A recent Chief Counsel's Ruling issued by the California Franchise Tax Board illustrates the issues and potential opportunities that arise as a result of adopting a factor presence nexus standard. Chief Counsel Ruling 2016-03, July 5, 2016. California, effective January 1, 2011, adopted a factor presence nexus standard for determining if a corporation was doing business in the state. That standard was amended and effective January 1, 2014 a corporation is doing business in California if its sales exceed the lesser of $529,562 or 25 percent of the total sales. The question is how that threshold is computed when a taxpayer is engaged in both the sale of tangible personal property and receives income form intangibles. In this case it was royalty income.
The company was engaged in the design and distribution of products that were marketed under various brand names. The products are sold through department stores, specialty retail outlets and online retailers. In addition the company licensed its trademarks to unrelated third parties. In turn, it received royalty income measured by sales. The FTB in computing the doing business threshold aggregated the revenue from the tangible personal property sales and the royalty income to determine if it had been met. In so doing, the FTB took the position that for purposes of determining the doing business threshold the safe harbor protection of P.L. 86-272 is not taken into consideration. The analysis raises an interesting question which has not been vetted as to the interaction between the safe harbor protection for the sale of tangible personal property and a factor presence standard for nexus. What is the proper ordering of the analysis or put bluntly does the federal safe harbor provision trump the revenue computation? It should be noted, that based on this FTB analysis corporations who have argued they are protected by P.L. 86-272 may actually be doing business in California because the company receives income from intangibles used in the state.
For every cloud there is also a silver lining. While there may be a downside for some corporations the analysis also provides an upside when applied in an apportionment concept. The question is what standard applies for determining if the throwback rule applies. The initial assumption would be that the FTB would merely have applied the factor presence nexus standard in the destination state to determine if the taxpayer is doing business in that state. Rather, than merely applying the statutory factor presence analysis the FTB used a convoluted analysis to reach the conclusion that the taxpayer was subject to tax in the destination state. The FTB acknowledged that the safe harbor protections of P.L. 86-272 applied but the nexus analysis did not stop there. The focus of the analysis was not on the threshold dollars but rather on the nature of the business activity in the destination state. The fact the company earned royalties in the states went beyond the P.L. 86-272 safe harbor protections. As a result, under the approach the taxpayer was subject to tax and the sales were not required to be thrown back. Utilizing the FTB's approach, if a company earns income from other than the sale of tangible personal property that alone is sufficient to establish that it is subject to tax in that state. Thus, the company avoids the application of the throwback rule.
This ruling raises a serious question as to whether the actual implications of the adoption of an economic presence standard have truly been vetted. The underlying theory is to capture and tax those corporations that earn income in the state from other than traditional means. However, what appears to be forgotten is the fact for every inbound transaction there is an outbound transaction and the same standards apply. Also, forgotten are the implications of the interaction of this nexus theory with other existing tax policies such as return filing methods.