California - Sourcing of asset management fees for investment advisors 

April 9:  The California Franchise Tax Board has proposed amendments to regulations concerning how the market-sourcing provision applies in instances when fees are earned by asset management corporations having California nexus.

Background

Effective for tax years beginning on or after January 1, 2013,1 California adopted single sales factor apportionment and market-based sourcing for sales of other than sales of tangible personal property.


Under the revised law, receipts from services are sourced to California to the extent “the purchaser receives the benefit of the service” in California.2 That phrase is further defined by regulations to mean “…the location where the taxpayer's customer has either directly or indirectly received value from delivery of that service.”3

Proposed amendments for market-sourcing provision

The California Franchise Tax Board (FTB) released proposed amendments to California Code of Regulations (CCR) section 25136-2 (the “-2 regulation”) that address how the market-sourcing provision applies in the case of fees earned by asset management corporations having California nexus.


The FTB indicated that the proposed amendments to the -2 regulation will be revised, and are intended, to be similar in application to CCR section 25137-14 (the “-14 regulation”)—i.e., the current rules applicable to advisors providing investment services to regulated investment companies (RICs).4


The current version of the proposed amendments to the -2 regulation includes examples describing the sourcing of fees earned from providing administration, distribution, and management services to pension plans, retirement accounts or other investment accounts.5


According to the proposed amendments, the benefit of the services is received by the shareholders, beneficial owners or investors of the plans or accounts that ultimately pay the investment manager’s fees. Therefore, income related to those services is sourced to the location of those shareholders, investors or beneficial owners.


  • If the asset management entity providing the services can determine through its books and records, kept in the normal course of business, the domicile of the shareholders, beneficial owners or investors, then gross receipts are to be assigned to California based on the ratio of owners in California over owners everywhere.
  • If the entity cannot determine through its books and records the domicile of the shareholders, beneficial owners or investors, then sales are to be assigned by reasonably approximating the domicile of the shareholders, beneficial owners or investors using information based upon zip codes or other statistical data. However, if the entity cannot reasonably approximate a method for determining the domicile of the shareholders, beneficial owners or investors using zip codes or other statistical data, then the receipts are disregarded and not includable in the sales factor numerator or denominator.

The FTB indicated it intends to maintain consistent rules between similarly situated taxpayers—e.g., taxpayers rendering services to shareholders of RICs and taxpayers rendering services to other third parties on behalf of shareholders, beneficial owners and other investors. In the case of management and advisory services provided to RICs, the -14 regulation looks to the place where the ultimate beneficiary of the service is located.6 According to the regulation, the ultimate benefit is received by the investors in the RIC.


Thus, a taxpayer is to “look-through” to the location of the investor and source its receipts to that location.


Other states, such as Delaware and New Jersey, apply similar “look-through” methodologies to source receipts from asset management corporations and asset management services when the shareholders, beneficiaries, owners or members of an investment company or institutional investors are located within the state.7

KPMG observation

Tax professionals expect that the final version of the proposed -2 regulation generally will adopt the sourcing methodology employed in the -14 regulation. Presumably, the final version of the proposed -2 regulation will apply to management companies providing services to all types of alternative investment funds (e.g., REITs, real estate funds, hedge funds, and private equity funds).8


Also, notwithstanding the reference to an “asset management corp” in the current version of the proposed -2 regulation, it is believed that the final version of the proposed -2 regulation will apply to all taxpayers—including partnerships and LLCs owned by individuals—similar to the rules under the -14 regulation.


The final version of the proposed -2 regulation is expected to be released later this summer, with a potential effective date of January 1, 2013.

FTB Chief Counsel letter ruling

A recently released FTB Chief Counsel letter ruling has caused some confusion as to the sourcing of receipts for investment advisors. In the letter ruling, the taxpayer—a nonresident individual member of a California-based limited liability company (LLC) and taxed as a partnership—managed a private equity fund that qualified as an “investment partnership” under California Revenue and Taxation Code (CRTC) section 17955(c).


Over 90% of the investment in the private equity fund was attributable to partners located outside of California, and over 90% of the funds of the private equity fund had been invested in portfolio companies that were not incorporated or headquartered in California.


The FTB determined that the taxpayer was to source its income under CRTC section 17951. That provision determines a nonresident individual taxpayer’s income from sources within California. Under CCR section 17951-4:


  • If a nonresident’s business is carried on entirely within California, the entire net income of the business is considered to be derived from California sources.
  • If the business is carried on both within and without California, the income is apportioned.

The taxpayer stipulated and FTB determined that the taxpayer’s business was conducted entirely in California; therefore, net income of the LLC was sourced entirely to California.

KPMG observation

Officials with the FTB informally explained that the conclusion in the letter ruling was based on its determination that the taxpayer was carrying on business solely in California. The conclusion may have been different if the taxpayer had been carrying on business in another state, as determined by applying California law to the other state—e.g., if the LLC had over $500,000 in sales attributed to another state.9


However, because the LLC in the letter ruling did not have the requisite presence in or sales attributed to a state other than California, the taxpayer was not eligible to apportion the LLC’s income. Therefore, all of the LLC’s income was sourced to California.


If the LLC had been carrying on business in another state, presumably the taxpayer would have been eligible to apportion, and California would have applied the look-through rules to source the LLC’s income based on the location of the investors in the private equity fund.

Action steps

Taxpayers may need to consider making extension payments for their 2013 California franchise (income) tax returns and calculating their 2014 estimated payments using the “look-through” methodology described in the -14 regulation and the proposed revision to the -2 regulation.


Assuming the final version of the proposed -2 regulation is released this summer and contains the anticipated retroactive effective date, taxpayers need to be able to take into account the methodology included in the proposed revision when filing their extended 2013 California tax returns.


For more information, contact a KPMG State and Local Tax professional:


Dave Turzewski

(212) 872 5628


Douglas Bramhall

(480) 459 3491


Scott Salmon

(202) 533 4202


1 Prior to that time, sales other than sales of tangible personal property were sourced using a “greater costs of performance” methodology.


2 Cal. Rev. & Tax. Code § 25136(a)(1).


3 Cal. Code Regs. tit. 18, § 25136-2(b)(1).


4 The rules for sourcing fees provided to RICs are included in Cal. Code Regs. tit. 18, § 25137-14.


5 Proposed Cal. Code Regs. tit. 18, § 25136-2(c)(1)(C)(5).


6 Cal. Code Regs. tit. 18, § 25137-14(b).


7 Del. Code Ann. tit. 30, § 1903(b)(7); N.J. Admin. Code § 18:7-8.10(e). A few states have adopted market-based sourcing rules similar to California, such as Michigan and Washington, which source receipts from services to where the purchaser receives the benefit of the service. Please note, however, that adoption of similar market-based sourcing rules does not necessarily equated to similar application of the rules.


8 The final version of the proposed -2 regulation also could apply to taxpayers that elected the single sales factor under Cal. Rev. & Tax. Code § 25128.5 for taxable years beginning on or after January 1, 2011, and before January 1, 2013, depending upon the effective date of the proposed -2 regulation.


9 Pursuant to Cal. Rev. & Tax. Code § 23101(b), a taxpayer with sales in California in excess of $500,000 is doing business (i.e., has nexus) in California.




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