California Issues Guidance on Throwback Rule for Sales Factor Apportionment

The most significant issue when applying the throwback rule is understanding when a taxpayer is “not taxable” in the other (i.e., destination) state.

By Tina M. Chunn, SALT Senior Manager

For companies that file in multiple states and therefore apportion income, computing each state’s apportionment factor is often very complicated due to the various rules used by the states.  One such rule that is often misunderstood (and sometimes not applied at all) is the “throwback” rule. The throwback rule generally provides that when receipts from the sale of tangible personal property[1] are sourced to a state (i.e., the purchaser’s state) where the taxpayer is not taxable, the sales are “thrown back” into the numerator of the taxing state’s sales factor.[2]   The impact of this rule is to limit the benefit of “nowhere” sales (i.e., receipts that, but for the throwback rule, would not be taken account in the taxpayer’s sales factor for any state in which it files).  The most common issue when trying to apply the throwback rule is understanding when a taxpayer is “not taxable” in the other (i.e., destination) state.  In the “All About Business” section of the California Franchise Tax Board’s December 2017 edition of Tax News, the state explains this requirement.

California rules provide that a taxpayer is taxable in another state if it is “subject to tax” in that state.[3]   This occurs if (i) the taxpayer conducts business activity in the state and (ii) the state imposes a net income tax, a franchise tax measured by net income, a franchise tax for the privilege of doing business, or a corporate stock tax on the taxpayer as a result of this activity.   A taxpayer is not subject to tax if the taxpayer voluntarily files and pays one of the taxes specified above in another state when not required to do so by the rules of such other state.   Additionally, a taxpayer is not subject to tax if the taxpayer pays a “minimum fee for qualification, organization, or for the privilege of doing business” in another state and either (i) does not engage in business activity in the other state or (ii) engages in some business activity in the state (not sufficient for nexus) and the “minimum tax bears no relation to the taxpayer’s business activity within such state.”[4]

For example, assume a taxpayer with facilities in California and Georgia sells tangible property for $1,000 that it ships from its California facility to a customer in Florida.   Under normal destination-based apportionment rules, the receipts from that sale would be sourced to Florida (i.e., they would not be in the numerator of either the California or Georgia sales factor).   However, for California purposes, since the taxpayer is not subject to tax in Florida, the receipts from that sale are subject to the throwback rules, and therefore are included in the numerator of the California sales factor.   Note that if the property was shipped from the taxpayer’s Georgia facility, the California throwback rule would not apply.

There are many issues that need to be addressed when trying to apply the “subject to tax” test, such as: (i) what constitutes a net income tax, (ii) what happens when the taxpayer is part of unitary group filing a combined report, and (iii) when does a minimum tax bear no relation to the taxpayer’s activity in the state?   Failure to apply the throwback rule correctly can be a costly mistake.   The SALT team at Aprio can assist with these and other specific apportionment rules to provide you the confidence you are paying the appropriate amount of tax in each state and do not incur unexpected tax exposure.   We constantly monitor these and other important state and local tax issues, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Tina Chunn at tina.chunn@aprio.com or Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at jeff.glickman@aprio.com for more information.

This article was featured in the February 2018 SALT Newsletter. 

[1] Not all states apply a throwback rule.   While the rule was initially adopted for sales of tangible personal property, some states have expanded the rule to sales of services as well.   The rule is applied a bit differently for services and is beyond the scope of this article.

[2] The throwback rule may also be applied when the purchaser is the U.S. government.

[3] Another taxability test is the “jurisdiction to tax” test.   This test is not covered in the guidance, but is generally met if the destination state would have the right to impose a net income tax on the taxpayer based on the taxpayer’s activity in the state, whether or not the state chooses to do so.   This rule ensures that the throwback rule is not applied just because the destination state doesn’t have a net income tax or chooses to exempt the taxpayer from the tax.

[4] California Rev. & Tax Code §§ 25122(a) and 25135; 18 CCR §§ 24122(a) and 25122(b)(1).

Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.