Tales From the California Tax Controversy Trenches: Navigating FTB Sales Factor Audits; Proper planning can lead to a successful auditor at last a more tolerable one.

Date01 July 2021
AuthorAnderson, Eric

One of the California Franchise Tax Board's1 guiding principles is to "administer the Revenue and Taxation Code ... and be vigorous in requiring compliance with the law."2 Our decades-long experience with California tax controversy provides perspective on the FTB's vigor for compliance. This vigor is never more apparent than during audits of a multistate taxpayer's apportionment of income to California.

Since 2013, companies other than financial institutions, farms, and extractive industries that conduct multistate activity are subject to California income tax based on a single-sales-factor apportionment formula, which is the ratio of gross receipts within California to total gross receipts during the taxable year. An issue that frequently arises on audit is whether the multistate taxpayer has properly computed its sales factor, which requires sourcing receipts to California according to a series of cascading rules. Determining which sourcing rule applies depends on the facts and circumstances of the transaction. Receipts from the sale of an intangible property right are sourced according to one rule, whereas receipts from the sale of services are governed by another.

This area of the law is complex and remains a work in progress, with the state having yet to clarify a number of open questions. It is in this legal environment that taxpayers can expect the state to raise questions about their sourcing methodology. Anticipating the FTB's scrutiny by preparing for an audit will help taxpayers to shape and substantiate a narrative leading to a favorable determination or, if necessary, lay the groundwork for potential litigation.

This article provides practical tips for preparing for an FTB audit and identifies sourcing issues that the FTB frequently flags.

A California income tax audit may appear daunting but is reasonably transparent and formal. The FTB's audit begins with an initial contact letter (ICL) that may or may not identify the issues. Taxpayers should consider using a designated representative familiar with the process and California law at the outset. It may be worth preparing a California Form 3520-BE (Power of Attorney Declaration) to apply to all years at issue and to grant a representative the power to add or remove representatives, which would ensure greater flexibility as the audit unfolds.

Following the ICL, the auditor prepares an audit plan. It is beneficial to engage with the auditor at this stage to identify the scope and timing of the audit. Prior to any exchange of information, the parties may meet for an opening conference, discuss the plan and processes, and agree to the time frame and deadlines for submissions. The auditors generally have a list of items to review that taxpayers may obtain to prepare the company's audit plan.

Communications during an audit are critical. Although the auditors objective is to verify compliance with the law, the audit should be viewed as a precursor to potential litigation. Auditors will use responses to information document requests (IDRs) to frame the facts and application of law. Taxpayers should be mindful that these requests set the record and effectively serve as administrative discovery. Taxpayers should treat their response to IDRs that request a legal position as an opportunity to state their position clearly and succinctly, but not as an invitation to brief the entire issue. Choose language carefully as reflected in the law and avoid phrases like "more likely than not" or "we think" or "it appears."

For factual IDRs, consider what the auditor is verifying and if there is any issue with the information available. Provide what is requested and no more. If a request appears irrelevant to the subject, seek to clarify the auditors intention before stating that the item is not relevant. If the item continues to appear irrelevant, explain why.

After concluding the audit, the auditor will issue an audit issue presentation sheet (AIPS) detailing the proposed adjustments. The...

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