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.

These rules begin with a presumption that, if rebutted, requires the taxpayer to move to the next rule in the cascade. For example, receipts from sales of services to individuals and businesses are sourced according to the location where the benefit of the service is received. For individuals, the location of the benefit is presumed to be the customer’s address; and for businesses, the presumption is established based on the taxpayer’s contract with the customer or on books and records. The first tier presumption provides a safe harbor for taxpayers sourcing receipts from sales of services to individuals. However, the presumption may be rebutted by the taxpayer or the FTB for sales of services to businesses. If the presumption is rebutted, the next tier requires a reasonable approximation of the location of the benefit.

Receipts from sales involving a complete transfer of intangible property are assigned to the state to the extent the intangible is used in the state. A rebuttable presumption is created based on the location of use identified in the contract between the taxpayer and the purchaser, or the taxpayer’s books and records. This rebuttable presumption can be overcome by either the FTB or the taxpayer. As with services, the next tier rule involves reasonably approximating the location of use of the intangible.

Receipts from licensing, leasing, rental or other use of non-marketing or manufacturing intangibles—patents, copyrights, or trade secrets used in a manufacturing process—also must be sourced to the location where the intangible is used. The taxpayer must determine this location by reviewing its contract with the licensee or its books and records. The taxpayer or the FTB can overcome this presumption by showing that this method does not determine the place of use.

The Proposed Regulation acknowledges (in the context of marketing intangibles) that determining the location of ultimate use may be challenging with respect to wholesale sales made by the licensee. The decision to look through to the location of the ultimate customer—rather than the taxpayer’s customer (i.e., the licensee)—is likely to be difficult even when such sales are made at retail, given that the taxpayer may not have detailed information regarding the location of the licensee’s sales. Thus, the feasibility of applying these provisions remains to be seen.