United States

California FTB approves staff request to proceed with apportionment changes

Sales factor market-based sourcing changes incoming

TAX ALERT  | 

In the California Franchise Tax Board (FTB) meeting held on Dec. 4, 2014, the board granted an FTB staff request to proceed with formalizing proposed changes to draft California Reg. section 25136-2, the state's sales factor market-based sourcing rules. The FTB has held three meetings among interested parties to obtain feedback and comments from the public regarding various portions of the original regulation. Now, the FTB will move forward with the formal approval process.

Other than some minor clean-up fixes, the final changes relate to five specific sections of section 25136-2, listed in order of appearance:

  • Definition of "marketable securities"
  • Assignment rules for asset management fees
  • Assignment rules for dividends and goodwill
  • Assignment rules for interest, and
  • Assignment rules for marketable securities

These five 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 IRC 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, and
  • All contracts to which IRC section 1256(a) applies will be treated as marketable securities.

A final revision was made to reflect that 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 asset management fees

Examples added in the “benefit of the services” section clarify that taxpayers described in the asset management fee examples who are not providing services to at least one regulated investment company are 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. For this purpose, the term “mutual fund service provider” means “any unitary business that derives income from the direct or indirect provision of management, distribution or administration services to or on behalf of a regulated investment company.” The term “asset management services” means “the direct or indirect provision of management, distribution or administrative services to entities other than regulated investment companies, if those services would be management, distribution or administrative services within the meaning of […] this regulation, if provided directly or indirectly to a regulated investment company.”

Historically, the FTB only applied California Reg. section 25137-14 to companies providing services to regulated investment companies and real estate investment trusts. Tax practitioners had concerns that the language in California Reg. section 25137-14 would allow the FTB to require other taxpayers to comply with the regulation. These other taxpayers may provide substantially identical services, but are not providing these services to real estate investment companies, with such taxpayers including private equity funds, smaller hedge funds, etc. The language in California Reg. section 25137-14 appears to allow for either interpretation, and tax practitioners were concerned that taxpayers conducting asset management services could be required to assign sales to states using the domiciles of the shareholders, rather than the previous cost of performance sourcing or market-based sourcing under California Reg. section 25136-2.

For purposes of maintaining consistency between similarly situated taxpayers, these new examples in California Reg. sections 25136-2(c)(1)(C)6 and 7 follow the assignment rules of California Reg. section 25137-14, including the provisions for (1) determining the domicile of the shareholders, beneficial owners, or investors, and (2) assigning receipts based on the ratio of the number of shareholders, beneficial owners or investors in California to the number of shareholders, beneficial owners or investors everywhere. The examples provide that if the domicile of the shareholders, beneficial owners or investors cannot be determined, the domicile may be reasonably approximated. However, if the domicile cannot be reasonably approximated, any receipts not assigned to a state will be disregarded.

Additionally, the apportionment rules of California Reg. section 25136-2 do not require that sales of services be “thrown-back” to California if the sales of services are assigned to states where the taxpayer is not filing. However, a new example in California Reg. section 25136-2 provides that “if asset management corp cannot reasonably approximate a method for determining the domicile of the shareholders, beneficial owners, or investors, then those receipts shall be disregarded for purposes of the sales factor." California Reg. section 25137-14 requires that any “nowhere” sales be assigned using California Reg. section 25136 and assigned to the state where the income-producing activities were performed.

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

Both the public and the FTB agree 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 , subsections (c)(2)(E)6 and 7 "Examples" of assignment of asset management fees, 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.

Given the extended period of feedback and revision for the proposed changes to California Reg. section 25136-2, the formal approval process is expected to run smoothly. In anticipation of near-term final approval, taxpayers should review these changes and analyze the impact on prior years, current cash, taxes, and deferreds. 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. 12, 2012.

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