A California Court of Appeal held that San Francisco may not impose a documentary transfer tax on the value of an existing 41-year leasehold interest upon the sale of the underlying property because the leasehold interest does not constitute “realty sold”. The taxpayer owned a commercial building and agreed to lease the ground floor to a separate business for 45 years. Upon recording the lease with the city and county of San Francisco, the taxpayer paid a real property transfer tax based on the value of the stream of rental payments due over the life of the lease. Six years later when the taxpayer sold the building, including the lease, it again paid the transfer tax and sought a refund for the amount paid based on the value of the payments due from the lessee during the remaining 41 years of the lease on the grounds the existing leasehold interest did not constitute “realty sold”.

The appellate court agreed with the taxpayer, holding that San Francisco cannot impose a documentary transfer tax on an existing leasehold interest with a remaining term of more than 35 years. Applying previous California decisions interpreting “realty sold”, the court looked to definitions of “change in ownership” as used in property tax provisions and found that a leasehold interest will be considered “realty sold” where there is a “creation of a leasehold interest in taxable real property for a term of 35 years or more.” Because the 41-year leasehold interest at issue was transferred, not created, the court concluded that the interest did not constitute “realty sold” and was not subject to the tax.

731 Mkt. St. Owner, LLC v. City & Cty. of San Francisco, No. A154369 (Cal. Ct. App. June 18, 2020).

On June 30, 2020, a California Court of Appeal affirmed a trial court decision that held the California Constitution’s requirement that local taxes be approved by a supermajority vote does not apply to taxes imposed by voter initiative. For background on the case and coverage of the trial court’s decision, see our prior Legal Alert.

The Court first addressed the claim that Article XIIIA, section 4 of the Constitution, which provides that “Cities, Counties and special districts” may impose certain special taxes “by a two-thirds vote of the qualified electors of such district,” applies to voter initiated taxes. The Court concluded that this provision “does not repeal or otherwise abridge by implication the people’s power to raise taxes by initiative, and to do so by majority vote.” Next, the Court addressed the argument that Article XIIIC, section 2(d), which precludes a “local government” from imposing, extending or increase a special tax absent approval by a two-thirds vote, likewise applies to taxes proposed by voter initiative. The Court rejected this argument as well, applying the reasoning of the California Supreme Court in California Cannabis Coalition v. City of Upland (a case interpreting a similar provision of the state Constitution) and concluding that the text of Article XIII, section 2 applies only to actions taken by local government.

There are several “Upland” cases currently pending before various California courts challenging, or seeking validation of, voter initiatives passed by a simple majority. This is the first appellate decision, likely priming it to be appealed to the California Supreme Court and giving that court a chance to clarify its decision in Upland.

Meet the newest member of our Eversheds Sutherland SALT Team, Olive, a French bulldog adopted by Partner Michele Borens less than two weeks ago. This Quarantine Frenchie pup is still only about 10 weeks old, but she is already starting to make her presence felt amongst our SALT team.

There was a lot of initial debate between Michele and her daughters on what this adorable puppy’s name should be. Ultimately, her youngest daughter won that debate, and chose the name Olive.

Olive, or “Ollie” as she has affectionately come to be known, has become a regular on SALT team video calls. She is really enjoying her remote orientation to the team. She particularly enjoys nap time, a special perk reserved only for young puppies on the team (no sleeping for SALT members). Another activity that has quickly become one of her favorite times of the day is lunch time, where she enjoys snacking on toes, shoes, tree branches and many other non-edible items.

Michele and Olive have quickly developed a great working relationship. We are excited to welcome Olive to our SALT Team and thrilled to feature her as the June SALT Pet of the Month!

Friday, June 26, 2020 was “Sine Die” or the 40th and final legislative day of the 2019–2020 legislative session at the Georgia General Assembly.

  • The legislative session was suspended since March 13, 2020 but resumed earlier this month for the remaining 11 days of the legislative session.
  • In the last days of the legislative session, the Georgia General Assembly passed key legislation, including conformity to the federal tax law, a new rideshare fee, changes to interest payments on direct pay permit holder’s refund claims, and amendments to the film tax credit.
  • However, bills limiting tax credits and exemptions, eliminating or reducing administrative deference at the Tax Tribunal, legalizing online sports betting, and facilitating contingency fees failed to pass.

Read our full Legal Alert here.

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).