Reforming California's Sales Factor Sourcing Rule for Sales of Tangible Personal Property to the U.s. Government in the Wake of the Covid-19 Pandemic

• Publication year: 2022
• Author: Joshua M Grossman

REFORMING CALIFORNIA'S SALES FACTOR SOURCING RULE FOR SALES OF TANGIBLE PERSONAL PROPERTY TO THE U.S. GOVERNMENT IN THE WAKE OF THE COVID-19 PANDEMIC

AUTHORS

Joshua M Grossman

Jamie Yesnowitz

Michael Caruso

This proposal was prepared by Joshua M Grossman, Jamie Yesnowitz, and Michael Caruso. The authors wish to thank reviewers Matt Cappel and Alisa Pinarbasi for their thoughtful comments. ¹,²,³

EXECUTIVE SUMMARY

This article reviews California's historical approach to sourcing receipts from sales of tangible personal property ("TPP") to the U.S. government for apportionment purposes, and discuss possible reforms to modernize California's current rule. California's statutory rule for sourcing sales of TPP to the U.S. government has existed in its current form for more than 50 years, and current economic and market conditions warrant that this historical approach be thoughtfully reviewed.

Since its language was first adopted in 1966, Cal. Rev. & Tax. Code ("CRTC") § 25135(a)(2) has required that when TPP is sold to the U.S. government and shipped from a place of storage in California, such sales are automatically sourced for sales factor purposes (i.e., "thrown back") to California irrespective of the destination of the goods. Only half of California's sister states currently have an analogous rule, which has historically presented taxpayers with many alternative locations to produce and store property

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prior to its shipment to the U.S. government. For this reason, the sourcing of U.S. government sales under CRTC § 25135(a)(2) has often been localized to smaller taxpayers with less sophisticated operational structures, or that were unaware of its provisions. Further, the impact of CRTC § 25135(a) (2) may have been elevated by the COVID-19 pandemic, which caused a surge in U.S. government purchases of personal protective equipment ("PPE"), ventilators, pharmaceuticals, and other medical equipment.

In evaluating potential reforms, the most recent draft proposed regulations released by the Franchise Tax Board ("FTB") for sourcing receipts from services provided to the U.S. government provide a helpful data point. Under these draft rules, receipts from services provided to the U.S. government are subject to the regulations' generally applicable market-based sourcing principles (looking to where the benefit of the service is received), and to the extent that the benefit of the service cannot otherwise be determined, the FTB has proposed to approximate where the benefit is received by dividing it amongst the states using U.S. census data.

With the FTB's proposed guidance for sourcing services in mind, as well as the potential impact that the current language of CRTC § 25135(a)(2) may have on California-based companies helping to respond to the COVID-19 pandemic, it seems appropriate to consider reforms to California's existing throwback rule for sales of TPP to the U.S. government. To that end, this paper proposes an amended approach that requires throwback when the taxpayer is not taxable in the destination of the sale and employs a census-based approximation when the ultimate delivery destination is foreign or unknown to the seller.

DISCUSSION

CURRENT LAW AND REASON FOR PROPOSED CHANGE

CALIFORNIA'S CURRENT RULE FOR SOURCING SALES OF TPP TO THE U.S. GOVERNMENT

Under CRTC § 25135(a), California has historically used a market-based methodology for sourcing sales of TPP based on the location to which the property is delivered or shipped, unless the taxpayer is not "taxable" in that state.⁴ When the property is shipped from a place of storage in California to a state where the taxpayer is not "taxable," California generally requires the sale to be "thrown back" and considered a California sale.⁵

CRTC § 25135(a)(2) also provides that the following situation involving U.S. government sales is automatically considered a California sale:

The property is shipped from an office, store, warehouse, factory, or other place of storage in this state and (A) the purchaser is the United States government . . .⁶

This statutory language has historically caused all sales of TPP to the U.S. government that are shipped from California to be "thrown back" and counted as a California sale irrespective of the shipping destination or where the property will ultimately be used or distributed by the U.S. government.⁷ Functionally, this "turns off" the market-based sourcing principle of CRTC § 25135(a) to the extent of U.S. government sales shipped from California, and attributes them entirely to California. In the case of a California filer in an income position, inclusion of these throwback sales in the sales factor numerator arithmetically causes the apportionment formula to attribute more business income to California, which in turn increases the seller's California tax to the extent sales of TPP are shipped to the U.S. government from a place of storage in California.⁸

From a historical perspective, the language of CRTC § 25135(a)(2) pertaining to U.S. government

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sales can be traced to Article IV of the Multistate Tax Commission's Original Model Multistate Tax Compact ("MTC") language first drafted in 1957.⁹ To the knowledge of the authors of this discussion paper, the methodology in CRTC § 25135(a)(2) has remained unchanged since this statute was first adopted in 1966.¹⁰

EFFICACY OF THE CURRENT THROWBACK RULE FOR U.S. GOVERNMENT SALES UNDER CRTC § 25135(A)(2)

Under the current language of CRTC § 25135(a)(2), the throwback of sales of TPP to the U.S. government is predicated on two conditions being met: (1) the TPP must be shipped from an office, store, warehouse, factory, or other place if storage is in California, and (2) the purchaser is the U.S. government.¹¹ The two-part test implies that when tangible goods are neither produced nor shipped from California, they are not ordinarily susceptible to throwback if sold to the U.S. government. In this regard, CRTC § 25135(a) (2) has historically disincentivized the production and storage of tangible goods in California for shipment to the U.S. government because, to the extent TPP is shipped from outside of California, the throwback of sales from such TPP is potentially avoided.

As an adaptation to the longstanding provisions of CRTC § 25135(a)(2), sophisticated taxpayers that provide material goods to the U.S. government consider, and often implement, plans to structure business operations outside of California as a mechanism to avoid the potential throwback of U.S. government sales. Over time, this reaction may have tended to localize the application of CRTC § 25135(a) (2) to smaller or less sophisticated businesses selling goods to the U.S. government. Discussed below, this issue may have been compounded by the fact that only half of California's sister states impose an analogous throwback rule for sales of TPP to the U.S. government.

IMPLICATIONS OF OTHER STATE APPROACHES TO THE THROWBACK OF SALES OF TPP TO THE U.S. GOVERNMENT

Because the language of CRTC § 25135(a)(2) can be traced to Article IV of the original Model MTC, many states have adopted similar statutes. A survey of other states reveals that 25 states and the District of Columbia currently employ a throwback rule for sales of TPP to the U.S. government that is analogous to CRTC § 25135(a)(2).¹² On the other hand, 25 states either do not currently have a throwback rule analogous to CRTC § 25135(a)(2) for sales of TPP to the U.S. government, or do not impose an apportioned tax on corporations.¹³

The ubiquity of states that do not require sales of TPP to the U.S. government to be thrown back and sourced to the state of shipment informs why California's historical throwback approach may have come to operate as a trap for unwary taxpayers. Furthermore, the geographic proximity of some of the states that do not apply a throwback rule, like Arizona and Nevada, may have historically reduced the hurdles to structuring business operations in a manner that minimizes the potential application of CRTC § 25135(a)(2) to U.S. government sales. Indeed, Arizona has adopted a sourcing regulation that explicitly excludes receipts from sales of TPP to the U.S. government from the sales factor numerator.¹⁴

One corollary implication of the variety of state approaches is that, to the extent a California taxpayer's sales to the U.S. government are subject to throwback under CRTC § 25135(a)(2), there may be an elevated likelihood of double taxation, i.e., the sale may be thrown back to California while also being treated as taxable in the destination state for the purposes of computing that state's apportionment percentage.¹⁵ For example, assume that PPE and other medical equipment is produced and stored in California, and then sold to the U.S. government for shipment to New York to assist with battling the COVID-19 pandemic. Under CRTC § 25135(a) (2), these sales would be thrown back and sourced to California for California Corporation Income or Franchise Tax purposes, and sourced to New York for purposes of New York's Corporation Franchise Tax (assuming the taxpayer is not otherwise protected from net income taxation in New York by P.L. 86-272).¹⁶ What's more, to the extent the same TPP is purchased by the State of New York and not the Federal government, the throwback treatment of U.S. government sales in CRTC § 25135(a)(2)

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would not occur (although application of a general throwback rule based on a lack of taxability could still be possible).

SUMMARY OF THE FTB'S PROPOSED APPROACH TO SOURCING OF RECEIPTS FROM U.S. GOVERNMENT SERVICE CONTRACTS

California's current approach to sales of TPP to the U.S. government also contrasts with the approach more recently taken by the FTB in its draft regulations interpreting CRTC § 25136 for sourcing receipts from services provided to the U.S. government.¹⁷

As background, CRTC § 25136 was amended to require market-based sourcing for all sales of other than tangible property (such as sales from services or...