California Market-Based Sourcing Regulation Impacts Asset Managers and Taxpayers with Receipts from Services and Intangibles

After nearly a decade of development, the California Franchise Tax Board promulgated changes to its market-based sourcing regulation for sales of other than tangible personal property. The amended regulation is particularly important for asset managers’ California sourcing of asset management fees.

California imposes a single sales factor apportionment formula, and Section 25136-2, Title 18 of the California Code of Regulations (Regulation) interprets how to source sales of other than tangible personal property (TPP), such as receipts from services and intangibles (e.g., sales of interests in business entities or the sale, lease, or licensing of nonphysical assets such as patents), within and without California for purposes of the sales factor. The California Franchise Tax Board’s (FTB) proposed changes to the regulation have been in development since 2017 and were recently adopted effective for tax years beginning on or after January 1, 2026.

The Regulation is important to the California sourcing of receipts from services and intangibles for sales factor purposes and also applies for determining whether a foreign or out-of-state taxpayer meets the economic nexus standard for filing a California return (which is $735,019 of California-sourced sales for 2024). We discuss the Regulation’s treatment of various types of receipts from sales of other than TPP below.

SALES OF SERVICES

Generally, sales of services are assigned to California to the extent the customer of the taxpayer receives the benefit of the service in the state. The Regulation provides a rebuttable presumption that sales of services are sourced as follows:

1. Services related to real property are sourced to the location of the real property;
2. Services related to TPP are sourced to the location of the TPP at the time the services were performed, unless the TPP is delivered to the customer after the services, in which case it is sourced to the delivery location;
3. Services related to intangible property are sourced to the location where the customer uses the intangible property; and
4. Services related to individual customers are sourced to the location of the individual customer at the time the services were performed.

These rebuttable presumptions may be overcome by demonstrating by a preponderance of the evidence that the benefit of the service is received at a different location.

ASSET MANAGEMENT SERVICES

The revised Regulation provides a framework for sourcing fees from asset management services. Under the Regulation, “asset management services” are defined as the “direct or indirect provisions of management distribution or administrative services to funds.”

The FTB has historically asserted that asset management fees are sourced to the location of the ultimate customers, rather than to the location of the payor fund. The new Regulation is consistent with the FTB’s interpretation that receipts from asset management services are sourced based on investor’s domicile, unless the investor holds title for someone else, in which case the receipts are sourced based on the domicile of the beneficial owner.

The investor or beneficial owner’s domicile is presumed to be the billing address as reflected in the records of the entity for whom the asset management services are provided, unless there is evidence that the primary residence or principal place of business is different from the billing address. A “beneficial owner” is one who makes independent decisions to invest but excludes decisionmakers for pooled or corporate investments (e.g., master funds and feeder funds) and those who participate in a defined benefit plan.

The taxpayer’s receipts from asset management services are assigned to the sales factor (i.e., included in the in-state numerator) in proportion to the average value of the interest in the assets held by investors or beneficial owners domiciled in the state. If the taxpayer does not have information regarding the average value of the assets held by investors or beneficial owners in California, then it may use a reasonable estimation.

If population is a reasonable approximation, then the population is generally the US population as determined by the most recent US census data as of the beginning of the taxable year. If the taxpayer can substantiate that the benefit of the service is substantially received (or intangible property is being materially used, as applicable below) outside the United States, then the populations of the foreign jurisdictions or geographic areas where the benefit of the service is substantially received (or the intangible property is being materially used) can be added to the US population.

While the Regulation is effective January 1, 2026, it is possible that the FTB may seek to assert that the Regulation is a clarification of current law for prior tax years, although retroactive application of the Regulation may be subject to dispute. Taxpayers who have sourced receipts from asset management services based on the location of the payor fund should consider the impact of the Regulation on prior tax years.

MUTUAL FUND SERVICE PROVIDERS

Note, mutual fund services providers are subject to pre-existing “look-through” apportionment rules under 18 CCR 25137-14. Mutual fund services providers are defined as any unitary business that derives income from the direct or indirect provision of management, distribution, or administration services to or on behalf of a regulated investment company (RIC). Mutual fund service providers generally source receipts to California based on shareholder location.

If a shareholder’s domicile is unknown to the mutual fund service provider because the shareholder is a person who holds the RIC shares as depositor for the benefit of others, then the mutual fund service provider may utilize any reasonable basis, such as the ZIP codes of underlying shareholders, in order to determine the proper location for the assignment of the shares. If no information is obtained such that a reasonable basis can be developed to determine the proper location, then all of the shares held by the shareholder are disregarded.

SALES OF CORPORATE STOCK, PASS-THROUGH ENTITY INTERESTS, AND DIVIDENDS

For sales of corporate stock or pass-through entity interests and receipts derived from dividends or goodwill, if more than 50% of the assets of the corporation or pass-through entity being sold or the dividend payor consists of intangible property, then the receipts are assigned to California (i.e., included in the numerator of the sales factor) based on the underlying entity’s sales factor. If more than 50% of assets are real or tangible personal property, then the receipts are assigned based on the average of the California property and payroll factors.

However, the 50% test excludes cash, cash equivalents, prepaid items, and accounts receivable. The Regulation also includes a cascading set of rules to apply if such information regarding the underlying entity or dividend payor is not available.

SALES OF MARKETABLE SECURITIES

The revised Regulation retains the general definition of a marketable security as any security that is actively traded in an established stock or securities market and is regularly quoted by brokers or dealers in making a market. The Regulation also continues to source the sale of marketable securities to customer location.

However, the definition of the term “customer” is now defined as the person, without regard to intermediaries, who gains the greatest possession of economic rights in a marketable security. As such, an investment fund that sells a marketable security may not know the customer (i.e., purchaser of the marketable security) and will need to use a reasonable approximation, such as population data.

LARGE-VOLUME PROFESSIONAL SERVICES

The Regulation provides a new rule for assignment of receipts of professional services, such as management services, tax services, payroll and accounting services, audit and attest services, actuary services, legal services, business advisory consulting services, technology consulting services, services related to brokering securities that generate commission, investment advisor services other than asset management services, and services related to the underwriting of debt or equity.

For large-volume professional services, which are defined as a taxpayer’s provision of a single professional service to more than 250 customers, receipts are assigned based on the customer’s billing address. If more than 5% of the receipts are derived from a single customer, then that customer’s receipts are excluded from the default billing address rule.

SALES OF INTANGIBLE PROPERTY

The Regulation’s requirements for sourcing sales of intangible property did not undergo major changes from the prior version of the regulation. Generally, receipts from sales of intangible property are assigned to California to the extent the intangible property is used in the state. In the event of a complete transfer of all rights in intangible property, the customer’s location of use is presumed to be where the contract between the taxpayer and customer or the taxpayer’s books and records at the time of the sale indicate the customer will use the intangible property. If such location cannot be determined by the contract or books and records, then the taxpayer may use a reasonable approximation.

If the location of use cannot be reasonably approximated, then the location of use is deemed to be where the taxpayer used the intangible property in the most recent full tax year. If none of these methods is determinative, then the receipts are sourced based on the purchaser’s billing address.

BUNDLED SALES OF SERVICES AND TANGIBLE AND INTANGIBLE PROPERTY

For receipts from bundled sales of both services and tangible or intangible personal property, each portion of the receipt must be separately assigned within and without California if the value of each portion is readily ascertainable. If it is not, then the principal purpose of entering contract determines the application sourcing methodology.

KEY TAKEAWAYS

Taxpayers should carefully consider the impact of the revised Regulation on their California sales factor sourcing requirements. In addition, taxpayers should review their sourcing methodologies for tax years that are open under the statute of limitations to consider any opportunities for more favorable sourcing or exposure in the event of audit. Specifically, asset managers with investors located in California should review their sourcing methodology as it relates to any management fees.