United States

California FTB adopts long-awaited market-based sourcing amendments

Clarifies sourcing of marketable securities and interest income

TAX ALERT  | 

On Sept. 15, 2016, the California Franchise Tax Board (FTB) adopted amendments to California Reg. section 25136-2, the state’s market-based sourcing rules for sales, formalizing long-proposed changes to the regulation. The FTB held three meetings between 2012 and 2014 among interested parties to obtain feedback and comments from the public regarding various portions of the proposed regulation. Subsequent to those meetings, the FTB began the rulemaking process, with the official notice of proposed rulemaking first published in August 2015.

The final changes relate to four specific sections of Reg. section 25136-2, listed in order of appearance:

  • Definition of marketable securities
  • Assignment rules for dividends and goodwill
  • Assignment rules for interest
  • Assignment rules for marketable securities

These four changes and the operative dates are discussed below.

Definition of marketable securities

The first change relates to a stand-alone definition for the term ‘marketable securities’ as used in California Revenue and Tax Code (CR&TC) section 25136(a)(2) for securities dealer taxpayers. The subsection provided definitions for a securities dealer and marketable securities, incorporating various subsections of section 475. Additional changes include:

  • A commodities dealer will be treated as a securities dealer under the securities dealer definition if the commodities dealer has made a section 475(e) election
  • All contracts to which section 1256(a) applies will be treated as marketable securities

Additionally, amounts received from hedging transactions involving intangible assets that are specifically excluded from gross receipts under CR&TC section 25120(f)(2)(L) are likewise not included in the sales factor for securities dealers.

Assignment rules for dividends and goodwill

Changes were made to the regulation to address the sale of intangible property where there has been a complete transfer of all property rights. Language has been added to provide that where gross receipts from intangible property are dividends, interest or goodwill, the sale of stock rules apply, consistent with Mobil Oil Corp. v. Commissioner of Taxes of Vt. (445 U.S. 425, 1980). Cascading rules were added to provide a method of reasonable approximation in the event a taxpayer does not have access to data enabling it to determine the necessary factor information for assignment of either the sale of a minority interest of a corporation or pass-through entity or the sale of an interest in a start-up corporation or start-up pass-through entity. These rules attempt to provide a fair and practical method of reasonably approximating the standard rules for the sale of stock or an interest in a pass-through entity for these two specific situations.

Assignment rules for interest

Receipts in the form of interest have been divided into three different categories with three different assignment methods. New California Reg. section 25136-2(d)(1)(A)(2) provides:

  • Interest from investments, other than loans, is assigned to California if the investment is managed in California
  • Interest from loans secured by real property is assigned to California if the real property is located in California
  • Interest from loans that are not secured by real property is assigned to California if the borrower is located in California

Loans are defined under the existing provisions of California Reg. section 25137-4.2(b)(7), addressing special apportionment rules for financial institutions.

Assignment rules for marketable securities

A new section has been added to specifically address the sourcing of receipts from the sales of marketable securities. New California Reg. section 25136-2(e) provides:

  • If the customer is an individual, the sale is assigned to the state if the customer's billing address is in the state.
  • If the customer is a corporation or other business entity, the sale is assigned to the state if the customer's commercial domicile is in the state. The customer's commercial domicile is determined at the end of the tax year and based on the taxpayer's books and records kept in the normal course of business. If the customer's commercial domicile is determined in this manner, the FTB will accept this method of assignment. This presumption of a customer's commercial domicile may be overcome by the taxpayer by showing, based on a preponderance of the evidence, that other credible documentation provides that the commercial domicile of the corporation or business entity is in a state other than the state as provided by the taxpayer's books and records kept in the normal course of business. The FTB may examine the taxpayer's alternative method to determine if the commercial domicile presumption has been overcome and if the taxpayer's alternate method of assignment reasonably reflects the location of the commercial domicile of the corporation or business entity.
  • If the individual customer's billing address cannot be determined, or the corporations or business entity's commercial domicile cannot be determined using the above rules, the location of the customer shall be reasonably approximated.

Finally, an example was added to the regulation to address situations where the location of the commercial domicile of the taxpayer's corporate or business entity customer was not readily apparent in the taxpayer's books and records. The example is consistent with Chief Counsel Ruling 2011-01, and the taxpayer addressed in the example used the billing address of its corporate or business entity customer to assign receipts.

Effective date of amendments

Through previous discussions, both the public and the FTB agreed that it is preferable to have the effective date of the amendments to the regulation in the actual regulation language itself. The new language provides:

  • The regulation applies to assignment of sales other than sales of tangible personal property for taxable years beginning on or after Jan. 1, 2011, but only if the taxpayer has made a single sales factor apportionment election, and is applicable for all taxpayers for taxable years beginning on or after Jan. 1, 2013.
  • The amendments contained in this regulation which includes subsection (a) ‘In General’ clarification of statutory reference, subsection (b)(5) definition of marketable securities, subsection (b)(6) definition of marketable securities for securities dealers, subsection (d)(1)(A)(1) assignment of dividends or goodwill, subsection (d)(1)(A)(2) assignment of an interest, and subsections (e)(1), (2) and (3), assignment of sales of marketable securities are applicable for taxable years beginning on or after Jan. 1, 2015.
  • Notwithstanding paragraphs (1) and (2), any taxpayer may elect to have the amendments apply retroactively to taxable years beginning on or after Jan. 1, 2012, but only if those taxable years are open to adjustment under applicable statutes of limitation.

Takeaways

The amendments to the regulation were anticipated and included only minor changes from the 2014 proposed version. Namely, the final version did not include examples added to the ‘benefits of the services’ section clarifying assignment rules for taxpayers not subject to the provisions of California Reg. section 25137-14, relating to apportionment rules for mutual fund service providers and asset management service providers.  

The FTB removed the two examples of asset management fees assignment due to concerns raised by some members of the public. Per the FTB Hearing Officer responsible for the changes to the regulation, the removed examples will likely be included in future revisions to the regulation since the FTB believes that the asset management fee assignment examples do reflect the appropriate method for assigning these types of revenues for sales factor purposes.

Taxpayers should review these changes and analyze the impact on prior years, current cash, taxes and deferred taxes. Taxpayers should also consider whether it would be beneficial to make a retroactive election to apply these changes to open tax years beginning on or after Jan. 1, 2012.

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