The 2018 calendar year included a number of interesting developments from a California tax perspective, including the ongoing saga of implementing Wayfair, proposed amendments to the market-based sourcing regulations, the decision not to conform to the federal transition and GILTI taxes, and the decision to conform to the federal partnership audit rules. In addition, the Office of Tax Appeals went through many rounds of regulation changes that will govern tax appeals into the future.
(This is a republication of Law360’s January installment of Reed Smith’s California Tax Takes monthly column.)1
Authors: Yoni Fix
2018 California tax highlights
As this year has come to a close, we thought it would be appropriate to provide a high-level recap of some of the most interesting and significant California tax developments from 2018.
- California’s attempt to implement Wayfair use tax collection rules for online retailers
On December 14, 2018, Senator Mike McGuire and Assembly Member Autumn Burke jointly introduced Assembly Bill 147 (“AB 147”) to implement the U.S. Supreme Court decision in South Dakota v. Wayfair, Inc.2 The use tax collection requirements under the bill would differ from the requirements announced by the California Department of Tax and Fee Administration (“CDTFA”) by way of a notice the previous week.
The CDTFA’s notice required remote sellers to collect use tax if they made $100,000 in sales into the state or 200 or more transactions during the preceding or current calendar year starting April 1, 2019. When asked about the enforceability of Wayfair via a notice, CDTFA representatives at the October 24, 2018 Wayfair Stakeholders Meeting stated that CDTFA’s lawyers currently believe that the California ‘Long-Arm’ provision gives the CDTFA authority to enforce the same nexus thresholds that the Supreme Court blessed in Wayfair without passing any additional legislation or regulation.
In response to the CDTFA’s notice, the Legislature is proposing in AB 147 to raise the use tax collection threshold to $500,000 in sales into the state, and to expand the definition of retailers to include marketplace facilitators that list or advertise the sale of tangible personal property by third party sellers and directly, or indirectly, collect payments from the customers and transmit them to the third party sellers.
AB 147 contains an urgency clause, so it will require approval by a two-thirds majority vote and will take effect immediately upon enactment.
As we discussed in greater detail in our October alert, unless AB 147 or similar legislation is passed by a two-thirds supermajority vote by the Legislature, any attempt by the CDTFA to enforce its use tax collection requirement by way of an administrative notice will likely be subject to challenges based on multiple grounds, including noncompliance with California Proposition 26 (which requires any tax increase to be approved by a two-thirds supermajority vote in the Legislature), and for noncompliance with the procedural requirements of the California Administrative Procedure Act.
- Market-based sourcing regulation for sales other than sales of tangible personal property
On May 18, 2018, the FTB held its third interested parties meeting (“IPM”) as part of its revision of California’s market-based sourcing rules for sales other than sales of tangible personal property. The latest round of amendments to the market-based sourcing regulations proposed to, among other things,
o Clarify how the reasonable approximation method should be applied to approximate a taxpayer’s market when sufficient books and records are not available;
o Provide a series of simplifying rules used to presume whether the benefit of the service is received by businesses and government entities in the state, in addition to the existing cascading rules for assignment of such sales;
o Provide guidance on how to source receipts in cases where the sale involves both services and tangible or intangible personal property;
o Add a rule requiring the FTB to accept the taxpayer’s reasonable approximation method unless the FTB shows by a preponderance of the evidence that the taxpayer’s method is not reasonable; and
o Clarify the assignment of receipts from asset management services and government contracts.
During the third IPM, practitioners and taxpayers expressed concerns regarding the latest version of the regulations, including the lack of clarity about whether to apply the simplifying rules before the cascading rules. The FTB said that it expected to release a new version of the draft regulations by the end of 2018.
Our takeaway is that the proposed changes to the regulations have clarified the FTB’s position on the sourcing of some industry-specific services. This creates potential opportunities and pitfalls for many multistate taxpayers. And for many other taxpayers, the rules still lack clarity, leaving taxpayers in an uncertain area when deciding how to file their next return.
- Impact of California’s non-conformity to the federal transition and GILTI taxes
As part of the 2017 federal tax reform, Congress added a deemed repatriation toll charge (the “transition tax”) and a global intangible low-taxed income (“GILTI”) tax.
Under the transition tax, any net “deferred foreign income” of a “deferred foreign income corporation” that was accumulated after December 31, 1986, and before December 31, 2017 (or, if resulting in a larger amount, November 2, 2017) is (1) treated as Subpart F income for the corporation’s last tax year beginning before January 1, 2018, and (2) taxed to its U.S. shareholders.
Under the GILTI tax, a U.S. shareholder of any controlled foreign company (“CFC”) must include in gross income its GILTI, which is defined as the excess of the U.S. shareholder’s CFC net “Tested Income” that exceeds a 10 percent return on the adjusted basis of tangible property used in the business less interest expenses.
Income from both the repatriation toll and GILTI are included in gross income in a manner similar to an inclusion of Subpart F income, where previously taxed income (“PTI”) is generated for purposes of IRC § 959 and is tracked in order to prevent double taxation of that income upon the subsequent actual distribution of those foreign earnings to the U.S. shareholder.
While California generally conforms to the federal income tax treatment of distributions under IRC § 301, it does not conform to IRC § 959 for distributions to the U.S. As a result, California does not allow for the exclusion for PTI under IRC § 959, or allow taxpayers to adjust their CFC stock basis under IRC § 961(a).
And the FTB made clear in 2018 that California does not automatically conform to the transition or GILTI taxes, and made no announcement as to its intention to conform in the near future.3 Thus, California does not currently allow for the exclusion for PTI generated due to the transition or GILTI taxes under IRC § 959, or allow taxpayers to adjust their CFC stock basis under IRC § 961(a) for such inclusions.4
To the extent a distribution from a CFC to its U.S. shareholder is treated as a dividend, a U.S. shareholder may not exclude the income from the distribution from California taxable income as PTI. However, the U.S. shareholder may exclude the dividend to the extent it was paid out of previously taxed income of the unitary business.5 To the extent a distribution is not excluded as previously taxed California unitary income, the distribution should be eligible for a 75 percent California dividends received deduction.6 As a result, taxpayers that decide to distribute foreign earnings out of federal PTI, might end up including 25 percent of those distributions in their California income tax base.
Based on U.S. Supreme Court precedent, there may be several arguments to reduce the California tax impact of having to include the remaining 25 percent of any PTI distribution.
- Conformity to federal partnership audit rules
Recent modifications to the Internal Revenue Service (“IRS”) partnership audit procedures now allow the IRS to assess and collect any tax, penalty or adjustment resulting from an audit at the partnership level, instead of at the individual partner level. The purpose behind this change was to avoid the administrative difficulties associated with audits of large partnerships with numerous partners. Because California is not a rolling conformity state, legislation would be required to conform the California FTB’s partnership audit procedures to those of the IRS. Thus, California Senator Steven Glazer introduced Senate Bill 274 (“SB 274”), which received bipartisan support and was signed into law by Governor Jerry Brown on September 24, 2018.
SB 274 adds Section 18622.5 to the California Revenue and Taxation Code, which also requires a partnership to report any changes or adjustments that the IRS made to its federal partnership return to the California Franchise Tax Board, within 6 months.7 SB 274 does not make any changes to the California audit process8. Under SB 274, California partnerships are subject to the same rules as applied at the federal level9. Thus, if the partnership reports and pays an increased tax at the federal level, it is required to do the equivalent in California. If the partnership elects to “push-out” any audit-related tax, penalty, or adjustment at the federal level, the same methodology applies in California, thus shifting the obligation to the individual partners. If the partnership opts to shift the obligation to the partners, all partners have ninety days to pay the amount in controversy.
SB 274 also contains a clause that provides partnerships with a preference to request an election different from their federal election.10 The partnership is only able to request a different election if the partnership is “able to establish to the satisfaction of to the [FTB] that [FTB’s] ability to collect any state income or franchise taxes would not be impeded, and the partnership properly computes the amount of tax due.”11 The granting of this election is wholly up to the discretion of the FTB.12
Office of Tax Appeals update
The Office of Tax Appeals (“OTA”) operated during 2018 under a set of emergency regulations adopted on December 26, 2017. Those emergency regulations expired on December 31, 2018. On October 10, 2018, the OTA submitted its proposed regulations to the Office of Administrative Law (the “OAL”) for review. On November 15, 2018, the OTA withdrew its proposed regulations in order to make an administrative correction to its application. After making the necessary changes to its application, the OTA resubmitted its proposed regulations on December 7, 2018. An OTA representative confirmed that the language and substance of the proposed regulations submitted to the OAL on October 10, 2018 and December 7, 2018 are identical. The representative also stated that the regulations will be effective on January 3, 2019. The OAL’s website states that it will issue a decision regarding the OTA’s proposed regulations no later than January 23, 2019.
- The authors would like to thank Akeen Patel, a law clerk with Reed Smith, for his contributions to the drafting of this alert.
- 138 S. Ct. 2080 (2018).
- FTB’s Summary of federal income tax changes 2017–Final Report.
- See Cal. Rev. & Tax. Code §§ 17024.5(a)(1)(P), 23051.5, 25116, 25110; California Guidance – Taxable Year 2017 IRC Section 965 Reporting (REV 05-22-18); FTB’s Summary of federal income tax changes 2017–Final Report.
- Cal. Rev. & Tax Code § 25106(a)(1).
- Cal. Rev. & Tax. Code § 24411(a).
- 2017 CA S.B. 274 Sec. 18622.5(a) (Sept. 23, 2018).
- See 2017 CA S.B. 274 (Sept. 23, 2018).
- 2017 CA S.B. 274 (Sept. 23, 2018).
- 2017 CA S.B. 274 Sec. 18622.5(c)(3) (Sept. 23, 2018).
- See id.