California’s long-anticipated market-based sourcing “guidance” is finally out. Legal Ruling No. 2022-01 provides the Franchise Tax Board’s take on how to find the market in certain business-to-business sales. Though the guidance emphasizes that a seller should look to where its direct customer receives the benefit of sales of services, it keeps with current market-based sourcing trends amongst states and directs taxpayers to source such receipts based on the location of the taxpayer’s customer’s customer.
The Franchise Tax Board (“FTB”) provides a four-step framework analyzing various business-to-business sales of services. The framework provides that taxpayers must determine the following:
(1) who is the customer?;
(2) what is the service being provided?;
(3) what is the benefit of the service being received by the customer?; and
(4) where is the benefit of the service being received by the customer?
Utilizing this framework, the Ruling analyzes the sourcing rules based on three business-to-business service scenarios: corporate event planning, pharmacy benefits managers (“PBMs”), and consulting services. For PBMs and consulting services, the Ruling walks through the framework before ultimately focusing on the only fact that appears to matter to the FTB and concludes that the benefit of the service is received at the location of the customer’s customer. More specifically, the FTB concludes that the taxpayers “directly engage” their customers’ customers and thus the benefit is received where those customers’ customers are located (despite thorough statements reciting all of the benefits provided to the taxpayer’s direct customers). Pursuant to California’s cascading sourcing rules, the Ruling presumes that taxpayer’s have information sufficient to determine the location of its customer’s customer, however in the absence of such records, taxpayer’s are directed to use another reasonable proxy to source such sales.
Notably, the Ruling purports to retroactively revoke two prior Chief Counsel Rulings (CCR 2015-03 and CCR 2017-01), which had previously provided support for sourcing sales on the basis of a taxpayer’s direct customer (i.e., not the customer’s customer).
The FTB’s Ruling lacks any economic rationale for concluding that a taxpayer’s customer receives the benefit of a taxpayer’s services at the location of the customer’s customers. We believe this conclusion simply cannot be reached for all situations that involve some engagement with or that may concern a customer’s customers. Though we understand that guidance is important to provide taxpayers certainty, such rulemaking through the normal statutory or regulatory process is preferred in order to allow taxpayer input. Furthermore, the constitutionality of such guidance outside the standard legislative or regulatory processes is questionable. Nonetheless, this latest Ruling is likely to have significant tax impact amongst business-to-business service providers. California taxpayers should carefully review sourcing and apportionment practices for purposes of California state income tax going back to January 1, 2013, the effective date of California’s adoption of market-based sourcing.