Volume 18 Number 4 December 2011 CALIFORNIA: SINGLE SALES FACTOR AND MARKET-BASED SOURCING Roburt Waldow Irvine 1.949.553.7573 [email protected]
Jessica L. Brown Dallas 1.214.969.5213 [email protected]
On December 1, 2011, the California Franchise Tax Board approved Proposed Regulation 25136-2, which provides detailed market-based sourcing rules for sales of other than tangible property. The proposed regulation is currently under review by the Office of Administrative Law and, when approved, will become a final regulation. Under current California law, market-based sourcing is required only where taxpayers make an annual election to apportion income using a single sales factor (“SSF”) formula. However, efforts are underway to make the use of an SSF mandatory, which some proponents argue will generate upwards of $1 billion in tax revenue for California. It is possible, then, that the market-based sourcing rules in Proposed Regulation 25136-2 will ultimately apply to all California taxpayers who apportion their income. Given California’s high profile in tax-policy trends, the state’s approach to market-based sourcing could have sweeping effects if other states look to the proposed regulation when fashioning their own market-based sourcing rules. Elective Single Sales Apportionment Factor For tax years beginning on or after January 1, 2011, many California taxpayers are permitted to make an irrevocable annual election to apportion income using a single sales factor formula rather than California’s standard three-factor apportionment formula (payroll, property, and sales), which double-weights the sales factor. 1 The election does not apply to taxpayers who derive more than 50 percent of their “gross business receipts” from conducting agricultural business activity, extractive business activity, savings and loan activity, or banking or financial business activity. 2
Rev. and Tax. Code § 25128.5. Rev. and Tax. Code § 25128.
©Jones Day 2011 While use of an SSF is elective, there are current efforts to make it mandatory. 3 On November 21, 2011, Californians for Clean Energy and Jobs introduced a ballot initiative that would make SSF apportionment mandatory, and last month the Think Long Committee on California, a bipartisan think-tank, also indicated that it will offer an initiative containing mandatory SSF apportionment for the November 2012 ballot. 4 Earlier in 2011, and with the strong support of Governor Jerry Brown, a bill was introduced to make the use of an SSF mandatory for many taxpayers. 5 Although the bill was defeated September 9, 2011, on the Senate floor, there is every indication that it will remain a hot political issue, especially with the governor describing current state tax policy as “outrageous and perverse” and advocating for a move to the SSF. 6 More than simply eliminating the elective nature of the current apportionment regime, a shift to a mandatory SSF would also mark a complete shift from cost of performance to marketbased sourcing for receipts from sales of other than tangible property. Market-Based Sourcing Rules and Proposed Regulation Under current law, taxpayers who make the SSF election must source receipts from the sales of services and intangibles, using market-based sourcing, rather than cost-of-performance sourcing. 7 Statutory authority provides that: (1) sales from services are in California to the extent the purchaser of the service received the benefit of the service in California; (2) sales from intangible property are in California to the extent the property is used in California; (3) sales from the sale, lease, rental, or licensing of real property are in California if the real property is located in California; and (4) sales from the rental, lease, or licensing of tangible personal property are in California if the property is located in California. 8 The statute authorizes the Franchise Tax Board to prescribe regulations as necessary or appropriate to carry out the purposes of the statute, and under this authority, the Board has adopted a proposed regulation that provides needed guidance regarding the practical operation of market-based sourcing in California. 3
Proposition 24, placed on the November 2, 2010, ballot by the California Teachers Association, would have mandated the SSF for all California taxpayers, but it was defeated by 58 percent of the vote. California 2010 Election Results, San Francisco Chronicle, available at http://www.sfgate.com/electionresults/2010/11/02/CA/c/i_proposition/i_24_seat_24/b_ballot_issue/c/california.shtml (web sites herein last visited Dec. 14, 2011). 4
Nathan Gardels and Nicolas Berggruen, A Blueprint to Renew California, Huffington Post, Nov. 20, 2011, available at http://www.huffingtonpost.com/nathan-gardels/a-blueprint-to-renew-cali_b_1104021.html. 5
California S.B. 116 (de Léon), introduced on Jan. 19, 2011.
Michael B. Marois and James Nash, Brown Seeks California Sales-Tax Cut on Manufacturing Gear to Spur Jobs, Bloomberg, Aug. 25, 2011, available at http://mobile.bloomberg.com/news/2011-08-25/brown-seekscalifornia-sales-tax-cut-manufacturing-equipment.html. 7 8
Rev. and Tax. Code § 25136. Id.
©Jones Day 2011 Proposed Regulation 25136-2 is intended to provide taxpayers with additional guidance on how to determine where the benefit of a service is received and where intangibles are used by the purchaser of the taxpayer’s services or intangibles. The Franchise Tax Board held three interested-party meetings to discuss the proposed regulation. At the initial meeting on February 20, 2010, the staff presented a 50-state analysis of other states’ provisions for sourcing of sales of services and intangible property and received considerable public input. Subsequent meetings were held on July 19, 2010, and November 8, 2010. The main concerns raised at the interested-party meetings related to how taxpayers could document their transactions to determine where the benefit of a service is received or where intangibles are used. Additionally, taxpayers raised concerns about how sales could be appropriately sourced in the event there was no documentation available to the taxpayer. In response to public comments, the draft regulation was revised numerous times. On December 1, 2011, the proposed regulation was approved by the Franchise Tax Board. Before becoming final, it must be approved by the Office of Administrative Law. The national trend is to market-based sourcing of services and intangibles. Currently eight states have adopted market-based sourcing rules, five of those becoming effective in the last three years. 9 As California is a tax-policy bellwether state, the proposed regulation, when formally adopted, may become the national model for applying market-based sourcing rules. Thus, taxpayers in other states would be well served to become familiar with California’s proposed regulation. Proposed Regulation 25136-2 Sales From Services Assignment of sales from “services” is based on the “extent” that the “benefit of the service” is received in California by the taxpayer’s customer. The regulation creates cascading assignment rules to direct sourcing of the benefit of the service. The term “service” is defined as activities engaged in by one for another for consideration. As defined by the proposed regulation, “benefit of a service is received” is the location where the taxpayer’s customer has either directly or indirectly received value from the delivery of a service. The definition excludes activities outside the taxpayer’s regular course of business as well as activities undertaken for other members of the taxpayer’s unitary business. The definition of “extent” makes clear that a receipt is to be divided proportionately between states when it relates to activities in more than one state according to the portion of the benefit of the services received in California.
California (effective in 2011), Oklahoma (effective in 2010), lllinois (effective in 2009), Utah (effective in 2009), Wisconsin (effective in 2009 for intangible receipts and 2005 for service receipts), Maine (effective in 2007), Ohio (effective in 2004), and Minnesota (effective in 1987).
©Jones Day 2011 Individual Customers Where the taxpayer’s customer is an individual, the primary rule for assigning sales of services is based on the billing address of the customer. This is a safe-harbor rule, so that if the taxpayer uses the individual customer’s billing address as the mechanism for assignment of the sales, the Franchise Tax Board must accept the assignment as presumptively correct. When the taxpayer establishes by a preponderance of evidence that the sales contract between the taxpayer and its customer and/or the taxpayer’s books and records kept in the regular course of its business indicate the extent to which the benefit of the service was received in California, assignment may be made on this basis. However, the Franchise Tax Board has the right to audit the alternative method to determine whether or not the taxpayer has overcome the presumption that the benefit of the service was received at the customer’s billing address and that the taxpayer’s method reasonably reflects where the benefit of the service was received by the taxpayer’s customers. If the assignment cannot be determined under the alternatives discussed above, the determination of the location must be reasonably approximated. Importantly, once a taxpayer has used a particular reasonable-approximation method under any provision of the regulation, the taxpayer must continue to use that method in subsequent taxable years. To use a different method, the taxpayer must seek permission of the Franchise Tax Board. Sales to Businesses The first rule of assignment for sales of services to corporations or other business entities presumes that assignment is based on the contract between the taxpayer and the taxpayer’s customer or on the taxpayer’s books and records, notwithstanding the billing address of the taxpayer’s customer. This presumption may be overcome if either the taxpayer or the Franchise Tax Board proves by a preponderance of the evidence that the contract and the books and records do not indicate the actual location of where the benefit of the service was received. The second rule of assignment is based on a reasonable approximation of the location where the benefit of service is received, by reference to the activities of the taxpayer’s customer. The second rule applies only if the presumption in the first assignment rule is overcome. If the first two rules cannot be used to source the benefits of service, the location from which the taxpayer’s customer placed the order for the service is the third-priority sourcing rule. This final-priority rule of assignment is based on the taxpayer’s customer’s billing address. The rule is a catch-all that applies only if none of the other rules can establish the location where the benefit of the services was received. Sales From Intangible Property As a general rule, sales of “intangible” property are assigned to California “to the extent” the “intangible property is used” in the state. “Intangible” is defined by a list of 22 specific terms and ends with the catch-all “other similar intangible assets.” The phrase “intangible personal property is used” is defined as the location where the intangible property is employed by the taxpayer’s customer or licensee. The definition of “to the extent” makes clear that a receipt is to
©Jones Day 2011 be divided proportionately between states when it relates to activities in more than one state according to the portion of the benefit of use of the intangibles in California. Complete Transfer Where a complete transfer of all property rights for a jurisdiction or jurisdictions has been made, assignment will be first based on the contract of sale or the taxpayer’s books and records kept in the normal course of business, if the locations where the purchaser will use intangible property are described in the contract or records. If the contract of sale or the taxpayer’s books and records do not provide information needed to assign the sales, then the location of the use of the intangible property must be reasonably approximated by reference to the activities of the purchaser limited to the jurisdictions where the purchaser will use the intangible at the time of the purchase, to the extent this information is available to the taxpayer. This rule assumes that the purchaser will use the intangible where it is doing business at the time of purchase. This rule also contains a limitation that the taxpayer cannot assign the use of the intangible to places where the purchaser does not conduct its business at the time of purchase. If assignment cannot be made under any of the above methods, the billing address of the purchaser will be used as a catch-all rule of assignment. Where the sale of intangible property is the sale of shares of stock in a corporation or the sale of an ownership interest in a pass-through entity, other than sales of marketable securities, special rules apply. 10 In the event that fifty (50) % or more of the amount of the assets of the corporation or pass-through entity sold, determined on the date of sale and using the original cost basis of those assets, consist of real and/or tangible personal property, the sale of the stock or ownership interest will be assigned by averaging the payroll and property factors of the corporation or pass-through entity in this state for the most recent twelve (12) month taxable year prior to the time of the sale to the extent indicated by the taxpayer’s books and records kept in the normal course of business. If, however, the sale occurs more than six (6) months into the current taxable year, then the average of the current taxable year’s payroll and property factors shall be used. In the event that more than fifty (50) % of the amount of the assets of the corporation or pass-through entity sold, determined on the date of the sale and using the original cost basis of those assets, consist of intangible property, the sale of the stock or ownership interest will be assigned by using the sales factor of the corporation 10
Draft Reg. § 25136-2(d)(1)(A)1.
©Jones Day 2011 or pass-through entity in this state for the most recent twelve (12) month taxable year prior to the time of the sale to the extent indicated by the taxpayer’s books and records. If, however, the sale occurs more than six (6) months into the current taxable year, then the current taxable year’s sales factor shall be used. Thus, unlike the standard market-based sourcing rules for other types of intangibles, which default to a review of sales contracts or the taxpayer’s books and records, the special rules for stock look instead to cost basis and apportionment detail of the corporation or pass-through entities whose stock is being sold. While this souring rule may be administratively feasible for majority owners who have access to cost basis and apportionment detail for the entities being sold, it is very likely that minority interest owners will not have access to this type of information and will not be able to appropriately source the receipts from sales of stock. The proposed regulation does not have a fallback or catch-all provision for sourcing stock sales, making it virtually impossible for many taxpayers to comply. This issue has been raised with the Franchise Tax Board. While no action is expected to address this gap before the proposed regulation is finalized, the Franchise Tax Board has indicated that it will seek approval to amend the regulation once it has become final. In the meantime, interim guidance on this issue is sorely needed for 2011 tax returns. Licensing, Leasing, Rental, or Other Use of Intangible Property Marketing Intangibles The proposed regulation creates specific sourcing rules for the sourcing of so-called “marketing intangibles.” As defined by the proposed regulation, “marketing intangibles” are sales where a license is granted to use intangible property in connection with the marketing of goods, services, or other items to customers in this state. “Marketing intangibles” are assigned to the location of the retail customers who purchased the goods. Under the first rule of assignment for “marketing intangibles,” the contract between the taxpayer and the licensee, or the taxpayer’s books and records, will establish the extent to which the goods are purchased by retail customers in California. If the contract does not provide the information required for assignment, the location of the use of the intangible may be reasonably approximated by reference to the activities of the licensee. In determining the licensee’s use of intangible property in connection with “marketing intangibles,” factors to be considered include the number of licensed sites in each state; the volume of property manufactured, produced, or sold in each state; or other data, including population. Where a licensee does not sell directly at retail, the taxpayer may use the percentage of California’s population to the total population of the geographic area in which the licensee markets its goods. This allows sourcing of licenses where neither the taxpayer nor the licensee would be able to determine where retail sales occur.
©Jones Day 2011 Non-Marketing Intangibles The proposed regulation also creates specific sourcing rules for the sourcing of “nonmarketing and manufacturing intangibles.” “Non-marketing intangibles” is defined as intangible property used in a manufacturing process or for another non-marketing purpose. “Non-marketing intangibles” are assigned to the location where the intangible property is used, i.e., the manufacturing plant or other place of use, rather than the location of the ultimate consumer who purchases the manufactured product. The first rule of assignment looks to the contract between the taxpayer and its licensee, or the taxpayer’s books and records, to source sales of “non-marketing intangibles.” Both the taxpayer and the Franchise Tax Board can overcome the presumption that the contracts or books and records reflect the extent of the use of the intangible property in California. The second rule of assignment requires that the location of use be reasonably approximated by reference to the activities of the licensee to the extent this information is available to the taxpayer. If this cannot be done, a third-priority rule of assignment uses the licensee’s billing address to source the use of the intangible. Mixed Intangibles In the case of “mixed intangibles,” where a license is granted for the right to use intangible property in both a marketing and manufacturing or other non-marketing purpose, separately stated fees will be accepted if they are reasonable; in such case, the rules described above with respect to each type of intangibles apply. Where the fees are not separately stated, then it is presumed that the fees are paid entirely for the intangible property in connection with the marketing of goods, services, or other items, and assignment will be determined accordingly. California Large Corporate Understatement Penalty and Reasonable Approximation The proposed regulation creates considerable flexibility for taxpayers applying the market-based sourcing rules. Flexibility exists where taxpayers interpret contracts and books and records in order to source sales, or where taxpayers must attempt to reasonably approximate the location of benefit of service or the location of use of intangibles. However, it is important to note that taxpayer positions can be audited and the Franchise Tax Board can disagree. California imposes a 20 percent penalty on underpayments of tax liability when the underpayments exceed the greater of $1 million or 20 percent of the tax shown on the original return. 11 While the flexibility of the market-based sourcing regulation is generally seen as a positive for taxpayers making complicated sourcing determinations, taxpayers could ultimately be penalized where this flexibility intersects with the strict-liability large corporate understatement penalty. Under SSF apportionment, a change to market-based sourcing determinations, alone or coupled with other miscalculations by the taxpayer, could easily result in the imposition of the large corporate understatement penalty.
Rev. and Tax. Code § 19138.
©Jones Day 2011 Conclusion The market-based sourcing rules approved by the Franchise Tax Board on December 1, 2011 provide California taxpayers much-needed guidance on the new market-based sourcing rules that apply to 2011 returns. The rules afford flexibility by allowing taxpayers who elect to use the SSF apportionment to apply the market-based sourcing scheme to their specific businesses and circumstances. With a potential move to mandatory SSF in California and the trend towards market-based sourcing in other states, California’s proposed Regulation 25136-2 is likely to have far-reaching effects in the coming years. But note, the rules leave open questions, such as the proper sourcing of sales of stock. Taxpayers should consider the large corporate understatement penalty when taking advantage of the flexibility of the market sourcing rules.
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