Earlier this year, the California Franchise Tax Board (the “FTB”) issued Chief Counsel Ruling 2017-01 (the “2017 Ruling”), which addresses the application of the state’s market-based sourcing rules to non-marketing services under California Revenue and Taxation Code (“Code”) section 25136 and California Code of Regulations (“Regulation”) section 25136-2. The 2017 Ruling concludes that receipts from non-marketing services should be sourced to California to the extent that a taxpayer’s direct customers (and not its customer’s customer) receive the benefit of the service in California. The 2017 Ruling reaffirms an earlier ruling, Chief Counsel Ruling 2015-03 (the “2015 Ruling”), where the FTB reached the same conclusion regarding receipts from non-marketing services. The 2015 and 2017 Rulings seem to foster a common theme developing under California’s market-based sourcing regime that the appropriate market is the location of a taxpayer’s direct customer (and not its customer’s customer).
Summary of Chief Counsel Ruling 2017-01
The taxpayer requesting the 2017 Ruling directly contracts with managed care organizations, i.e., health insurers, sponsored benefit plans, government health care programs, etc. (collectively, “Health Plans”), to manage and administer health benefit services that the Health Plans would otherwise be contractually obligated to provide to their clients and members. Some of the taxpayer’s services include: providing customer service and technology functions, securing discounts, and processing payments. Typically, in the event a Health Plan does not contract with the taxpayer to perform such services, the Health Plan would be contractually required to self-administer the services to its clients and members from its primary base of operations. The taxpayer’s services do not include marketing the Health Plan’s services.
The taxpayer sought a ruling that sales from its non-marketing services (i.e., services that do not market a product, service, or other items) should be assigned to the location of the taxpayer’s direct customer (i.e., the Health Plans) and not the location of its customer’s customer (i.e., the Health Plan’s clients and members) and the FTB agreed.
Pursuant to Code section 25136(a)(1), service receipts are sourced to California to the extent the purchaser of the service received the benefit of the service in California. The location where the benefit of the service is received means the location where the taxpayer’s customer has either directly or indirectly received value from the delivery of that service. See Regulation section 25136-2(b)(1). However, in the case of a non-marketing service where both the taxpayer’s customer and the taxpayer’s customer’s customers receive a benefit from the service, neither Code section 25136 nor Regulation section 25136-2 expressly address how to determine which party receives the benefit of the service.
The FTB was presented with this same issue in the 2015 Ruling. In the 2015 Ruling, the taxpayer provided integrated financial information and analytical applications to business entity customers (e.g., investment banks and other financial professionals), who in turn used the financial data and applications to provide financial services to their clients. The taxpayer requested a ruling to determine whether service receipts from its non-marketing services should be sourced to the location of its direct customers (e.g., investment banks) or its customer’s customer (e.g., the investment bank’s clients). The FTB concluded that the taxpayer’s service receipts should be sourced to the location of its direct customers; not its customer’s customer. In reaching its conclusion, the FTB analogized the rules and examples in the Regulations governing the sale of intangibles. Specifically, Regulation section 25136-2(d)(2) expressly distinguishes between “marketing” intangibles and “non-marketing” intangibles such that a marketing intangible is sourced to the location of the ultimate customer and non-marketing intangible is sourced to the location where the direct customer uses the intangible in its business.
Ultimately, relying on the 2015 Ruling, the FTB concluded that the taxpayer’s sales from its non-marketing services should be sourced to California to the extent its direct customers, i.e., the Health Plans (and not its customer’s customers, i.e., the Health Plan’s clients and members) receive the benefit of the taxpayer’s service in California. The FTB found that non-marketing services are analogous to non-marketing intangibles such that non-marketing services should be sourced in the same way as non-marketing intangibles. Additionally, the FTB found that each of the cascading rules under Regulation section 25136-2(c)(2) contemplate that it is the taxpayer’s direct customer who is receiving the benefit of the service; not its customer’s customer.
With more and more states, like California, adopting market-based sourcing and issuing a myriad of guidance, a number of issues and challenges have emerged for taxpayers trying to navigate these divergent market-based sourcing regimes. A common issue has been dealing with attempts by state revenue authorities to source certain types of receipts using a look-through approach (or, customer’s customer approach).
In California, the 2015 and 2017 Rulings provide clear and consistent guidance that receipts for non-marketing services should be sourced to the location of the taxpayer’s direct customer (not the customer’s customer). This is consistent with holdings in other states requiring sourcing to the location of the direct customer. For example, in Lutheran Brotherhood Research Corp. v. Commissioner of Revenue, 656 N.W.2d 375 (Minn. 2003), the Minnesota Supreme Court held that an investment advisor’s fee revenue for services provided to a Minnesota-based mutual fund should be attributed to Minnesota rather than to the locations of the advisor’s ultimate customers (the mutual fund’s shareholders). Taxpayers may be able to rely on the California rulings and these cases to support a similar position that receipts derived from the performance of non-marketing services should be sourced to the location of the direct customer (and not the customer’s customer). Nevertheless, it is imperative to recognize that divergent market-based sourcing regimes present both opportunities and pitfalls and that defining the appropriate market is heavily dependent on each taxpayer’s unique facts and circumstances.