This Week in State Tax

The California Franchise Tax Board (FTB) recently issued a long-awaited Notice of Proposed Rulemaking to amend its regulation, 18 CCR 25136-2, that covers market-based sourcing rules for sales of other than tangible personal property. A prior version of this regulation was finalized in 2016 and became operative on January 1, 2017. Since then, the FTB has held six Interested Parties Meetings, the last of which was held in June 2021.

The text of the regulation issued by the FTB with its Notice features a limited number of changes to the 2021 draft of the amended regulation. Specifically, the current draft revises the industry-specific assignment rules for providers of large volume professional services to provide clarity and ensure the proper application of these rules. The regulation provides a listing of activities that are considered qualifying professional services including, among others, tax services, audit, legal, actuary, business advisory consulting, investment management and certain brokerage services. The language in the June 2021 draft provided that if a taxpayer provides substantially similar professional services to more than 250 customers, then gross receipts would be assigned to the billing address of each customer. The updated language indicates that if a taxpayer provides services to more than 250 customers in any single type of professional service, then gross receipts will be assigned to the billing address of each customer. The updated proposed regulation has retained the proviso that if more than five percent of the taxpayer’s receipts from the sales of that service are derived from a single customer, then the billing address presumption does not apply, and the taxpayer would need to determine the specific location where the benefit of the service was received by this customer.

The proposed regulation provides that the amendments would apply for taxable years beginning on or after January 1, 2024, though the FTB may view certain amendments as merely providing clarity to a result of applying the “market sourcing” statutory changes, which generally became effective for taxable years beginning on or after January 1, 2013. Written comments on the proposed rulemaking will be accepted until October 31, 2024, and a public hearing will be held if a written request for a hearing is received no later than 15 days prior to the close of the comment period. For questions about 18 CCR Section 25136-2, please contact Abner Chong, Candace Axline, Oksana Jaffe, or Geoffrey Way.

The New York City Department of Finance (“City” or “Finance”) recently released an update on its development of regulations implementing the New York City Business Corporation Tax (“BCT”). Recall, in December 2023, the New York State Department of Taxation and Finance (“State”) adopted its own regulations to implement sweeping New York State corporate franchise tax reform which took effect for tax years beginning on or after January 1, 2015. Although the BCT closely tracks the state corporate franchise tax, it was previously unclear in which areas the City would parallel the State regulations and in which they might diverge. During discussion sessions held in May 2024, Finance announced several areas in which it was considering departures from policies contemplated in the State regulations. The recent announcement by Finance provides an update on the major areas in which the City previously announced that it was considering deviations from the State regulations.

First, Finance announced that it no longer intends to deviate from the allocation approach used by the State for flow-through partnership income. The notice indicates that Finance considered the comments received and has opted to forego its originally proposed allocation in favor of uniformity across the State and City corporate tax regimes. Briefly, a corporation with partnership flow-through income will apportion such income using the procedures applicable to other corporate income, instead of the rules of the City’s Unincorporate Business Income Tax as originally proposed. Finance indicates this “will streamline the process of tax administration and reduce the cost of doing business in the City of New York.”

Second, the City also plans to forego an initially proposed deviation from the number of business customers needed before a taxpayer can use the billing address of the customer as a safe harbor in determining the primary use location or where the benefit of certain products or services are received. Finance initially proposed increasing this threshold from 250 customers to 1,000, but ultimately opted against this as it would have been a departure from the income allocation model used by the State as well as the one developed by the Multistate Tax Commission, which other states have also adopted.  Third, the City reiterated that while it plans to conform to the State’s primary allocation rule for income from passive investment customers (i.e., to the location of the individual investors), it is considering a deviation from the State’s fallback method of apportionment when the taxpayer does not have the information to allocate to the customer. According to the update, rather than looking to the location where the contract is managed by the passive investment customer (as proposed by the State), Finance is proposing an 8 percent flat allocation of such receipts to New York City. Finance says that this 8 percent allocation reflects a fair estimation of the economic activity within the City relative to the nation and is a percentage often used to allocate financial assets in the BCT.

The City also restated its intent to deviate from the State rule requiring “clear and convincing evidence” to overcome certain presumptions related to allocation or the existence of a unitary business. In City’s view, the clear and convincing evidence standard is “excessively burdensome” on the City and its taxpayers, and applying a specific standard would “inappropriately charge Finance with a judicial or quasi-judicial function.” Rather than set a specific standard, Finance will continue to base its determinations on the facts and circumstances of each matter. Finally, the City reiterated that it continues to consider diverging from the State treatment of IRC Section 860E “excess inclusion” in a real estate mortgage conduit’s entire net income. While the State excludes this amount from entire net income, the City would instead conform to the Federal rule requiring that taxable income of an interest holder be no less than its excess inclusion. Finance did note that it is continuing to examine this rule because of concern about its interplay with the calculation of net operating losses. For questions about the New York City’s update, please contact Russ Levitt, Aaron Balken, or Alec Schwartz.

The Comptroller of Public Accounts has proposed amendments to the regulation governing treatment of data processing services under the state sales and use tax law. Texas imposes a tax on sales of data processing services (with 20 percent of the value of the services being exempt). In 2021, the State Legislature amended the statutory definition of “data processing service” to exclude various services related to electronic payments and payment processing. This regulatory change seeks to better conform the regulatory framework to the statutory definition, as well as to various decisions and rulings that have been handed down since the adoption of the regulation.

The new regulation begins by simplifying the general definition of data processing service to cover “the computerized entry, retrieval, search, compilation, manipulation, or storage of data or information." Specific statutory inclusions and exclusions are then described. The regulation also provides rules for determining the taxability of services that include a data processing component. A transaction involving a data processing service combined with another service will be treated entirely as either data processing or the other service, unless the services are distinct and identifiable, and each service is of a type that is commonly provided on a stand-alone basis or as an additional service for a greater single charge. When the services are not separable, the Comptroller will identify the primary service being sold by considering (a) the extent to which the service provider exercises discretion or judgment in individual application of the processed data based on knowledge of the physical sciences, accounting, law, or other fields of study, and (b) whether the service depends on the repetitive or routine manipulation of data by the seller. Notably, this determination is based on the nature of the service provided by the seller, not on the purchaser’s object in purchasing the service.

The regulation then identifies examples of combined services that will be considered as taxable, nontaxable, or potentially taxable depending on various factors. Specifically, payroll services, the production of business accounting data, the insertion of data into form title and loan documents, and Internet hosting services (as defined by law) will all qualify as taxable data processing services. By contrast, the preparation of financial statements in accordance with generally accepted accounting principles is not a data processing service because it depends on the discretion and certified opinion of an accounting professional. Streaming video subscriptions and streaming video game subscriptions are similarly excluded from the definition of taxable data processing services (but are taxable as cable television and amusement services, respectively). Marketplace provider or facilitator services, the compiling of survey data, 3-D rendering, and website design may or may not be taxable data processing services, depending on the nature of the service.

Further, the proposed rule continues the ability of a purchaser to issue a certificate attesting to multistate use of the data processing service. Issuing a multistate benefit certificate means the purchaser is responsible for allocation of the appropriate tax across the states in which the service is used, and absolving the seller of the responsibility for collection of the tax, if the seller acted in good faith. Notably, the proposal says the tax is to be apportioned based on where the benefit of the service is used and deletes existing language regarding sourcing based on separate lines of business or business location benefiting from the service, concepts seemingly set aside in an earlier Comptroller decision ( No. 116,293, April 2022). The regulation also clarifies that a data processing service is taxable regardless of the ownership of the computer and that the 20 percent exemption is based on the total amount charged for the data processing service. For questions about Tex. Admin. Code 34 § 3.330, please contact Karey Barton.

The Comptroller of Public Accounts (Comptroller) recently issued a letter ruling on the taxability of membership fees for a product that combined nontaxable business consulting services with taxable data processing and information services. The taxpayer provides “consulting and coaching services” to contractors in the HVAC, electrical, plumbing and roofing industries. The services include assistance in identifying and executing strategic business goals; website creation and maintenance; and access to a library of tools such as call scripts, dispatching procedures, and budget templates.

In its decision, the Comptroller identified the assistance in making and meeting strategic goals as a nontaxable business consulting service. However, website creation was identified as a taxable data processing service, and access to the library of assistance tools was identified as a taxable information service. The Comptroller rejected the taxpayer’s argument that access to the library of tools was an “inconsequential perk” with only “nominal value” because it was advertised as a valuable benefit on the taxpayer’s website. After determining the membership fees were paid for both taxable and nontaxable services, the Comptroller applied its rules for determining taxability of the transaction. Under the rules, the business consulting service could not be treated as an unrelated service because the taxpayer did not also provide it on a stand-alone basis. Considering the entire transaction, the Comptroller determined that the entire transaction was presumed taxable because the taxable component reflected more than five percent of the total charge. As a result, the entire membership fee was subject to tax. For questions about Private Letter Ruling No. PLR20230117142804, please contact Karey Barton.