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Where are we Today – Part 4 Apportioning Corporations

In this article we will focus on Apportioning Corporations[1] and will summarize some of the recent changes in California law that have occurred over the last three years that may affect your business clients that do business both in California and elsewhere. While we cannot cover all issues, this article is provided to assist you with some of the questions you may have as a result of these changes:

What has not changed?

Corporations will generally file on California Form 100, California Corporation Franchise or Income Tax Return, unless the corporation has made a Water’s-edge election or elected to be taxed under Subchapter S.

A corporation that is “doing business” in California is required to file a tax return and pay the Corporate Franchise Tax imposed under Part 11, Chapter 2 (commencing with R&TC Section 23101). A corporation that is not doing business in California, but which has net income derived from sources within California, is required to file a tax return and pay the Corporate Income Tax imposed under Chapter 3 (commencing R&TC Section 23501), according to or measured by its net income. A corporation is not subject to the Corporate Income tax if its activities in this state are within the activities protected by the provisions of Public Law 86-272, 15 U.S.C. Sections 381 et seq. (PL 86-272), or it is expressly exempt from tax as provided in Part 11 of the Revenue and Taxation Code or the Constitution of the State of California. In addition, a corporation doing business in this state is not subject to the measured franchise tax if its activities are protected by PL86-272; however, it is subject to the minimum franchise tax.

PL 86-272 prohibits states and political subdivisions from imposing a tax on or measured by net income derived within its borders from interstate commerce if the only business activity of the company within the state consists of the solicitation of orders for sales of tangible personal property.[2] When PL 86-272 applies, it protects an out of state business from an income-measured tax, but not from California’s minimum franchise tax imposed for the privilege of doing business in California, because the minimum tax is not measured by income.

The requirement to file a return and pay the taxes owed is imposed on each entity, including Corporate “taxpayers” that are members of a combined reporting group. Two or more taxpayer members of a combined reporting group, if eligible, may annually elect to be included in a “group tax return.” This is an affirmative election that must be made using the Schedule R-7 of the Schedule R, and must be filed by the “key corporation ” on behalf of itself and all electing taxpayer members with the California Form 100. [3]For more information on the Election to File a Group Return, including the eligibility requirements, manner, and consequences of making this election see Regulation Section 25106.5-11.

If a taxpayer’s business, trade, or profession is conducted wholly within California, the entire net income will be sourced to California, and unless otherwise provided, is taxable by California.

If a taxpayer’s business, trade or profession earns business income from or attributable to sources both within and outside of California, that business, trade or profession’s tax is determined (measured) by the net income derived from or attributable to sources within California using California's apportionment rules (R&TC Sections 25120 to 25139); and when applicable the taxpayer’s business income is required to be determined using a combined report.

Nonbusiness income, which is all income that is not business income, is allocated under the provisions of R&TC Section 25123. In addition, transactions generating non-business income are not included in the taxpayer’s apportionment factors (sales, property, or payroll see R&TC Sections 25134, 25129, and 25132, respectively) used to apportion business income to this state.

The general rule for most apportioning corporations, which is new, and therefore, is discussed in the next section, is that most taxpayers are required to apportion their income using only a sales factor, which is known as the "single-sales factor method." However,taxpayers that derive more than 50 percent of their gross business receipts from a qualified business activity – agricultural, extractive, savings and loan, and banking or financial business (see R&TC Section 25128(b)) continue to be required to apportion business income using the three-factor formula of property, payroll, and sales.

Generally, the special industry apportionment and allocation regulations under R&TC Section 25137, which are applicable to specific taxpayers, still apply. Taxpayers apportioning income under these regulations, however, should take into consideration their required formula (single-factor sales or three-factor) when deciding whether they are required to use all of the apportionment factors referenced in the applicable regulation, or just the sales factor provisions. Stated differently, the sales factor provisions in the special regulations apply to single-sales factor taxpayers and all of the provisions apply to the three-factor formula taxpayers (those that meet R&TC Section 25128(b)). Taxpayers should also be aware that in addition, Regulation Section 25316-2(g)(3) makes inoperable specified sales factor provisions in the special industry regulations of Regulation Section 25137.

What changed?

California's Legislature has determined an economic presence standards determined by specified amounts of sales, property, or payroll, in this state which now constitute “doing business” in California. Physical presence is no longer required for a corporation to be “doing business” in California, and thus to be subject to the franchise tax.[4]

As of January 1, 2011, corporations are doing business in California if it actively engages in any transaction in California for the purpose of pecuniary gain or profit, or if it is organized or commercially domiciled in California. In addition, a corporation is doing business if its sales, property, or payroll in California exceed 25 percent of its total sales, property or payroll; or if its sales, payroll, or property exceeds one of the applicable amounts in subdivisions (b)(2), (b)(3), or (b)(4) (sales, property or payroll) respectively, of R&TC Section 23101, as indexed each year. For taxable years beginning on or after January 1, 2013, the applicable amounts for sales, property, and payroll that constitute doing business are $518,162, $51,816, and $51,816, respectively.[5]

The impact of these new provisions means that for taxable years beginning on or January 1, 2011, a taxpayer is doing business in California, and thus, it is subject to the applicable franchise tax, even where the taxpayer's only contact with this state is sales, property, or payroll exceeding the amounts specified in R&TC Section 23101.

In addition, all trade or businesses that are not engaged in qualified business activities described in R&TC Section 25128(b), must now apportion their income to California based on sales alone using the single-sales factor method. [6] In addition, R&TC provides new market-based rules for apportionment of sales of other than tangible personal property.

There are other changes as well. The definition of “sales” in R&TC Section 25120 has changed, “sales” means all gross receipts of the taxpayer not allocated. As of January 1, 2011, clarifying language was added, so that “gross receipts” means the gross amount realized in a transaction that produces business income, but excludes specific items and amounts. Most noteworthy is the exclusion of amounts received from transactions in intangible assets held in connection with a treasury function and hedging transactions. Here is a link to a comparison of changes in R&TC Section 25120 – Definitions.

If your client is a seller of tangible personal property, sales will generally continue to be assigned to the state where the property is delivered or shipped, unless the purchaser is the United States government or the taxpayer is not taxable in the state of the purchaser, as defined in R&TC Section 25135.

What has changed, for taxable years beginning on or after January 1, 2011, is how you determine if the taxpayer is considered to be taxable in the state of the purchaser. The general rule for sales of tangible personal property is that they are assigned to the point of destination. Thus, when considering the assignment of sales into California, R&TC Section 23135, goods shipped to California are included in the sales factor numerator (considered California sales) when the seller or any member of the seller's combined reporting group is taxable in California. This means all sales of the combined reporting group made into California regardless of whether or not the member making the sale is subject to taxation will be included in the sales factor numerator of the taxpayer members. Conversely, under California’s throwback rule (see R&TC Sections 25135 and 25122), goods shipped from California to another state are considered California sales (i.e., "thrown back" to California), and thus, are included in the sales factor numerator, if no member of the unitary group is taxable in the destination state. When considered the assignment of sales you must also consider PL 86-272, California’s new doing business standards, and whether the sale occurs in foreign, as opposed to interstate, commerce. [7]

For sellers of other than tangible personal property (services, sales of intangibles and income from tangible or real property), sales are no longer sourced to the location of the greater costs of performance of the income-producing activity. Rather, receipts are assigned for California purposes to the sales factor numerator to the state where the benefit of the service is received or where the property is used by the customer under the market rule (for taxable years beginning on or after January 1, 2013 for all apportioning businesses and for taxable years beginning on or after January 1, 2011 and before January 1, 2013 for apportioning businesses electing single-sales factor apportionment). Effective for taxable years beginning on or after January 1, 2013,[8] taxpayers no longer have the option to elect which apportionment formula they want to use. As stated above, except for taxpayers engaged in qualified business activities described in R&TC Section 25128(b) all taxpayers must apportion their income using the single-sales factor apportionment formula. This change makes the use of R&TC Section 23136 market rules mandatory; and thus, all apportioning trade or businesses must assign sales of other than tangible personal property under these new market-based rules (see Regulation Section 25136-2) for 2013 and beyond. And, as noted above, Regulation Section 25316-2 incorporates the sales factor apportionment rules that apply to special industries (Regulation Sections 25137 through 25137-14) with the modifications set forth at Regulation Section 25136-2 (g)(3). Most significantly, Regulation Section 25137(c)1(C) is no longer operative. This was the “special rule” that previously excluded business income from sale of intangible property from the sales factor if the income producing activity could not be identified.

Now you need to determine if the sale is from:

  • A service (see Regulation Section 25136-2(c)) to a customer who is:
    • An individual.
    • From a corporation or other business entity.
  • Intangible property (see Regulation Section 25136-2(d)).
    • A complete transfer or
    • Other than a complete transfer of:
      • Marketing intangible.
      • Non-marketing and manufacturing intangible.
      • Mixed intangible.
  • Sale, lease, rental, or licensing of real property (see Regulation Section 25136-2(e)).
  • Sale, lease, rental, or licensing of personal property (see Regulation Section 25136-2(f)).
  • If special rules (see Regulation Section 25136-2(g)) apply.

Then taxpayers should follow the applicable rules for the assignment of the sale provided in the regulation, including, if necessary, the rules that are provided if the location where the “benefit of service” is received or the extent of use in this state “cannot be determined.”

[1] Corporation for the purposes of this article is defined in R&TC Section 23038, which includes check-the-box eligible entities that elect to be taxed as a corporation.
[2] See our Publication FTB 1050, Application and Interpretation of Public Law 86-272, for more information on protected and unprotected activities.
[3] Caution: If the information on Schedule R-7 is not filled out completely, incorrect processing of the tax return may occur and, more importantly; elections may be disallowed.
[4]However, as stated in Technical Advice Memorandum 2012-1, the amendment to California law (Section 23101) specifically provides that the newly enacted circumstances applied only to taxable years beginning on or after January 1, 2011.
[5] The 2014 thresholds amounts will be released later this year, as the index calculation requires the inclusion of items through June of the current year. Prior year amounts are available on our website.
[6] R&TC Section 25136.1 (new law) provides special sales factor rules for certain cable system operations.
[7] See the Appeal of Dresser Industries (82-SBE-307), decided on June 29, 1982 and Appeal of Christie Electric Corporation (87-SBE-062), decided on August 18, 1987.
[8] This change was the result of the Proposition 39.

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