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California: New Draft of Market-Based Sourcing Regulation Released

Listen to a brief overview of state tax developments this week, including California, or read full California development below.

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Detailed California Development

On July 21, 2020, the California Franchise Tax Board will hold its fifth Interested Parties Meeting to discuss more proposed changes to Cal. Code Regs. Section 25136-2, the regulation that addresses sourcing for sales of other than sales of tangible personal property. The last IPM was held July 19, 2019. In advance of the meeting, the Franchise Tax Board has issued draft language to facilitate the discussion.

Elimination of Distinction between Individual and Business Customers: The general rule in California is that receipts from sales of services are assigned to California to the extent the taxpayer’s customer receives the benefit of the service in the state. One key change in the recently-released language is that the different rules for determining where the benefit is received for sales to individual and business customers are eliminated. In previous iterations, there were separate provisions and examples based on whether the customer was an individual or a business.

The revised language provides that for all types of customers the location where the benefit of the service shall first be presumed to be received will be in California to the extent the taxpayer's contracts or books and records kept in the normal course of business indicate the benefit of the service is in California. Previously, this was the rule for business customers, but the benefit of the service was first presumed to be received based on billing location for individual customers.  According to the latest changes, the hierarchy is generally:

  1. The location based on the taxpayer's contracts or books and records kept in the normal course of business. There are certain presumptions that apply at this stage. For example, the benefit of a service shall be presumed to be in California if it relates to real property in the state.
  2. If the taxpayer’s contracts and books and records are not helpful, or one of the presumptions has been overcome, all other sources of information may be used to substantiate the benefit of the service.
  3. If neither of those options apply to identify the location where the benefit of the service is received, the location can be reasonably approximated.
  4. If the location cannot be reasonably approximated, the customer billing location is where the benefit is deemed received.
  5. For services provided under U.S. government contracts, if the sale cannot be assigned under the general rules, such as when a contract cannot be disclosed and no information about the service is publicly available, the benefit of the service is deemed received by each of the fifty states. The receipt will be assigned to California based on its proportion of the U.S. population.

The regulation provides a number of revised examples to illustrate where the benefit of a service is presumed to be received.

Asset Management Service Fee Provisions: The recently-released draft regulation includes the same provisions for sourcing receipts from asset management services that were included in the 2019 iteration of the regulation. Specifically, when gross receipts are from asset management services, but are not subject to Cal. Code Regs. Section 25137-14, the benefit of the asset management services is received at the domiciles of the investors in the assets unless the investor is holding title to the assets for a beneficial owner (as defined). If the investor is holding title to the assets for a beneficial owner, the benefit of the asset management services is received at the domiciles of the beneficial owner of the assets. The domicile of an investor is presumed to be the investor's billing address indicated in the records of the taxpayer. If the taxpayer has actual knowledge that the investor's principal place of business is different than the investor's billing address, there is no presumption. The domicile of a beneficial owner of assets managed by an asset manager shall be presumed to be the beneficial owner's billing address indicated in the records of the entity for whom the asset management services are rendered, or on the records of the asset manager. If the entity for whom the asset management services are rendered, or the asset manager, has actual knowledge that the beneficial owner's primary residence or principal place of business is different than the beneficial owner's billing address, the presumption does not control. The regulation provides two options for determining the location of the receipt of the benefit for asset management services.

Effective Dates: Importantly, the latest language provides that new amendments to the regulation are applicable retroactively to taxable years beginning on or after January 1, 2019. Any taxpayer may elect to have the amendments apply retroactively to taxable years beginning on or after January 1, 2018, but only if those taxable years are open to adjustment under applicable statutes of limitation. Please contact Gina Rodriquez at 916- 551-3132 with questions.

This Week's Developments

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Featured Speaker

Sarah McGahan

Sarah McGahan

Director, State & Local Tax, KPMG US