- California has formally adopted its long-awaited amendments to its market sourcing rules.
- It sets forth basic prioritization rules for sourcing sales other than tangible personal property.
- It also provides industry specific guidance for government contractors and asset managers.
Background
The Franchise Tax Board’s (“FTB”) proposed amendments to the California sourcing rules for sales of services and intangibles were finalized on August 27th. The amendments, modifying 18 Cal. Code Regs. Section 25136-2, include general sourcing rules as well as detailed guidance for certain industries. The amendments are effective for tax years beginning on or after January 1, 2026.
General Sourcing Provisions
The rules operate to source receipts to California based upon the location of the receipt of the “benefit of the service.” The benefit of the service is deemed received at the location where the taxpayer’s customer has either directly or indirectly received value from the delivery of the service. These sourcing rules are presumptions that may be rebutted by either the FTB or the taxpayer based upon a preponderance of the evidence to the contrary.
It is presumed that the benefit of any real property related service is in California under the regulations to the extent that the service predominantly relates to real property located in California. A similar rule applies for services related to tangible personal property; however, if the tangible personal property is delivered to the taxpayer’s customer directly or indirectly after the service is performed, the receipts from the service are sourced to the location of delivery rather than the location where the service was performed.
The location of the benefit of the service with respect to intangible property is presumed to be in California if the service predominantly relates to intangible property used in the state. The “use of intangible property in the state” means the location where the intangible property is employed by the taxpayer’s customer/licensee. Services delivered to individuals are deemed to be California sourced if the individual in question is physically present in California at the time the service was delivered.
Substantiation
As with the sourcing provisions, the regulation provides a hierarchy for substantiating the sourcing of receipts. The first source for substantiation is the taxpayer’s books and records kept in the normal course of business. If the location of the receipt of the benefit of the service cannot be adequately determined via the taxpayer’s books and records, the taxpayer may use all other sources of information to substantiate the location of the benefit. If the second methodology does not result in a determination of the location of the receipt of the benefit of the service, a taxpayer may use “reasonable approximation”, defined as “…the location of the market for the benefit of the services or the location of the use of intangible personal property…determined in a manner…consistent with the activities of the customer to the extent such information is available to the taxpayer.” Taxpayers may use the most recent U.S. census data as of the beginning of the taxable year if population constitutes a reasonable approximation method; foreign population data may be used if the benefit of the service or the use of the intangible property is in a foreign jurisdiction. If all else fails, customer billing address, as reflected in the taxpayer’s books and record, may be used to source receipts.
Forvis Mazars Insight: Taxpayers have long used population factor as a proxy for sourcing sales when adequate information is unavailable, which this modification to regulation recognizes. The regulation contains multiple examples of the application of sourcing and substantiation requirements.
Specific Industry Guidance
The modified regulation provides some interesting insight for specific industries, including government contractors, asset managers, and professional service providers.
Government contractors are given special dispensation if they cannot adequately source receipts based upon their books and records, all other sources of information, or reasonable approximation. The regulation acknowledges this can occur when the contract cannot be disclosed and there is no publicly available information about the service provided. In this instance, the receipts from the service are assigned to California in proportion to its share of the entire U.S. population using the most recent census data at the beginning of the taxable year.
The benefit of asset management services not otherwise subject to 18 Code Cal. Regs. 25137-14 (applicable to mutual fund service providers) is deemed to be received at the domiciles of the investors in the assets; however, if the investor is holding title for a beneficial owner, the regulation requires taxpayers to “look through” the titleholder to the domiciles of the beneficial owners. The regulation provides rules around determining investor domicile, and the location of the receipts of the benefit of these services are sourced to California in proportion to the average value of the interest (averaged based upon the beginning of the year and the end of the year) in the assets held by investors or beneficial owners located in California. If this cannot be determined using books and records, receipts may be assigned using a reasonable estimation.
Large volume professional service providers (those who provide substantially similar professional services to greater than two hundred and fifty customers in certain professional services enumerated in the regulation) assign receipts for sourcing purposes based upon customer billing address. Receipts from customers that account for more than five percent of the service providers’ receipts fall outside the ambit of the rule; if the service provider has fewer than two hundred and fifty customers, it must use the general sourcing provisions.
Forvis Mazars Insight: The formalization of “look-through” sourcing for asset management services, as well as some guidance about black box government contracts, help clear up some historic uncertainty around the sourcing of such receipts.
How Forvis Mazars Can Help
Forvis Mazars can help you navigate the new regulation and its applicability to your business, enabling you to reach an appropriate determination for sourcing of California receipts.