The California Franchise Tax Board (FTB) issued draft regulations—Cal. Code Regs. tit. 18, § 25136-2—with a retroactive effective date of January 1, 2015.
Until the rules are finalized, they have no legal effect. In the meantime, what steps do asset managers need to consider?
Beginning in 2013, California’s single sales factor apportionment and customer-based sourcing for receipts from services became mandatory for most taxpayers. Cal. Rev. & Tax. Code §§ 25128.7 (single sales factor) and 25136(a)(1) (market-based sourcing).
Under the statute, receipts from services are sourced to California “to the extent the purchaser of the service received the benefit of the services” in California. Cal. Rev. & Tax. Code § 25136(a)(1). That phrase is further defined by the existing regulation to mean, “the location where the taxpayer’s customer has either directly or indirectly received value from delivery of that service,” Cal. Rev. & Tax. Code § 25136(b)(1).
A number of other states have adopted customer-based sourcing rules for gross receipts from services. Asset managers, in applying these rules to management fees received from funds, generally have sourced such receipts to the commercial domicile of the fund paying the management fees.
The California FTB’s draft rules take a different approach. Specifically, the draft regulations would require an asset manager collecting fees from certain investment accounts, including funds, pension plans and retirement accounts,* to “look-through” to the investors in the accounts or funds to determine where the benefit of the service was received. Under this approach, fees from asset management services generally would be sourced based on the domiciles of the investors in the accounts or funds.
*The draft regulations do not apply to taxpayers that provide services to at least one regulated investment company (RIC). Instead, the rules for sourcing fees of taxpayers that provide management services to a RIC are included in Cal. Code Regs. tit. 18, § 25137-14 (the “-14 regulation”). The -14 regulation provides that fees relating to the provision of management, distribution, or administration services are sourced based on the domicile of the RIC’s shareholders. Additionally, if a taxpayer that provides such services to a RIC also provides asset management services to non-RICs, the fees for those services are sourced to the state of the domicile of the beneficial owners. FTB has suggested that the -14 and -2 regulations would derive similar results; however, there are differences in the two regulations.
Although this “look-through” provision would be effective January 1, 2015, the regulations could be applied retroactively to tax years beginning on or after January 1, 2012, at the election of the taxpayer.
These look-through sourcing rules would also be applied in determining whether an asset manager has economic nexus in California (asset managers with receipts in excess of $519,000 from California sources are deemed to have nexus for the 2015 tax year).
In light of the approach taken in the draft rules, asset managers need to determine how these rules (if finalized) would apply, given their specific circumstances. Such an analysis might include the following considerations:
Asset managers also would need to make certain decisions regarding the application of the draft regulation to their circumstances and take affirmative steps to enable them to comply with the rules. For example:
Currently, only a couple of other states specifically require this look-through approach in sourcing asset management fees from investment accounts and funds.
**See, e.g., Del. Code Ann. tit. 30, § 1903(b)(7)(b)(1), N.J. Admin Code § 18:7-8.10(e)(1). Note, however, a number of states apply this approach to management fees received from a mutual fund set up as a RIC, see, e.g., Conn. Gen. Stat. § 12-218(f); Minn. Stat. Ann. § 290.191(subd. 5(k)); N.Y. Tax Law § 210-A(5)(d); Tex. Tax Code Ann. § 171.106(b).
Therefore, it is possible that, under the rules of other states, the same fees that are received by asset managers and sourced to California under the draft regulations also could be sourced to such other states.
For example, another customer-based sourcing state may source an asset manager’s fees to an account’s or fund’s state of commercial domicile or state to which the service is delivered (if the state does not apply California’s look-through approach).
Further, that same income also could be sourced by certain other states to the state in which the asset manager is located if the state uses cost-of-performance sourcing. Or, in the case of services provided by a California-based asset manager to an account or fund domiciled in California with investors located outside California, some management fees could end up not being sourced to any state at all.
For more information, contact a tax professional with the Alternative Investment Fund practice of KPMG’s State and Local group:
Doug Bramhall |+1 (480) 459-3491 | firstname.lastname@example.org
Abner Chong | +1 (213) 593-6618 | email@example.com
Mike Deal | +1 (312) 665-1798 | firstname.lastname@example.org
Julia Flanagan | +1 (212) 954-8139 | email@example.com
Scot Grierson | +1 (949) 885-5643 | firstname.lastname@example.org
Scott Salmon | +1 (202) 533-4202 | email@example.com
Hernan Stigliano | +1 (212) 872-6967 | firstname.lastname@example.org
Dave Turzewski | +1 (212) 872-5628 | email@example.com
Lori Wiseman | +1 (214) 840-6041 | firstname.lastname@example.org
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