California income tax ruling tied to benefit site


Nonresident’s work for in-state company not taxable since service primarily served out-of-state client


In a nonprecedential decision, the California Office of Tax Appeals (OTA) held that a nonresident individual subcontractor working for an unrelated California-based company did not derive income from a California source and was not required to file a California nonresident personal income tax return.1 Specifically, the OTA concluded that the benefit of the individual’s services was received at the location of the customer’s own customer, which caused the income to be earned from sources outside California.






The individual, a Texas resident, worked as a designer in both an employee and independent contractor capacity for a California company during 2015.2 The individual conducted a unitary business as a sole proprietorship and had no other connection to California. The professional services consulting agreement between the individual and the company provided that his services as a subcontractor were to assist the company’s clients “in designing the user experience of their products and services.” Further, the individual agreed to various contractual obligations imposed on him by the company’s Canada-based customer and performed the services from his Texas home. The company issued a Form 1099-MISC to the individual to report the income.

The individual did not file a 2015 California nonresident income tax return. Subsequently, the California Franchise Tax Board (FTB) obtained information regarding the Form 1099-MISC issued to the individual, concluded that the income was solely derived from California sources, and notified the individual that he must file a 2015 nonresident personal income tax return. The individual responded to the notice indicating that no business was performed in California and no tax was due. The FTB disagreed and issued a Notice of Proposed Assessment (NPA) based on the entire amount of Form 1099-MISC income. The individual unsuccessfully protested the NPA, and ultimately filed an appeal with the OTA. In part, the individual argued in his appeal that, upon completion of his design services, he was required to present the resulting designs to the company’s clients who were primarily located in Vancouver, Canada.




California nonresident filing requirements, income sourcing from services 


California generally requires the filing of a personal income tax return by every individual taxable under the Personal Income Tax Law3 with income exceeding the threshold filing level for the tax year at issue.4 Nonresident individuals are generally subject to tax in California only upon taxable income derived from California sources.5 Under the applicable nonresident personal income tax regulations, a nonresident taxpayer must meet four conditions to have California source income and a filing requirement: (i) the taxpayer must be conducting business as a sole proprietorship; (ii) the taxpayer’s business must be conducted within and outside California; (iii) the taxpayer must be carrying on a unitary business; and (iv) the taxpayer must derive California source income.6

For purposes of determining income from California sources earned by a sole proprietorship that conducts a unitary business within and outside California, Cal. Code Regs. tit. 18, Sec. 17951-4(c) looks to the allocation and apportionment provisions found within California’s Uniform Division of Income for Tax Purposes Act (Cal. Rev. & Tax. Code Secs. 25120-25139), which includes the market-based sourcing rules for receipts from other than tangible personal property set forth in Cal. Rev. & Tax. Code Sec. 25136 and the regulations thereunder. Restated more simply, this regulation requires a nonresident individual engaged in business as a sole proprietorship conducting a unitary business within and outside California to use the same statutory allocation and apportionment provisions generally applicable to corporations doing business within and outside of California.7




The OTA’s decision


The primary issue facing the OTA was whether the individual had California source income that created a nonresident individual tax filing obligation. Under the applicable UDITPA sourcing rules for receipts from sales other than sales of tangible personal property, service receipts are sourced to the location where the customer receives the benefit of the service.8 California’s market-based sourcing regulations define “benefit of a service is received” as “the location where the taxpayer’s customer has either directly or indirectly received value from delivery of that service.”9 Further, these regulations provide that when a corporation or other business entity is the taxpayer’s customer, receipt of the benefit of the service is determined under specific cascading rules.10 The first applicable cascading rule provides that the location of the benefit is presumed to be in California to the extent the contract between the taxpayer and its customer indicate the benefit of the service is in California. The presumption may be overcome by the taxpayer or the FTB showing, by a preponderance of evidence, that this was not the actual location where the benefit of the service was received.11

In applying these sourcing rules, the OTA considered whether the individual’s direct customer or the individual’s indirect customer (i.e., the customer’s customer) was determinative of where the benefit was received. Although the regulations appear to focus on the location where the taxpayer’s direct customer receives the benefit of the services, the OTA recognized that there are certain situations which warrant looking to the indirect customer. To support looking to the customer’s customer in this instance, the OTA referenced examples 4 and 5 of Cal. Code Regs. tit. 18, Sec. 25136-(2)(c)(2)(E), where sales from a website’s advertising services for its direct customers are sourced to the location from where the advertisement is viewed and/or clicked on by ultimate customer viewers. To further support looking to the customer’s customer, the OTA also referenced the FTB’s analysis in various Chief Counsel Rulings concluding that the benefit of “marketing services” is received at the location of the ultimate customer, while the benefit of “non-marketing services” is localized where the direct customer uses the services in its business.12
In applying the first cascading rule, the OTA concluded that the contract between the taxpayer and the company in this instance did not indicate where the company’s customer received the benefit of the services at issue. Thus, it turned to the second rule, which provides that if neither the contract nor the taxpayer’s books and records provide the location where the benefit of the service is received, or the first presumption was overcome, the location is reasonably approximated.13 Because the individual was able to substantiate that the benefit of his services were received by the company’s customer located in Canada, the OTA held that the receipts were properly sourced outside of California.14 As a result, it was not reasonable and rational for the FTB to rely on the applicable regulations to source all of the individual’s service income to California simply based on the company’s billing address. Absent the presence of California source income, the nonresident individual was held to have had no 2015 nonresident personal income tax return filing requirement. 






While this decision is nonprecedential, it is significant in that the OTA referenced the FTB’s regulations and Chief Counsel Rulings distinguishing between “marketing services” and “nonmarketing services” to support its conclusion that the benefit of the service at issue was received at the location of the customer’s customer. While this decision related to the treatment of an individual in determining whether he had a California filing obligation, corporate taxpayers that provide services to businesses should take particular note of the potential for far-reaching application of this analysis. In its first opinion (though non-precedential) to specifically address this issue, the OTA appears to accept the logic of the FTB in distinguishing between certain types of services where the benefit is indirectly received by the customer’s customer. Although this decision is nonprecedential, it could embolden the FTB to assert under audit that certain types of service receipts should be sourced to the location of the ultimate beneficiary, rather than the direct consumer. On the other hand, this decision could provide a valuable data point for taxpayers seeking to categorize their services as “marketing services” or “nonmarketing services,” as the case may be, for purposes of properly sourcing service receipts to either a direct customer or an indirect customer location.

1 In the Matter of the Appeal of Christopher J. Wood, California Office of Tax Appeals, Case No. 18042717, July 8, 2019.
2 The parties agreed that the wages paid to the taxpayer were not subject to California personal income tax.
3 CAL. REV. & TAX. CODE § 17001.
4 CAL. REV. & TAX. CODE § 18501(a)(1)-(4). The taxpayer’s subcontractor income exceeded the California filing threshold amount.
5 CAL. REV. & TAX. CODE § 17951(a); CAL. CODE REGS. tit. 18, § 17951-1(a).
6 CAL. CODE REGS. tit. 18, § 17951-(4)(c).
7 CAL. CODE REGS. tit. 18, § 17951-(4)(c)(2).
8 CAL. REV. & TAX. CODE § 25136(a)(1). 
9 CAL. CODE REGS. tit. 18, § 25136-2(b)(1).
10 CAL. CODE REGS. tit. 18, § 25136-2(c)(2)(A)-(D).
11 CAL. CODE REGS. tit. 18, § 25136-2(c)(2)(A),
12 This interpretation is consistent with FTB Chief Counsel Rulings 2015-03 (Dec. 31, 2015) and 2017-01 (April 7, 2017). Both are non-binding, but stand for the proposition that CAL. CODE REGS. tit. 18, § 25136-2 makes a distinction between marketing and non-marketing intangibles – sourcing income from the former to the location of the ultimate customer, and the latter to the location where the direct customer uses the intangible in its business.
13 CAL. CODE REGS. tit. 18, § 25136-2(c)(2)(B).
14 Relying upon the definition of “reasonably approximated” provided in CAL. CODE REGS. tit. 18, § 25136-2(b)(7).





Dana Lance

Dana Lance is the Tax Practice Leader for the Greater Bay Area and the SALT Practice Leader for the West Region. Dana is based in San Jose, California.

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