California Tax Update: How to Use Recent Tax Law Changes to Your Advantage


Californians exercised their right to shape tax policy in the last election, voting to try to capture more revenue from out-of-state businesses and to increase revenue from sales tax. Simultaneously the Franchise Tax Board published a decision on corporations operating within and without the state of California. This article will discuss how your company can successfully adapt to the recent changes in California tax law.

Strategy #1: Re-evaluate sales to customers outside of California and outside the US
In August, the California Franchise Tax Board issued Chief Counsel Ruling 2012-03, which addresses the throwback rules for corporations. For tax years starting on or after January 1, 2011, sales of tangible personal property shipped from California to other states are "thrown back" (or assigned) to California if the sales are not subject to tax in the destination state. Also for tax years starting on or after January 1, 2011, California has adopted the "economic nexus" standard, which means that a corporation is considered doing business in state, regardless of its physical presence, if its sales in California exceed the lesser of $500,000 or 25% of total sales.

As a result of the above, corporations can reduce their sales sourced to California if the corporation has a certain level of presence in another state or foreign country, resulting in a reduced tax liability for 2012 and future years.

Strategy #2: Optimize between the 4-factor or single-sales factor election for 2012
In November, California voters passed Proposition 39, which makes mandatory the single-factor apportionment formula and eliminates the 4-factor apportionment formula beginning in 2013. Before the passage of Prop 39, most multistate taxpayers were able to choose between either one, allowing them to minimize their tax liability. The new law is expected to bring in $1 billion in additional state revenue each year.

Until January 1, taxpayers still have the option of choosing between the two methods. The 4-factor method weights a company's property, payroll, and sales (with sales factored twice), resulting in California-based companies apportioning a higher percentage of their income to California. The single-sales method calculates tax liability based only on in-state sales, resulting in a lower apportionment percentage for California-based companies. Profitable companies should elect the single sales factor method, while companies operating at a loss should elect the standard 4-factor apportionment method in order to preserve large net operating losses.

Strategy #3: Work with your customers to understand how your service is used
The move to the single-sales factor method will require a company to change the way it sources service- or intangible product-based revenue. Under the 4-factor method, the company calculated its taxes based on where the cost of performing its services were incurred. Thus, California-based companies had to source 100% of their service revenue to the state, creating a larger California taxable income.

Now that the single-sales factor method is de facto, a company will have to move from the cost-of-performance rules for apportioning sales to the market-based apportioning rules. The market-based method allows for sales from services to be sourced to the state in which the purchaser of the service received the benefit of the service. Therefore, a California-based company could potentially end up with no services sourced to California if none of the benefits derived by the customer were in California. This would drastically reduce its California income.

Based on California Regulation 25136(b), sales from services are to be sourced to California if the purchaser of the service received the benefit of the service in the state. Sales from intangible property are to be sourced to California if the property is used in the state. For the purposes of this regulation, “benefit of a service” is defined as the location where the taxpayer’s customer has either directly or indirectly received value from the delivery of that service.

Companies will have to determine where the true benefits of their services should be sourced. They can begin by looking through service contracts and speaking with customers to provide evidence if the benefit is derived outside of California.