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Closing out a process that began nearly nine years ago, the California Franchise Tax Board (FTB) recently submitted proposed amendments to its market sourcing regulation, California Code of Regulations, title 18, section 25136-2, to the Office of Administrative Law (OAL) for final approval. The version submitted to OAL includes the same simplifying presumptions for sourcing receipts from services, special sourcing rules for receipts from asset management services, and special assignment rule for professional services provided to more than 250 customers that had appeared in recent drafts. The latest version also includes clarifying language regarding how a taxpayer may substantiate where the benefit of a service is received. Additionally, the effective date of the amendments has been revised, with the amendments applicable to taxable years beginning on or after January 1, 2026. Under California’s Administrative Procedure Act, OAL has 30 working days to approve or disapprove the rulemaking action.

See our prior coverage here and here for additional information on the proposed amendments and background on the entire process. 

At long last, the California Franchise Tax Board (FTB) issued a Notice of Proposed Rulemaking today to amend FTB’s market sourcing regulation: California Code of Regulations, title 18, section 25136-2 (“Reg. 25136-2”). This is the latest step in a long journey that began over seven years ago, when FTB held its first interested parties meeting (IPM) on the subject in January 2017. After five additional informal IPMs, each with its own iteration of draft amendments, the governing three-member Board authorized the agency to begin the formal amendment process in September 2021. Now, three years later, that process begins.

The proposed amendments largely mirror those found in the draft circulated in advance of FTB’s last informal IPM in June 2021. Among other things, the amendments include simplifying presumptions for sourcing receipts from services related to real property, tangible personal property, and individuals, special sourcing rules for receipts from asset management services, and a special assignment rule for professional services provided to more than 250 customers. See our prior coverage (here and here) for additional information on the proposed amendments and background on the entire process. If adopted, the amendments will apply to taxable years beginning on or after January 1, 2024.

FTB will accept written comments on the proposed amendments until October 31, 2024. FTB also will hold a public hearing on the draft language if it receives a written request for a hearing at least 15 days prior to the close of the comment period.

On June 4, 2021, the California Franchise Tax Board (“FTB”) held its sixth interested parties meeting (“IPM”) to discuss the latest proposed amendments to FTB’s market-based sourcing regulation, Cal. Code Regs., Title 18, Section 25136-2.  At the IPM, FTB staff provided an explanation of the newly-proposed regulation language, which includes:

  1. A definition of “asset management services;”
  2. A definition of “professional services” that includes “management services, tax services, payroll and accounting services, … legal services, business advisory consulting services, [and] technology consulting services,” among others;
  3. A special assignment rule for “professional services” providing for the use of a customer’s billing address where the taxpayer provides “substantially similar professional services” to more than 250 customers;
  4. A change to the applicability date of the amendments to taxable years beginning on or after January 1, 2023; and
  5. The removal of a proposed election to apply the amendments retroactively.

Responding to a comment that some taxpayers already have taken return positions consistent with the proposed amendments based on the now-deleted retroactive election provision, Staff reiterated that under the latest draft, the amendments are intended to apply prospectively only.

Please see our previous posts here and here for additional background on FTB’s proposed amendments to the market-based sourcing regulation.  FTB will accept written comments on the proposed regulation language until July 5th and will release a summary of the comments received after that date.  There was no discussion about whether FTB’s next step will be to issue another round of proposed amendments or proceed to the formal rulemaking process.

On Friday, June 4, 2021 at 10:00 a.m. PST, the California Franchise Tax Board (“FTB”) will hold its sixth interested parties meeting (“IPM”) to discuss its latest proposed amendments to the market-based sourcing regulation, Cal. Code Regs., Title 18, Section 25136-2. At the IPM, FTB will discuss and solicit public input on the newly-proposed regulation language and will walk through FTB’s explanation of the new language. Additional information on the IPM, including how to dial-in, is available here.

Please see our previous posts here and here for background on FTB’s proposed amendments to the market-based sourcing regulation. We will provide additional coverage after the meeting.

 

On December 18th, the three-member Board of the Franchise Tax Board (FTB) will hold its final quarterly meeting of 2020.  At the meeting, the Board will consider the 2021 Rulemaking Calendar.  The Calendar contains the agency’s schedules for its administrative rulemaking processes on various regulation projects.  Two significant corporate franchise tax regulation projects on the Calendar include amendments to California’s market-based sourcing regulation, FTB Regulation 25136-2 and California’s alternative apportionment regulation, FTB Regulation 25137.

FTB’s 25136-2 regulation project aims to provide more clarity and detail surrounding the state’s market-based sourcing regime for sales of services and intangibles.  The most recent iteration of the proposed regulation provides additional guidance around terms used in the regulation and provides new sourcing rules for specific industries. The draft language also includes new presumptions for sourcing sales of services to business and government entity customers based on the type of services performed.  For a more detailed discussion of the 25136-2 regulation project, please see our previous post: How Does California Source Sales of Services and Intangibles for Apportionment Purposes?

The 25136-2 regulation project has been ongoing since 2017 and FTB has held five interested parties meetings to obtain public comment on different iterations of the proposed amendments.  Those meetings were contentious at times as FTB’s proposed changes have raised significant questions on both substantive and procedural issues, including the effective date of the final regulation. The proposed 2021 Rulemaking Calendar provides that this regulation project will be completed by spring 2021 and that the regulation will be finalized by fall 2021.

Next, FTB’s 25137 regulation project is intended to provide guidance on the state’s process for petitioning the Board to use an alternative apportionment formula.  The latest iteration of the proposed regulation provides guidance on how taxpayers can preserve their rights and privacy during the alternative apportionment petition process.  For a more detailed look at the 25137 regulation project, please see our previous post: The Long Road to Clarity: FTB Holds Latest Meeting in Multiyear Project to Clarify Alternative Apportionment Petition Process.

This regulation project also has been ongoing since 2017 and FTB has held a total of four interested parties meetings on the proposed amendments.  The proposed Rulemaking Calendar provides that this regulation project will be completed in late spring 2021 and that the regulation will be finalized by late 2021.

The Board meeting is open to the public and will be hosted virtually.  Information on how to attend the meeting is available here, and interested parties have the opportunity to make comments at the meeting.  Please contact the Eversheds Sutherland SALT team if you have questions or concerns about these draft regulations or the meeting process.

California uses market-based sourcing to apportion sales of other than tangible personal property to the state. Under the governing statute, sales of services are sourced to California to the extent the purchaser of the service receives the benefit in the state.1 Sales of intangible personal property are sourced to California to the extent the property is used in the state.2 The California Franchise Tax Board (FTB) also has also issued regulations within Code of Regulations, Title 18, section 25136-2 (“Section 25136-2”) which provide guidance for determining where the benefit of the service is received and where the intangible property is used.3

In 2017, FTB started a new regulation project to amend the market-based sourcing rules in Section 25136-2.4 Over the past few years, FTB has held four interested parties meetings to obtain public comment on different iterations of the proposed amendments. This regulation project aims to provide more clarity and detail surrounding the state’s market-based sourcing regime for sales of services and intangibles. For instance, FTB’s latest version of the proposed amendments includes simplified sourcing rules for service receipts from business and government entity customers and provides specific sourcing rules for certain industries.5

Sourcing Sales of Services

Under existing Section 25136-2, the “benefit of a service is received” within California when “the taxpayer’s customer has either directly or indirectly received value from delivery of that service” in the state.6 The regulation provides cascading rules to determine where a customer receives value from delivery of the service. There are separate sets of rules depending on whether the taxpayer’s customer is an individual or a business entity.

Individual Customers

First, where an individual is the taxpayer’s customer, the benefit of the service is presumed to be received at the customer’s billing address.7 A taxpayer may overcome the presumption by showing that either the contract with its customer or its books and records kept in the normal course of business demonstrate where the benefit is received. If neither of the first two rules apply, the location where the benefit is received will be reasonably approximated.8

Business Entity Customers

Alternatively, where a business entity is the taxpayer’s customer, the first rule provides that the benefit of the service is presumed to be received at the location indicated by the contract between taxpayer and its customer or the taxpayer’s books and records kept in the normal course of business.9 Unlike the presumption for individual customers, this rule does not consider the business customer’s billing address. Either the taxpayer or FTB may overcome the presumption for business customers by showing that the location indicated by the contract or by taxpayer’s books and records was not the actual location where the benefit was received.10

The second rule uses “reasonable approximation” to determine the location where the benefit is received.11 The regulation includes examples of “reasonable approximation.” In one example, “Web Corp” provides internet content to viewers and receives revenue from advertising services. Web Corp uses a ratio of its viewers in the state to its viewers everywhere for reasonably approximating where its advertisements are viewed or clicked on (i.e., where the benefit of the services is received).12 In practice, though, FTB auditors often default to using the ratio of the California population to the entire U.S. population when applying “reasonable approximation”.

If the location of the benefit cannot be determined using the first two cascading rules, the benefit is presumed to be received at the location from which the customer placed the order for taxpayer’s services.13 Finally, if the location of the benefit cannot be determined through any of the above rules, the fourth and final rule provides that the benefit is received at the customer’s billing address.14

As discussed in more detail below, FTB’s proposed amendments to Section 25136-2 substantially alter the sourcing rules for services provided to business entity customers.

Sourcing Sales and Licenses of Intangibles

Sale of Intangibles

Sales of intangible property are sourced to California to the extent the property is used in the state.15 As with services, current Section 25136-2 sets forth cascading rules to determine where intangible property is used. For transactions involving the complete transfer of all property rights in an intangible, the first rule presumes the location of use to be in California if either the taxpayer’s contract with the customer, or the taxpayer’s books and records kept in the normal course of business indicate the property is used in California at the time of the sale.16 The taxpayer or FTB may overcome the presumption by showing that the actual location of use is inconsistent with the contract or books and records. The regulation provides additional rules for sales of intangible property such as shares of corporate stock, ownership interests in a pass-through, sales where gross receipts from the intangible property are dividends or goodwill, and sales where gross receipts from the property are interest.17 For example, interest from investments is assigned to where the investment is managed.

The second rule uses “reasonable approximation” of the location where the intangible property is used.18 Finally, if the location of use cannot be determined under either of the first two rules, the third rule provides the sale is assigned to the location of the customer’s billing address.19

License or Lease of Intangibles

Alternatively, the regulation provides specific rules for the licensing, lease, rental or use of intangible property, not including the sales of intangibles described above.20 First, the regulation addresses license of “Marketing Intangibles”, which includes “license of a copyright, service mark, trademark, or trade name where the value lies predominantly in the marketing of the intangible property in connection with goods, services or other items.”21 Royalties or other fees paid by licensees for use of Marketing Intangibles are sourced to the location of the licensees’ “ultimate customers.”22 Next, the regulation addresses license of “Non-Marketing and Manufacturing Intangibles”, which includes “the license of a patent, a copyright, or trade secret to be used in a manufacturing or other non-marketing process, where the value of the intangible property lies predominately in its use in such process.”23 Licensing fees paid by licensees for use of Non-Marketing Intangibles are sourced to the location where the intangibles are used.24 Finally, the regulation discusses license of “Mixed Intangibles”, which includes the license of intangible property “where the value lies both in the marketing of goods, services or other items . . . and in the manufacturing process or other non-marketing purpose[.]”25 Similar rules to those described above for sales of intangible property apply in determining the locations of “ultimate customers” and locations where intangible property is used.26

FTB’s Market-Based Sourcing Regulation Project

As mentioned above, FTB is conducting a regulatory project to amend California’s market-based sourcing rules within Section 25136-2.27 FTB’s most recent iteration of the amended regulation language, issued in July 2019, includes additional guidance around terms used in the regulation and provides new sourcing rules for specific industries. For instance, the draft language now includes specific rules for sourcing asset management receipts to the location where the investor is domiciled, or to the beneficial owner’s domicile when an investor is holding title to the assets for the beneficial owner.28 There are also a number of new examples involving asset management services.

The draft language also includes new presumptions for sourcing sales of services to business and government entity customers based on the type of services performed.29 For example, if the service is related to real property, the benefit of the service is presumed to be received at the location of the real property. If the service is related to intangible property, the benefit is presumed to be received where the intangible property is used by the customer. There are also specific presumptions for sourcing services related to tangible personal property, individuals and mixed services. The taxpayer or FTB may overcome these presumptions by showing that the benefit of the service is received at another location. Assignment of sales based on these rules must be “substantiated” using the taxpayer’s contracts or books and records, or by use of “all sources of information” which is reasonably available to the taxpayer. Further, if services provided under U.S. government contracts cannot be sourced using any of these rules, then the receipts are sourced to California based on the ratio of the California population to the entire U.S. population.

This year, FTB is expected to hold its fifth interested parties meeting to discuss the latest round of proposed amendments.

Conclusion

To date, FTB has only issued limited and sporadic administrative guidance interpreting Section 25136-2.30 There also has yet to be a corporate income tax case interpreting Section 25136-2. However, in the Appeal of Christopher Wood, the California Office of Tax Appeals (OTA) applied Section 25136-2 in the context of a personal income tax case.31 The taxpayer was a Texas sole proprietor who provided user-experience services to a California based LLC, including services to assist the LLC’s customers in designing software and technology products. In its decision, OTA noted that Section 25136-2’s sourcing provisions “appear to focus on the location where a taxpayer’s direct customer received the benefit of the services.”32 Nevertheless, OTA asserted that “there may be circumstances where the benefit of the taxpayer’s services will be received by the customer’s own customer” and applied Section 25136-2 to source the benefit of the taxpayer’s user-experience services to the locations of the LLC’s customers (i.e., the taxpayer’s customer’s customers).33

California’s rules for sourcing sales of services and intangible property are complex and involve a multi-step analysis. It can be difficult for some taxpayers to determine which cascading rule applies to their sales of services or intangibles. FTB is currently working to issue amended regulations which are anticipated to deliver more clarity and specific sourcing rules for taxpayers. Please contact any member of Eversheds Sutherland’s SALT team should you have any questions regarding California’s market-based sourcing rules.

1 Cal. Rev. & Tax. Code § 25136(a)(1).
2 Id. § 25136(a)(2).
3 See 18 Cal. Code Regs. § 25136-2.
4 See Franchise Tax Board, Discussion Topics and Explanation of Draft Language Amending California Code of Regulations, Title 18, (CCR) Section 25136-2, available at https://www.ftb.ca.gov/tax-pros/law/regulatory-activity/07192019-Discussion-Topics.pdf.
5 See id.
6 18 Cal. Code Regs. § 25136-2(b)(1).
7 Id. at (c)(1)(A).
8 Id. at (c)(1)(B).
9 Id. at (c)(2)(A).
10 Id.
11 Id. at (c)(2)(B).
12 Id. at (c)(2)(E)(5).
13 Id. at (c)(2)(C).
14 Id. at (c)(2)(D).
15 Id. at (d)(1).
16 Id. at (d)(1)(A).
17 Id. at (d)(1)(A)(1)-(2).
18 Id. at (d)(1)(B).
19 Id. at (d)(1)(C).
20 Id. at (d)(2).
21 Id. at (b)(4)(A).
22 Id. at (d)(2)(A)(1).
23 Id. at (b)(4)(B).
24 Id. at (d)(2)(B)(1).
25 Id. at (b)(4)(C).
26 See id. at (d)(2)(A)(1)-(2); id. at (d)(2)(B)(1)-(3).
27 See Franchise Tax Board, Discussion Topics and Explanation of Draft Language Amending California Code of Regulations, Title 18, (CCR) Section 25136-2, available at https://www.ftb.ca.gov/tax-pros/law/regulatory-activity/07192019-Discussion-Topics.pdf.
28 See id.
29 Franchise Tax Board, Draft Language Amending California Code of Regulations, Title 18, (CCR) Section 25136-2, available at https://www.ftb.ca.gov/tax-pros/law/regulatory-activity/07192019-Draft-Language.pdf.
30 For example, in Chief Counsel Ruling 2017-01 and Chief Counsel Ruling 2015-03 FTB addressed market-based sourcing rules for certain non-marketing services as applicable to specific taxpayers. Note that FTB Chief Counsel Rulings are only authoritative with respect to the named taxpayer in the Ruling.
31 Appeal of Christopher Wood, 2019-OTA-264 (July 8, 2019) (nonprecedential).
32 Wood at 9 (ital. in orig.).
33 Id. at 9-10.

On December 1, 2011, the California Franchise Tax Board (FTB) approved Proposed Regulation 25136-2, which implements a market rule for sourcing receipts from sales of services and intangibles for those taxpayers electing a single sales factor apportionment formula. The Proposed Regulation now moves to the Office of Administrative Law to be finalized. The FTB’s decision follows a nine-month interested parties process and a regulatory process that began in June 2011.

Proposed Regulation 25136-2 applies a series of cascading rules, establishing separate rules for receipts from: 

  1. Sales of services to individual customers; 
  2. Sales of services to businesses; 
  3. Complete sales of intangibles; and 
  4. The licensing, leasing, rental, or other use of intangibles.

Continue Reading California Franchise Tax Board Decides Fate of Proposed Market Sourcing Regulation