California FTB publishes “final” proposed market-based sourcing regulatory changes

What happened?

On September 13, 2024, the California Franchise Tax Board (FTB) published a formal Notice of Proposed Rulemaking (Notice) for proposed changes to current California Code of Regulation section 25136-2 governing the sourcing of receipts from sales of other than tangible personal property. The Notice marks the likely conclusion of the regulatory process begun back in 2016, and once approved by the Office of Administrative Law (OAL), changes to the regulation would be effective for all tax years beginning on or after January 1, 2024.  

Why is it relevant? 

The proposed changes may impact how taxpayers source receipts from services and intangibles in the current tax year. This includes several substantive changes to the existing regulation, such as: 

• new default rules and presumptions for determining the location of the benefit of services,  
• new definitions and unique sourcing rules for receipts from asset management services, 
• a new definition for professional services and a new sourcing rule for large volume professional services, 
• new rules for sourcing receipts from certain government service contracts, and  
• new definitions and presumptions for sourcing receipts from the sale of marketable securities.  

Actions to consider 

A timely review of the proposed rules could be critical for ascertaining tax obligations for the current year. Taxpayers should review the proposed changes to the regulation to determine the proper application and ascertain the potential impact on their California returns for 2024 and subsequent tax years. 

According to the FTB, “[r]egulation 25136-2 provides rules for determining the correct amount of sales to be included in the sales factor numerator for sales, other than sales of tangible personal property, which includes: sales from services; sales from intangible property; sales from the sale, lease, rental, or license of real property; and sales from the rental, lease, or license of tangible personal property.”  According to the FTB, “[t]he regulatory amendment project seeks to improve compliance and administrability both through simplification of rules for assignment of sales and through creating specific rules for certain industries.”

The FTB initially promulgated regulation 25136-2 in 2012 in response to California’s change to market-based sourcing and then amended the regulation in 2016. Efforts to change that new regulation began almost immediately with the first of six Interested Parties Meetings (IPMs) conducted on January 20, 2017, and ending with the sixth and last IPM on June 4, 2021.  

Observation: The stated goal of the regulatory amendments is to improve compliance and administrability both through simplification of rules for assignment of sales and through creating specific rules for certain industries. While some provisions of the regulation have been hotly contested, the new rules could bring much-needed stability and certainty to this area of the law.    

Written comments on the proposal may be provided not later than 5:00 PM on October 31, 2024. Taxpayers may request a public hearing in writing if submitted not later than October 16, 2024 (15 days prior to the close of the written comment period).  

Observation: The timing of the Notice and the effective date indicate that the FTB intends to finalize the regulation by the end of this calendar year. 

Regulation 25136-2 provides some new rules for determining the amount of sales to be included in the sales factor numerator for sales, other than sales of tangible personal property. These sales include sales from services; sales from intangible property; sales from the sale, lease, rental, or license of real property; and sales from the rental, lease, or license of tangible personal property.   

Change in the default rules and presumptions (§§ 25136-2(c)(1)(A) – (1)(F)) 

The proposed regulation establishes a new framework of presumptions for determining the location of the benefit of the service as follows: 

• The proposed regulation begins with the same initial presumption that the location of the benefit of the service is presumed to the extent that the location is indicated by the taxpayer’s contracts or books and records kept in the normal course of business. 
• However, the proposed regulation departs from the current regulation by establishing further presumptions regarding the location of the service receipt to the extent the service predominantly relates to real property in the state, services related to tangible personal property used or delivered into the state, intangible property used in the state, and individuals in the state when the service is delivered. 
• The presumption may be overcome by showing based on a preponderance of the evidence that the benefit of the service is received at a different location after first considering information from the contracts or books and records.  
• If the initial presumption does not apply or has been overcome, all other sources of information may be used to substantiate the location of the benefit. 
• If location still cannot be determined, the location must be reasonably approximated.  
• If a presumption does not apply or has been overcome, and cannot be reasonably approximated, then the location of the benefit of the service is determined using the customer’s billing address as indicated by the taxpayer’s books and records. 
• If a sale is for services provided under US government contracts and the location of the benefit cannot be assigned based on presumptions or reasonable approximation, such as when a contract cannot be disclosed and no relevant information is publicly available, then the benefit is deemed to be received by the 50 states based on relative population.  

The proposed regulation provides new or revised examples illustrating how the new framework should be applied to services relating to real property, government contracts, logistics and delivery operations, milestone payments for research and development, internet advertising, call centers, and personal property.  

Observation: By establishing presumptions based on specific factual scenarios, e.g., the location of services related to real property, the proposed regulation may answer ongoing taxpayer questions at least regarding the areas covered by the specific presumptions.  

Further, under the proposed regulation, when the presumptions may not apply, taxpayers and the agency are free to consider “all other sources of information” to determine the location of the benefit of a service.   

Observation: Notably, this condition applies before considering the billing address of the customer as the location of the benefit of the service. The change reflects an inherent mistrust of the billing address but may allow taxpayers broader means to determine the true market for their services.  

In addition, the specific rule for government service contracts now allows for specific delivery information, when available, to be used for apportionment purposes.  

Observation: In the past, such a departure would require a taxpayer to request to apply the distortion provisions of Cal. Rev. & Tax. Code section 25137. 

New rules for receipts from asset management services (§§ 25136-2(b) and (2)(c)(2)) 

The proposed regulation provides a new definitional framework for receipts from asset management services, defined as the “direct or indirect provisions of management distribution or administrative services to funds.” The proposed regulation also defines administrative services, distributions services, management services, and fund. It also includes a definition for the “beneficial owner” as one who makes independent decisions to invest. The definition excludes decision-makers for pooled or corporate investments and who participate in a defined benefit plan.   

The proposed regulation establishes specific rules for determining the location of gross receipts from asset management services based on the domicile of the investors in the assets unless the investor is holding title to the assets for a beneficial owner, in which case the benefit of the service is received at the domicile of the beneficial owner.  Location of domicile is presumed to be the investor’s billing address as reflected in the taxpayer’s books and records, unless the taxpayer has actual knowledge that the investor’s principal place of business is at a different location. Location of domicile of a beneficial owner is presumed to be the billing address of the beneficial owner as reflected on the records of the entity for whom the asset management services are rendered unless there is evidence that the primary residence or principal place of business is different.  

Receipts from asset management services are assigned in proportion to the average value of the interest in the assets held by investors or beneficial owners domiciled in the state. If a taxpayer does not know the average value of the interests held by investors or beneficial owners in the state, receipts are assigned based on a reasonable estimation.  

Observation: This proposed change brings the broader asset management community under the same rules previously only applied to mutual fund service providers under Regulation Section 25137-14. By defining the provision of asset management services broadly, the FTB is indicating that investor-based sourcing is the appropriate means for service providers earning income from the provision of investment-related services to funds, regardless of the nature of those funds. 

New rule for large volume professional services (§§ 25136-2(b)(9) and (2)(c)(3)) 

The proposed regulation adds a definition for professional services to include management services, tax services, payroll and accounting services, audit and attest services, actuary services, legal services, business advisory consulting services, technology consulting services, services related to brokering securities that generate commission income, investment advisory services other than asset management services as defined in this regulation, and services related to the underwriting of debt or equity securities.  

The proposed regulation provides a new rule and an example for assignment of receipts from “large volume professional services.” If a taxpayer provides any single professional service to more than 250 customers, then receipts from that service are assigned based on the customer’s billing address. If more than 5% of the receipts from the sale of a specific service are derived from a single customer, then receipts from that customer do not fall under this rule.  

Observation: The proposed regulation would apply to large national service providers and recognizes the difficulty inherent in providing the detailed information necessary to determine the location of the benefit of the service on a customer-by-customer basis.  Rather, the proposed regulation essentially allows for sourcing based on billing address in recognition that the billing address for the customers of large volume service providers will be relatively easy to obtain and provide a serviceable estimate of the location of the benefit of the services.  

Other changes

Rule for assignment of sales from intangible property (§§ 25136-2(d)(1)(A)-(D)) 

The rule for assignment of sales from intangible property remains basically the same as in the current regulation, providing that sales from intangible property are assigned to California to the extent the property is used in the state.  In the case of a complete transfer of all property rights in intangible property, receipt is presumed to be in the location where the contract between the taxpayer and the purchaser, or the taxpayer’s books and records, at the time of the sale, indicate where the purchaser will use the intangible property. If the extent of the use of the intangible property in the state cannot be determined by application of the standard presumptions or the presumptions are overcome, then the location should be reasonably approximated, and if location of use may not be reasonably approximated, the location should be determined based on the billing address of the purchaser.  

Special rules for reasonable approximation (§ 25136-2(i)(2)) 

The proposed regulation also allows priority to a taxpayer’s method of reasonable approximation in some cases unless the FTB shows by a preponderance of the evidence that the method is not reasonable. In that case, the FTB must use its own method of reasonable approximation. Further, any method of reasonable approximation must reasonably relate to the income of the taxpayer. Once a method of reasonable approximation is used by the taxpayer, the taxpayer must continue to use that method or notify the FTB of any new method of reasonable approximation.  

Receipts from sale of both service and intangible property (§25136-2(e)) 

The proposed regulation provides a framework for sourcing receipts from the provision of a service, tangible or intangible property, or both tangible and intangible property. In such cases, if the value of each portion of the receipt is readily ascertainable, then each portion must be separately assigned. If the value of each portion is not readily ascertainable, then the principal purpose of entering into the contract will determine how to assign the revenue.  

Receipts derived from the sale of marketable securities (§25136-2(f)(1)) 

The proposed regulation generally preserves the same rule contained in the prior regulation for sourcing receipts from the sale of marketable securities. However, proposed regulation 25136-2(f)(1) defines a customer as the person who gains the greatest possession of economic rights in marketable securities without regard to intermediaries. Where the customer is an individual, the sale is located based on the customer’s billing address as determined at the end of the tax year. Where the customer is a corporation or other business entity, the sale is located at the customer’s commercial domicile as determined based on the taxpayer’s books and records.  

Receipts from sale of marketing, non-marketing, manufacturing, and mixed intangibles (§25136-2(d)(2)(A) – (D).) 

With one exception, the proposed regulation generally preserves the definitional and sourcing provisions for receipts from marketing intangibles, non-marketing and manufacturing intangibles, and mixed intangibles, as well as the related examples. The proposed regulation adds a new regulation at section 25136-2(d)(2)(D).7, which sources the receipt of an upfront payment for the use of licensing rights for drug compounds to the state based on the location where the drug compounds would be used.