California’s Long-Awaited Market-Based Sourcing Regulation Amendments: Why Participate in the Formal Regulatory Process?

Five years and six interested parties meetings later, California is finally ready to proceed with the formal rulemaking process to adopt substantial amendments to its market-based sourcing rules.  At the Franchise Tax Board’s September 9, 2021 meeting, FTB staff requested permission and received approval from its three-member Board to commence the formal regulatory process under California’s Administrative Procedure Act (APA) to amend California Code of Regulations, Title 18, section 25136-2 (Regulation 25136-2).

The proposed amendments to Regulation 25136-2 for which FTB staff requested permission to proceed to the formal rulemaking process are identical to the language published in the discussion draft for the sixth interested parties meeting held earlier this year and can be found here.  FTB staff confirmed in recent written communication that no revisions were made to the proposed amendments as a result of the sixth interested parties meeting.

The Proposed Amendments, In Short

FTB staff’s request to proceed with the formal rulemaking process explains “the proposed major amendments” as follows:

Subsections (b)(1), (b)(2), and (b)(9) were added to provide definitions of key terms used throughout the Regulation.  Definitions were included to provide detailed clarity, provide consistency within the Regulation, and to avoid redundancy.

Subsection (c)(1) was substantially rewritten as the simplified sourcing rule for services sold to both individuals and businesses.  The functions of unamended (c)(1) and (c)(2) have effectively been merged into (c)(1) as amended.

Subsection (c)(2) was substantially rewritten as a specific sourcing rule for asset management services.  The rule that had been at unamended (c)(2) has been merged into (c)(1) as amended.

Subsection (c)(3) was added as a new rule for the sourcing of professional services.

Subsection (f)(1) was amended to define the customer when there is a sale of marketable securities.

Subsection (i)(2) was amended to clarify the rules for using reasonable approximation as a sourcing methodology.

See FTB Request for Permission to Proceed with the Formal Regulatory Process to Amend California Code of Regulations, Title 18, Section 25136-2, Relating to Sourcing of Sales of Other than Tangible Personal Property.

The FTB’s foregoing explanation of the “proposed major amendments” is scant and taxpayers are encouraged to read the entire proposed amendments carefully.  The FTB’s proposed changes raise significant questions on both substantive and procedural issues and create implementation issues that impact virtually every industry.

As currently drafted, the FTB deleted the provision that would have allowed taxpayers to elect to have the amendments retroactive to taxable years beginning on or after January 1, 2012, and instead the amendments would be prospective only and applicable for taxable years beginning on or after January 1, 2023.

California’s Formal Rulemaking Process and Why Participation Is Important

The six interested parties meetings conducted by the FTB from 2017 to 2021 on proposed amendments to California’s market-based sourcing regulation have been part of an informal rulemaking process, separate from California’s formal rulemaking process under its APA.   When Selvi Stanislaus, the FTB’s Executive Officer, was appointed to the FTB in 2006, she substantially increased the FTB’s offering of interested parties meetings in connection with the agency’s rulemaking activities to create additional transparency and foster better collaboration and communication between the agency and its stakeholders.  Those efforts continue to be welcomed and should be applauded.

The formal rulemaking process about to be underway is different and warrants participation and renewed interest by affected taxpayers and other stakeholders.  The formal rulemaking process includes comprehensive public notice and comment requirements and requires that documents and information on which the rulemaking action is based are available for review and inspection.  The comprehensive process is intended to further the goal of public participation in the rulemaking process and to create a fulsome rulemaking record for review and ultimate approval by California’s Office of Administrative Law (OAL).  The FTB will be required to summarize and respond to all written and oral comments and may have to make changes to the proposed text, making participation in the formal regulatory process important for interested parties.

To initiate the amendments to Regulation 25136-2, the FTB will publish a notice of proposed action in the California Regulatory Notice Register.  The FTB must also mail the notice of proposed action to those interested parties who have requested notice of regulatory actions, and post the notice of proposed action, proposed text, and initial statement of reasons on its website.  The FTB’s regulatory activity webpage can be found here.

Once the notice of proposed action is published in the California Regulatory Notice Register, the APA rulemaking process officially begins and the FTB has one year in which to complete the rulemaking process and submit the completed rulemaking file to OAL.

Interested parties and stakeholders will have a 45-day opportunity to comment on the amendments and seek revisions.  The 45-day period commences when the notice of proposed action is published in the California Regulatory Notice Register.  The notice of proposed action will specify the contact person and address where the comments must be directed and the date the written comment period closes.

The FTB will have the option whether to hold a public hearing on the proposed rulemaking action.  If the FTB does not schedule a public hearing, any interested party can submit a written request for a hearing.  The hearing request must be submitted in writing at least 15 days before the close of the written public comment period.  If timely requested, the FTB will be required to hold a public hearing.  Because of this requirement, the FTB usually schedules a public hearing at the outset of the rulemaking process.  Both written and oral comments must be accepted at the public hearing.

For all timely written and oral comments submitted during the rulemaking process, the FTB will be required to summarize the comments and respond during the rulemaking action.  For each comment, the FTB will be required to include either an explanation of how the proposed action has been changed to accommodate the comment or state the reasons for rejecting the comment.   In summarizing and responding to public comments, the FTB must demonstrate that it understood and considered the comment.  The summary and response to comments will be included as part of the rulemaking file in the Final Statement of Reasons issued by the FTB.

If the FTB makes changes to the originally proposed text in response to public comments or on its own, it will be required to classify the change as (1) nonsubstantial, (2) substantial and sufficiently related, or (3) substantial and not sufficiently related.

Nonsubstantial changes do not alter the regulatory effect of the proposed provisions and thus no further public notice is required.

Substantial changes are deemed to alter the meaning of the regulatory provisions and therefore require further notice to the public.  Most commonly, substantial changes are “sufficiently related,” which means the changes are reasonably foreseeable based on the notice of proposed action.  Substantial and sufficiently related changes must be made available for public comment for at least 15 days.  Under these circumstances, the FTB would be required to mail a notice of opportunity to comment on proposed changes and a copy of the text of the proposed changes to each party who has submitted written comments on the proposal, testified at the public hearing, or asked to receive any notices of proposed modification.  The FTB would also be required to post the notice on its website.  Another public hearing is not required.  Interested parties and stakeholders must submit their comments in writing and such comments must be limited to the proposed modifications.  The FTB would then be required to consider any comments received during the 15-day comment period directed at the proposed changes.  Multiple 15-day opportunities to comment are not unusual during the formal rulemaking process before there is a final version of the amendments.

Much less common are the third type of changes, substantial changes not sufficiently related to the original proposal.  These are changes that are not reasonably foreseeable based on the notice of proposed action and would require the FTB to publish another 45-day notice in the California Regulatory Notice Register similar to the original notice of proposed action.

When the FTB has completed the comprehensive public notice and comment requirements

and the proposed amendments are finalized, the FTB will transmit the entire record to the OAL for review and approval.  Once submitted, the OAL has 30 working days to conduct its review of the rulemaking record to ensure the FTB satisfied the comprehensive requirements of the APA’s and OAL’s regulations.  The OAL will then either approve the rulemaking action and file the proposed regulation with the California Secretary of State or disapprove the rulemaking action.

Concluding Thoughts

California’s market-based sourcing rules for sales of services and intangibles are multifaceted and complex in both interpretation and application.  As the FTB enters the formal regulatory process, interested parties will be presented with a series of opportunities to submit written and oral comments that stand to improve the clarity and application of the proposed rules.  Please contact any member of the Pillsbury SALT team if you have questions about the regulatory process or the substance of the FTB’s proposed amendments to Regulation 25136-2.