May 23, 2018 California FTB held its third interested parties meeting to discuss next round of proposed amendments to market-based sourcing rules On Friday, May 18, 2018, the California Franchise Tax Board (FTB) held its third Interested Parties Meeting (3rd IPM (preceding IPMs referred to sequentially as described later)) 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. Affected taxpayers should consider submitting written comments by the July 19, 2018 deadline. For a recap of what was discussed at the first IPM held on January 20, 2017 (1st IPM), see Tax Alert 2017-0148. For a recap of what was discussed at the second IPM held on June 16, 2017 (2nd IPM), 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 derives from general legal and federal use of the term. At the 3rd IPM, no comments were received on the definition of "beneficial owner." In addition, a section would be added to define "domicile." Under the proposal, 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 also would add a definition of what is meant by "domicile" in the context of a "beneficial owner" for its new asset management assignment 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.1 If, however, the entity for which 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. At the 3rd IPM, no comments were received on the definition of "domicile." 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. 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 a 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. In the notice for the 3rd IPM, the FTB explained that the changes to the rule emanated from businesses that had world-wide intellectual property licenses, but only utilized the licenses in specific countries or geographic areas. The FTB further stated this would avoid an unreasonable use of world-wide population when taxpayers only did business in small specific regions. Commenters noted that implementation of this rule would be awkward and would require taxpayers to obtain region-by-region data from this point forward. Another comment noted that the FTB should expand the definition to include the market for a taxpayer's customers as this could be applicable and the FTB agreed to consider this point. 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 nor included in prior drafts of the proposed regulations. Notably, however, simplifying rules were not added to sales of services to individuals, as those rules were kept intact. Simplifying rules 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."2 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 simplifying rules. 1. Services that are directly related to real property will be sourced to the location of the real property. Predominance rule To the extent the taxpayer received one fee for a service that related to more than one of the simplifying rules, the service would be characterized by the simplifying rule to which the service predominantly relates. During the 3rd IPM, commenters asked whether this predominance rule should be broadened to apply when multiple activities fall under the same simplifying rule: Sourcing sales to the location of whichever activity was predominant. The FTB agreed that this treatment should be considered. Additionally, commenters questioned the purpose and meaning of the fifth simplifying rule: Sourcing to the extent the customer's business is located in the state. Commenters questioned how to determine what portion of the activities were related to a business within the state, and additionally, how to treat services rendered to multistate businesses. Finally, a commenter added that the first four simplifying rules were sourced to specific elements of a business, while the fifth discussed the business as a whole. The FTB staff agreed it would reconsider the fifth simplifying rule. Rebuttable presumptions The FTB recognizes that some services cannot be sourced accurately using the simplifying rules. Therefore, a rule would be added that would allow the FTB or the taxpayer to overcome the presumption of a simplifying rule 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 a simplifying rule. During the 3rd IPM, commenters questioned how these rules and presumptions interacted with the cascading rules left intact in the draft regulation. According to the FTB, the simplifying rules would create a rebuttable presumption that the simplifying rule itself should be used. Once the correct simplifying rule is determined, the cascading rules would be used to determine the location indicated by that simplifying rule. For example, once it has been determined that a predominance of a taxpayer's service derives from services related to TPP, a taxpayer will use the cascading rules to best determine the location of the relevant TPP. Further, for the first time, additional language would be added in these cascading rules to provide that the taxpayer may reasonably approximate the location by using the ratio of California over US population 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 FTB reiterated that the rationale for this proposed addition is that US government services are predominantly intended to benefit the interests of US citizens domestically. Commenters suggested that other nations or regions may benefit from the US government's activities, especially to the extent the services were provided to the military for use overseas. The FTB disagreed and opined that services should be seen as generally for the benefit of the US domestically, and added that this rule was intended only when the benefit had not already been determined by books and records. Examples 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. Commenters questioned whether the examples were part of the presumptions under the simplifying rules, or rather suggested methods of reasonable approximation. According to the FTB, the examples show the application of the applicable simplifying rules to certain industries. There were multiple comments about the added examples, illustrating the complexity of applying the simplifying rules. In addition, commenters questioned whether the simplifying rules effectively reach the location where the customer receives the actual benefit, or simply source to the location where any work is performed. Commenters repeatedly questioned whether the proposed language of the regulation, in effect, pulls away from market-based sourcing and back into a cost-of-performance regime. Additionally, when questioned about the application of specific facts to certain examples, the FTB said that treatment could be substantially different given factual deviation from the examples, even within the industry described. 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 would be received in California because the service relates to TPP 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 would 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 are assigned to where the goods are located when the service is received. The benefit of the service received would be 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 would be 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 would be 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 TPP. Asset management fees For asset management fees, the FTB deleted its previously proposed examples entirely and instead determined that new assignment rules would be more appropriate. The new assignment rules are patterned after CCR section 25137-14, the special industry regulation for mutual fund service providers that provide services to regulated investment companies. During the 3rd IPM, the hearing officer stated that the goal of the new rules is to treat asset managers that are subject to CCR section 25136-2 in the same manner as asset managers subject to CCR section 25137-14. The FTB hearing officer explained that the reason for changing from proposed examples to proposed assignment rules is that the examples were becoming too complicated. 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"3 of the shareholders, beneficial owners, or investors, then the receipts from the asset management services are assigned to California to the extent the domicile of the shareholders, beneficial owners or investors is in California. During the 3rd IPM, the FTB stated that proposed CCR section 25136-2(c)(4)(B) was intended to address a situation in which an asset manager provided services to a well-known California fund but the shareholders were unknown. The FTB stated that, under CCR section 25136-2(c)(4)(B), it could then be reasonable to approximate the benefit in California. There were comments regarding proposed CCR section 25136-2(c)(4)(C) and concern that the last cascading rules for asset management fees ended with sourcing based on US population. One commenter noted that CCR section 25137-14 did not include a sourcing provision based on US population and thus the FTB's statement that two rules were intended to treat asset management taxpayers similarly rang hollow. The FTB stated it would be open to suggestions on a better methodology. A commenter suggested that sourcing based on US population could be expanded to include foreign investor location, since certain funds typically had significant foreign investors. In its explanations of its rationale behind 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 [when] 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." During the 3rd IPM, the FTB again stated that it had considered and discarded a method in which the sales would be assigned to the first tier entity. 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 1st and 2nd IPMs 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 2nd 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." During this 3rd IPM, the FTB clarified that, if a seller of a stock or partnership interest, dividends or goodwill, was not privy to the underlying factors of the corporation/partnership, that the sale would be assigned using the corporation's/partnership's domicile. Commenters noted that this treatment seems inconsistent with other aspects of the market-based sourcing rule changes that utilize population, whereas a taxpayer would be required to utilize domicile under this particular section. The FTB stated it had not pondered this aspect and would revisit the issue. This proposed change may affect whether companies are 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 would 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 would clarify 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 the 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 (not the most recent 12-month period). Licensing of marketing and non-marketing intangible assets The FTB 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). An 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 R&D. Since the location of the use of the licensed drug compounds are in California, the lump-sum payment would be assigned to California. 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 California, 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 In a change from the 2nd IPM, the FTB now proposes 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, however, 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." Commenters noted that the prior reasoning for a "clear and convincing" standard was to give taxpayers the benefit of the doubt on the reasonableness of their approximation method. Commenters noted, however, the change to a lower burden of proof standard would make it easier for FTB auditors to raise a different reasonable approximation method, which would possibly lead to increased application of LCUP penalties. The FTB countered that this change in standard was done solely to make the standard consistent throughout the FTB's regulations. Commenters also noted that, unless a clear definition of "preponderance of the evidence" is added to the definition section, FTB auditors could be inconsistent in their understanding of the term. A commenter asked whether a "preponderance of the evidence" standard was used in other states; the FTB responded that it was not certain which standard other states used. Effective date of proposed changes A commenter asked whether the FTB had considered an effective date, especially for the proposed asset management assignment rules. The FTB said it was not dealing with applying an effective date yet because the FTB expected additional changes to the proposed language based on this IPM. The FTB did note, however, that it discussed the asset management fee issue at the 1st and 2nd IPMs, which seems to imply the FTB could still press for retroactive application. One commenter suggested the ability to elect, but not require, retroactive application. The FTB said it would take this under consideration. 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 approved, would essentially affect almost every industry. While some of the revisions from the 2nd IPM were retained and many others were deleted entirely, most of the proposed revisions are new. The introduction of the proposed simplifying rules and the complexity of how these rules will apply looks to be an area of focus for the FTB as it considers comments from interested parties. Concerns from interested parties as to whether the proposed language of the regulation, in effect, pulls away from market-based sourcing and back into a cost-of-performance regime will be another area to track. The uncertainty of an effective date for the proposed changes still looms over the process and will continue to cause concern for taxpayers as they determine applicable sourcing methods. The FTB stated that there would be at least one more IPM, although the timing for this 4th IPM was not provided. We will continue to monitor the discussions and send Alerts as the regulatory process continues. ———————————————
——————————————— 1 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. 2 The definition of "[b]enefit of a service is received" has been moved to subsection (b)(2) of the proposed regulation. 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, the previous version of 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. 3 See the prior discussion for the newly inserted definition of "domicile." | |||||||||||||||||||
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