Businesses that follow a market-based sourcing approach to state taxes apportionment will need to comply by 2023.
Last month, the California Franchise Tax Board (FTB) issued proposed amendments to its market-based sourcing regulations. Market-based sourcing is an approach to apportioning sales of services for tax purposes in which services are assigned to the state in which the services are received or where the customer is located.
The regulations are scheduled to go into effect Jan. 1, 2023. However, readers should be aware that state auditors are already using them as guidance.
What’s in the Regulations
The regulations address how to treat sourcing of services for professional services, asset management services, and services related to tangible and intangible property in the state. The revised regulations no longer bifurcate the sourcing rules between business-to-business and business-to-individual transactions. The business-to-individual sourcing rules have been eliminated and now follow the same sourcing rules as the business-to-business transactions.
Asset management services are sourced to the investor’s state of domicile or to the location of the beneficial owner. This seems simple enough. However, the receipts are also to be assigned to California in proportion to the average value of interest in the assets held by each investor. If the investor is a partnership, the asset management company will need to know the location of their partners.
The amendments also address sourcing options for services rendered. They are to be sourced in the following order:
Sourcing shall be based on the taxpayer’s books and records or contracts indicating where the benefit of the service is received.
If benefit cannot be substantiated with the books and records or contract, all other sources of information may be used to substantiate the benefit.
If the sourcing cannot be determined using 1 and 2 listed above, it must be reasonably approximated.
If the source cannot be reasonably approximated, the taxpayer shall use the customer’s billing address as indicated in their books and records.
For U.S. government contracts in which the location cannot be disclosed, the taxpayer shall use California population in proportion to US population.
The previous regulations allowed taxpayers to use the billing address for their clients. This option is now the last option available for sourcing and requires more analysis to be performed.
Special Rules for Professional Services
When it comes to providing professional services, the FTB has proposed special rules when the number of clients in a line of business exceeds 250. When the taxpayer provides substantially similar professional services to more than 250 customers, then gross receipts from such services shall be assigned to the customer’s billing address. However, if more that 5% of its receipts are derived from a single customer, the receipts of that customer do not fall under this rule. The revenue from those customers must use the rules discussed above.
Special Rules for Services Related to Real or Tangible Property
Services for real property are sourced to the location of the real property. In general, services to tangible personal property are sourced to where the services are performed. However, if the tangible property is serviced and shipped to the customer, the location of the services will be sourced to the customer’s location. For example: Rental Property Corp. owns 100 rental properties in California and 400 rental properties in State A, and contracts with Landscape Corp. for landscape services for all rental properties. The benefit of the service is received in both State A and California because it relates to real property located in both State A and California.
When a taxpayer sells stock or partnership interest of a nonmarketable security or receives gross receipts from intangible property which are derived from dividends or goodwill, special rules apply. Depending on whether the invested entity has physical assets or intangible assets, different sourcing rules are required to be used. If more than 50% of the investee’s assets are real and tangible property, the taxpayer will use the investee’s payroll and property factor to source the income to California. If the majority of the investee’s assets are intangible property, the taxpayer will use the investee’s sales factor apportionment to calculate income sourced to California.
To Understand the Full Impact on Your Business, Consult Your BPM SALT Professional
The proposed rules require different rules to be applied depending on the nature of the taxpayer’s business and the type of income generated. Although they are not scheduled to take effect until 2023, businesses may be held to the rules upon audit. The full proposed regulations can be found on the FTB’s website.
To discuss with a trained professional how the proposed rules will affect your business, contact a member of the BPM SALT team today.