In Defense of Regulations: California, Market-based Sourcing, and the Defense Industry

JurisdictionCalifornia,United States
AuthorBy Shail Shah & Alexis Binazir
CitationVol. 25 No. 4
Publication year2016
In Defense of Regulations: California, Market-Based Sourcing, and the Defense Industry1

By Shail Shah & Alexis Binazir2

EXECUTIVE SUMMARY

California enacted mandatory market-based sourcing rules for sales of other than tangible personal property for most taxpayers for taxable years beginning on or after January 1, 2013.

Relevant to this discussion are the market-based sourcing rules applicable to services. In general, the statute provides receipts from services are sourced to where the benefit of the services is received. The regulations define where the "[b]enefit of a service is received" as the location where the taxpayer's customer received value from delivery of the service, either directly or indirectly.3 The market-based sourcing regulations require receipts from services performed for business-entity customers to be assigned based on the cascading rules provided in the regulations. The regulations are not meant to be a one-size-fits-all solution for most taxpayers but do provide general guidance for many diverse industries.

An area where the regulations provide no guidance is how government contractors should assign service receipts, specifically defense contractors providing services to the United States ("U.S.") government. How do contractors determine where the U.S. government benefits from a service? Generally, neither the books and records, nor the agreement between the defense contractor and the taxpayer indicate where the U.S. government "benefits" from the services provided. Even less clear is how a taxpayer should reasonably approximate the receipt of benefit by the U.S. government. Finally, even the catch-all rules in the regulation - place of order by customer or customer billing address - provide little certainty for defense contractors as the U.S. government may place the order from multiple or undefined locations and billing addresses may not be reflective of the market that received the benefit of services performed.

In this paper we explore the abovementioned problem, suggest possible solutions, and discuss the need for the Franchise Tax Board ("FTB") to provide guidance for defense contractors providing services to the U.S. government. While the issue is readily apparent to taxpayers in the defense industry, the lack of guidance and resulting problems have also been recognized by the FTB. FTB guidance will allow taxpayers in the defense industry to assign receipts to California with some certainty and alleviate the burden on the FTB with extensive audits and inquiries from these taxpayers.

DISCUSSION

This paper seeks guidance in an area that is unclear and potentially traps taxpayers in the defense industry. Requested guidance by the FTB will help taxpayers assign receipts to California with more certainty, reduce the examination burden on the FTB, and possibly provide a model for other states that currently adopt or plan to adopt market-based sourcing rules.

This paper will discuss the burden on taxpayers as a result of the lack of guidance by the FTB and make suggestions to provide a level of certainty for taxpayers to assign receipts to California when providing services to the U.S. government. Finally, this paper will discuss why guidance is prudent tax policy and the possible broader implications nationwide.

I. OVERVIEW OF MARKET-BASED SOURCING RULES

The genesis of the disconnect for defense contractors providing services to the U.S. government is the shift in California from the "cost of performance" methodology for sales of other than tangible personal property to market-based sourcing. The "cost of performance" approach measures income producing activity within a state while market-based sourcing looks to where customers receive the benefit of services provided by taxpayers. As a background, it is helpful to understand the current rules before discussing the impact on defense contractors.

A. Sales Factor for Services - Generally

The sales factor is a fraction with a numerator comprised of "the total sales of the taxpayer in [California] during the taxable year" and a denominator comprised of "the total sales of the taxpayer everywhere during the taxable year."4 Different rules apply to sourcing receipts from sales of tangible personal property and sales of "other than tangible personal property."5 For taxable years beginning on or after January 1, 2013, sales of "other than sales of tangible personal property" are sourced to California under varying methodologies depending on whether the receipt is from a manufacturing intangible, a non-manufacturing intangible, or a service.6 Specifically, sales of services are considered California sales, and included in the numerator of a taxpayer's California sales factor, "to the extent the purchaser of the service received the benefit of the services" in the state.7

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The statute mandating market-based sourcing also gives the FTB authority to prescribe regulations necessary or appropriate to carry out the purpose of the statute.8

B. "Benefit of a Service Received"

The regulation defines the phrase "benefit of a service received" as "the location where the taxpayer's customer has either directly or indirectly received value from delivery of that service."9 The regulation also creates a hierarchical methodology for sourcing services provided to a business entity. For business entity customers, the taxpayer looks first to the contract with the customer or its own books and records, which may "indicate [whether] the benefit of the service is in" California.10 If these documents do not establish where the customer received the benefit from the services provided, the location of the benefit may be "reasonably approximated."11

The use of a reasonable approximation methodology allows the taxpayer to approximate the location of where the customer receives the benefit of the services in a manner consistent with the activities of the customer to the extent such information is available to the taxpayer.12The method used also must "reasonably relate to the income of the taxpayer."13 Where a taxpayer assigns sales using a reasonable approximation method, the taxpayer must continue to use that method in subsequent taxable years and must request permission and receive approval from the FTB to use a different approximation method.14 If the FTB audits the reasonable approximation method and issues a written acceptance of it, the audited method will be accepted indefinitely "absent any change in material fact."15

The regulation provides a number of industry-specific examples of how taxpayers should navigate the cascading rules in the regulation. An example follows:

Web Corp provides internet content to its viewers and receives revenue from providing advertising services to other businesses. Web Corp's contracts with other businesses do not indicate the location (or locations) where the benefit of the service is received. The advertisements are shown via the website to Web Corp viewers and the fee collected is determined by reference to the number of times the advertisement is viewed and/or clicked on by viewers of the website. If Web Corp, through its books and records kept in the normal course of business, can determine the location from which the advertisement is viewed and/or clicked on by viewers of the website, then gross receipts from the advertising will be assigned to this state by a ratio of the number of viewings and/or clicks of the advertisement in this state to the total number of viewings and/or clicks on the advertisement. 16

The regulation uses this same set of facts to illustrate reasonable approximation:

Same facts as [above] except Web Corp cannot determine the location from which the advertisement is viewed and/or clicked on through its books and records, so Web Corp shall reasonably approximate the location of the receipt of the benefit by assigning its gross receipts from advertising by a ratio of the number of its viewers in this state to the number of its viewers everywhere. 17

If a taxpayer cannot reasonably approximate the location of the benefit received by its customer, it must then assign receipts to California based on where the customer placed the order for the service.18 Iforder location is unknown, the taxpayer must use the customer's billing address as a proxy to where the customer received benefit from the services provided.19

II. DIFFICULTIES SPECIFIC TO DEFENSE CONTRACTORS / NEED FOR GUIDANCE

Not all industries fit neatly within the rules prescribed in the regulations. Some industries, like defense contractors, are not addressed by the regulation examples. If the reasonable approximation examples fail to provide any guidance, it is unclear whether a taxpayer must try to establish a reasonable approximation before using customer order location or customer billing address. This anomaly applies to defense contractors where the contracts are often complex and multifaceted, and the FTB has acknowledged the uncertainty resulting from lack of guidance for this industry.20

A. Unique Nature of a Defense Service Contract

A...

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