02.10.12

California Franchise Tax Board Approves Sourcing Regulation

In late 2011, the California Franchise Tax Board (“FTB”) approved California Proposed Regulation §25136-2 (“Regulation”).  The Regulation implements a market-based approach to determining the methodology for sourcing receipts from sales of services and intangibles for those taxpayers electing a single-sales factor apportionment formula in California.  This approach is a significant change from the prior method, cost-of-performance.  The Regulation also shows that California, like many other states, is moving towards a sourcing methodology that may better balance the origin-based property and payroll factors.  In some regards, market sourcing may also better address sales of non-tangible personal property, which are now a significant component of today’s economy.

Beginning in tax year 2011, businesses other than those described as Alternative Industries (businesses that derive more than 50% of gross receipts from extractive, agricultural, savings and loan business activities or banking and financial activities), may make an irrevocable election to apportion income to California using a single-sales factor apportionment formula for corporate income tax purposes.  Otherwise in California, a four-factor formula is used.  Under the Regulation, a market rule for sourcing receipts from sales of services and intangibles is imposed under the single-sales factor election, rather than the costs of performance sourcing methodology.  The Regulation impacts only the receipts factor determination and pertains only to sellers of services or other defined intangibles.  Also, because the single-sales factor election is irrevocable, a taxpayer should undergo an analysis to determine whether the election is beneficial based on its activity in California.

Under the Regulation, receipts from sales of services to individuals and businesses are sourced according to the location where the “benefit of the service is received.”  For individuals, the location of the benefit is presumed to be the “customer’s address.”  For businesses, the presumption is established based on the taxpayer’s “contract with the customer or on books and records.”  According to the Regulation, receipts from sales involving a complete transfer of intangible property (including, but not limited to, stocks, bonds, notes - whether secured or unsecured, bank deposits, accounts receivables, patents, trademarks, copyrights, goodwill, fungible goods, partnership interests, life insurance policies, and franchise, license or contract interests) are assigned to the state to the extent the intangible is used in the state.  Receipts from licensing, leasing, rental or other use of non-marketing or manufacturing intangibles also must be sourced to the location where the intangible is used.

Generally in California, all business income is apportioned to the state by multiplying a taxpayer’s taxable income by a fraction that represents a taxpayer’s pro-rata share of property, payroll and sales in the state.  The sales aspect is double-weighted, thus making it a four-factor apportionment formula.  However, the four-factor apportionment formula does not apply when the business is engaged in an Alternative Industry.  Taxpayers engaged in these activities must apportion their income using a three-factor, single-weighted sales factor.  Under the standard formula, receipts from sales of intangibles, other than from the sales of tangible personal property and those activities subject to the special rules, in respect to a particular income producing activity are attributable to California if (a) the income-producing activity is performed wholly in California or (b) if the activity is performed both in-state and out-of-state but the greater proportion of the income-producing activity is performed in-state, based on costs of performance. 

The Regulation has yet to be finalized by the California Office of Administrative Law.

For more information on this Regulation, please contact Michael Fletcher at 703-770-0533 or mfletcher@argy.com.

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