New regulations are on the way with respect to statutory changes regarding apportionment and sales of other than tangible personal property. There is still time to consider California’s new direction.

Over forty years ago, the California Legislature adopted the Uniform Division of Income for Tax Purposes Act (“UDITPA”) sales factor for its apportionment formula.1 One primary objective in doing so was to “promote uniformity in allocation practices among the … states which impose taxes on or measured by the income of corporations.”2 With regard to sales of other than tangible personal property, the UDITPA sales factor was designed to reflect a taxpayer’s “income producing activity,” which is defined by California regulations as “transactions and activity directly engaged in by the taxpayer in the regular course of its trade or business for the ultimate purpose of obtaining gains or profit”3 and the location of which is based on where the “costs of performance”4 are incurred.

The California Legislature recently discarded the design of the UDITPA sales factor regarding sales of other than tangible personal property and repealed the cost of performance rules for sourcing such sales for inclusion in the California sales factor for apportionment purposes.5 One primary objective in doing so was to “address[ ] the fiscal emergency declared by the Governor by proclamation issued on December 19, 2008, pursuant to the California Constitution.”6 In addition, the Legislature’s repeal of the costs of performance provisions was intended to provide “fair treatment” of service providers for sales factor apportionment purposes.7 California’s current costs of performance rule is an all-or-nothing rule that can sometimes produce inequitable results. For example, neither UDITPA nor California’s statutory provisions deals explicitly with the assignment of receipts from services for sales factor purposes. As a result, receipts from services are subject to the general “costs of performance” rule for assigning sales of other than tangible personal property. For service providers that expend substantial amounts of time or costs in more than one state, some states will receive no tax, whereas other states will receive tax windfalls from services performed, to a considerable extent, in other states.

Thus, for tax years beginning on or after January 1, 2011, sales, other than sales of tangible personal property, are sourced to California as follows: (1) sales from services are in California to the extent the purchaser of the service received the benefit of the service in California; (2) sales from intangible property are in California to the extent the property is used in California, except for sales of marketable securities, which are in California if the customer is in California; and (3) sales from the sale, lease, rental, or licensing of real or tangible personal property are in California if the real or tangible personal property is located in California.8

The California Franchise Tax Board (“FTB”) was authorized in 2009 to “prescribe regulations as necessary or appropriate to carry out the purposes” of the new marketstate- based approach established by the Legislature.9 With 2010 now well under way, the FTB has begun the process of amending its regulations to reflect these statutory changes. On February 10, 2010, the FTB held its first Interested Parties Meeting (“IPM”)10 to discuss and brainstorm regarding possible amendments to California Code of Regulations, title 18, section 25136 (sales other than sales of tangible personal property) (“Regulation 25136”). In attendance was a group of approximately 50-60 individuals (with perhaps another 20 or so individuals participating via telephone), primarily comprised of tax practitioners and FTB attorneys and staff. A handful of members of the business community participated as well. Among other things, participants questioned the need for definitions of certain statutory terms, such as the seemingly interchangeable “purchaser” and “customer.” More importantly, questions raised during the IPM underscored the difficulty of indentifying where a party “received the benefit of [a] service” and ascertaining “the extent [ ] property is used in [a] state.”11

The California Court of Appeal addressed similar questions in the context of tangible personal property over fifteen years ago in McDonnell Douglas Corp. v. Franchise Tax Board.12 There, the court permitted an aircraft manufacturer to exclude sales of aircraft that were destined for use outside of California but that were delivered to purchasers in California from the manufacturer’s California sales factor numerator for apportionment purposes.13 In determining where the tangible personal property was used, the court applied the “destination” rule rather than the “place of delivery” rule and declined to follow the FTB’s regulation in effect at the time.14

In reaching its decision, the court in McDonnell Douglas considered the rulings of a number of different states in rejecting the FTB’s regulation and upholding the destination rule.15 The FTB now intends to follow suit and will undoubtedly draw inspiration for its new regulations from other states that have gone before. Prior to the IPM, the FTB encouraged would-be participants to review the relevant provisions of Iowa’s and Ohio’s laws and rules regarding the situsing of sales of other than tangible personal property under similar market-state-based approaches.16

Iowa law, for example, applies language similar to California’s new statutory “received the benefit of [a] service” language. Specifically:

Gross receipts are includable in the numerator of the apportionment factor in the proportion which the recipient of the service receives benefit of the service in this state.17

With respect to a specific contract or item of income, all gross receipts from the performance of services are includable in the numerator of the apportionment factor if the recipient of the service receives all of the benefit of the service in Iowa. If the recipient of the service receives some of the benefit of the service in Iowa with respect to a specific contract or item of income, the gross receipts are includable in the numerator of the apportionment factor in proportion to the extent the recipient receives benefit of the service in Iowa.18

Iowa offers a number of “noninclusive examples of the application” of its rules, including:

(b) A corporation headquartered in State Y is building an office complex in Iowa. The corporation from State Y contracts with an engineering firm from State X to oversee construction of the buildings on the site. The engineering firm performs some of their service in Iowa at the building site and also some of their service in State X. The gross receipts from the engineering service are attributable to Iowa and included in the numerator of the apportionment factor because the recipient of the service received all of the benefit of the service in Iowa.

(c) A corporation from State A contracts with a computer software company from State D to develop and install a custom software application in a business office in Iowa of the company from State A. The software firm does consulting work on the project in State A and in Iowa. The software development is done in State D and in Iowa. The software package is delivered to the corporation from State A in Iowa. The gross receipts from the software development are attributable to Iowa and included in the numerator of the apportionment factor because the recipient of the service received all of the benefit of the service in Iowa.19

Likewise, Ohio situses gross receipts for services to the location of the ultimate use or benefit of the service for the purposes of its commercial activity tax:

In general, gross receipts from services are sitused to Ohio in the proportion that the purchaser’s benefit in Ohio with respect to what was purchased bears to the purchaser’s benefit everywhere with respect to what was purchased. Except as otherwise set forth in this rule, the physical location where the purchaser ultimately uses or receives the benefit of what was purchased is paramount in determining the proportion of the benefit received in Ohio.20

Ohio, however, offers flexibility in the manner in which a taxpayer may comply with the rule, specifically:

The tax commissioner will not require taxpayers to upgrade their systems in order to comply with the general provisions of this rule as long as the taxpayer makes a good faith effort to situs receipts from services in a reasonable, consistent, and uniform method that is supported by the taxpayer’s business records as they existed at the time the service was provided or within a reasonable time thereafter.21

Rather than examples, Ohio law offers a “list” of no less than 54 specifically enumerated “services and the situsing method to be used for commercial activity tax purposes.”22 Such services include “Accounting Services,”23 “Computer Programming Services”24 and “Payroll Services.”25

During the IPM, other states’ rules were discussed, including those of Minnesota, which provide for a cascade approach:

(i) Sales of intangible property are made within the state in which the property is used by the purchaser. If the property is used in more than one state, the sales must be apportioned to this state pro rata according to the portion of use in this state. If the portion of use in this state cannot be determined, the sale must be excluded from both the numerator and the denominator of the sales factor. Intangible property is used in this state if the purchaser used the intangible property in the regular course of its business operations in this state.

(j) Receipts from the performance of services must be attributed to the state where the services are received. For the purposes of this section, receipts from the performance of services provided to a corporation, partnership, or trust may only be attributed to a state where it has a fixed place of doing business. If the state where the services are received is not readily determinable or is a state where the corporation, partnership, or trust receiving the service does not have a fixed place of doing business, the services shall be deemed to be received at the location of the office of the customer from which the services were ordered in the regular course of the customer’s trade or business. If the ordering office cannot be determined, the services shall be deemed to be received at the office of the customer to which the services are billed.26

By the close of the meeting, most questions as to how the FTB will proceed remained unanswered: e.g., which terms need or do not need to be defined, whether the regulation will include industry-specific provisions or merely illustrative examples, and which states’ laws will the FTB consider. Taxpayers should have a better idea of the direction California will take shortly, as the FTB must move quickly on this project in order to have new regulatory provisions in place for taxable years beginning January 1, 2011. As of the date of the writing of this article, the FTB is working on the first draft of the amendments to its Regulation 25136. Upon completion, the FTB will likely publish the draft and hold a second IPM for comment. Stay tuned for developments.