California ~ Corporate Income Tax: Non-Marketing Services Sourced to State Where Taxpayer’s Customers Would Have Provided the Services

In a Chief Counsel Ruling, the California Franchise Tax Board (FTB) ruled that, under the corporation franchise and income tax apportionment rules, a taxpayer that contracts with health plans to manage and administer certain non-marketing services that the health plans are contractually obligated to provide to their clients and members must assign the sales of its services to California to the extent its direct customers (i.e., the health plans), and not its customer’s customers (i.e., the health plan sponsors or their members), receive the benefit of the service in California. In addition, the FTB ruled that the benefit received by the health plans is that of being relieved of the obligation to perform the business functions required under their health plan agreements. Therefore, the taxpayer must assign the sales of its services to the state where the health plans have their current base of operations.

According to the FTB, California law provides that (1) sales from services are in California to the extent that the purchaser of the service received the benefit of the services in the state, and (2) the benefit of a service is received at the location where the taxpayer’s customer has either directly or indirectly received value from delivery of that service. However, California law does not expressly specify how to determine which party receives the benefit of the service in the case of a non-marketing service where both the taxpayer’s customer and the taxpayer’s customer’s customers receive a benefit from the service. Chief Counsel Ruling 2015-03 provides that, just as sales of non-marketing services are sourced to the location where the taxpayer’s customer receives a benefit of the service through its use in the business, the same approach should be used for sales of services. Additionally, each of the cascading rules under Reg. Section 25136-2(c)(2) contemplate that it is the taxpayer’s direct customer who is receiving the benefit of the service. Therefore, because the taxpayer provides sales of non-marketing services to its health plan clients, the FTB stated that the benefit received should be determined with respect to a health plan’s direct benefit and not the indirect benefit received by the health plan’s customers (i.e., the plan sponsors or their members).

In addition, the FTB noted that, under Reg. Section 25136-2(b), “benefit of a service is received” means the location where the taxpayer’s customer has either directly or indirectly received value from delivery of that service. In the case at hand, the taxpayer contracted with health plans to manage and administer benefits that the health plans are contractually obligated to provide under agreements entered into with the plan sponsors or their members. In order to take advantage of benefits such as operational efficiencies and costs savings, the health plans choose to outsource this function to the taxpayer. However, should the health plans choose to terminate their contracts with the taxpayer, they would be contractually obligated to administer the benefits portion of the agreements themselves. Therefore, according to the FTB, the benefit to the taxpayer’s customers (i.e., the health plans) is that of being relieved of the obligation to perform these business functions that they would otherwise be required to perform themselves, but for their contracts with the taxpayer.

Finally, having determined that the benefit received by the health plans is that of being relieved of the obligation to administer the benefits portion of the agreements, the FTB focused on determining the location of the benefit of this service to the direct customer in accordance with the cascading rules of Reg. Section 25136-2(c)(2). In applying this regulation to the taxpayer’s services for the health plans, the FTB found it is necessary to determine how the taxpayer would establish where the health plans receive value from not having to perform this service themselves. To the extent that this information is unavailable or unclear in the agreements or the taxpayer’s books and records, the taxpayer should source the services pursuant to the other cascading rules under Reg. Section 25136-2(c)(2), including using reasonable approximation to determine the location where the health plans would perform the services based on existing information of the account managers and other publicly available information regarding the health plans. Based on the facts presented, the best reasonable approximation of the location of where the benefits are received would be the location that the health plan clients would conduct prescription drug benefit services, if they cancelled the taxpayer’s contracts. This would be the location where the health plans currently conduct residual benefit services and other health plan functions (i.e., their current base of operations). According to the FTB, this may be the best indicator of where the health plan clients would perform the services themselves, especially since the taxpayer generally has information in its books and records to determine this location because of the ongoing working relationship between the taxpayer and the health plans.

Chief Counsel Ruling 2017-01, California Franchise Tax Board, April 7, 2017, released July 2017, ¶406-698

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