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California FTB provides service sourcing guidance
April 2022
UPDATE (4/12/22): On April 12, 2022, the FTB issued a News Release providing that if a taxpayer relied on either of the revoked Rulings when determining its tax filing position, the Large Corporate Understatement Penalty will not be assessed against it, and an Accuracy Related Penalty will also not apply, assuming the taxpayer filed a California return. However, if a taxpayer relied on the Rulings analyses to determine it did not have a filing requirement, and consequently filed a late return, a delinquent penalty will apply. Furthermore, interest will be assessed on any underpayment amounts resulting from a taxpayer's reliance on the CCRs.
In brief
On March 25, the Franchise Tax Board (FTB) issued a Legal Ruling addressing the following considerations when determining the assignment of gross receipts from the sales of services:
- who is the customer when third parties are involved?
- what is the service being provided when there is and is not a contract?
- what is the benefit of the service being received by the customer?
- where is the benefit of the service being received by the customer?
The Legal Ruling provides guidance regarding these questions inquiries and applies the considerations to three factual scenarios.
The takeaway. The Ruling appears to indicate that the FTB is taking a look-through "customer's customer" approach for services that the FTB characterizes as being directed toward the customer's customers. This look-through may be broader than the previous "marketing service" approach.
Observation: Additionally, although the Ruling refers to the current version of the Sourcing Regulations, those Regulations are in the process of being revised to adopt a look-through type approach for services that "relate to individuals" even if provided to a business customer.
The Regulation changes were supposed to be prospective, but this Ruling appears to apply the look-through concept currently and possibly retroactively.
Pursuant to FTB Notice 2009-08, Chief Counsel Rulings 2015-03 and 2017-01 are revoked. To the extent this Legal Ruling conflict with any other prior guidance of the FTB, this Legal Ruling supersedes such guidance.
[California Franchise Tax Board, Legal Ruling 2022-01 (3/25/22)]
In detail
Considerations for applying cascading rules to apportion sales from services
By statute, California provides that sales from services are apportioned to California “to the extent the purchaser of the service received the benefit of the services” in California. California regulation 25136-2 provides that the “benefit of a service received” means the location where the taxpayer’s customer has either directly or indirectly received value from delivery of that service.
The Legal Ruling raises four questions that a taxpayer must answer to determine how sales of services are to be assigned: (1) who is the customer, (2) what is the service being provided, (3) what is the benefit of the service being received by the customer, and (4) where is the benefit of the service being received by the customer.
When third parties are involved the “customer” is the ultimate customer, not the third party
The Ruling acknowledges an issue when a third party receives the benefit of a taxpayer’s service. Although this third party may receive a benefit, only the customer’s customer benefit is considered relevant.
What is the service provided when there is and is not a contract?
Generally, the contract evidencing the service agreement will identify the specific service that is to be performed. If there is no contract, or the contract does not describe the service performed, the taxpayer will have to identify the activities engaged in for consideration.
What is the benefit being received?
The value of a service is usually the “direct effect of the action or function being performed” as supported by books and records or a reasonable approximation of value. The Ruling cites example 4 in Regulation 25136-2(c)(2)(E) stating that the benefit of placing online advertisements is the “potential sales and interest from the viewers of the advertisement.”
Where is the benefit of the service received by the customer?
According to the Ruling, “[w]hen the value of the service is the direct effect of the action or function being performed, the location of the benefit will be where the direct effect impacts the taxpayer’s customer.”
The Ruling cites the same example 4 above to provide that the benefit received for advertising services is located where viewers are clicking or viewing online advertisements.
When the taxpayer’s service is directed at its customer’s customer, the Legal Ruling states that the benefit received by the customer is likely located at the customer’s customer location. Examples from the Legal Ruling include sales and marketing services, customer support services, in-person services involving a third-party contractor, and subcontracting agreements.
Cascading rules
After the above inquiries have been addressed, the cascading rules of Regulation 25136-2(c)(2)(A) through (D) provide guidance on measuring the location of where the benefit was received. These cascading rules are:
(A) The location of the benefit of the service shall be presumed to be received in this state to the extent the contract between the taxpayer and the taxpayer's customer or the taxpayer's books and records kept in the normal course of business, notwithstanding the billing address of the taxpayer's customer, indicate the benefit of the service is in this state. This presumption may be overcome by the taxpayer or the Franchise Tax Board by showing, based on a preponderance of the evidence, that the location (or locations) indicated by the contract or the taxpayer's books and records was not the actual location where the benefit of the service was received.
(B) If neither the contract nor the taxpayer's books and records provide the location where the benefit of the service is received, or the presumption in subparagraph (A) is overcome, then the location (or locations) where the benefit is received shall be reasonably approximated.
(C) If the location where the benefit of the service is received cannot be determined under subparagraph (A) or reasonably approximated under subparagraph (B), then the location where the benefit of the service is received shall be presumed to be in this state if the location from which the taxpayer's customer placed the order for the service is in this state.
(D) If the location where the benefit of the service is received cannot be determined pursuant to subparagraphs (A), (B), or (C), then the benefit of the service shall be in this state if the taxpayer's customer's billing address is in this state.
Application of the considerations to three situations
The Legal Ruling applies the above considerations to several hypothetical situations, including the following.
Tracker Corp (located in State X) provides consulting services for companies looking to efficiently manage their power consumption used in manufacturing. Manufacturing Corp enters into an agreement for Tracker Corp’s services. Manufacturing Corp has its manufacturing plant in State Y. Tracker Corp engages Niche Corp (a subcontractor located in State Z) to assist with advising on certain aspects of Manufacturing Corp’s manufacturing plant’ power consumption.
- Customer. The taxpayer (Niche Corp.) entered into a contract with Tracker Corp to assist with providing consulting to Manufacturing Corp. Niche Corp’s customer is Tracking Corp.
- Service. Niche Corp’s service is providing consulting to Manufacturing Corp.
- Benefit received by customer. The direct effect and benefit of the service being provided to Tracker Corp is that its customer (Manufacturing Corp) receives consulting. This improves Tracker Corp’s service performance to Manufacturing Corp.
- Benefit location. Niche Corp’s service directly engages the customer’s customer (Manufacturing Corp). Manufacturing Corp’s State Y plant is where Niche Corp’s consulting is utilized, and this is where the impact of this benefit occurs for Tracker Corp. Therefore, Tracker Corp receives the benefit of having consulting services for its customers where those services are utilized.
Applying the cascading rules, the Legal Ruling conclusions that Niche Corp should assign gross receipts from consulting services to the location of Manufacturing Corp’s manufacturing plant location. It is anticipated that Niche Corp will have this information in its books and records.
Chief Counsel Rulings revoked
Legal Ruling 2022-01 revokes Chief Counsel Ruling 2017-01, which involves the guidance determining whether the benefit of a service is received. Also revoked is Chief Counsel Ruling 2015-03, which involves application of market-based sourcing rules for non-marketing services.
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