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    Fact Pattern – Service Based Business such as law firms, valuation and consulting firms, engineering firms, architect firms, CPA Firms, IT Services.

    Issue - How are service based revenues sourced and apportioned to California and other states?  Is the “throwback” rule applicable to the performance of services?

    Analysis - In general, California has conformed to an economic nexus and “market-based” sourcing of revenue, specifically, services are sourced to the state where the economic benefit of the service is being received.  However, merely having revenue sourced to a specific state does  not always indicate that a tax return must be filed or a tax liability has been incurred.  The taxpayer must have “nexus” with that state.  Nexus in general refers to an entity that is connected or has a connection with a state.  Income Tax Nexus is normally obtained if that state has in addition to revenue to that state, payroll and/or property located in that state.  The details of nexus are complicated and are beyond the scope of this article.  Currently under California law, taxpayer's will source their revenue to each state where the benefit of the service is being received.  In most cases this is straightforward, but as outlined below there is room for interpretation. 


    Service Company operates in California and Arizona and has offices and payroll in both states.  Because Service Company has payroll and property in both California and Arizona, Service Company is deemed doing business in both states and also has income tax nexus to each of these states.   Additionally, the Service Company provides services to a New York based client, but Service Company has no payroll or property located in or allocated to the state of New York.  The services are performed in California but for the benefit of a New York client.  Under these facts and the market-based sourcing rules, the revenue applicable to this New York client is sourced away from California and included in the numerator factor for New York. 

    However, the California Service Company does not have nexus in New York, nor does it have payroll or property in New York and thus there is no New York filing requirement for the California (and Arizona) Company.  In this case we have several questions:

    1.       What happens to the revenue sourced to New York?

    2.       Do we disregard the nexus rules and file a New York return? 

    3.       Do we “throwback” the revenue to California or Arizona and include in California’s/Arizona’s total revenue? 

    4.       Is it actually possible to have revenue sourced “nowhere” and thus have untaxed revenue at the state level?

    The “throwback” provision applies only to the sale of tangible personal property (“TPP”).  Under the California rule there is a specific distinction between sales of TPP and sales other than the sale of tangible property (e.g. service revenue).  The TPP rule specifically discusses the sourcing of sales when the taxpayer is not “taxable” in the state of jurisdiction (i.e. Throwback to California when there is no nexus). 

    In contrast, the rule for service revenue is silent on this issue.  When California moved to an economic nexus criteria and market-based sourcing in 2011 (if you elected into the single sales factor) it did not change its sourcing rule for service revenue when a taxpayer is not taxable in the state where its customer receives the benefit of the service.  California Revenue and Taxation Code 38006 codifies the apportionment rules and explains when a taxpayer can apportion its revenue.  

    For service based taxpayers, CRTC 38006 applies in determining whether a taxpayer has the right to apportion its income.  The code indicates that a taxpayer must have a physical presence outside of California for a taxpayer to apportion its income to another state.  In other words – the California Service Company must also have nexus to at least one other state outside of California. 

    In our example, if the Service Company did not have a physical presence in Arizona it would not have the right to apportion its income either to New York or Arizona (and 100% of its income would be taxable in California, regardless of the location of their clients).

    Because Service Company has nexus with Arizona, the rule allows us to apportion the income.  The rule only requires that at a taxpayer have nexus in only one other state.  Because it has economic nexus and meets economic nexus criteria in at least one other jurisdiction (i.e. Arizona), the code allows us to apportion income to all applicable states where the benefit of the services are being received.  Specifically in our example, we can apportion income to Arizona, New York and any other state where Service Company has clients.

    So what happens?

    ·         The revenue is sourced to New York and thus its NOT included or taxed at California or Arizona. 

    ·         A New York return is NOT required and the Service Company is NOT deemed doing business in New York and thus is NOT taxable in New York.

    ·         Additionally, because the throwback rule is only applicable to TPP, the New York sales are NOT thrown-back to California or Arizona. 

    ·         As such, the New York revenue is actually – “no-where” income and escapes state taxation indefinitely. 

    To date there has been no regulatory, judicial or administrative guidance on how to source service revenue to the extent a taxpayer is not taxable in the state where its customer receives the benefit (i.e. New York in our example).  Therefore, we are left with the statutory guidance which does not specifically mention the “throwback” or “assignment” of services to the state where the services are performed. 

    California, currently and in the past has adopted the UDIPTA definition of “throwback” which relates only to the sale of TPP.  Most of the administrative guidance put out by the Franchise Tax Board (FTB) has been in relation to the economic nexus rules and the sale of TPP (see Chief Counsel Ruling 2012-03).  Proponents of this position have stated that the FTB has allowed refund claims over the past few years in regards to taking this position and that the FTB knows that its service sourcing rule is silent on “throwing back” of sales of services.  The FTB is aware that by not specifically addressing this issue in administrative pronouncements or other guidance, many taxpayers will “throwback” these sales if a taxpayer is not taxable in another jurisdiction. 

    With the above said, the FTB could definitely challenge this position on an audit.  However, given the history of the code and rules, this position is not overly aggressive based on the current statutory support and the FTB’s silent and non-explained position on the sourcing of services. 

    For more information, please give Jarin Maurer a call at (714) 937-3900 or email at