On March 25, 2022, the California Franchise Tax Board (FTB) issued Legal Ruling 2022-01 to address the application of California’s market-based sourcing rules set forth in California law and regulations1 to certain services provided to business entity customers.2 The FTB had previously issued two Chief Counsel Rulings (CCRs) addressing where a business entity customer receives the “benefit of the service” under certain taxpayer-specific fact patterns.3 The new ruling marks a shift in the FTB’s historical administrative guidance by revoking prior CCRs and providing three scenarios to address the relevant considerations when assigning receipts from the sale of services to business entities for sales factor numerator purposes.
Background on revoked FTB CCRs
CCRs are taxpayer-specific rulings issued by the FTB in response to a distinct fact pattern submitted for evaluation by a particular taxpayer. Although now revoked by Legal Ruling 2022-01, the two CCRs provide helpful background for understanding the changes represented in Legal Ruling 2022-01.
CCR 2015-03 addressed the application of California’s market-based sourcing rules to a taxpayer’s receipts from providing integrated financial information services and analytical applications to business entity customers who in turn provide financial services to their own customers. These services aggregated data from hundreds of databases into a consolidated warehouse accessible from a “one-stop” portal, which in turn allows the customer to provide “enhanced service and product offerings to their own customers” (i.e., the customer’s customer).
In CCR 2015-03, the FTB recognized that neither Cal. Rev. & Tax. Code Sec. 25136 nor Cal. Code. Regs. Sec. 25136-2 address where the benefit of a service is received “where both the taxpayer’s customer and the taxpayer’s customer’s customers receive a benefit from use of the service.” As such, the CCR analogizes to rules contained in Cal. Code. Regs. Sec. 25136-2 for sourcing receipts from “marketing” and “non-marketing” intangibles, and then identifies the service at issue as a “non-marketing service” for which “the value lies in the service being used in the business operations of the taxpayer’s customer.” Concerning the sourcing of receipts from a “non-marketing service,” the FTB reasoned that “sales from these services would be sourced to the location where the taxpayer’s customer receives a benefit of the service through its use in the business.” Conversely, a “marketing service” – i.e., one that is “used to sell, promote, or advertise its customer’s product, service or other item” – would potentially be a situation where it is appropriate to look through to the customer’s customer to determine where the benefit of the service is received.
Two years later, the FTB again addressed the application of California’s market-based sourcing rules for service receipts in CCR 2017-01. In this CCR, the taxpayer was in the business of providing outsourced healthcare plan administration services that its direct customers (the Health Plans) would otherwise be contractually obligated to provide to their own clients and/or members.
Drawing from the framework established by CCR 2015-03, CCR 2017-01 identified the services at issue as “non-marketing services,” and defined the benefit to the customer as “that of being relieved of the obligation to perform these business functions that they would otherwise be required to perform themselves.” Based on this articulation of the benefit of the services, the FTB concluded that the best reasonable approximation for where the benefit is received by the direct customer “would be the location where the Health Plans currently conduct the residual benefit services and other health plan functions, i.e., the current base of operations.” In this regard, the CCR followed the logic and reasoning of CCR 2015-03 by again looking to the operational benefit to the direct customer when considering how to apply the “benefit received” sourcing methodology of Cal. Rev. & Tax. Code Sec. 25136(a)(1) to “non-marketing services.”
Taken together, CCRs 2015-03 and 2017-01 were generally construed to distinguish between a “non-marketing service” and a “marketing service” when determining where the benefit of the service is received for purposes of applying Cal. Rev. & Tax. Code Sec. 25136(a)(1). As discussed below, Legal Ruling 2022-01 has revoked both CCRs 2015-03 and 2017-01 and indicates that it supersedes any conflicting prior guidance of the FTB.
Legal Ruling 2022-01
Legal Ruling 2022-01 outlines the relevant considerations and proper analysis to determine the assignment of gross receipts from the sales of services to business customers under California law and regulations. To achieve this goal, the ruling provides three scenarios for evaluation that are each analyzed under the following four-question framework: (i) who is the customer?; (ii) what is the service being provided?; (iii) what is the benefit of the service being received by the customer?; and (iv) where is the benefit of the service being received by the customer?
Who is the customer?
The ruling provides that under California’s market-based sourcing statute and regulations, only the value to the taxpayer’s customer is relevant to the analysis, even though it is acknowledged that a third party might also benefit from the performance of the service.
What is the service being provided?
The ruling points to the contract between the taxpayer and its customer as identifying the specific service that is to be performed.
What is the benefit of the service being received by the customer?The ruling generally states that the value of a service is “the direct effect of the action or function being performed” and cites example 4 of Cal. Code Regs. Sec. 25136-2(c)(2)(E) for support.4 In that example, the taxpayer provides internet content and places online advertisements that garner the engagement and interest in the taxpayer’s customer’s products from the viewers. Based on these facts, the ruling states that “the benefit of the service received by the taxpayer’s customer is potential sales and interest from the viewers of the advertisement.”
Where is the benefit of the service being received by the customer?
Concerning how to analyze and determine the location where the benefit is received, the ruling states that “[w]hen the value of the service is the direct effect of the action or function being performed, the location of the benefit will be where the direct effect impacts the taxpayer’s customer.” To explain this approach, the FTB again cites example 4 of Cal. Code Regs. Sec. 25136-2(c)(2)(E) for support and identifies the value of a service as being “the direct effect of the action or function being performed,” which then makes the location of the benefit “where the direct effect impacts the taxpayer’s customer.” Following this determination, the cascading rules contained in Cal. Code Regs. Sec. 25136-2(c)(2)(A)-(D) govern how to specifically measure the location of where the benefit is being received, which often turns on what level of information the taxpayer has with respect to the transactions and/or its customer base.
The three scenarios analyzed in Legal Ruling 2022-01
The ruling examines the four questions described above in the context of three situations to illustrate the application of California’s market-based sourcing rules to receipts from business-to-business services.
Situation One – Planner Corp.
In the first situation, Planner Corp plans and coordinates corporate events and is engaged by a box manufacturer located in State X to plan a cancer charity event in State Y. Under these facts, the customer is identified as the box manufacturer, the service as the planning and coordination of the event, and the benefit of the service as the customer having received a “planned and coordinated event.” The location where the benefit of the service is received is identified as “where the event will occur in state Y,” not the location of the taxpayer, or the location where the direct customer (the box manufacturer) would have performed the planning activity on its own without a contract. The FTB notes that for purposes of applying the cascading rules, the taxpayer should have the event location information in its books and records.
Situation Two – Pharmacy Benefit Manager Corp.
Bearing close resemblance to the facts at issue in CCR 2017-01, the second situation involves a pharmacy benefit manager providing the service of administering drug benefit programs for employers, unions, and health plans. The pharmacy benefit manager at issue contracts with a health plan provider to provide the service of processing member claims and fulfilling delivery of pharmaceuticals to members, which are sent to the member’s home or picked up at a pharmacy.
In this situation, the FTB identifies the customer as the health plan provider and the service as “the processing and fulfilment of prescription drug claims.” Further, the FTB describes the benefit of the service as the health plan beneficiaries being “able to obtain pharmaceuticals.” Casting the benefit of the service as the customer’s customers being able to receive their pharmaceuticals, the FTB concludes that “[t]he location of the benefit to the Health Company is where the pharmaceuticals are delivered to the members . . ..” For purposes of applying the cascading rules, the FTB notes that while the pharmacy benefit manager should have the location of the ultimate customers in its books and records, it may be reasonable to use the pharmacy location at which the transaction takes place as a substitute for the location of the ultimate customers as a reasonable approximation. Importantly, both the articulation of the benefit of the service and conclusion on the location where the benefit is received starkly contrast with the FTB’s prior analysis in CCR 2017-01, which framed the benefit of similar services as the direct customer being relieved of the need to administer the health plan itself in the absence of the contract.
Situation Three – Niche Corp.
In Situation Three, the taxpayer, Niche Corp, is hired by Tracker Corp as a subcontractor to assist in providing consulting services to Manufacturing Corp. The terms of the agreement require Niche Corp to assist with advising on certain aspects of Manufacturing Corp’s manufacturing plant’s power consumption. Under these facts, the FTB identifies the customer to be Tracker Corp. Despite classifying the customer as Tracker Corp, the FTB defines the service being provided as “providing consulting to Manufacturing Corp” despite the contract at issue being between Niche Corp and Tracker Corp only. Concerning the benefit of the service, the FTB states that “[t]he direct effect and benefit of the service being provided to Tracker Corp is that its customer, Manufacturing Corp, receives consulting.” Based on this characterization of the benefit of the service, the ruling concludes that “Manufacturing Corp’s manufacturing plant is where Niche Corp’s consulting is utilized, and this is where the impact of this benefit occurs for Tracker Corp.” The FTB notes that for purposes of applying the cascading rules, the taxpayer should have the manufacturing plant location information in its books and records.
Unlike Legal Rulings, CCRs are limited in application to the specific taxpayer making the request. It has long been the FTB’s position that CCRs are not binding guidance for other taxpayers to cite as authority. By contrast, Legal Ruling 2022-01 sets forth guidance that may have broader application to both taxpayers and FTB auditors when examining market-based sourcing fact patterns. This follows because it is the FTB’s position that a published Legal Ruling can be cited as an interpretation of existing law and have retroactive application unless specifically stated otherwise in the Legal Ruling.5
There may be concern within the taxpayer community that Legal Ruling 2022-01 reaches a “look through” approach (i.e., it sources receipts based on the impact to the ultimate customer in Situations Two and Three) by employing an analysis wholly distinct from that present in CCRs 2015-03 and 2017-01, which focused on the presence of “non-marketing” versus “marketing” services. Coupled with the potential for retroactive application, the casting aside of the analytical framework in the prior CCRs may be of material concern to taxpayers that attempted to apply the best available administrative guidance in prior years. Perhaps in an effort to address these concerns, the FTB recently issued guidance clarifying that large corporate understatement and accuracy-related penalties would not be assessed against taxpayers who relied on either of the revoked CCRs in determining their tax filing position as long as they filed a California return, but interest will be assessed on underpayments resulting from reliance on the CCRs.6
Legal Ruling 2022-01 arguably sets forth a less defined framework than the now revoked CCRs in determining when to stop at the direct customer’s operational benefit versus looking through to the ultimate customer’s benefit to determine the proper sourcing. The FTB’s revised sourcing approach appears to be summarized in its statement that “[w]hen the service provided by the taxpayer is directed at the customer’s customer(s), the benefit received by the customer is likely located at the customer’s customer(s)’ location.” This starkly contrasts with the analytical framework of the prior CCRs, which clearly stated that when dealing with a “non-marketing service,” the location where the benefit is received will be based on the benefit to the direct customer’s business from an operational perspective.
Many taxpayers have historically construed CCRs 2015-03 and 2017-01 to suggest that Cal. Rev. & Tax. Code Sec. 25136 and Cal. Code. Regs. Sec. 25136-2 require direct customer-based sourcing by default unless there is some limited exception to that general rule, such as the presence of a “marketing service.” With the revocation of these two rulings, the approach of Legal Ruling 2022-01 may create material uncertainty for taxpayers who have long relied on the FTB’s previous analytical framework, and may also spur more audit controversies centered around which services are (or are not) “directed at the customer’s customer(s)” in some regard, thereby warranting a look-through approach to the sourcing of service receipts.
1 CAL. REV. & TAX. CODE § 25136(a)(1); CAL. CODE REGS. tit. 18, § 25136-2. All regulation references are made to Title 18 of the California Code of Regulations.
2 Legal Ruling 2022-01, Numerator Assignment of Gross Receipts from Sales of Services to Business Entities, California Franchise Tax Board, Mar. 25, 2022.
3 Chief Counsel Ruling 2017-01, California Franchise Tax Board, Apr. 7, 2017; Chief Counsel Ruling 2015-03, California Franchise Tax Board, Dec. 31, 2015.
4 CAL. CODE REGS. tit. 18, § 25136-2(c)(2)(E), ex. 4 provides the following: “Web Corp provides internet content to its viewers and receives revenue from providing advertising services to other businesses. Web Corp’s contracts with other businesses do not indicate the location (or locations) where the benefit of the service is received. The advertisements are shown via the website to Web Corp viewers and the fee collected is determined by reference to the number of times the advertisement is viewed and/or clicked on by viewers of the website. If Web Corp, through its books and records kept in the normal course of business, can determine the location from which the advertisement is viewed and/or clicked on by viewers of the website, then gross receipts from the advertising will be assigned to this state by a ratio of the number of viewings and/or clicks of the advertisement in this state to the total number of viewings and/or clicks on the advertisement.”
5 Manual of Audit Procedures, Chapter 10.4.3, FTB Legal Rulings, California Franchise Tax Board, rev. Nov. 2017.
6 In contrast, the guidance states that delinquent penalties will apply to taxpayers who determined that they did not have a filing requirement under the revoked CCRs and later filed a late return. News Release, FTB Issues Legal Ruling on California’s Market-Based Rules, California Franchise Tax Board, Apr. 11, 2022.
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Joshua “Josh” is a State and Local Tax (“SALT”) Principal in the San Francisco office of Grant Thornton LLP. Mr. Grossman specializes as a subject matter expert in California Corporation Income or Franchise Tax matters.
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Jamie Yesnowitz, principal serving as the State and Local Tax (SALT) leader within Grant Thornton's Washington National Tax Office, is a national technical resource for Grant Thornton's SALT practice. He has 22 years of broad-based SALT consulting experience at the national and practice office levels in large public accounting firms.
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