On January 8 and 9, the California Franchise Tax Board (“FTB”) conducted Interested Parties meetings to discuss certain apportionment regulations focusing on special industries, as well as special rules for applying costs of performance (“COP”) sourcing. The participation in these meetings by the business community and its representatives was notably high, and the discussions (summarized below) underscore potential areas for collaboration and controversy, as the FTB revisits and takes stock of several of its long-standing regulations.
Old and Cold? Should California Regulations Be Updated to Reflect Recent Changes in Technology?
California Reg. Sec. 25137-12: “Print Media”
The Interested Parties meeting on California Reg. Sec. 25137-12 was held to elicit public input on the sourcing of receipts for publishers, sellers, licensors, or distributors of print media as governed by the regulation. As a result of changes in the industry since the regulation was adopted in 1995, the FTB is reviewing whether revenue from online advertising and other non-printed sources should be addressed in the regulation. The discussion was led by Marguerite Mosnier, FTB Attorney.
Most of the discussion centered around the different types of advertising revenue that may need to be addressed in the regulation – e.g., electronic, online – and whether technology exists for companies to determine the location of these types of advertising revenue. This would suggest that the FTB prefers to source these types of receipts under a “market approach.” For example, it was discussed whether online advertisers can determine who is “clicking” their sites or ads. While the discussion participants indicated that some businesses can track “clicks” or “hits,” many businesses do not track hits or rely on other companies to obtain this information – which may be costly. A question was also raised about what would happen if an online advertiser had a certain percentage of “clicks” in a state where they did not have nexus – should a throwback rule be applied in these instances? If so, to which jurisdiction would these receipts be thrown back? It was suggested that these receipts could be thrown back to the location of the server.
Sutherland Observation: The proposed use of a throwback rule for services or intangible property has not been widely adopted, if at all, by any of the states because of the inherent difficulties in determining the state of origination. Under the traditional rule for sales of tangible personal property, the “origin” state from which the goods originate (e.g., shipping state) can more easily be determined. However, this could be problematic for online advertising revenue.
Because the existing regulation only provides for special rules for the sourcing of receipts for print media, the FTB also raised the question of whether there were special payroll or property issues for this industry that should also be addressed in the regulation. There was no response from the participants on this issue. The FTB stated that it assumed that meant the standard payroll and property apportionment rules were sufficient.
In conclusion, the FTB stated that while the consensus was that the existing print media regulation works for the industry for which it was designed (sellers of printed media), it may need to be updated to address other types of advertising revenue not covered by the regulation. Alternatively, separate regulations could be drafted to address advertising revenue, subscription media revenue and other types of revenue not covered in the current regulation. Because the FTB continues to harbor concern about how online advertisers track the location of their revenue, it was agreed that other businesses would be contacted to provide insight on these issues. Another Interested Parties meeting will be held in a few months to discuss any new information.
Ready for its Close-Up? Considering “Tweaks” or More to the Motion Picture/Television Regulation
California Reg. Sec. 25137-8: “Apportionment of Income for Motion Picture and Television Film Producers and Television Networks”
Advertising revenue continued to the topic of discussion at the FTB’s Interested Parties meeting on the formula apportionment rules for Motion Picture and Television Film Producers and Television Networks as set forth in California Reg. Sec. 25137-8. The FTB was particularly interested in understanding whether the regulation addresses changes that have occurred in the industry since its adoption in 1972, including, but not limited to, the application of formula apportionment rules to revenue from online advertising, both in this industry and other online advertising-driven media industries.
Carole Rouin, FTB moderator of the Interested Parties meeting, noted that the “primary problem is that the regulation is old (25-30 years).” Nevertheless, she responded to later questions by industry and said that the FTB “has no hidden agenda,” but rather wants to see what needs to be done – “maybe nothing.” She frequently referred to this process as being more “housekeeping”-focused than substantive in nature.
Many industry participants who heard Ms. Rouin’s statements might not feel mollified. However, given the vigorous discussion by various FTB attorneys, including Carl Joseph and Karen Smith, of scenarios that have evolved (e.g., ruling requests, positions on audit), the FTB attorneys said they feel justified in amending the regulation to provide more specific and/or generally binding guidance. In addition, they cited certain types of taxpayers (e.g., independent distributors) that fall outside the scope of this regulation. These taxpayers should be analyzed to assess whether this or a new regulation should be developed to address their apportionment.
Industry representatives and service providers generally emphasized that the industries that have been applying this regulation for long periods of time understand it without any significant difficulties in applying it. [The potential to address “new” media and new technologies in a regulatory context was generally not discounted by these participants, although one commentator stated it would be impossible either to anticipate or react to every new technology or media business model in the context of a regulation.]
A particular question posed to the meeting attendees was whether the regulation should be amended to explicitly state that advertising revenues constitute gross receipts subject to the regulation’s sourcing provisions. Some FTB representatives noted that California Reg. Sec. 25137-12 (addressing print media; see above) is explicit on this point, and it would be logical to make the two regulations parallel in this regard. Industry participants stated that they have always treated advertising revenues as gross receipts, and sourced them pursuant to the general rules contained in the regulation. However, the FTB responded that at least one taxpayer has asserted in an appeal that advertising revenues are not subject to the regulation, because the regulation does not explicitly address these revenues.
Sutherland Observation: At different points during the two days of meetings, it appeared that the FTB was interested in making explicit certain rules or approaches that industry participants retorted were implicit. Often, this response triggered a reaction by one or more FTB personnel that, based upon their experiences in administering the regulations, these regulations were not as clear as industry participants believed. “Interested Parties” seek a better understanding of the FTB’s specific questions and concerns with each regulation (e.g., through the FTB’s “hypotheticals,” which might well be based on real-life experiences of FTB staff and used to test the effectiveness of existing regulations). These hypotheticals in turn may stimulate a more effective dialogue.
Define or Not Define… What Constitutes “Bank or Financial Business Activity?”
California Reg. Sec. 25128: “Apportionment of Business Income,” and the Definition of “Banking or Financial Business Activity” With robust attendance by practitioners and the financial industry (primarily banks), the Interested Parties meetings on the term “banking or financial business activity” in California Reg. Sec. 25128 generated a flurry of discussion. When the regulation was adopted in 1993, the term “banking or financial business activity” was not defined, nor was it defined in any other section of the California tax code or regulations. Reg. Sec. 25128 provides that a business that derives more than 50% of its “gross business receipts” from a “banking or financial business activity” shall apportion its income using a single-weighted sales factor, whereas most other corporations apportion income using a double-weighted sales factor.
The FTB began the discussion by raising the question of whether a comprehensive definition of “banking or financial business activity” should be provided in the regulation and, if so, whether it should be tied to the definition of “financial corporation” as contained in Reg. Section 23183(a). “Financial corporation” is defined therein as “a corporation which predominately deals in money or moneyed capital in substantial competition with the business of national banks.” While there was no strong support or opposition to dove-tailing the two regulations, industry representatives did express some concerns that the definition of “financial corporation” in Reg. Section 23183(a) was very broad. They noted that this broad definition could result in a wide range of companies being forced to use a single-weighted sales factor. For example, the “business of national banks” can encompass a wide range of activities – e.g., renting foreclosed properties. Thus, it was raised whether a property management company could be considered to be in “competition with the business of national banks” and hence be limited to use of a single-weighted sales factor. There was also some discussion about the differing tests that are set forth in Reg. Sections 25128 and 23183. Reg. Sec. 25128 provides that 50% or more of the “gross business receipts” must be derived from a “banking or financial business activity,” whereas Reg. Sec. 23183 provides that “over 50% of a corporation’s total gross income” must be attributable to “dealings in money or moneyed capital in….” in order to qualify as a “financial corporation.”
Sutherland Observation: Several participants also noted that the test under Reg. Sec. 25128 (reference to “bank or financial business activity”) is intended to be applied to a unitary group, whereas the test under Reg. Sec. 23183 (defines “financial corporation”) is applied to distinct entities, which individually qualify as “financial corporations.” The FTB staff acknowledged that they have relied on Reg. Sec. 23183 in practice when making Reg. Sec. 25128 determinations on audit. It remains unclear whether consensus exists now or can be reached that this is a justifiable method for either the FTB or taxpayers to employ, taking into account the various differences noted above (including the unitary-group-versus-individual-entity filters that the respective regulations employ).
In the end, the FTB decided to create a working group with industry and practitioner participants to discuss the issue further. A second Interested Parties meeting will then be scheduled to discuss the findings and outcome of the working group discussions.
Whose “On Behalf Of” Counts? Will the FTB Expand COP to Include Activities Performed by Independent Contractors?
California Reg. Sec. 25136: “Sales Factor: Sales Other Than Sales of Tangible Personal Property in This State”
The last meeting of the two-day session covered California’s regulation addressing costs-of-performance sourcing – Reg. Sec. 25136. The FTB sought input as to whether the State should adopt the Multistate Tax Commission’s amendment to its Model Allocation and Apportionment Regulations, requiring that payments to independent contractors be included in the calculation of “income producing activity.” The meeting was presided over by FTB staff member Melissa Wulff.
Currently, California Reg. Sec. 25136 provides that the calculation of “income producing activity” for purposes of sourcing receipts from other than tangible personal property does not include transactions and activities performed on behalf of a taxpayer, such as those conducted on its behalf by an independent contractor.” In Legal Ruling 2006-02, (May 3, 2006), the FTB interpreted this regulation to allow a taxpayer who contracts with a member of the same unitary group to include the affiliate’s activities in determining the income producing activity of the taxpayer.
If California adopts the MTC’s new provision, the current FTB rule will be substantially altered. At the meeting, some business participants expressed appreciation for the existing rule, while others favored adoption of the amendment. If the rule is adopted, one issue raised was how a taxpayer should determine the analytical ending-point if its contractors subcontract out the work. Another problem identified was that the throwout provision, which operates if the location of the subcontractor’s services or customer’s commercial domicile cannot be identified, could cause distortion in calculation of the sales factor.
Sutherland Observation: This discussion highlights the inherent unpredictability of the “on behalf of” rule, which operates in tandem with the sourcing of “on behalf of” costs to the state where the affiliate/contractor performs its services. The impact of moving from a narrow rule (consider only the activities of unitary affiliates) to a broad rule (consider the activities of, and payments to, all affiliates and independent contractors) will depend upon a given taxpayer’s facts and circumstances. For every taxpayer that experiences a shifting of receipts to California through application of the proposed amendment, there may be another taxpayer that finds its receipts are sourced to another state pursuant to the “on behalf of” rule. For a detailed examination of the Multistate Tax Commission’s “on behalf of” proposal (which certain FTB attorneys helped to draft), and its interaction with FTB Legal Ruling 2006-2, please refer to SAB’s Legal Alert entitled “Legal Alert: California FTB Rules That “On Behalf Of” Exception Does Not Exclude Third Party Costs When Performed by a Member of the Taxpayer’s Combined Reporting Group,” May 18, 2006.
The conversation briefly digressed to whether a uniform definition of “taxpayer” was needed, and whether the use of independent contractors to perform services would give a taxpayer nexus in a particular state. Returning to the topic at hand, supporters of the amendment noted that under the current system, the determination of where the costs of performance are incurred is based arbitrarily on whether the taxpayer’s own employees perform a function or whether the taxpayer contracts out that function. Some participants appeared to support the change because it would arguably move California closer to market state sourcing (i.e., by coincidence of the location of the taxpayer’s contractors and its customers). A participant questioned whether the FTB should abstain from making changes, because the National Conference of Commissioners on Uniform State Laws (“NCCUSL”) is commencing a comprehensive review of UDITPA. Most people thought that the NCCUSL process would take so long (possibly a decade) that it did not make sense to wait for action from that organization. Finally, Ben Miller of the FTB noted that if the Board did adopt this change, it would likely be applied on a prospective basis, due to the change in position being implemented by the FTB.
The FTB is accepting written comments for the next 30 days. The next Board meeting is scheduled for March 6, 2008.