifies the primary cascading rule.

The assignment rule that is based on where the taxpayer used the intangible property has now been relocated to the reasonable approximation provisions under that same subsection. Therefore, if taxpayer cannot determine, based on the contract or books and records, where the purchaser will use the intangible property and the use of the intangible property cannot be reasonably approximated by any other method, then the gross receipts from the sale of the intangible property would be assigned to the location where the intangible property was used by the taxpayer for the most recent 12-month tax year. The location of use by the taxpayer is based on the most recent 12-month tax year, not a 12-month period.

Licensing of marketing and non-marketing intangible assets

The FTB has deleted a prior proposed rule that would have thrown out sales of marketing intangibles, if such sales were assigned to jurisdictions where sales represented 5% or less of total sales (i.e., de minimis sales).

A R&D example would be added in which R&D Corp located in California enters into an agreement with Pharmaceutical Corp located in State A for development of pharmaceuticals. R&D Corp receives an upfront, lump-sum payment from Pharmaceutical Corp for the licensing rights of the licensed drug compounds that are used in this state for continuing research and development in this state. Since the location of the use of the licensed drug compounds are in California, the lump-sum payment is assigned to this state.

This example, according to the FTB, has been proposed to be added to explain that, if the lump sum was for past R&D, and the R&D was done in this state, then the lump-sum payment should be assigned to California. While this example only touches the surface of the complexities involved in sourcing these types of payments in this industry, it is interesting that the FTB decided to add it to the intangible property assignment rules given the difficulty of determining whether such arrangement is for the sale of intangible property or services. This is especially so when the FTB included an example of milestone payments — which, like the lump-sum or upfront payment, is another payment generated under R&D collaboration agreements — under its service assignment rules, discussed previously.

Burden of proof of a taxpayer's reasonable approximation method

One proposed change from the second IPM provided that a taxpayer's reasonable approximation method shall be used unless the FTB shows, by "clear and convincing evidence," that such method is not reasonable. The FTB is now proposing to replace "clear and convincing" with a "preponderance of the evidence" standard for the reasonableness of a taxpayer's offered approximation, which is consistent with the evidence standard found throughout the regulation. It would appear that this change in evidentiary standard gives the FTB more leeway to challenge taxpayers' reasonable approximation methods because "clear and convincing" is generally a more rigorous standard to meet than "preponderance of the evidence."

Implications

As can be seen, the proposed changes to California's market-based sourcing regulation contain some of the most sweeping and far-reaching revisions of the rule to date, and, if enacted, would essentially affect almost every industry. While some of the revisions from the prior IPM were retained and many others were deleted entirely, most of the proposed revisions are new.

Also, despite taxpayers' request at the prior IPM to apply changes prospectively (particularly for the asset management industry), there is currently no effective date being proposed for any of these revisions should they be adopted. As a result, they may apply retroactively upon audit, with the possibility of the imposition of penalties unless taxpayers can show reasonable cause for abatement or the FTB issues guidance, similar to Notice 2017-02, that provides for procedures to request abatement under certain circumstances.

We will continue to monitor the discussions and send Alerts as the regulatory process continues.

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ENDNOTES

¹ Note that the FTB also provided a 50-state analysis in matrix format of the rules all of the states use to assign sales of services and intangible property, assignment of asset management fees, assignment of freight forwarder receipts, and the definition of sales. This multistate analysis was completed by the FTB for purposes of guiding its proposed regulatory changes and providing a framework from which to pattern some of those changes.

² According to the FTB, this definition is derived from the special industry regulation for mutual fund and asset management service providers found under CCR section 25137-14.

³ It should be noted that the definition of "[b]enefit of a service is received" has been moved to subsection (b)(2). The definition has been slightly tweaked with the removal of "delivery of" so that the definition now reads: "'Benefit of a service is received' means the location where the taxpayer's customer has either directly or indirectly received value from delivery of that service." It is unclear why the FTB thought this change was necessary. Further, subsection (b)(2) contained a number of general examples illustrating what this term meant. These examples have now been relocated to subsection (c)(2)(E) to follow the newly-added simplifying and cascading rules.

⁴ See the prior discussion for the newly inserted definition of "domicile."