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California’s latest draft rules for market-based sourcing of sales of intangibles are confusing and could harm defense contractors and asset managers, representatives of those industries told the Franchise Tax Board.
Two FTB attorneys leading a discussion meeting for interested parties May 18 said they plan to make multiple changes to the draft, but that they aren’t sure how to fix some of the criticism and confusion they heard from corporations and practitioners. FTB Tax Counsel Melissa Williams told Bloomberg Tax after the meeting that the FTB will work to release a new version of the draft rules in about six months.
Through the draft, the FTB is attempting a second round of amendments to regulations the agency adopted when California shifted from the cost-of-performance method to market-based sourcing when assigning income from sales of intangibles. The shift came with California’s switch to elective single-sales-factor apportionment for multistate taxpayers in 2011 and mandatory single-sales-factor apportionment in 2013. The latest round of amendments attempts to define reasonable approximation of a taxpayer’s market when books and records don’t suffice, and clarify how market sourcing applies to asset management and government contracts. Using examples, the draft addresses questions about how to determine where the benefit of the service is received.
Concerns from meeting attendees fell into several general categories, and Williams said the FTB plans to revisit them before issuing the next draft. Those concerns included:
Overall, taxpayers and practitioners at the meeting said the FTB’s draft is difficult to follow. The draft proposes a series of simplifying rules used to presume whether the benefit of a service is received in California, followed by cascading rules and examples to follow if the simplifying rules don’t result in a presumption. Taxpayers said the order in which the rules would be applied, and the interaction between them, isn’t clear.
They also asked the FTB to define the “preponderance of the evidence” standard that would be applied for taxpayers to overcome presumptions about where sales should be assigned.
Without a clear definition, auditors could more easily reject a taxpayer’s good-faith efforts to reach a reasonable approximation, practitioners said. With the large corporate underpayment penalty and other penalties in the FTB toolbox, a lack of clear definition could be used against them, practitioners said.
“This wasn’t done to give the FTB a leg up,” Williams said. A taxpayer’s approximation will continue to be considered first, as long as it is reasonable, she said.
The FTB is taking comments on the draft until July 18 and is working on the next round of changes, Williams said.
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