California Office of Tax Appeals Pronounces That It Has No Authority to Invalidate Regulations

The California Office of Tax Appeals (OTA) stated that it lacked authority to overrule the Franchise Tax Board’s (FTB’s) regulations. In the Matter of the Appeal of Janus Capital Group, Inc. and Subsidiaries¹ (“Janus”), the OTA denied the taxpayer’s $4.2 million refund claim and refused to invalidate 18 California Code of Regulations (CCR) § 25137-14, an FTB regulation that applies to certain financial business services. This nonprecedential opinion comes several weeks after the OTA’s executive director submitted a written query to the California Attorney General to settle a dispute between the OTA and tax professionals on whether the OTA has authority to invalidate regulations.

Janus is an investment management company headquartered in Colorado and provides management, administrative, and distribution services to mutual funds and other institutions. Only services provided as a “mutual fund service provider”² are at issue in this appeal. Janus timely filed its California tax returns for the 2013 through 2016 tax years utilizing a single-sales factor formula and the special “look-through” sourcing method prescribed for mutual fund service providers by 18 CCR § 25137-14. Under this regulation, Janus assigned the gross receipts received from sales of services to mutual funds to the locations of the mutual funds’ shareholders for the 2013 through 2016 tax years. Janus later filed refund claims for these years and assigned mutual fund service receipts to the locations of the mutual funds themselves (not to the locations of the mutual funds’ shareholders). Janus purported that 18 CCR § 25137-14 should not be applied and, alternatively, that FTB was required to assert distortion before applying the regulation. When the FTB denied the claims for refund, Janus appealed the decision to the OTA.

In its appeal, Janus argued that the FTB did not provide evidence regarding the economic impact of 18 CCR § 25137-14 on taxpayers when the FTB proposed it adoption in 2007; therefore, the regulation was not adopted in accordance with the California Administrative Procedure Act (APA) and was invalid. In addition, Janus claimed that when 18 CCR § 25136-2, California’s market-based sourcing regulations, was amended in 2012 to replace the “cost-of-performance” sourcing rule with a rule that sources receipts on where a “purchaser” received the “benefit of the services,” the FTB failed to follow APA notice and evidentiary procedures. This regulation generally provides that the “look-through” sourcing method prescribed by 18 CCR § 25137-14 will still be applicable to mutual fund service providers despite the amendment to 18 CCR § 25136-2 in 2012.

In response to the first claim, the OTA asserted that there is no statute that confers upon them the authority to determine whether a regulation of another agency was adopted in compliance with the APA. For that reason, the OTA opined that it lacks jurisdiction to consider the merits of Janus’s arguments that FTB failed to follow APA procedures when 18 CCR §§ 25137-14 and 25136-2 were adopted. 

The second issue the OTA considered was whether the sales factor sourcing methodology under 18 CCR § 25137-14 or the sourcing methodology under 18 CCR § 25136-2 should apply. The OTA determined that where such a special apportionment formula like 18 CCR § 25137-14 applies, the taxpayer and FTB are bound to follow it, unless a party seeking to deviate from it establishes by clear and convincing evidence that the regulation does not fairly represent the extent of the taxpayer’s activities in this state and the party’s proposed alternative is reasonable.

The OTA found that Janus did not provide any evidence demonstrating that its apportionment percentage should have been calculated differently, either with an equally weighted three-factor formula (property, payroll, sales) or by some other combination of factors; therefore, the OTA determined that 18 CCR § 25137-14 is the standard apportionment rule for assigning Janus’s service receipts.

Janus’s position failed because the evidence provided did not establish where the purchasers received the benefit of Janus’s services. The OTA opined that no convincing evidence was provided by Janus to support the position of determining the location of benefit to customers. The burden of producing evidence to support its proposed sourcing methodology under 18 CCR § 25136-2 was not met, resulting in denial of the claims.

Although this decision does not definitively support the application of the look-through approach to sourcing asset management fees, it lessens the impact of arguments against the position. This position is in line with California’s continued assertion that if the provider receives service revenue that may benefit its customer’s customer, the revenue be sourced on a “look-through” to the location the customer’s customer receives the benefit.³ Further, the decision reinforces the requirement for taxpayers to provide evidence to support their sourcing methodology, as the OTA added in dicta that the taxpayer’s asserted sourcing had not been sufficiently substantiated.

For guidance on revenue sourcing for apportionment factor purposes for a financial institution or when you are rendering services to your customer’s customer, please reach out to the Ryan professionals listed below.

¹ California Office of Tax Appeals, No. 20096605.

² California Code § 25137-14(a)(5) defines a mutual fund service provider 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.”

³ California FTB Legal Ruling No. 2022-01 (March 25, 2022).
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