July 31, 2019 California FTB held its fourth interested parties meeting to discuss the next round of proposed amendments to its market-based sourcing rules On July 19, 2019, the California Franchise Tax Board (FTB) held its fourth Interested Parties Meeting (4th IPM (and preceding IPMs referred to sequentially as described below)) continuing ongoing discussions between the FTB and the public 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 (Regulation)). In anticipation of the 4th IPM, the FTB released draft language and discussion topics with explanations 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 September 19, 2019 deadline.1 For a recap of what was discussed at the third IPM held on May 18, 2018 (3rd IPM), see Tax Alert 2018-1098. Discussion topics The following two topics were up for discussion at the 4th IPM:
The FTB did not receive any comments at the 4th IPM on the first topic. During the 4th IPM, commenters were generally supportive of including a safe-harbor rule for high-volume identical service providers. As the commenters noted, taxpayers want certainty under these rules and generally, they viewed a safe-harbor in the Draft Regulation as providing greater certainty. In addition, some commenters stated that a safe-harbor rule would be in line with uniformity principles and similar model rules promoted by the Multistate Tax Commission. General definitions Additional amendments were proposed to the general definitions section of the Regulation. The definition of "beneficial owner" is a term used in the proposed rules for the sourcing of asset management fees. The updated definition defines "beneficial owner" in terms of a person's ability to control an asset and clarifies the tier level being addressed. "'Beneficial owner' means any person who made an independent decision to invest assets." The definition also carves out what is not a beneficial owner, namely: master funds, feeder funds, a shareholder of a publicly-traded corporation, and a participant of a defined benefit plan. At the 4th IPM, a commenter stated that the statute uses "purchaser," while the regulation also uses "customer" and "beneficial owner." The FTB stated that purchaser and customer are synonymous, but "beneficial owner" is simply used as a method for determining where the purchaser receives its benefit for the asset management fees. The commenter followed up by stating that some sections used "purchaser or customer," which seemed to indicate a difference in definition. The FTB stated it would review the draft language to revise such inconsistencies and ambiguities. The four examples under the definition of "benefit of a service is received" were all deleted as the FTB deemed they were no longer relevant because of the changes to assigning sales from services to business entity and government customers. There were no comments at the 4th IPM on this topic. Under the definition of "reasonably approximated," the FTB proposed to delete the phrase "foreign countries" and replace it with "foreign jurisdictions or geographic areas;" and to change the word "shown" to "substantiate" in the definition. The FTB stated the purpose of these proposed changes was to more accurately reflect the taxpayer's market when using population as a reasonable approximation method, and to also limit assignment of sales to foreign jurisdictions and geographic areas where the taxpayer actually has sales, since including large foreign populations where the taxpayer has immaterial sales in an approximation method could unreasonably distort the sales factor. This limitation applies when the taxpayer uses population as a reasonable approximation method. Comments at the 4th IPM related to the level of substantiation required, given that a taxpayer must substantiate that the benefit of the service is being "substantially received" or use of an intangible is being "materially used" in the jurisdictions outside the United States. Commenters pointed out that none of these modified terms are defined, and failure to define them could cause issues, especially given the difficulty of obtaining foreign jurisdictional data. Additionally, a commenter suggested that these modified terms could provide an opportunity for taxpayers to establish that jurisdictions within California were not applicable, allowing taxpayers to remove portions of the California population from the population numerator. In response to this observation, the FTB stated that this was unlikely to be allowed because using the California population would not unreasonably distort the percentage. Simplifying rules for assignment of sales of services to businesses and government entities The FTB again revamped its rules for the assignment of sales of services to businesses and government entities by making further proposed changes to what the FTB is calling the "simplifying rules." Simplifying rules The "simplifying rules" were added for the 3rd IPM. In the 4th IPM, the FTB further modified these rules; they provide a rebuttable presumption of how various kinds of services should be sourced. The following are the proposed four presumptive methods for the sourcing of services:
In the 4th IPM, the FTB further modified the rules for assigning receipts from services provided to customers that are businesses or government entities by proposing a two-step analysis: first, the method of locating the benefit is determined using the four simplifying rules above; and second, the location of the sales is substantiated within that method under CCR Section 25136-2, subsection (c)(2)(B). Commenters raised a significant number of comments about the difficulty of determining which simplifying rule would be applied to a particular set of circumstances. Several hypothetical examples, including common fact patterns such as consulting services, were provided and the sourcing for those examples appeared to be difficult to determine. Commenters noted that for services related to TPP, using the delivery location could result in "dock sale" issues. Commenters suggested alternatively enacting an ultimate destination rule or providing greater clarification. Additionally, commenters questioned the treatment of the language in simplifying rule #2 if the TPP was delivered to the customer's customer, rather than to the taxpayer's direct customer. One of the new examples provided by FTB involves a call center service and provides that applying a customer's customer sourcing approach is appropriate in that case. Commenters also noted that a high percentage of services would be related to individuals in some fashion under the fourth simplifying method. They suggested that in sourcing revenues for most business-to-business services, if one follows where the benefit is ultimately received, it will reach an individual. Several comments focused on which individuals the service "relates to," and to what extent the sourcing would be focused on the customer's employees, or rather the customers of the customer. Additionally, commenters queried how a service relating to multiple individuals across several states should be sourced. The FTB stated that these situations should be analyzed on a fact-specific basis. Predominance rule To the extent the taxpayer receives one fee for a service that relates to more than one of the proposed simplifying rules, the service will be characterized by the simplifying rule to which the service predominantly relates. Rebuttable presumptions The proposed draft language for the 4th IPM added that if the simplifying rules do not provide an applicable item to which the service relates, the information reasonably available may be used to identify the location where the benefit of the service is received. The FTB recognizes that some services cannot be sourced accurately by using the simplifying rules. Therefore, the FTB proposed adding yet another rule 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 such simplifying rule. Significant modification to cascading rules for services The FTB proposes to modify the cascading rules that would be applied to substantiate the location of where the benefit of services is received by businesses or government entities after applying the simplifying rules. While the rules still begin with substantiation through books and records, the FTB proposes that if books and records do not provide adequate substantiation, taxpayers would next use all other sources of information, to the extent such information is reasonably available, to substantiate the precise location of where the benefit of the service is received. If all sources of information reasonably available to the taxpayer cannot substantiate the precise location, then this information can be used to approximate the location where the benefit is received. The proposed language removes separate cascading rules for using location of order and customer billing address because these methods would be included in the definition of "all sources of information." During the 4th IPM, commenters asked about the difference between "approximation" and the current "reasonable approximation" method. The FTB explained that "approximating" under the proposed substantiation step is intended to be different than the "reasonable approximation" method in the current version of the cascading rules. In the proposed language to source services for businesses and government entities, approximation is being used to substantiate the location of where the benefit of the service is received that would already be identified under the simplifying rules, whereas "reasonable approximation" in the current rules is intended to identify the location of where the benefit of the service is received. The FTB also confirmed that the change to substantiation for services provided to businesses and government entities did not remove the rebuttable presumption of billing address for services where the customer is an individual. Commenters discussed the amount of effort that would be required for taxpayers to substantiate, especially using books and records, before moving to the next level of substantiation. In addition, commenters asked what "reasonably available" information would taxpayers be required to provide. Commenters requested a safe-harbor for smaller taxpayers who may not be able to provide adequate sourcing information, or when the burden of the analysis may be too great. The FTB responded that they would take into consideration the burden and expense to the individual taxpayer based on the taxpayer's own facts. Regardless, the FTB said it did not intend to provide a specific safe harbor for these types of taxpayers. Government sales The new scheme set forth above applies to sales to government entities, however, FTB also provides a new rule to specifically address what should occur if the sale could not be assigned pursuant to these general rules, "such as when the government contract cannot be disclosed and no information about the service is publicly available." The new rule provides that in these circumstances, the receipt shall be assigned to California based on the ratio of California population over US population. During the 4th IPM, while some commenters appreciated a safe-harbor rule, other commenters took issue with using "shall" as mandating use of California population, and suggested "may." Some commenters argued that the benefit of many US government contracts applies to foreign locations, and the benefit should be sourced outside of the United States, such as services that benefit NATO allies. The FTB responded that these contracts are presumed to benefit the citizens of the United States and that the California population is therefore appropriate to reflect the California benefit of the services. Commenters added that this would presumably give most entities with confidential or secret US government contracts nexus in California due to the state's economic nexus thresholds and that this could raise constitutional concerns. Commenters suggested that information about the service could be privately available, and suggested modifying the language to "public or private" or removing the modifier all together. Presumably the ability to provide any information would return the sourcing to the general simplifying rules. Examples During the 4th IPM, further changes were proposed to the examples regarding the method for locating the benefit of the service received at CCR Section 25136-2, subsection (c)(2)(A). The examples demonstrate the restructured rules for assigning sales of services to customers that are businesses or government entities, attempting to apply the simplifying rules as well as examples of reasonable approximations. On pages 8 through 11 of the proposed draft language, the FTB has revised several examples to locate the benefit of the service. During the 4th IPM, commenters asked the FTB to add:
Receipts from the sale of stock or a partnership interest, dividends and goodwill In general, the current version of this subsection in the Regulation provides that if more than 50% of the assets of the underlying corporation that pays a dividend, or corporation/partnership whose stock or interest is being sold by the taxpayer, consist of tangible or real property, then the receipts from the dividend or sale of the asset are assigned based on the average of the payroll and property factors of that corporation/partnership entity. 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. In the draft language for the 4th IPM, the FTB removed cash and cash equivalents from the 50% test. The draft language added a safe-harbor when the information for the 50% test is not obtainable by allowing receipts to be sourced based on commercial domicile of the underlying corporation. In the 4th IPM, commenters expressed their view that the removal of cash from the test was both surprising and not a reasonable exclusion. While using tax basis is potentially more administrable than fair market value, the exclusion of cash does not reflect the value within the company, and cash makes it easier to determine current value. The FTB stated that they had intended to remove items without a tax basis from the test. Commenters appreciated the safe-harbor language, however, they questioned whether commercial domicile of the underlying corporation was necessarily a reliable answer. Additionally, commenters questioned how much effort would be required to establish the 50% test before commercial domicile would be allowed under the safe-harbor. Commenters also asked whether the 50% test should apply to dividends at all. The concern relates to whether applying these rules to dividends could result in unsuspecting individuals or entities establishing economic nexus under CR&TC Section 23101 simply because the underlying payor of the dividend has sales or activities in California. Asset management fees In its language for the 3rd IPM, the FTB deleted its previously proposed asset management examples and instead determined that a new set of assignment rules, specific to asset managers, would be more appropriate. The new assignment rules were 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 was 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 was because the examples were becoming too complicated. Under these new provisions, the benefit of the asset management services is deemed to be 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. For the 4th IPM, the FTB again adjusted the method for asset managers and provided additional clarification as well as new examples. The FTB added specifics to the definition of "beneficial owner," applying separate rules to master fund and feeder funds and shareholders of publicly-traded corporations. The language excludes feeder funds from the definition of beneficial owners, stating that these funds do not make independent decisions and are required to invest. Shareholders of a corporation are likewise not beneficial owners, as the corporation — not the shareholder — makes the decision to invest. The language also excludes participants of a defined benefit plan for similar reasons. The FTB also proposed revised rules that differed from the 3rd IPM, including removing the US population as a presumptive approximation when lacking. In these changes, however, the FTB continues to focus on "beneficial owner" and a look-through approach to source revenues to the ultimate investor. The language sources the receipts to the investor's domicile, or to the domicile of the "beneficial owners" if the investor is holding title to the assets for a beneficial owner. To determine the amount sourced to California, the draft language provides a methodology whereby the asset management service receipts will be multiplied by the ratio of the value of assets held by California domiciled investors or "beneficial owners" over the total value of assets. If the value of assets of California domiciled investors is unknown, the draft language proposed that it should be approximated. Extensive examples of this calculation are also included in the new draft language. In the 4th IPM, the FTB noted that removing the US population rule from the previous draft language did not exclude use of population, but rather, the FTB considered it a form of reasonable approximation under the new language. Commenters discussed whether the "beneficial owner" definition and rules sufficiently applied the benefit to the "purchaser" as described in the statute. The statute uses the word "purchaser," while the regulation uses the terms "customer" and "beneficial owner." The FTB responded that they saw "purchaser" and "customer" as synonymous, but saw "beneficial owner" as merely a proxy for determining the location of the benefit to the purchaser. Commenters queried whether "asset management services" were defined anywhere, and the FTB stated that they were not, nor did they refer to definitions elsewhere in the California statutes or regulations. As discussed below, commenters discussed whether these rules and the application thereof would be applied retroactively when the regulation is finally adopted. The FTB did not state whether they intended to attempt to apply the methodologies retroactively, but did mention that earlier drafts used similar language potentially indicating the FTB might attempt some level of retroactivity. Modification to cascading rules for sourcing of intangible assets In the draft language, the FTB proposes to remove the third cascading rule related to billing address and its related example for the sourcing of revenues from intangible assets. The draft language's explanation states that "reasonable approximation" allows consideration of "all other information" and a separate cascading rule for billing address is not necessary. During the 4th IPM, the FTB stated that the removal of billing address was not intended to remove billing address as a possible sourcing method, but rather that it should only be applied if reasonable as a method of reasonable approximation. Another area discussed during the IPM related to clarification of location of use. 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 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). This new rule seems to directly contradict the main rule that the location for assignment should be related to the purchaser and not the seller. A commenter raised this to FTB as a possible area that needs further work. For the 4th IPM, the FTB also added an example applying this rule to research and development (R&D) upfront payments for the development of pharmaceuticals. The example reasoned that if the R&D company is continuing research in California, the upfront payment should be sourced to California as the location where that license is continued to be used. Arguably, such a rule does not reflect the intent of the statute, as the license is generally for the potential right to sell the pharmaceutical not research it, and the rule in the example is more akin to a cost of performance approach. Changing reasonable approximation method The current Regulation has language requiring a taxpayer using reasonable approximation or customer location for marketable securities as a sourcing method to request a change from the FTB before using a different method. The draft language for the 4th IPM adds that the taxpayer must notify the FTB of its new method and provide a brief description of the method in the manner prescribed by the FTB. In the 4th IPM, some commenters stated that the FTB did not clarify the level of change that would be deemed a change in method nor address the repercussions for changing the method without prior permission from the FTB. Commenters suggested disclosure as a substitute for requesting permission. Effective date of proposed changes A commenter at the 4th IPM asked whether the FTB had considered an effective date, especially with respect to the proposed asset management assignment rules. The FTB said it was not prepared to propose an effective date yet since it expects additional changes to the proposed language based on this IPM. However, the FTB noted that it discussed the asset management fee issue at the 1st and 2nd IPMs, which seems to imply the FTB may still press for retroactive application of these provisions.2 The FTB seemed to consider using terminology such as "applicable date" in an attempt to differentiate from the effective date requirements for regulations. 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 discussed at the 4th IPM contain some of the most sweeping and far-reaching revisions of the rule to date, and, if approved, would essentially affect almost every industry. The continued inclusion of the proposed presumptions 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. The proposed draft language that focuses on location of performance or location of the customer's customer may require further modification of the methodologies. 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 likely be another IPM, although the timing for this 5th IPM was not provided. We will continue to monitor the discussions and issue Tax Alerts as the regulatory process continues. ———————————————
——————————————— 1 The initial notice stated a comment deadline of August 19, 2019, however EY has confirmed with the FTB that the intended deadline is September 19, 2019. 2 CR&TC section 19503 requires that a regulation can only apply to a tax year after taxpayers are given "notice substantially describing the expected contents of any regulation is issued to the public." | |||||||||||
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