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.
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.
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).
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.