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A California Superior Court (court) has found California Technical Advice Memorandum 2022-01 (TAM 2022-01) and revised Publication 1050¹ — in which the California Franchise Tax Board (FTB) discussed the application of P.L. 86-272² to activities conducted over the internet — to be "invalid 'underground regulations'" in violation of the California Administrative Procedure Act (APA).³

The San Francisco Superior Court on December 13, in granting American Catalog Mailers Association's Motion for Summary Adjudication, rendered TAM 2022-01 and revised Publication 1050 void, saying both were regulations within the meaning of the California APA but neither was adopted in compliance with the APA's requirements.

Background

In 2022, the FTB issued TAM 2022-01 (the TAM) and revised Publication 1050 (Pub. 1050) to address how out-of-state sellers should apply P.L. 86-272 to common fact patterns as a result of technological advancements (i.e., activities conducted over the internet and telecommuting). The FTB's positions on protected and unprotected internet activities largely followed those expressed by the Multistate Tax Commission (MTC) in the revised Statement of Information concerning practices of the MTC and supporting states under P.L. 86-272 (Statement) without specifically adopting or referencing the Statement. In the TAM, the FTB listed three internet activities it viewed as protected business activities for purposes of P.L. 86-272 and nine internet activities it viewed as unprotected. (See Tax Alert 2022-0281.) Although the TAM did not state an effective date, the FTB applied it retroactively.

American Catalog Mailers Association (ACMA) filed a complaint for declaratory relief in August 2022 and later moved for summary adjudication seeking to have the TAM and Pub. 1050 declared invalid as contrary to P.L. 86-272 and the U.S. Constitution. In response to the motion, the FTB conceded that the TAM and Pub. 1050 "were not enacted as regulations in compliance with the APA … " The FTB argued that the court could not resolve a facial challenge to the constitutionality of the guidance without first determining whether the TAM and Pub. 1050 were "invalid underground regulations." The FTB "acknowledged that if the TAM and [Pub.] 1050 constituted regulations within the meaning of the APA, they would be void." In August 2023, the court denied ACMA's motion, finding that ACMA failed "to show that the TAM and Publication 1050 are facially invalid in their entirety." The court also found TAM 2022-01 and [Pub.] 1050 are generally applicable rules subject to the APA, but nevertheless denied ACMA's motion because it was not brought on those grounds.

In the instant motion, ACMA sought to have the TAM and Pub. 1050 declared "invalid underground regulations."

TAM and Publication qualify as regulations under the APA

In granting ACMA's motion, the court held the TAM and Pub. 1050 are invalid underground regulations,⁴ as they are "generally applicable and describe the manner in which the FTB will apply P.L. 86-272 to out-of-state businesses engaged in interstate commerce over the internet." The court said the APA defines the term regulation very broadly to include "every rule, regulation, order, or standard of general application or the amendment, supplement, or revision of any rule, regulation, order, or standard adopted by any state agency to implement, interpret, or make specific the law enforced or administered by it, or govern its procedure." Citing the California Supreme Court ruling in Tidewater,⁵ the court explained that a regulation subject to the APA has the following identifying characteristics: (1) the agency intends its rule to apply generally, not to a specific case, and (2) the rule must implement, interpret, or make specific the law enforced or administered by the agency.

The court reasoned that the TAM outlined various fact patterns that apply to out-of-state businesses that make sales to California customers and have no other activity in California, while Pub. 1050 provides a general rule for when a business's interaction with customers via its website or app constitutes engaging in business activity with a California customer. The guidance, the court concluded, "articulates general rules that declare how a certain class of cases will be decided."

Further, the court noted the FTB did not dispute that the TAM and Pub. 1050 interpret its application of P.L. 86-272 to out-of-state business. The TAM's stated purpose, the court said, is to determine the internet-related fact patterns to which the protections of P.L. 86-272 apply, while Pub. 1050's purpose is to notify taxpayers "as to how the state will apply the statute" and of the FTB's intent to apply Pub. 1050 uniformly. Moreover, the court noted that the FTB in its own declarants confirmed the TAM and [Pub.] 1050 (1) are generally applicable and (2) interpret its application of P.L. 86-272 to out-of-state businesses.

Additionally, the court rejected the FTB's argument that the TAM and Pub. 1050 do not constitute a "regulation" because they are not a binding rule, finding that a generally applicable rule does not need to be formal or "binding" on the agency or public.

Because the TAM and Pub. 1050 constitute regulations that were not adopted in compliance with APA requirements, they are void.

The court dismissed as moot ACMA's additional arguments that the TAM and Pub. 1050 are invalid because they contradict P.L. 86-272 and the U.S. Constitution and are invalid under Cal. Code of Civil Procedure Section.

Implications

The immediate implication of the court's ruling is that the TAM and the revised version of Pub. 1050 are invalid unless the FTB appeals the court's ruling. The FTB could also begin the formal regulatory process to adopt the TAM's P.L. 86-272 positions. The formal regulatory process would take time to complete and likely would limit the FTB's ability to apply the P.L. 86-272 positions retroactively.

The court's ruling leaves taxpayers with active FTB audits or protests involving the TAM in an uncertain state. Some taxpayers had already been experiencing delays while the FTB waited for the court's ruling in AMCA's. In addition, for some taxpayers, the FTB has issued extensive information requests related to the TAM. Impacted taxpayers are likely to experience further delays while the FTB decides whether to appeal and how to move forward with the current audits and protest involving the TAM.

Because the FTB's TAM followed the MTC's Statement, other states may also be watching how this matter plays out in California and may potentially adjust how they present similar guidance for P.L 86-272.

This California court holding invalidating an FTB Technical Advice Memorandum comes only months after the California Office of Tax Appeals (OTA) disagreed with the FTB's long-standing Legal Ruling 2006-01.⁶ Given these recent taxpayer victories challenging the FTB's written guidance, taxpayers could seek to challenge other recent written guidance from the FTB. EY will continue to monitor this case and related FTB activity.

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Published by NTD’s Tax Technical Knowledge Services group; Chris DeZinno, legal editor

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ENDNOTES

¹ For more on the TAM, see Tax Alert 2022-0281.

² P.L. 86-272 is a federal law prohibiting states from imposing state income tax on out-of-state sellers whose in-state activities do not exceed soliciting orders of tangible personal property.

³ American Catalog Mailers Association v. Franchise Tax Board, Case No. CGC-22-601363 (Cal. Superior Ct., San Francisco Cnty., Dec. 13, 2023).

⁴ As a procedural matter, the court rejected the FTB's argument that ACMA's motion was "improper" because it was not entitled to file multiple summary judgment motions raising the same issue, finding the issues in the two motions differed — determination of whether the TAM and Pub. 1050 are invalid regulations (second motion) or facially unconstitutional (first motion).

⁵ Tidewater Marine Western, Inc. v. Bradshaw, 14 Cal.4th 557 (Cal. S.Ct. 1996).

⁶ See Appeal of Southern Minnesota Beet Sugar Cooperative, OTA Case No. 19034447; 2023 — OTA — 342P (Cal. OTA March 17, 2023).