Discussion of Common Tax Audit Issues Affecting California Corporate Taxpayers

• Publication year: 2014
• Citation: Vol. 23 No. 2
• Author: By E. Scott Ewing, Benjamin Elliott & Natasha Ng

Discussion of Common Tax Audit Issues Affecting California Corporate Taxpayers1

By E. Scott Ewing, Benjamin Elliott & Natasha Ng²

In its April 2014 issue of Tax News, the California Franchise Tax Board ("FTB") identified the most common franchise/income tax audit issues currently affecting corporations.³ In this article we restate the common audit issues identified by the FTB, summarize the technical aspects of each issue and provide general insight regarding the potential prevalence of such issues in future FTB audits, including a discussion of some of the recent and contemplated changes in the California Revenue and Taxation Code and California Code of Regulations, title 18 adopted thereunder that may affect these issues.⁴

The FTB identified the following four areas as some of the most common audit issues affecting corporations: (1) Cost of Performance and Sourcing of Intangible Sales; (2) Sales Factor and Gross Receipts; (3) Abusive Tax Shelters; and (4) Credits.

I. COST OF PERFORMANCE AND SOURCING INTANGIBLE SALE

A. The FTB's Observations

For tax years beginning before January 1, 2011, sales from intangible sales and services are assigned based on the cost of performance. The complex rules of identifying income-producing activities and documentation necessary to do a cost-of-performance analysis may result in incorrect assignment of sales from intangibles and services. For tax years beginning on or after January 1, 2011, taxpayers who elect a single sales factor for apportioning business income to California will use market rules for assigning sales from intangibles and services instead of cost of performance rules.⁵

B. Practitioner Observations

While California law currently requires taxpayers to source the sales from intangibles and services under the market-based sourcing rules,⁶ many corporate taxpayers are under audit for tax years in which the cost-of-performance rules ("COP Rules") apply to such sales.⁷ Section 25136(a) sets forth the manner in which sales, other than sales of tangible personal property (i.e., intangible sales and services), are included in the numerator of the sales factor for corporate franchise tax apportionment purposes.⁸ Under this statute, sales are assigned to California if the income-producing activity is performed in California.⁹ If the income-producing activity is performed both in and outside California, the sale is assigned to California if the greater proportion of the income-producing activity is performed in California than in any other state, based on costs of performance ("COP").¹⁰ The initial step when analyzing a COP issue is to identify the income-producing activity or activities related to each separate item of income. The income-producing activity is defined as "the transactions and activity engaged in by the taxpayer in the regular course of its trade or business for the ultimate purpose of producing an item of income."¹¹ Income-producing activity may include the rendering of personal services; the utilization of tangible or intangible personal property; or the sale, rental, leasing, licensing or other use of real, tangible, or intangible personal property.¹² A taxpayer may engage in multiple income-producing activities as part of its business. For taxable years ended January 1, 2008, and thereafter, a taxpayer's income-producing activity also includes transactions and activities performed on behalf of a taxpayer, such as by an agent or independent contractor.¹³ COP are direct costs incurred by the taxpayer in performing the income-producing activity that gave rise to the particular item of income.¹⁴

In applying California's COP Rules, the FTB and taxpayers often have different views on: (1) the transactions and activities that should be tested for the purposes of applying the COP Rules (e.g., identification of a separate income-producing activity, or identification of the COP incurred in order to perform the income-producing activity); and (2) the level of documentation that is required to substantiate the taxpayer's income-producing activities and COP.

First, the FTB and taxpayers often differ on defining a specific income-producing activity or activities that are subject to the COP Rules, which may significantly affect the sales that are sourced to the California sales factor numerator. A major cause of this difference is that Regulation 25136 does not provide specific rules on how taxpayers are to define income-producing activities. This lack of specific guidance is compounded by the differing levels of analysis when auditing the income-producing activity that generated the sales. In some cases the parties may take a narrow view when identifying the income-producing activities (i.e., a transaction-based analysis), while in other instances, the parties may take a more broad view (i.e., an operational analysis).

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Second, some taxpayers appear to devote a substantial amount of time during an audit of a COP issue to assembling and providing documentation in order to substantiate: (1) the underlying transactions and activities in which the taxpayer engages in the regular course of its trade or business, and (2) the costs incurred to support such transactions and activities that generate the income. This is likely caused by an inconsistency between the level of analysis used by either party to define the income-producing activities and the taxpayer's organization of its operating business units or divisions, which, in many cases, is ultimately how the taxpayer originally identified its income-producing activities when conducting its COP analysis. As a result, when an FTB auditor requests information on the income-producing activities that is inconsistent with the methodology in which the taxpayer has structured and operates its business units and divisions (and used to determine its separate income-producing activities), taxpayers are often unable to meet the FTB auditor's request.

Finally, it is important to note that for tax years beginning on or after January 1, 2011, California introduced market-based sourcing rules.¹⁵ For tax years...