California finalizes amendments to regulation Section 25136-2

Market-based rules for sales other than tangible personal property

Generally, under California’s market-based sourcing framework, sales other than sales of tangible personal property are sourced to the location where the taxpayer’s market for the sales is located.³ 

Sourcing of services

“Service” is defined as “a commodity consisting of activities engaged in by a person for another person for consideration.”⁴ Sales from services are sourced to California to the extent the customer receives the benefit of the service in California.⁵

Sourcing of intangibles

“Intangible property” is defined to include, without limitation, “patents, copyrights, trademarks, service marks, trade names, licenses, plans, specifications, blueprints . . . and other similar intangible assets.”⁶ Sales from intangible property are sourced to California to the extent that the property is used in the state.⁷

Sourcing mixed sale of services/intangibles

For transactions involving both a service and tangible or intangible property, the value of each portion of the sale is separately sourced.⁸ If the value of each portion is not readily available, the principal purpose under the contract will govern how to source the revenue.⁹

Sourcing of marketable securities

“Marketable securities” refers to “any security that is actively traded in an established stock or securities market and is regularly quoted by brokers or dealers in making a market.”¹⁰ Sales from marketable securities are sourced to the location of the customer.¹¹ For individual customers, the sale will be sourced to California if the customer’s billing address is in California.¹² In the case where the customer is a corporation or other business entity, the sale is sourced to California if the customer’s commercial domicile is California.¹³

Sourcing of sale, rental, lease or license of tangible property

Sales from the sale, lease, rental, or licensing of real property or tangible personal property are sourced to California to the extent that the property is located in the state.¹⁴

Special rules

A new section notes that, when determining the method of reasonable approximation, “the taxpayer’s reasonable approximation method shall be used unless the California Franchise Tax Board (FTB) shows, by a preponderance of the evidence, that such method is not reasonable.”¹⁵ While that rule allows the taxpayer some level of flexibility in determining the reasonable approximation to be used, the taxpayer must notify and describe to the FTB the revised reasonable approximation method. The FTB has the right to evaluate the taxpayer’s chosen reasonable approximation method. Once accepted, the FTB is compelled to accept the reasonable approximation method in future years absent a change of a taxpayer’s material facts that results in such method no longer being considered reasonable.¹⁶

Notable changes from prior version of the regulation

Asset management services

One of the most significant changes in the updated regulation is the introduction of a “look-through” sourcing rule for asset management services. The revised regulation requires that receipts from asset management services be sourced to each investor’s domicile or a beneficial owner’s domicile if the investor is holding title to the assets on behalf of a beneficial owner.¹⁷ A beneficial owner is defined as “any person who made an independent decision to invest assets.”¹⁸ However, master funds, feeder funds, and participants in defined benefit plans are not beneficial owners for purposes of applying the rules governing the sourcing of asset management services.¹⁹ As such, the regulations require the asset manager to “look through” these types of entities to the location of the investor in the master fund or feeder fund to determine where the benefit is received.

Once the locations of the beneficial owners are determined, receipts from asset management services are sourced to the sales factor “in proportion to the average value of the interest in the assets held by the investors or beneficial owners domiciled” in California.²⁰ If the taxpayer does not have information regarding the average value of the assets held by investors or beneficial owners in California, then it may use a reasonable estimation.²¹

Asset managers often source asset management receipts to different states based on actual management fees paid by the beneficial owners. When that sourcing method is used, the state receipts factor reflects reduced fees paid by seed investors, insiders, or other investors with side letters. However, California’s use of an average value of interest method may not reflect when a class of investors has negotiated or is subject to alternate fee arrangements.

Safe harbor for professional services

The updated regulation introduces a safe harbor rule for large-volume professional services. Businesses that provide services to more than 250 customers in any single professional service are now required to source receipts based on the billing addresses of those customers, unless any single customer accounts for more than 5 percent of a taxpayer’s receipts from that service.²² “Professional services” includes a wide range of services, including “management services, tax services, payroll and accounting services, audit and attest services, actuary services, legal services, business advisory consulting services, technology consulting services, services related to brokering securities that generate commission income, investment advisory services other than asset management services defined in [the] regulation, and services related to the underwriting of debt or equity securities.”²³

The safe harbor rule is designed to simplify apportionment for firms that would otherwise face significant challenges in determining the precise location where each customer receives the benefit of the service. However, depending on a taxpayer’s facts, this change may be either beneficial or detrimental, and a thorough review of how billing address details align with where the benefit of a service is received could be recommended in various cases.

General changes to presumptions and hierarchy related to service sales

California has removed the differentiations in sourcing of sales of services based on whether a customer is an individual or business entity. It has instead implemented a new set of rules that state that the location of the receipt of the benefit of the service is presumed to be in California to the extent that the service predominantly relates to real property located in the state, tangible personal property located in the state when the service is received (or where the tangible personal property is delivered after the service is performed), intangible property used in the state, or individuals who are physically present in the state at the time the service is delivered.²⁴

California has also modified the hierarchy of what data should be used to determine the location of where the benefit of the service is received:

• The taxpayer's contracts or books and records kept in the normal course of business.
• If that location is not determinable, all other sources of information may be used to substantiate the location of the benefit.
• If the location is still not determinable, reasonable approximation is used.
• If the location is still not determinable, the customer’s billing address is used.
• If a service is provided under a U.S. government contract, and the location cannot be determined under the above rules, the receipts are sourced via the ratio of California population over U.S. population.²⁵

There are also several new and modified examples providing guidance on how to determine where the benefit of a service is received within Cal. Code Regs. tit. 18, § 25136-2(c)(1)(G).

Intangible assets

The updated regulation also provides detailed guidance for sourcing receipts from the sale of intangible property, including stock, partnership interests, goodwill, and patents. The sourcing methodology depends on the composition of the assets of the entity being sold. If more than 50 percent of the entity’s assets consist of real or tangible personal property, the sale is sourced based on the average of the entity’s California property and payroll factors (either based on the prior 12 months or current year based on when the sale occurs during the tax year).²⁶ If more than 50 percent of the assets are intangible property, the sale is sourced based on the entity’s current-year California sales factor.²⁷

In cases where the taxpayer does not have access to sufficient data to determine the asset composition or apportionment factors, the regulation provides fallback methods. If no factor data is available, the sale may be sourced based on the commercial domicile of the entity being sold.²⁸ These rules also apply to receipts from dividends and goodwill, ensuring consistency across various types of intangible transactions.

This change is particularly relevant for taxpayers involved in mergers, acquisitions, or other extraordinary transactions, and is designed to ensure that California ultimately receives a portion of tax revenue from the sale of businesses with significant operations or market presence in the state.

Commentary

California’s amendment to its market-based sourcing regulation provides an updated framework for determining the amount of sales sourced to the state. Businesses should evaluate current sourcing practices to align with the amended regulation.

Since the amendments apply to tax years beginning on or after Jan. 1, 2026, taxpayers are not required to amend prior returns. However, it is not yet clear if the state will look to the guidance included in the amended regulations while reviewing positions under audit. Also, the updated guidance brings into question the applicability of prior guidance provided by the state, such as Legal Ruling 2022-01. In this legal ruling, the FTB analyzed the relevant considerations and proper analysis to determine the sourcing of gross receipts from the sales of services.²⁹ Certain portions of the analysis provided may still apply, as long as language in the prior version of the regulations remains substantially similar in the amended regulations, but taxpayers should carefully consider how prior guidance aligns with the amended regulations while documenting positions.

With the effective date approaching, taxpayers should begin preparing to comply with the updated regulation. Key action items include:

• Reviewing revenue streams to identify those affected by the new sourcing rules
• Updating data collection processes to align with updated methodologies required by the new regulation
• Modeling the impact of the changes on California sales factor and overall apportionment
• Documenting sourcing positions to prepare for future audit defense and ensure consistency.

Taxpayers should also monitor guidance from the FTB, which may issue additional clarifications or examples to assist with implementation.