California Issues New Ruling on Sourcing Service Revenue, Revokes Prior Guidance

May 24, 2022

By: Aspen Fairchild, SALT Senior Associate

At a glance:

  • Key takeaway: In March, the California Franchise Tax Board issued a legal ruling that revises its interpretation for sourcing service revenue for California apportionment and revokes prior guidance.
  • Impact on your business: The ruling impacts prior apportionment positions as well as nexus, since California imposes an income tax obligation on service providers whose California receipts exceed a certain threshold.
  • Next steps: Aprio’s State and Local Tax (SALT) team has experience with these sourcing rules and can assist your business to determine the appropriate filing position and pursue a refund.

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The full story:

As a business, you probably know your customer’s location, but do you know the location of your customer’s customers? On March 25, 2022, the California Franchise Tax Board (FTB) issued Legal Ruling 2022-01, which highlights the importance of this question when assigning gross receipts from the sales of services for apportionment purposes, and in doing so, revoked two prior Chief Counsel Rulings (CCRs) on which taxpayers previously relied.[1]

When sourcing service revenue for income tax apportionment purposes, California is a market-based state, which means that service revenue is assigned where the “benefit of a service is received,” regardless of where it is performed.[2] The regulations explain that this means “the location where the taxpayer’s customer has either directly or indirectly received value from the delivery of that service.”[3] But how exactly does this rule get applied to determine where the benefit is received? 

Sourcing service revenue under the new ruling

Previously, the FTB issued two CCRs that provided guidance on whether the benefit is received at the location of the taxpayer’s customer or the location of its customer’s customers.[4] In those rulings, the FTB classified services as either marketing or nonmarketing services. Benefits from nonmarketing services were generally viewed as being received by the customer at the customer’s location, and benefits from marketing services were generally viewed as being received by the customer at the location of the customer’s customers.

For example, in CCR 2017-01, the taxpayer — a health plan administrator — provided certain health plan administration services to businesses such as managed care organizations, health insurers and government health programs for the health benefits that these businesses provide to customers under their various health insurance plans. These are services that the healthcare insurer would have otherwise provided to its customers, but instead chose to subcontract to the taxpayer.

In addressing where the taxpayer should assign its receipts, the CCR first determined that the services qualified as nonmarketing services, and therefore “the benefit received should be determined with respect to the [customer’s] direct benefit and not the indirect benefit received by the [customer’s] customers.” Therefore, that CCR concluded that the benefit received by the taxpayer’s customer is that the customer is relieved from performing these services, and the location of this benefit is where the customer would have otherwise performed them: its base of operations.

In Legal Ruling 2022-01, the FTB eliminated the need to distinguish between a marketing and nonmarketing service, focusing instead on what the benefit of the service is and where it is received. If the service provided is directed at the customer’s customers, the “benefit received by the customer is likely located at the customer’s customer(s)’ location.” Types of services that may utilize this approach include sales and marketing services, customer support services, in-person services involving a third-party contractor and subcontracting arrangements. The ruling provides three situations to illustrate how these new rules and the regulations apply to different service providers.

For example, in Situation Two, a company that administers drug benefit programs contracts with a health plan provider to provide processing and fulfillment of prescription drug claims for the plan’s members. The company’s receipts are primarily from processing members’ claims and fulfilling the delivery of pharmaceuticals to members. The benefit of this service is that the health plan’s customers (i.e., the customer’s customers) can obtain pharmaceuticals, and this benefit is received where the pharmaceuticals are delivered to those members (i.e., its customer’s customers). Thus, receipts received for this service are assigned to where the health plan members are located.

The FTB retroactively revoked CCR 2015-03 and CCR 2017-01 with this legal ruling and issued a news release on April 11, 2022, offering penalty relief for certain taxpayers affected by the change, stating:

“If a taxpayer relied on either of the revoked CCRs when determining its tax filing position, the Large Corporate Understatement Penalty (LCUP) will not be assessed against it, and an Accuracy Related Penalty (ARP) will also not apply, assuming the taxpayer filed a California return. However, if a taxpayer relied on the CCRs’ analyses to determine it did not have a filing requirement, and consequently filed a late return, a delinquent penalty will apply. Furthermore, interest will be assessed on any underpayment amounts resulting from a taxpayer’s reliance on the CCRs.”[5]

The bottom line

Service providers and their tax advisors need to address the impact of this new ruling, regarding both prior apportionment positions as well as nexus, since California imposes an income tax obligation on service providers whose California receipts exceed a certain threshold. There may also be refund opportunities for taxpayers who relied on the revoked CCRs to source receipts to California.  Aprio’s SALT team has experience with these sourcing rules and can assist your business to determine the appropriate filing position and pursue a refund. We constantly monitor these and other important state tax topics, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

This article was featured in the May 2022 SALT Newsletter.

For more information contact Aspen Fairchild, SALT Senior Associate at [email protected] or call 770-353-2762 Jeff Glickman at [email protected] or call 770-353-4791.


[1] State of California Franchise Tax Board, Legal Ruling 2022-01 (3/25/2022).

[2] See Cal. Rev. & Tax Code § 25136(a)(1).

[3] California Code of Regulations, title 18, section 26136-2(b)(1).

[4] State of California Franchise Tax Board, Chief Counsel Ruling 2015-03 (12/31/2015); State of California Franchise Tax Board, Chief Counsel Ruling 2017-01 (4/7/2017).

[5]FTB issues Legal Ruling on California’s Market-Based Rules” (4/11/2022).

Disclosure

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.