Editor: Kevin D. Anderson, CPA, J.D.
State & Local Taxes
In Technical Advice Memorandum (TAM) 2012-01 (11/29/12), the legal staff of the California Franchise Tax Board (FTB) answered a question from the FTB audit staff regarding whether a taxpayer is subject to taxation in another state for purposes of Cal. Rev. & Tax. Code Section 25122 when the taxpayer’s only contact with that state was more than $500,000 in sales of tangible personal property for tax years beginning before Jan. 1, 2011. Pursuant to Cal. Rev. & Tax. Code Section 25120(g), the term “state” means any state of the United States, the District of Columbia, the Commonwealth of Puerto Rico, any territory or possession of the United States, and any foreign country or political subdivision thereof. This TAM raises a number of interesting issues related to California’s new definition of “doing business” and its impact on taxpayers engaging in foreign commerce.
The TAM holds that for tax years starting before Jan. 1, 2011, physical presence in a state is necessary to subject a corporation to taxation. Such physical presence can be manifested by the presence of employees, agents, or contractors, or by having an office or other types of activity or property being used in the business within a state. Being subject to taxation permits a corporation to avoid having to assign sales of property on the basis of where the shipment of the property originates if such property is destined for states where the taxpayer is not taxable, commonly referred to as the “throwback” rule.
Analysis of the Holding
This TAM solely addresses the sale of tangible personal property. Therefore, it is important to note that the activity of soliciting for sale of tangible personal property in the context of interstate commerce remains protected under the Interstate Income Tax Act of 1959, P.L. 86-272. However, in the TAM, the FTB noted that limitations under P.L. 86-272 do not apply to sales to and from foreign jurisdictions or sales of other than tangible personal property. Accordingly, the TAM appears to have been issued in response to questions specifically directed at sales of tangible property in foreign commerce. The question most likely raised by taxpayers is with respect to the newly expanded definition of “doing business” set forth in Cal. Rev. & Tax Code Section 23101—specifically, the $500,000 rule and its application in foreign commerce. Basically, the TAM holds that the $500,000 threshold test is applicable for tax years starting Jan. 1, 2011, and later. The TAM does not explain how the state’s reliance on a threshold amount of sales to create nexus was supported by the U.S. Constitution.
Starting with tax years beginning on or after Jan. 1, 2011, California adopted the doctrine of economic nexus, in part based on sales activities. In adopting the economic nexus concept, the California definition of “doing business” was expanded to provide bright-line nexus tests. These tests include property, payroll, and sales tests described under Cal. Rev. & Tax. Code Section 23101(b). Specifically, the sales nexus test under Section 23101(b)(2) provides that a taxpayer is considered to be doing business in the state if it has California sales that exceed the lesser of $500,000 or 25% of the taxpayer’s total sales. This dollar amount may be adjusted annually for inflation and for 2012 was $509,500.
For taxpayers in the business of selling tangible personal property, sales can be assigned to California based on one of three criteria: the ultimate destination of the purchaser, the aforementioned throwback rule, or the more obscure “double throwback” rule. Throwback can be avoided if the taxpayer is subject to tax in the state of destination. The ability of a state to impose a net income tax on a taxpayer is limited by federal constitutional provisions, mainly the Commerce Clause and the Due Process Clause. Both of these clauses require that nexus must exist between a taxpayer and a state for the state to impose a tax. Once constitutional nexus had been established, the ability to impose a net income tax was further limited by Congress through the enactment of P.L. 86-272, which provides that certain activities engaged in by businesses associated with the solicitation and sale of tangible personal property in interstate commerce are protected from state taxation. In California, due to the California State Board of Equalization’s decision in Appeal of Dresser Industries, Inc., 82-SBE-307 (Cal. State Bd. of Equalization 6/29/82), the FTB applies federal constitutional standards to companies engaged in foreign commerce because the decision held that P.L. 86-272 does not apply to foreign commerce. Many tax practitioners have long held the view that the nexus threshold under P.L. 86-272 is stricter than that under the constitutional standards. Now, with California’s enactment of the new doing-business definition, it appears that the FTB believes a lower threshold exists for the imposition of an income tax in foreign commerce. In effect, a new California nexus standard has been established—one that differs from the standards under P.L. 86-272 and the U.S. Constitution.
The interplay among the new California “doing business” nexus standards, P.L. 86-272, and constitutional nexus provides for an interesting twist. As suggested by a California Chief Counsel Ruling (CCR 2012-03), for tax years beginning on or after Jan. 1, 2011, a taxpayer considered taxable in California would likewise be considered taxable in a foreign country when its tangible personal property sales assignable to that country exceed $500,000. A taxpayer in this situation will no longer have to throw back its sales to California since it has established substantial nexus in the other country under the new California nexus principles but not necessarily under either constitutional nexus standards or P.L. 86-272. The reverse is true, too. California holds that foreign companies delivering goods to purchasers in California are now subject to the net income tax solely because the sales exceed $500,000. The state appears to believe the delivery of goods to California creates a substantial nexus, which permits it to assert a tax. In addition, as stated previously, California holds that activity in foreign commerce is not protected under P.L. 86-272.
This FTB policy appears to create a number of unintended administrative burdens. For example, companies might not exceed the threshold of $500,000 in sales until late in the tax year, yet the $800 minimum tax will have been due earlier in the year, with first-quarter estimates. Not paying the minimum tax due on time will subject the entity to a penalty. Another example involves tax elections. For California franchise tax purposes, water’s-edge elections must be made on timely filed original returns. A foreign corporation that delivers goods into California that is unaware of the FTB foreign commerce policy might not be able to make a timely water’s-edge election and, as a result, could be taxed on its worldwide income.
The “doing business” definition also needs to be fine-tuned in the context of intercompany or related-party sales. For example, a California-based company’s purchase of goods from its China-based affiliate could subject the Chinese-based company to the California minimum tax. The same would be true for sales between domestic affiliates. Imposing such a policy could cause importers to think about using ports and warehouses outside California and to ship their goods through or store their property elsewhere.
In summary, the issues highlighted by the TAM provide food for thought for taxpayers. Certainly, the TAM illustrates the FTB’s point of view on foreign commerce. The TAM also raises the question whether the FTB’s reliance on a law change defining “doing business” could be tested for accuracy. In other words, if substantial nexus exists in 2011 based on sales exceeding $500,000, would not substantial nexus exist for years before 2011? Stay tuned; there is likely more to come.
Kevin Anderson is a partner, National Tax Services, with BDO USA LLP, in Bethesda, Md.
For additional information about these items, contact Mr. Anderson at 301-634-0222 or email@example.com.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.