California Draft Market-Based Sourcing Rules Need Work

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By Laura Mahoney

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.

Nexus, Timing Concerns

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:

  •  Nexus: Practitioners said the proposal to use the ratio of California’s population to the U.S. population as a reasonable approximation when a taxpayer can’t substantiate sales could trigger nexus for many taxpayers that aren’t in the state and don’t currently have a filing obligation. The definition of “doing business” in California changed in 2011 to say that annual sales into the state of more than $500,000—adjusted for inflation annually—or 25 percent of total sales constitutes doing business. Williams said the FTB needs to look more carefully at the issue, adding that “many more folks are going to have a California filing requirement.”
  •  Cost of performance: Practitioners said some of the examples used to illustrate the rules are too similar to cost of performance, the previous rule that assigned sales based on where the income-producing activity took place. They also said many auditors in the field are still following cost-of-performance rules despite the change in the law, and the examples in the draft give auditors more latitude to take that position. Williams said auditors receive extensive training on the rules and shouldn’t be taking such a position.
  •  Pass-through entities: The draft would assign sales to the first tier below asset managers when shareholders and investors in multiple layers aren’t known to the asset manager for reasonable approximation purposes, based on comments the FTB received from asset managers. Practitioners said they are concerned that the ratio of California to U.S. population would assign one-twelfth of the sales to California under this proposal, which may not be fair.
  •  Foreign entities or customers: Practitioners and taxpayers said the reasonable approximation ratio fails to recognize that the benefit of the service could be received in a foreign country, or that a pass-through entity has foreign members. This is especially a problem for defense contractors, or asset managers with funds that have multiple foreign owners, practitioners said. Williams said in the case of defense contractors, the FTB considers service performed for the U.S. government to be a benefit to the country, therefore the formula doesn’t consider items outside the country.
  •  Timing: The laws shifting to market-based sourcing took effect in 2011 and 2013, but the regulations aren’t in place yet for some sectors. Practitioners said that the time lag means auditors in the field don’t have clear guidance, but the final rules aren’t imminent. When the regulations are final, they may be applied retroactively to taxpayers that were making a good-faith effort to follow the law.

Simplifying, Cascading

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.

To contact the reporter on this story: Laura Mahoney in Sacramento, Calif., at lmahoney@bloomberglaw.com

To contact the editor responsible for this story: Ryan C. Tuck at rtuck@bloombergtax.com

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