California Franchise Tax Board Archives

California FTB Schedules Interested Parties Meeting on Short Notice to Discuss Issues in the Regulations on Sourcing Income from Services and Intangibles

The California Franchise Tax Board has scheduled an Interested Parties Meeting to discuss proposed changes to its apportionment regulations. Several years ago, when the statute called for sourcing receipts from services and intangibles at the location of income producing activity, based on cost of performance, the FTB, after a series on interested parties meetings, adopted new regulation 25137-14 sourcing receipts for mutual fund service providers and asset management service providers not at the location of the service provider, but at location of customers. That was good news for California service providers and bad news for out-of-state service providers.

The FTB scheduled on December 22, 2016 an Interested Parties Meeting for January 20, 2017 to discuss a series of issues arising under the new market- based sourcing regulations. A Discussion Topic Paper (attached) was issued on January 3, 2017, and included (1) draft examples of souring income from asset management fees, (2) a discussion of “reasonable approximation”, including who makes that reasonable approximation, (3) clarification of the term “benefit of a service” in several contexts, including timing, government contracts, R&D contracts and patent sales, (4) dividend assignment, (5) a freight forwarding example, (6) interest received from a business entity borrower and (7) marketing intangibles.

The FTB takes these Interested Parties Meetings seriously. Taxpayers should pay immediate attention to whether any of these issues are of significance to them, and consider participating.

California FTB to Discuss Apportionment of Combined Group Income

The California Franchise Tax Board (FTB) will hold a second Interested Parties Meeting at their office in Rancho Cordova on April 20, 2016, dealing with the apportionment of income for combined reporting groups with both financial and non-financial members. The Notice of Interested Parties meeting provides a description of the sourcing methods used in other states and solicits comments on four specific proposals.

The current statute and regulations, applied literally, in effect assign the majority of combined income of bank(s) and broker-dealer(s) to the location of the bank(s) or broker-dealer(s) and its customers. This can produce an issue worth many hundreds of millions of dollars to the bank or broker dealer. We understand that the California FTB has issued ad hoc Notices of Proposed Assessment to some taxpayers based on a distortion theory; some of these cases have gone to the Settlement Bureau, where both the FTB and the taxpayers have settled and executed confidentiality agreements.

The FTB takes these Interested Parties Meetings very seriously. They have an unusual format in that there is not a record of who said what, the goal being to have a full and frank discussion on a non-attribution basis. An early example of collaboration between the FTB and interested parties produced what is now Reg. 25137-10. Before the regulation, many years ago Sears argued that it was not engaged in a unitary business with a finance company subsidiary. Sears lost in the trial court on that issue, but the court also held that Sears was entitled to include intangible personal property in the property factor, and the situs of that property was Illinois, resulting in a refund for Sears. Regulation 25137-10 represented an effort to harmonize the income-producing character of intangible personal property with tangible property in the property factor, and the outcome was that intangible property would be included in the property factor at 20 percent of face value. This regulation and the bank regulation 25137-4.2 provide the current regulatory basis for modification of the statutory formula where high volume, low profit activity is combined with other activity in a combined return, but Reg. 24137-10 only applies where the principal business activity of the combined group is not financial.

Taxpayers should follow these regulatory activities carefully, as evidenced by the adoption of a regulation a few years ago on sourcing income of mutual fund service providers, which was favorable to California-based taxpayers. The statute provided for sourcing income from services at the location of income-producing activities, measured by cost of performance. The adopted regulation instead provides for a form of market sourcing.