California Provides Guidance on Application of Market-Based Sourcing Rules to Service Revenues

August 25, 2017

New rules around sourcing revenue based on where a taxpayer’s customer receives the benefit of the service can raise questions of application, as a recent California ruling demonstrates.

By Jeff Glickman, SALT partner

Over the last decade, one of the most notable trends in the area of state income taxes has been the shift in the methodology states require for sourcing service revenues for the sales factor of the apportionment formula (i.e. determining whether or not revenues are in the numerator of the state’s sales factor ratio).

Historically, states used the income-producing activity approach, which sourced sales to the state with the most “cost of performance” associated with providing that service (i.e., where most of the services were performed in order to generate a specific amount of revenue). Beginning around the mid-2000s, states began changing the rule to the market-based method, which sources revenues based on where the customer receives the benefit of the service. Currently, about half of the states use the market-based methodology.

While the market-based methodology presents opportunities for companies to lower their overall state income tax liability, there are two notable challenges arising from the change. [1] First, the taxpayer may not know where its customer receives the benefit of the service being provided. Second, because these rules are fairly new, guidance is limited on the application of the rules.

One area in which this arises is when a taxpayer provides services to its customer which ultimately benefits its customer’s customers. Is the benefit of the service received where the customer is located or where its customer’s customers are located? On April 7, 2017, the California Franchise Tax Board (the “FTB”) issued Chief Counsel Ruling 2017-01 in which it addressed this issue. [2]

The taxpayer provides managerial and administrative services to health plans (e.g., insurers, managed care organizations, employers, government-sponsored health plans, etc.). Normally, these are services that the health plans would provide themselves but may choose to outsource to a company, such as the taxpayer, that specializes in providing these services and therefore can do so on a more cost-effective basis. The services provided are all back-end functions related to administering the health plan to the health plan’s customers, and they do not involve any marketing of the health plan’s services.

Under California’s market-based approach for sourcing service revenues, the taxpayer requested a ruling that the health plan (and not the health plan’s customers) is the recipient of the services, and that those services were received by the health plan at the location where the health plan would have otherwise been required to perform these services it if did not outsource them to the taxpayer. [3]

The FTB first noted that under the regulations, the service is received at the location where the taxpayer’s customer has either directly or indirectly received value from the delivery of the service, and that the regulations don’t specify how to make that determination when both the taxpayer’s customers and the taxpayer’s customer’s customers receive a benefit from the service. [4] The FTB in this case distinguished between a marketing service and a non-marketing service. A marketing service is related to the promotion or advertising of a product, service or other item, and a non-marketing service is a service being used by the vendor’s customer in the operation of its business. [5] The FTB determined that in the case of non-marketing services, as is the case here, the taxpayer’s direct customer (i.e., the health plan) is the one receiving the benefit of the services, since the health plan would otherwise have to perform the services if it did not outsource them to the taxpayer.

The FTB then stated that the benefit being received by the health plan is that it is relieved of having to provide those services itself, and that the location of that benefit is to be determined under California’s cascading rules under Regulation 25136-2(c)(2), which includes using reasonable approximation based on existing or available information. Applying those rules in this case, the FTB concluded that the location from where the health plan would have otherwise provided these services if it cancelled its contract with the taxpayer is the location where it receives the benefit of the taxpayer’s services (i.e., its base of operations).

This ruling is helpful in making a distinction between marketing and non-marketing services for purposes of determining who is receiving the benefit of a service. In the absence of specific guidance provided by other states with similar rules, these concepts may be used to help advisors and businesses make market-based sourcing decisions.

Aprio’s SALT team understands the nuances associated with state apportionment rules and can assist you with making sure you are not apportioning more income than is necessary to a particular state, thereby lowering your state income tax liability. We constantly monitor these and other important state tax issues in order to assist you with your specific tax situation, and we will include any significant developments in future issues of the Aprio SALT Newsletter.

Contact Jeff Glickman, partner-in-charge of Aprio’s SALT practice, at for more information.

This article was featured in the August 2017 SALT Newsletter. You can view the full newsletter here.

[1] A service company that can provide services from its “home” state to customers located mostly outside the state will see a significant drop in its home state income tax liability under market-based sourcing, which may not necessarily be offset by an increase in state income tax liability in states where its customers are located, particularly if the company doesn’t have nexus in those states.

[2] California Franchise Tax Board, Chief Counsel Ruling 2017-01 (April 4, 2017). A Chief Counsel Ruling is similar to a private letter ruling and is based on a particular taxpayer’s facts.

[3] These rules are found in Cal. Rev. & Tax Code § 25136 and Cal. Code of Regs. § 25136-2.

[4] In this case, the insured also benefits from the taxpayer’s services because the insured gets its claims administered and can call the taxpayer to address any questions or for general customer support issues.

[5] See California Franchise Tax Board, Chief Counsel Ruling 2015-03 (Dec. 31, 2015).

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.

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About the Author

Jeff Glickman

Jeff Glickman is the partner-in-charge of Aprio, LLP’s State and Local Tax (SALT) practice. He has over 18 years of SALT consulting experience, advising domestic and international companies in all industries on minimizing their multistate liabilities and risks. He puts cash back into his clients’ businesses by identifying their eligibility for and assisting them in claiming various tax credits, including jobs/investment, retraining, and film/entertainment tax credits. Jeff also maintains a multistate administrative tax dispute and negotiations practice, including obtaining private letter rulings, preparing and negotiating voluntary disclosure agreements, pursuing refund claims, and assisting clients during audits.