California: VAT Imposed on Services Included in Sales Factor

The California Office of Tax Appeals recently held that, for the tax year at issue, VAT imposed on the provision of services was included in the sales factor. The taxpayer, a California-based consulting firm, provided services to clients within and without California. VAT was imposed and invoiced on sales of services to foreign customers. On its 2008 California franchise tax return (filed on a worldwide basis), the taxpayer included VAT collected as part of the purchase price for services in its sales factor. This increased the taxpayer’s sales factor denominator because the VAT was related exclusively to foreign sales. Upon audit, the Franchise Tax Board determined that the taxpayer improperly included VAT in the sales factor. The taxpayer protested the resulting corporate tax assessment to the Office of Tax Appeals (OTA).

Under California law for the 2008 tax year at issue, the term “sales” was defined as “all gross receipts of the taxpayer not allocated” as nonbusiness income. The taxpayer argued that, “all gross receipts” should be broadly construed, consistent with prior California cases, to include the “whole amount received.” The FTB, however, argued that the regulation addressing the sales factor specifically allowed sales or excise tax (including VAT) on sales of tangible personal property to be included in the sales factor. The regulation did not, however, include similar language regarding sales of services, meaning in the FTB’s view, that such taxes imposed on sales of services were not included in the sales factor. After reviewing a number of cases addressing what was included in “all gross receipts,” the OTA concluded that VAT (and other taxes) on sales of services should likewise be included in the sales factor. The OTA noted that the use of the term “includes” was a general term of enlargement and not a term of limitation. Further, the court in the Microsoft case had directly addressed a similar argument with respect to whether return of principal was included in the sales factor and had concluded that the term “all gross receipts” meant all gross receipts. The OTA noted that the sales factor statute was revised effective for tax years beginning on or after  January 1, 2011 to adopt a new definition of gross receipts and that this decision concerned only the 2008 tax year at issue.  Please contact Gina Rodriquez at (916) 551-3132 with questions on this decision.