TWIST - This Week in State Tax

California: Recently Adopted Regulation Addresses Aspects of the Marketplace Facilitator Law

The California Office of Administrative Law has finalized amendments to California Code Regulations section 1684.5, addressing marketplace sales. The finalized regulation is generally unchanged from a proposed version that was released earlier. Recall, under California law, on and after October 1, 2019, a marketplace facilitator is a retailer engaged in business in the state if its total combined sales (i.e., including both sales of its own property and sales it facilitates on behalf of marketplace sellers) of tangible personal property for delivery into California exceed $500,000. Similarly, a marketplace seller must include both direct sales and marketplace facilitated sales in determining whether it exceeds the economic nexus threshold. One amendment to the regulation confirms that a marketplace facilitator and a marketplace seller must include both taxable and nontaxable sales in determining whether it exceeds the $500,000 threshold.  Another amendment clarifies that to be considered a “marketplace,” a physical or electronic place must offer tangible personal property for sale by multiple marketplace sellers. As such, a company that sells web hosting services and related services (e.g., payment processing) to other sellers who use the services to create their own e-commerce websites is not considered a marketplace facilitator. The revised regulation also makes clear that a person is not required to provide payment processing services to be considered a marketplace facilitator.

Another set of amendments to the regulation address the statutory carve out for websites that merely advertise tangible personal property for sale and refer a purchaser to the seller to complete the sale. Under California law, such entities are not considered to be facilitating a sale. The amended regulation adopts a new subsection to address “advertising” to clarify that when the advertising exclusion applies to a sale, the person publishing the advertisement is not considered the seller and retailer for the sale and that such person is not the retailer selling or making the sale of the tangible personal property sold through the advertisement. This is true regardless of whether the person is a marketplace facilitator, the seller is a marketplace seller, the tangible personal property is advertised in a marketplace, or the advertisement contains an offer to sell tangible personal property.  One of the new examples in the “advertising” section confirms that when a person takes orders for sellers that advertise goods on the person’s website, that person is facilitating the sale of tangible personal property and is considered the retailer for those sales. “Order taking” is newly defined to mean the process of getting or obtaining a buyer’s order to buy a marketplace seller’s tangible personal property by telephone, fax, email or any other physical or electronic means, including but not limited to, the customer including the items in a physical or virtual shopping cart at checkout. The regulatory action is effective August 28, 2023, but the CDTFA may enforce the regulations retroactively as the changes were not the result of a change in statute and are therefore declarative of existing law. Please contact Jim Kuhl with questions on California’s marketplace facilitator regulation.

California:  Taxpayer Required to Use Mutual Fund Service Provider Sourcing Rule

The California Office of Tax Appeals or OTA recently addressed whether (1) the OTA had jurisdiction to determine if California Code of Regulations (CCR) section 25137-14 was properly promulgated, and (2) a mutual fund service provider taxpayer was required to use CCR section 25137-14 to apportion its service receipts. California Code Regulation section 25137-14 was adopted in 2007 and provides a “look-through approach” for sourcing service receipts of a mutual fund service provider. Under this approach, a mutual fund service provider selling services to regulated investment companies, including mutual funds, must assign those sales to the domicile of the funds’ shareholders. In contrast, the statutory rule for sourcing service receipts is to source such receipts to the location where the taxpayer’s customer (the purchaser of the services) received the benefit of the service. The taxpayer, a mutual fund service provider, first argued that CCR section 25137-14 was not adopted in accordance with the state’s Administrative Procedures Act (APA). The taxpayer further asserted that the FTB failed to follow APA notice and evidentiary procedures when FTB promulgated CCR section 25136-2(g)(3), which generally provides that the alternative apportionment method for mutual fund service providers will be applicable in lieu of the state’s general market-based sourcing rules for service receipts. The OTA observed that the promulgation of regulations is governed by the Office of Administrative Law, which is the sole California agency vested with the authority to determine whether a regulation of another agency was adopted in compliance with the APA. As such, the OTA concluded that it lacked jurisdiction to consider the merits of appellant’s arguments that the Franchise Tax Board (FTB) failed to follow APA procedures when promulgating CCR sections 25137-14 and 25136-2.

The OTA next rejected the taxpayer’s position that the look-through approach in CCR 25137-14 was improper because it conflicted with the statutory market-based sourcing rules and that the FTB was required to show clear and convincing evidence of distortion before it could require the taxpayer to use CCR section 25137-14.  California’s alternative apportionment statute, R&TC section 25137, allowed the FTB to require a taxpayer to use an alternative method of apportionment and the FTB had authority to promulgate alterative apportionment regulations. Once a special apportionment formula is promulgated under R&TC section 25137, it becomes the standard method, and taxpayers and the FTB are bound to follow it unless a party seeking to deviate from the alternative method establishes by clear and convincing evidence that the regulation does not fairly represent the extent of the taxpayer’s activities in California and the party’s proposed alternative is reasonable. The OTA further rejected the taxpayer’s position that alternative apportionment was inappropriate because the receipts at issue were not “nonrecurring” or “unique” as required under R&TC 25137. While the alternative apportionment statute ordinarily applies to non-recurring situations, it can be applied when application of the statutory formula would create distortion for an industry as a whole, which was the case at hand for mutual fund service providers.  The OTA next determined that the taxpayer had not provided any evidence, let alone clear and convincing evidence, demonstrating that its apportionment percentage should have been calculated using a different method.  As such, the OTA concluded that CCR section 25137-14 was the appropriate rule for assigning the taxpayer’s receipts.  One Administrative Law Judge concurred in the result, but noted that in his view, even if the taxpayer’s receipts had been sourced under the statutory market sourcing rules, the taxpayer had not established that the purchasers of its services received the benefit in their states of domicile. The taxpayer’s contracts did not indicate where the benefit of the service was received, and the taxpayer provided no evidence to reasonably approximate where purchasers received the benefit, as required under California’s cascading rules for determining where the benefit of a service is received.  Please contact Oksana Jaffe with questions on Appeal of Janus Capital Group, Inc. and Subsidiaries.

New Jersey: Division Adopts New Nexus P.L. 86-272 Guidance; Incorporates Aspects of MTC Statement

The New Jersey Division of Taxation recently released a Technical Bulletin (TB-108) addressing Corporation Business Tax (CBT) nexus for privilege periods ending on and after July 31, 2023. The Bulletin notes that Assembly Bill 5323 adopted a bright line economic nexus standard for CBT purposes. Notably, a corporation deriving receipts exceeding $100,000 from in-state sources or that has 200 or more separate transactions delivered to New Jersey customers during the taxable year will be deemed to have substantial nexus with New Jersey for privilege periods ending on and after July 31, 2023.  The Bulletin makes clear that a corporation with sales/transactions below these thresholds may still have New Jersey nexus if the corporation’s activities/contacts with the state are nevertheless sufficient to establish jurisdiction. A corporate partner will have nexus with New Jersey if the corporate partner’s proportionate share of a unitary partnership’s activities in New Jersey satisfies the bright-line economic thresholds. In the context of unitary business groups, a group member may be taxable if it meets the economic nexus standards regardless of whether the receipts are the member's own receipts or are receipts derived from intercompany transactions with other members of the combined group that are eliminated in computing the return. 

The Bulletin also addresses New Jersey’s previously announced policy to follows tax treaties unless a combined group is filing on a worldwide basis. A non-U.S. corporation that is a member of a water’s-edge combined group or an affiliated group will be a taxable member if it has nexus with New Jersey.  However, treaty protected income (or loss) will be excluded from the income of the combined group. If a non-U.S. corporation separate return filer has nexus with New Jersey and all its income (or loss) are protected by a tax treaty, the corporation will still be required to file a return and pay the Corporation Business Tax minimum tax.

Finally, the Bulletin addresses P.L. 86-272 and confirms that if one group member exceeds P.L. 86-272 protection, then no group member may claim protection. The Bulletin also sets forth a list of activities that, in the Division’s view, would cause a taxpayer to lose or retain P.L. 86-272 protection. Importantly, this list incorporates aspects of the Multistate Tax Commission’s revised statement on P.L. 86-272.  Certain of the enumerated unprotected activities are not particularly surprising given that P.L. 86-272 protection applies to sellers of tangible personal property only. Therefore, sellers of digital assets, NFTs, streaming services, or Internet advertising, or businesses that provide services related to such items, would not be protected under P.L. 86-272.  Certain of the activities listed, however, may apply to a seller of tangible personal property that has a website or app. For example, the Bulletin treats placing software or ancillary data (e.g., apps or “internet cookies”) on computers and devices in New Jersey to gather market or product research that is packaged and sold to data brokers or other third parties, and providing post-sales assistance through an electronic chat, email, or application that customers access through the company’s website, as unprotected activities. Inviting and/or accepting applications for employment through an Internet-based platform that is not specifically targeted to in-state residents or for in-state job positions, other than for sales positions, is also an activity that may cause the loss of P.L. 86-272 protection. Please contact Jim Venere with questions on TB-108.

New York: Application of Broker-Dealer Sourcing Rule Results in Distortion

In a non-precedential decision, an Administrative Law Judge for the New York Division of Tax Appeals recently ruled in a broker-dealer taxpayer’s favor in a dispute involving the application of the customer-based sourcing rules for such entities, which remained in place after the state’s 2015 tax reform and continue to apply for the New York State and City corporate taxes and the New York City Unincorporated Business Tax purposes.1 The taxpayer’s clients were primarily institutional investors and not retail clients (i.e., individuals).  On amended returns, the taxpayer took the position that brokerage commissions, gross income from principal transactions including accrued interest, margin interest, clearing fees and management fees should be sourced based on an approximation of the locations of the underlying investors of the institutional intermediaries, and not based upon the locations of the institutional intermediaries themselves. In other words, the underlying investors were the relevant customers. The auditor disagreed and adjusted the taxpayer’s apportionment based on treating the institutional intermediaries as the relevant customer. Under this approach, receipts were attributed to New York if the institutional intermediaries’ address in the taxpayer’s records was in New York. The taxpayer disagreed with the adjustment and the matter eventually made it to the administrative law judge level of the New York State Division of Tax Appeals.

As support for its position, the taxpayer argued that because the payment of the commissions and fees came from the institutional investor’s custodial account, which contained the funds of the underlying investors, the commissions were “paid” by the underlying investors and not the institutional investors.  In the taxpayer’s view, the term “customer should be interpreted to mean the customer responsible for paying.”  The ALJ disagreed. Although the facts showed that the underlying investors of the institutional intermediaries were the customers responsible for paying the taxpayer, the tax law’s broker-dealer “customer sourcing” statute did not operate to allow the taxpayer to look through to the underlying investors’ location.  The taxpayer next asserted that the Division should be required to exercise its discretionary authority, provided for in a general sense under the corporate tax law, to correct a distortive apportionment result, so as to source its receipts based upon a reasonable approximation of the locations of the underlying investors of the institutional intermediaries. An expert testifying on behalf of the taxpayer established that from an economic perspective, the customers in the securities industry who paid the securities transactions costs were the individual investors, whether they invest in securities directly or indirectly. The expert further examined various ways to approximate the locations of those individual underlying investors when their locations are unknown and concluded that using New York’s U.S. Census percentage to source the taxpayer’s receipts was the most reasonable method because population is a direct and reliable measure of where individual investors are likely to be located. The ALJ agreed. In her view, given the expert’s “cogent analysis,” it was clear the Division’s method to allocate the receipts factor grossly overstated, by a factor of three or four times, the results reached using an allocation method that reasonably approximated the location of the individual investors, i.e., the customers from an economic perspective. As such, the ALJ concluded that using New York’s share of the U.S. Census, i.e., 6.48 percent, was appropriate in this case.

Citing to the U.S. Supreme Court’s decision in Hans Rees, the taxpayer also asserted that the Division’s method of allocating its receipts violated the Commerce and Due Process Clauses because it attributed income to New York State that was out of all proportion to the income generated in the state. Although the ALJ had already determined that use of New York’s census percentage (6.48%) was appropriate, she went on to hold that the Division’s calculation of the receipts allocation factor (at 22.44% and 20.65% for the tax years at issue) was grossly overstated, by a factor of three or four times, which resulted in an unconstitutional distortion of the taxpayer’s income.

As an ALJ decision, the case is not binding precedent.  If an appeal is filed with the State’s Tax Appeals Tribunal, then the Tribunal’s decision would constitute binding precedent (including for the parallel New York City corporate tax regime and the City’s UBT; see NYC Charter section 170.d), though the Tribunal’s decision could potentially be subject to further appeal to New York’s appellate court (always the right of a taxpayer, and recently extended as well to the State but for this matter only to the extent that the Tribunal’s decision is grounded in New York State or Federal constitutional law).  The timeframe for appealing to the Tribunal is within 30 days of the August 31st decision, though, on motion, the Tribunal often grants an additional 30 days. Please contact Russ Levitt with questions on Jefferies Group LLC & Subsidiaries.

¹Jefferies Group LLC & Subsidiaries (August 31, 2023.)  The decision also addressed, and resolved in the taxpayer’s favor, disputes over the taxpayer’s investment capital “cash” election and claimed financial services investment tax credits, which are not addressed in this summary. Note, however, that the ALJ held that certain guidance published by the State had too narrowly applied the financial services ITC, and the financial services ITC and its associated “employment incentive credit” expired for property placed in service on or after October 1, 2015, though some taxpayers might still have their amended return statutes of limitation still open for filing refund claims.