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The California Franchise Tax Board Fails to Follow the Order of Its Market-Based Sourcing Cascading Rules

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In the Appeal of Sheward, 2022-OTA-228P (May 25, 2022), the California Office of Tax Appeals (OTA) held the California Franchise Tax Board (FTB) failed to follow its own market-based sourcing apportionment regulation by prematurely using reasonable approximation to source the income of a multistate unitary business.  During the tax year 2017, the taxpayer operated a business providing in-person services as a horse racetrack judge in California and Minnesota but failed to file a California return.  Related to such services, the taxpayer received Form 1099s from the State of California, the State of Minnesota, and Minnesota Harness Racing, Inc.

In general, the FTB’s market-based sourcing regulation for sales of services requires the income of a multistate unitary business to be sourced to California based on the ratio of a taxpayer’s California receipts to everywhere receipts.  Under the state’s cascading sourcing rules, if there is insufficient information in a taxpayer’s contract, or books and records, to calculate a taxpayer’s California receipts, the taxpayer or the FTB may reasonably approximate the taxpayer’s California receipts.

In this case, the FTB issued an assessment based on the Form 1099 issued by California, sourcing the entire amount to California.  Although the FTB was in possession of the taxpayer’s federal income tax return and information that established the taxpayer’s income was exclusively from her horse racing judge business, the FTB contended that information was insufficient and that it was entitled to use the Form 1099 issued by California to reasonably approximate the taxpayer’s California-source income.

The OTA disagreed, holding the FTB was required to use the information provided by the taxpayer under the FTB’s first market-based sourcing cascading rule.  That information established the taxpayer’s total gross receipts, all of which should have been treated as apportionable business income according to the OTA.  Thus, only the proportion of California service receipts to everywhere receipts should have been used to source the taxpayer’s income to California.

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