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.

Following up on our recent coverage of the California budget negotiations, on June 29th Governor Newsom signed a package of bills comprising the state’s budget for the 2020-2021 fiscal year. The budget package is composed of the primary budget bills, AB 89 and SB 74, along with numerous budget trailer bills. One trailer bill included in the budget package, AB 85, raises taxes on business taxpayers by suspending net operating loss deductions and limiting the amount of business tax credits that can be claimed annually to $5 million. These provisions are now law for tax years 2020 to 2022.

On June 18, 2020, the Ohio Court of Appeals held that Cincinnati’s excise tax on the gross receipts generated by billboards does not violate the First Amendment to the United States Constitution. The court found persuasive Clear Channel Outdoor, Inc. v. Director, Department of Finance of Baltimore, 223 A.3d 1050 (Md. Ct. Spec. App. 2020), where the Maryland Court of Special Appeals held that that Baltimore’s excise tax on billboards did not violate the First Amendment. That case is on appeal at the Maryland Court of Appeals. Here, the advertising company plaintiffs and the city did not dispute that billboards are a means of speech entitled to First Amendment protection. But the court concluded that Cincinnati’s billboard tax did not offend the First Amendment because the tax: (1) applies to billboards regardless of the message displayed and is, therefore, content neutral; (2) does not threaten to suppress the expression of certain viewpoints; and (3) does not single out a particular group of billboard operators to bear the tax burden.

However, the court concluded that the city violated the First Amendment by prohibiting billboard operators from issuing bills to advertisers displaying the tax or even making indirect statements that the advertisers will absorb the tax. This provision failed to satisfy the intermediate scrutiny standard applicable to commercial speech. This prohibition was broader than necessary to achieve the city’s interest in ensuring that the billboard tax remains an excise tax and not a sales tax. Rather, “a simple disclaimer to the customers would clear up any would-be confusion that the billboard tax remains the operators’ responsibility to pay.”

Lamar Advantage GP Co. v. City of Cincinnati, 2020-Ohio-3377 (Ohio Ct. App. June 18, 2020).

On June 19, the Mississippi House and Senate adopted the conference report on HB 379, bringing the state one step closer to adopting marketplace facilitator legislation. The bill would mandate marketplace facilitators to collect and remit tax on behalf of marketplace sellers if the facilitator makes more than $250,000 in sales into the state in any consecutive 12-month period. The bill excludes from marketplace facilitator collection certain sales by third-party food delivery services. It also allows certain marketplace sellers with over $1B in United States gross sales to contractually agree with marketplace facilitators to retain collection responsibilities. The bill will now go to the governor. If enacted, the legislation would take effect July 1, 2020.

On June 12, 2020, a federal court partially denied Kroger Co.’s motion to dismiss a putative class action complaint regarding Oregon’s bottle deposit on beverages. The complaint alleged that Kroger had misrepresented the cost of certain beverages by charging a ten-cent bottle deposit for beverages that were exempt from the bottle deposit and failing to disclose that the exempt containers could not be returned for a ten-cent refund. Kroger argued that the federal court did not have jurisdiction based on the Tax Injunction Act (TIA), that the plaintiffs failed to allege causation and damages, and that the plaintiffs failed to allege unlawful trade practices or willful conduct necessary for a claim under Oregon’s Unfair Trade Practices Act (UTPA).

The court found that the bottle deposits did not constitute a tax for purposes of the TIA and therefore the TIA did not bar federal court jurisdiction because the bottle deposit does not raise revenue and has only an indirect public benefit. The court further held that principles of comity did not require dismissal of the case because the complaint did not involve a challenge to the bottle deposit statute but was instead a challenge of Kroger’s practice of charging its customers for the deposit on exempt containers. Therefore, the court held that Kroger had not shown why a state court would be in a better position to address the issues presented. The court granted Kroger’s motion to dismiss based on Kroger’s other arguments, but provided the plaintiffs the opportunity to amend their complaint to cure the deficiencies.

Solano v. Kroger Co, Case No. 3:18-cv-01488-AC (D. Or. June 12, 2020).

The Texas Comptroller has delayed until October 2021 the effective date of a new regulation that affects where local sales tax is allocated. The rule, which amends 34 TAC § 3.334, is meant to reduce the portion of sales tax revenue received by localities that host online retailer’s order-processing centers. The current rule generally provides that, when an internet order is received by a seller at a place of business in Texas, the sale is consummated at the place of business at which the order is received, and thus is the situs for local tax imposition. The new rule amends the definition of a seller’s “place of business” to exclude “a computer server, an Internet protocol address, a domain name, a website, or a software application,” which will prevent internet order-processing facilities in the state from being treated as the “place of business” where residents’ orders are received by an in-state retailer.

The Alabama Tax Tribunal held that a taxpayer’s payments to an affiliated entity for employee services were not included in the payroll factor of the apportionment formula for business-income tax purposes because the payments were not made directly to the taxpayer’s employees.

During the years at issue, an Alabama regulation stated that only amounts paid directly to employees were included in the payroll factor. Payments to independent contractors or persons not properly classified as an employee were excluded from the payroll factor. Ala. Admin. Code r. 810-27-4.13(a)(3) (repealed in 2016). Thus, the taxpayer apportioned its income to Alabama with no payroll factor because it had no employees in Alabama or elsewhere. The Department of Revenue, however, adjusted the taxpayers reported payroll factor to include in both the numerator (for Alabama services) and denominator (for total services) the payments to the affiliated entity for the employee services based on prior Administrative Law Division rulings.

Even though prior rulings of the Administrative Law Division (the Tax Tribunal’s predecessor) held that the regulation impermissibly enlarged the statute, the Tax Tribunal concluded that it was not required to follow the rulings because the Legislature did not reference the Administrative Law Division or expressly state that the Tax Tribunal was bound by the Administrative Law Division’s prior decisions. Rather, the Tax Tribunal was established as independent from the Department of Revenue and the Administrative Law Division. Thus, based on the Tax Tribunal review, the language in the regulations was consistent with the statutory provisions. The Tax Tribunal looked to the statutory definition of “compensation,” which was defined as “wages, salaries, commissions any other form of remuneration paid to employees for personal services.” Because the definition stated that compensation is paid “to employees,” the regulation’s language clarifying that payments must be made directly to employees to be considered “compensation” was consistent with the statute. Therefore, the taxpayer’s payments for employee services to its affiliated entity were properly excluded from the payroll factor.

Complete Payment Recovery Servs. Inc. v. Dep’t of Revenue, Docket Nos. BIT. 17-583-LP, BIT. 17-751-LP, BIT. 17-752-LP (A.T.T. Jun.)

Calling all trivia fans! Don’t miss out on a chance to show off your SALT knowledge!

We will award prizes for the smartest (and fastest) participants.

This Week’s Question:
Which Supreme Court justice penned the majority opinion in Quill Corp. v. North Dakota?

E-mail your response to SALTonline@eversheds-sutherland.com.

The prize for the first response to today’s question is a $20 UBER Eats gift card.

Answers will be posted on Monday. Be sure to check back then!

On June 11, Louisiana’s Governor signed SB 138 into law. The law, which takes effect July 1, will mandate sales tax collection and remittance by marketplace facilitators with either $100,000 of in-state sales or 200 in-state transactions. The law (now known as Act 216) excludes from its requirements third-party payment processors, derivatives clearing organizations, advertising services platforms, businesses reselling hotel rooms, certain lodging platforms, and car rental businesses. It also allows certain marketplace sellers with over $1B in annual revenue to contractually agree with marketplace facilitators to retain collections responsibilities. The collected tax must be reported and remitted to a central entity – the Louisiana Sales and Use Tax Commission for Remote Sellers.

In addition, the Louisiana Sales and Use Tax Commission for Remote Sellers approved a draft information bulletin that will provide guidance for marketplace facilitators and sellers under the provisions of Act 216.