Business Income Where are we Today, Part 2
In our September 2013 edition of Tax News, we summarized several law changes that affect your business clients that do business both in California and elsewhere, an apportioning trade or business. In this article, we will focus on the changes and the effects on nonresidents who have income from an apportioning business, trade, or profession.
California taxes nonresidents who have income sourced to this state. Because of the recent law changes, you may have a nonresident client with an apportioning trade or business that in the past may have had little or no income that was sourced to California; you may find these clients will now have California sourced income. This is especially true if the client’s business income is derived from the sale of intangibles or services.
If the client’s business, trade, or profession (including a sole proprietorship) is one line of business (unitary) conducted partly within California and elsewhere, Regulation Section 17951-4 requires the business income sourced within California to be determined using California apportionment rules (R&TC Sections 25120 to 25139).
In addition “an apportioning trade or business,” is now required to apportion business income using the single sales factor.
Public Law (PL) 86-272 will still protect out-of-state business owners from taxation if their only in-state activities consist of all of the following:
- Solicitation of orders for sales of tangible personal property (goods)
- Orders that are sent outside the state for approval
- Orders that are filled from a stock of goods maintained outside the state.
However, the protections of PL 86-272 will not apply if the out-of-state business entity uses its own vehicles to ship the goods to the in-state purchaser.
Protection under PL 86-272 does not apply to businesses that derive in-state income from the solicitation or sale of:
- Any combination of goods and services.
What have changed are the way services and intangibles are assigned for sales factor purposes. You no longer will look to where the service is performed, but rather, you now need to source the receipts the taxpayers received from services to the location of where the customer receives the benefit of the service. This will generally be the location of the taxpayer’s market for the sales.
This also means intangibles will no longer be assigned to California where the greater cost of performance occurred; instead you need to assign receipts from sales of intangibles to California to the extent the property was used in California.
R&TC Section 25136 (which is the provision for determining if sales of other than tangible property are sourced to California) now states (formerly R&TC Section 25136(b)):
(1) Sales from services are in this state to the extent the purchaser of the service received the benefit of the services in this state.
(2) Sales from intangible property are in this state to the extent the property is used in this state. In the case of marketable securities, sales are in this state if the customer is in this state.
(3) Sales from the sale, lease, rental, or licensing of real property are in this state if the real property is located in this state.
(4) Sales from the rental, lease, or licensing of tangible personal property are in this state if the property is located in this state.
Regulation Section 25136-2 was adopted for taxable years beginning on or after January 1, 2011, to provide guidance on how to assign sales using the new market-based rules (described under former R&TC 25136, subdivision (b)).
Taxpayers who are required to follow special industry apportionment and allocation regulations (special industry taxpayers) under Regulation Section 25137 will follow the 25137 sales factor provisions incorporating the new 25136 rules, and incorporating the exclusions in Regulation Section 25136-2(g)(3). Special industry taxpayers will not use the property and payroll factor rules, unless the trade or business is within one of the exceptions of R&TC Section 25128(b) (taxpayers that derive more than 50 percent of their gross business receipts from a qualified business activities – agricultural, extractive, savings and loan, and banking or financial business).You should also be aware that law changes that affect income sourced within California can also effect the taxation of estates and trusts (see Regulation Section 17742).
For purposes of this discussion the “intangible properties” are those that are considered to generate business under the Transactional or Functional tests.
Unless the trade or business is within one of the exceptions of R&TC Section 25128(b)). A multistate taxpayer who is required to follow special industry apportionment and allocation regulations under Regulation Section 25137 must follow the sales factor provisions, with the exception of any rule excluded by the provisions of Regulation Section 25136(g)(3), and is not required to use the property and payroll factor rules
This change was the result of the Proposition 39.
R&TC Section 25136.1 (new law) provides special sales factor rules for certain cable system operations, but even those taxpayers must use the new market rules.