Proposed changes to services sourcing under California’s market-based sourcing regulations

By Peter Seidel, J.D., LL.M., Los Angeles, and Jonathan Kraft, San José, Calif.

Editor: Mark G. Cook, CPA, CGMA

For California corporate franchise tax purposes, sales from services or other intangibles are sourced based on the market for those services or intangibles. In the case of services, taxpayers must determine where the benefit of those services is received to properly include or exclude those receipts from their California gross receipts (Cal. Code Regs. tit. 18, §25136-2(c)). For other intangibles such as patents and trademarks, sales of that property are assigned to California to the extent it is used in California (Cal. Code Regs. tit. 18, §25136-2(d)).

To provide guidance for this rule, California adopted Cal. Code Regs. Section 25136-2, effective for tax years beginning on or after Jan. 1, 2012, based in part on proposed market-sourcing regulations from the Multistate Tax Commission (MTC). (The revised MTC regulations for market-based sourcing are found in the MTC's adoption of the Uniform Division of Income for Tax Purposes Act (UDITPA). Specifically, the revised MTC market-based sourcing provisions are found in UDITPA Section 17.) The proposed MTC regulations addressing market-based sourcing were officially adopted by the MTC on Feb. 24, 2017. Before the MTC rules were officially adopted in February 2017, the California Franchise Tax Board (FTB) responded to practitioner and industry requests to address questions and calls for clarification of issues related to Section 25136-2.

On Jan. 20, 2017, the FTB hosted an interested parties meeting (IPM) to address a number of topics, including the sourcing of asset management fees, clarification of the term "benefits received" for certain industries, the assignment of dividends, and the treatment of marketing intangibles. This discussion primarily addresses the definition of "benefits received" under the regulation for sourcing service receipts.

General definitions: 'Benefits received'

After the first IPM on Cal. Code Regs. Section 25136-2, the FTB hosted a second IPM on June 16, 2017, and provided examples of proposed changes to the existing language of Section 25136-2. In its definitions, Section 25136-2 provides examples to explain the application of the phrase "benefit of the service received." Under subsection (b), the proposal adds another example. Under this new example, Cal. Code Regs. Section 25136-2(b)(1)(E), the FTB addresses service providers who provide services (on the ground) to a federal government agency, where the fieldwork is performed in multiple states. According to the proposal, the receipts from those services are apportioned to each state to the extent (the proportion) the benefit of the service is received in each state.

Observation: Instead of assigning the receipts to the location of the paying entity, which may be in Washington, D.C., this clarifies that even for federal government services, the sourcing is based on the actual locale (state) where the government receives the benefit, consistent with other forms of service contracts.

General definitions: 'Reasonably approximated'

One of the more controversial aspects of the new market-based sourcing analysis under Cal. Code Regs. Section 25136-2 is the use of the term "reasonable approximation." (Note that the "reasonable approximation" method is not original with California. See, e.g., MTC §17(d)(3) et seq.) Under several scenarios within Section 25136-2, where a taxpayer cannot fully determine the location of the benefit of its service, or the market for its service under traditional means (e.g., service contract language or books and records), the taxpayer may use a reasonable approximation based on evidence other than traditional evidence. For example, a taxpayer may look to population statistics to determine where its customer received the benefit of the service. Where a taxpayer must address the benefit received in a foreign country, the proposal makes the following suggested changes to Cal. Code Regs. Section 25136-2(b)(7) (additions in bold type, subtractions in strikethrough):

If it can be shown by the taxpayer that the benefit of the service is being substantially received or intangible property is being materially used outside the U.S., then the populations of those other countries [foreign jurisdictions or geographic areas] where the benefit of the service is being substantially received or the intangible property is being materially used shall be added to the U.S. population. Information that is specific in nature is preferred over information that is general in nature.

Observation: This proposed language and removal of "other countries" addresses situations where a service provider's customer has a market both within California and in a high-population country like China or India. Where that taxpayer must use a reasonable approximation to determine the benefit of the service, use of a population method could result in a high percentage of receipts being sourced from the United States (i.e., California) to China, if one bases sales factor apportionment on the comparative populations of California and all of China. From the FTB's perspective, the population method could result in too many receipts being removed from California, and the term "geographic areas" will allow auditors to adjust the assignment of receipts to countries where the results appear distortive. How the FTB will determine the appropriate "geographic area" in these situations is unclear. (Informally, the FTB has indicated it will provide additional clarification through more proposed examples.)

The FTB's proposed examples: 'Benefits received'

Under Cal. Code Regs. Section 25136-2(c)(2)(E), the original regulation provides several examples of how to make the determination of where a customer's benefits are received for purposes of sourcing those receipts. In its proposal, the FTB has not altered any of the existing examples under this section but has added seven new examples of services provided to business entities. These newly proposed examples have been initially added as subsections 25136-2(c)(2)(E)(8)-(14). While the results for each individual example will vary based on the facts, the FTB's analysis for arriving at its separate conclusions appears to be consistent with earlier examples.

For application to specific industries, taxpayers will want to review the existing and proposed examples carefully to determine if their own industry is addressed directly. Because the examples, though reasonably extensive, cannot address every factual scenario, it is more important to determine the proper analysis that can apply to multiple scenarios. With that in mind, this discussion does not address each new example in detail but provides a working list of the considerations, based on those examples, that the FTB appears to be following when arriving at its separate conclusions. (Also note that the proposal includes additional new language that addresses separate topics such as marketing versus nonmarketing intangibles, but those are beyond the scope of this discussion.) The analysis assumes at least some receipts are attributable to California sources:

  • To reach a determination of the proper sourcing of service receipts, the taxpayer must first determine the nature of the taxpayer (e.g., a general service provider or asset management company) and the nature of the taxpayer's customer (individual or business entity).
  • If the customer is a business entity, it must be determined whether it is a government entity or nongovernment entity (Cal. Code Regs. tit. 18, §25136-2(c)(2)(E), Example 8 (proposed)).
  • A taxpayer must then decide if there is sufficient information within its own books and records to determine the various states where its customer received the benefit of the service. If the answer is yes, then, depending on the facts, the taxpayer can source its receipts based on data such as contract terms or the location of the service order (Cal. Code Regs. tit. 18, §25136-2(c)(2)(A). See also Cal. Code Regs. tit. 18, §25136-2(c)(2)(E), Examples 9, 11, and 13 (proposed)). If the answer is no, then the analysis continues.
  • If the information within the taxpayer's books and records is not sufficient to determine the location of the benefit(s) of the taxpayer's service, then reasonable approximation may be used (Cal. Code Regs. tit. 18, §25136-2(c)(2)(B)).
  • The method of reasonable approximation depends in part on the nature of the customer. For example, if the customer is a government entity, the reasonable approximation is based on the percentage of population in California compared to the population of the United States (Cal. Code Regs. tit. 18, §25136-2(c)(2)(E), Example 10 (proposed)).

The method of reasonable approximation also depends on the nature of the taxpayer. For example, if the taxpayer is an asset management company, and sufficient information is available from the taxpayer's books and records to determine the location of the customers and their interests, sourcing of receipts is based on the location of those customers (e.g., shareholders, beneficial owners, and investors) based on the value of their interests (Cal. Code Regs. tit. 18, §25136-2(c)(2)(E), Example 13 (proposed)). However, where an asset management company must use a reasonable approximation to assign its service sales, the proposal provides that the taxpayer assign receipts by reasonable approximation of the domicile of the shareholders, beneficial owners, or investors (using data such as ZIP codes and other statistical data) (Cal. Code Regs. tit. 18, §25136-2(c)(2)(E), Example 14 (proposed)).

Observation: Even within the sourcing rules specifically addressing receipts from services, a brief review of the FTB's existing and proposed rules and related examples reveals that making a determination for sourcing purposes is an involved, complex process. The FTB should be commended for adding additional examples in response to taxpayer/industry input. In complex tax areas, more guidance is typically a good thing. Taxpayers working through this analysis should also be aware that, among the new sections the FTB has proposed, a new paragraph has been added to the Special Rules section for determining the method of reasonable approximation. Under Cal. Code Regs. Section 25136-2(h)(2), the FTB has proposed the following language:

The taxpayer's reasonable approximation method shall be used unless the Franchise Tax Board shows, by clear and convincing evidence, that such method is not reasonable. If the Franchise Tax Board shows that the taxpayer's approximation method is not reasonable, the Franchise Tax Board shall reasonably approximate the location of the receipt of the benefit of the services, the location of the use of the intangible property, or the location of the customer for sales from marketing securities. [Cal. Code Regs. tit. 18, §25136-2(h)(2)(C) (proposed)]

Note that the standard of review within the existing regulation is a "preponderance of evidence." For example, this "preponderance" standard applies when the FTB challenges the taxpayer's assigning of receipts based on the customer's billing address (under subsection (c)(1)(A)), the contract language or books and records in the normal course of business (under subsection (c)(2)(A)), or where the taxpayer assigns intangible property (under subsection (d)(1)(A)).

Observation: Though only proposed at this point, this language could be a cause of concern for several reasons. First, while the FTB should be commended for setting a higher standard for adjusting a taxpayer's result under the reasonable approximation method ("clear and convincing evidence"), the current proposal does not provide additional detail about what that phrase means in the corporate tax context. It is clear that it is a higher standard than "preponderance of the evidence," but how much higher is not clear.

Multistate taxpayers following the MTC regulation developments should also be aware that this differs from the recently adopted MTC market-sourcing rules. Under the MTC provisions, the use of the reasonable approximation method, if proper under the MTC regulations, is presumed correct (MTC §17(a)(7)). Therefore, the same analysis applied to the same type of receipts received outside of California in another state that has also adopted the MTC regulations could yield different results if that state has not adopted a modification similar to California's proposed Cal. Code Regs. Section 25136-2(h)(2).

It is also unclear whether the FTB intends to maintain that higher standard in subsequent proposals. Applying a lower "preponderance of the evidence" standard would be consistent with other provisions within the existing regulation, but is not likely a positive step for taxpayers, as it will provide the FTB a lower threshold for adjustment on audit. Second, it is unclear at this point whether the audit standard that is established (allowing the FTB to revise the reasonable approximation method) will have sufficient taxpayer or industry input. Third, the new language does not provide a method for a taxpayer to challenge the FTB's interpretation of "reasonable approximation." If the FTB's method of determining a taxpayer's "reasonable approximation" can be challenged, that should be made clear in subsequent proposals.

More clarifying changes to come

For all of these proposed changes and additions, multistate service providers with a customer base in California must not only be aware of the existing complex of market-based sourcing rules under Cal. Code Regs. Section 25136-2, but also be aware of the current thinking of the FTB. The FTB's proposed changes in its recent communications to the tax community give some insight to its approach to rules applicable to multiple industries. These proposed changes can provide some clarity where clarity was previously lacking. However, until more clarity is provided for a "reasonable approximation" standard, for both taxpayers and the FTB, certain changes such as the newly proposed Section 25136-2(h)(2)(C) may also cause additional uncertainty. The FTB has indicated it will host another IPM on these issues. (The FTB indicated at its second IPM that it expects to host a third IPM within six months of the June 16 meeting.) Time will tell if the taxpayer community will receive sufficient clarity before any pieces of the FTB's proposal reach final approval.


Mark G. Cook is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600 or

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.

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