California: 2022 Changes to Sourcing Services Revokes Prior Rulings, Some Penalty Relief Available

The California Franchise Tax Board (FTB) on March 25, 2022, issued Legal Ruling 2022-01, which changes the sourcing of gross receipts from sales of certain types of non-marketing services for purposes of California’s single-sales factor apportionment formula. In doing so, the FTB also revoked two prior Chief Counsel Rulings involving sourcing of gross receipts from non-marketing services upon which taxpayers may have relied. In a news release on April 11, 2022, the FTB offered penalty relief under certain circumstances for taxpayers that can prove reliance on the revoked rulings.


California is one of at least 35 states and localities, including the District of Columbia and New York City, that require the use of market-based sourcing for receipts from sales of services and licenses/sales of intangibles. A number of these taxing jurisdictions apply a look-through sourcing rule, or so-called “customer-of-the-customer” approach to source receipts from sale of services. Under a look-through sourcing approach, if a service provider performs services for a customer that are also delivered to or benefit that customer’s customer, the receipts are sourced to where the customer’s customer is located. 
In two prior rulings, Chief Counsel Ruling 2015-03 (December 31, 2015) and Chief Counsel Ruling 2017-01 (April 7, 2017), the FTB had declined to adopt a look-through sourcing approach for sourcing of gross receipts from non-marketing services. For example, in Chief Counsel Ruling 2015-03, the FTB ruled that when a service does not market a product or service, it is considered a non-marketing service and the California regulations’ rules for sourcing sales of non-marketing intangibles should be applied. In that case, there is no look-through sourcing. Specifically, the FTB concluded in this ruling that investment advisory services provided to portfolio managers, analysts, risk managers, and other investment and banking professionals and firms were non-marketing services and should be sourced to the location of the direct customer and not to that customer’s customer, even though the services also benefitted the latter.
Likewise, in Chief Counsel Ruling 2017-01, a taxpayer managed and administered programs for various health plans that the plans were contractually obligated to provide to their health plan customers. Applying the same sourcing rationale, the FTB ruled that the non-marketing services receipts should be sourced to the location of the health plans and not to the locations of the health plans’ customers. 

Discussion of Legal Ruling 2022-01

In its new ruling, the FTB first provides that “it is essential that certain determinations be made to ascertain how sales of services are to be assigned” (or sourced). These determinations are:

  • Who is the customer?
  • What service is being provided?
  • What is the benefit of the service being received by the customer?
  • Where is the benefit of the service being received by the customer?

The ruling emphasized that in determining who is the customer, while a third party (i.e., the customer’s customer) may benefit from a service, it is only the direct customer’s benefit that is relevant to the sourcing analysis. However, when the service provided by the taxpayer is directed at the customer’s customer(s), the customer likely receives the benefit at the third party’s location under the FTB’s new look-through sourcing.  
While not excluding any specific types of services, Legal Ruling 2022-01 sets forth some types of services that are likely to result in look-through sourcing of services receipts: sales and marketing services, customer support services, in-person services involving a third-party contractor and subcontracting arrangements. 
The ruling also examines three fact patterns, two of which involve arrangements for application of the FTB’s new look-through sourcing:

  • In “situation two,” the taxpayer provides processing and fulfillment of prescription drug claims for its customer, a health plan company. The benefit of the taxpayer’s performance of its services to its health plan company customer is that the health plan’s customers are able to obtain prescription drugs. Thus, the third parties’ benefit is also a benefit to the taxpayer’s direct customer, the health plan company. As a result, the taxpayer’s services receipts are sourced to the location of the health plan company’s customers.
  • In “situation three,” the taxpayer is a subcontractor that entered into a contract with a general contractor to provide consulting services to a manufacturing corporation. The general contractor is the subcontractor’s customer. The manufacturing corporation is the customer of the general contractor. Because the taxpayer’s services are performed directly for the manufacturing corporation, the benefit of the service to the manufacturing corporation benefits the taxpayer’s direct customer. The taxpayer’s services receipts are sourced to the location of the manufacturing corporation. 

Lastly, Legal Ruling 2022-01 revokes Chief Counsel Ruling 2015-03 and Chief Counsel Ruling 2017-01 retroactively, as well as any other guidance that relied on those rulings. California’s normal statute of limitations to audit is four years (six years if gross income is omitted by 25% or more), therefore taxpayers that relied on the revoked rulings might still be open to audit for these issues.

Penalty Relief

The FTB’s retroactive revocation of the prior rulings presents an exposure issue for taxpayers that relied on those rulings, including for penalties and interest. As noted, on April 11, the FTB issued a news release offering some penalty relief to taxpayers who can show reliance on the prior rulings. The release clarifies that Legal Ruling 2022-01 applies to services performed for or provided to direct business customers and taxpayers whose filing obligations and tax liabilities are determined in reference to Cal. Rev. & Tax. Code section 25136 and 18 Cal. Code Regs. section 25136-2. 
If a taxpayer relied and proves reliance on either of the revoked Chief Counsel Rulings when it made its services receipts sourcing determination for purposes of its filed California tax returns, the Large Corporate Understatement Penalty (for underpayments of $1,000,000 or more or 20% of the income tax paid) and Accuracy Related Penalty will not be assessed, but interest will apply to underpayments.  However, if the rulings were relied on by the taxpayer to determine it did not need to file a California return (i.e., the state’s factor-presence sales threshold was not satisfied in a prior year), a “delinquent penalty” will apply. (The California sales threshold is inflation-adjusted each year. For example, for tax year 2017 the threshold was California sourced receipts of at least $561,951.  For tax year 2021, the threshold is $637,252.)