In Legal Ruling 2022-01 (March 25, 2022), the California Franchise Tax Board (FTB) sets forth the "relevant considerations and proper analysis" that should be used to determine how to assign gross receipts from the sale of services to business entities under California Code of Regulations, title 18, section 25136-2 (Regulation 25136-2) for the purpose of market-based sourcing rules. Legal Ruling 2022-01 supersedes any prior FTB guidance to the extent there is a conflict and specifically revokes FTB Chief Counsel Rulings 2015-03 and 2017-01.¹

FTB Legal Ruling 2022-01 comes just as the FTB is entering the formal regulatory process on its second round of amendments to Regulation 25136-2 (see Tax Alert 2021-1167). While the proposed amendments to Regulation 25136-2 would apply to tax years beginning on or after January 1, 2023, FTB Legal Ruling 2022-01 reflects the FTB's interpretation of the current version of Regulation 25136-2. With the revocation of two prior Chief Counsel Rulings, the FTB's interpretation of the current version of Regulation 25136-2 with respect to the sale of services to business entities has changed.

In FTB Legal Ruling 2022-01, the FTB lists four questions to answer when applying Regulation 25136-2 to determine where to assign sales of services:

1. Who is the customer?
2. What service is being provided?
3. What benefit is being received?
4. Where did the customer receive the benefit of the service?

Once these questions are answered, the cascading rules in Regulation 25136-2 are applied to determine the location of where the benefit was received for purposes of the sourcing rules.

This framework is applied to three situations in FTB Legal Ruling 2022-01. Situation One involves an event-planning company working remotely from its home office while planning an out-of-state event for a customer located in a third state. Situation Two involves a pharmacy benefits management company that administers drug benefit programs for employers, unions, government entities and health plans, with its primary activity being the processing and fulfillment of prescription drug claims. Situation Three involves a company providing consulting services to entities that want to manage their power consumption used in manufacturing, where a subcontractor based in another state is engaged to advise on certain aspects of a customer's manufacturing plant's power consumption.

For Situations 1 and 3, FTB Legal Ruling 2022-01 concludes that the location where a service is performed does not determine where to assign the gross receipts from the sale of that service. Rather, the gross receipts are assigned to the location where the direct benefit of the service is received by the customer. For Situation 2, FTB Legal Ruling 2022-01 holds that the benefit of the service for the taxpayer's customer is received at the location of the taxpayer's customer's customer.

Implications

Before FTB Legal Ruling 2022-01, FTB guidance reflected the idea that where the benefit of the service is assigned should relate to where the taxpayer's customer receives the benefit of the service, not the location of the customer's customer (unless the service was a "marketing" service). This distinction is rejected in FTB Legal Ruling 2022-01 through the express revocation of FTB Chief Counsel Rulings 2015-03 and 2017-01.

The FTB sets forth a new position in Legal Ruling 2202-01 that expands the use of so-called "look-through sourcing" rules by determining that the location of a taxpayer's customer's customer is the proper location to assign the benefit of the service whenever the service is "directed at" the customer's customer. Specifically, FTB Legal Ruling 2022-01 states:

Common examples of direct engagement include sales and marketing services, customer support services, in-person services involving a third-party contractor, and subcontracting arrangements. As mentioned above, the taxpayer's customer receives a benefit from the services performed even though a third party might also receive a benefit.

In particular, subcontracting arrangements by a business entity with a corporate subcontractor may involve the location of the customer's customer, because the service provided is directed towards persons or things other than the subcontractor's customer. There should be no difference in where gross receipts are assigned when the service is performed by a subcontractor instead of directly by the subcontractor's customer.

This new position may result in many more taxpayers having to "look through" to the location of their customer's customer to assign gross receipts for California sales factor apportionment purposes.

Taxpayers currently involved in an FTB audit or administrative controversy regarding the sourcing of gross receipts from the sale of services should be aware of FTB Legal Ruling 2022-01. The second amendment to Regulation 25136-2 is not final and would not be effective until tax years beginning on or after January 1, 2023. FTB Legal Ruling 2022-01 appears to be the FTB's attempt to interpret the current Regulation 25136-2 in a way that would retroactively reach the same result for the sourcing of services to business entities as proposed in the amendment to Regulation 25136-2.

With the revocation of FTB Chief Counsel Rulings 2015-03 and 2017-01, FTB Legal Ruling 2022-01 is now the sole administrative guidance from the FTB on the sourcing of gross receipts from market-based services provided to business entities. EY will continue to monitor developments regarding FTB Legal Ruling 2022-01 as well as the progress of the second amendment to Regulation 25136-2 as it enters the formal regulatory process.

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ENDNOTES

¹ FTB Chief Counsel Ruling 2015-03 addresses applying market-based sourcing rules for non-marketing services under Regulation 25136-2; FTB Chief Counsel Ruling 2017-01 addresses whether a taxpayer's service is marketing or non-marketing and how to determine where the benefit of a service is received when a taxpayer's service relieves its customer's obligations to another party.