California Tax Developments: The Implications of New Regulations with Michael Cataldo

Meredith: 00:01:02

Welcome to SALTovation.

The SALTovation show is a podcast series featuring the leading voices in SALT where we talk about the issues and strategies to help you make sense of state and local tax.

Meredith: 00:01:14

Today on the Saltivation show, we welcome back friend of the podcast Michael Cataldo, who joins us to talk about key.

Meredith: 00:01:22

oners should be tracking into: 2025

We love repeat guests, so it's good to have you back with us again.

Meredith: 00:01:40

Excellent. Thank you for having me.

Meredith: 00:01:42

Happy to be here and thank you for your California brain.

And in that spirit, do you have anything of particular interest or item associated with California that you're thinking about that might be of interest to our listeners?

Meredith: 00:02:02

Oh yeah, there's.

Michael: 00:02:04

There's quite a few things or, or many items.

Meredith: 00:02:08

Yeah, there's quite a few things going on in California, but there always seems to be quite a few things going on in California.

Michael: 00:02:14

Indeed. Yes.

Meredith: 00:02:16

Not special. I think probably number one on the radar is the market based sourcing regulations there.

ts to the regulations back in: 2017

So now they have they published more formal amended regulations which they intend to go through the formal process and make them final as they took some public comments on these regulations which have been kind of moving around all over the place from draft to draft and they are going to be holding a public hearing on them on the 30th of January, which is open to the public and, and we'll see what they do there.

I submitted some comments as well as several other practitioners submitted comments on these proposed regulations and FTB has then responded but didn't really address any of these things and they made a few adjustments. A lot of it was just cleanup work, small editing, not anything real substantive.

tion beginning with tax years: 2024

So kudos to them for doing that. There are a variety of other things but there it doesn't seem that they're going to be interested in in making these changes.

The one thing that they're really kind of moving towards more than they had before. Is this concept of look through when you were talking about sourcing income from services.

Meredith: 00:04:49

So kind of customers, customer concepts.

Meredith: 00:04:52

Yes, yes. And this is not an issue isolated to California. There's other states doing the same thing.

We got Maine, they have a regulation now where they're trying to use more of a, a look through approach.

There was this Minnesota tax court case, I think Humana is the name of it, or they're applying a look through approach and California, they're also, and you know, these, the Maine and Minnesota areas where they're applying look through was with this factual scenario of a pharmacy benefits management companies.

So it's interesting that that's the issue arising in all of the states that are kind of looking to this look through process now what FTB did in the pharmacy benefits management world.

So just to back up a little bit about what's the factual scenario, so you have insurance companies that provide health insurance and they hire pharmacy benefits management companies to make sure the insured, the individuals who are buying insurance are able to get their pharma, pharma products.

So ftb, this was, and this is all in the, in the midst of a constantly evolving regulatory process, constant interested parties, meetings for considering amendments. They issue a, a legal ruling on this pharmacy benefits management.

And what they conclude initially is all right, well where's the benefit of the service?

And they say, well if the insurer, the one who's paying, had to do this pharmacy benefits management stuff themselves, they would have done it at their headquarters. So we just go right to the headquarters. That's not look through approach.

So several years later they came out with another ruling and basically just reversed that, withdrew that ruling and said, you know what, this should actually be sourced to where the insured are. So it kind of gets spread all over depending on where the insured are.

Meanwhile, during the regulatory process and amending the regulation, they don't address this at all. They don't include any examples, they don't even really acknowledge these legal rulings. So it's a bit of a mystery as to why.

And we'll see if they respond to any actual public comments about why not have something in this regulation.

Because the ruling which applied this look through approach had this whole process in place about how to do it and why it looks like a regulation in and of itself. Identify the customer, identify the benefit, identify where. And I just think shouldn't this be in a regulation?

Since we're doing the regulation now, why don't we put it in, but they haven't yet. So that's really the hot topic in California, I think as far as income tax goes, because these market day sourcing rules are broadly applicable.

Really almost every company nowadays is going to get tied up in this. One of the big things is so California, like many states, has a factor Presence Nexus. It's $500,000 of sales source to California.

That's adjusted for inflation annually. So it's almost 800,000 now. But how do you get to that number? It's by applying these regulations. And you could get lost in these regulations.

You could be in Florida, you could be in China, it doesn't really matter anywhere in the world. And through application of this look through, you could find yourself subject to California tax.

When you really don't have a market in California, your clients aren't in California, but they just happen to serve other clients.

So I think there's a lot of areas with this reg that are going to raise some due process concerns when, because due process requires there's some intentional, intentionally going to the market in California.

And if they're, if the regs are just kind of saying, hey, we're going to go and do this look through process, well, maybe you didn't really intentionally avail yourself of the California market. And I think that there are, I think a lot of taxpayers will have these arguments right now.

Michael: 00:09:52

Agreed. And I think that then that could be true in other states.

Meredith: 00:09:55

100%. 100%, yeah.

So like, because what I usually most clients, when they're trying to figure things out, and Stacey, you probably know this better than I at the beginning stage, like reporting, they're usually like, let's raise due process. They don't usually do that. They want to just report what is required. Nobody wants to get in a fight and have protracted litigation with the state.

So nobody wants to.

Michael: 00:10:23

That costs money too, right?

Meredith: 00:10:25

That costs money too. And also like these companies are in business to do whatever their business is, is not like me fighting the state of California. That's my business.

That's not their business. We don't really want to do that. But then you get an audit and then you get audit adjustments and then suddenly there's this big bill.

And that's generally when I get involved. And when I get involved now, I'm not really. And the client is not really looking at, hey, you know what? We want to just comply, not have any trouble.

Don't get in the soup. Too late, you're in the soup.

So now all of these other arguments which before you Maybe you didn't want to raise because you just don't want to deal with it. Well, now you're there, you're in the soup. It's time to fight. So that's when these, these arguments usually get raised is, is after the fact.

Michael: 00:11:17

Have you seen the state audit this pretty regularly or they've been kind of picking this item up because the sourcing rules haven't. I mean they're not new necessarily for services.

It's just, you know, like you said over this regulatory process, over time they've tried to, I don't know, make it more complicated whether that was intentional or not.

I think in their minds they were trying to provide guidance for taxpayers with all these different situations and going through, hey, if you're an advertising company, this is what you do, right? But I don't know, from your perspective, are you seeing the FTB really kind of audit these and I mean, are you seeing more activity related to that?

Meredith: 00:12:04

There's been a lot of activity in this area for a while and I don't see it stopping just because it's so significant.

There's single sales factor apportionment and for many companies, companies involved in services, this is where it's all at all of your, this is where the whole thing is decided. Apply this regulation to a portion of your service income, apply that percentage to your income and that's it.

So and then also those who deal in intangibles kind of same thing. So yeah, I think there's quite a bit of activity in this area on audit for ftb.

Meredith: 00:12:40

So then what happens though if you can't prove the look through, do they have that cascading like. Well, if you don't know or if you can't substantiate, then it's just billing, you know, like default billing address.

Meredith: 00:12:51

They. So they do not like the billing address?

Meredith: 00:12:54

Well, of course not, but that's the only thing that.

Michael: 00:12:57

Because it's probably outside of California. Yes.

Meredith: 00:13:00

Well, you know, I really think it's because they're worried about people abusing it. And this is. It all started at the very beginning. So this, I mean this is a bit of history.

But I, I love looking at the history even though it's a long time ago because it explains the presence.

ngly in a real pickle back in: 0809

Not a heck of a lot of ledge history or anything because it was in the dead of night and they were able to raise some revenue with like vehicle license fees and temporary tax increases. But the, the trade was. And this is where single sales factor got brought into California. Hey, okay, we're going to do a single sales factor.

Of course the companies are like, okay, you know, the in state ones are like, this is good. The out of state ones who are holding things up, not so good.

But the thing that they did that made it just great for everybody was they said, let's make it an election.

You can elect to apply your single sales factor and market based sourcing or you can elect to stick with the, the old way, the three factor double weighted sales formula and using cost of performance. So this was, this went on for a year and this is not sustainable.

I mean you might as well just eliminate the corporate tax if you're going to do this. And people realize that.

But instead of getting the legislature to amend it, they put it to the voters and Proposition 19 basically said no more election, no more three factor double weighted generally and market based sourcing. So the electorate like you, I saw commercials for this and I'm like, my mom's going to vote on this.

The commercials were 20 seconds of showing a picture of jobs in California blowing to the east coast and saying, we need to keep jobs here. If you don't vote for this, we're going to lose the jobs.

Oh, and by the way, here's another way to get this thing to pass is all of the revenue generated from this is going to be put into a fund for green energy development. Another thing people tend to vote yes for. And that's. Yep.

Meredith: 00:15:36

Welcome to a little glimmer of Colorado tabor. And you know, the, the people voting for, you know, tax changes.

Meredith: 00:15:45

Yeah. So I don't know. I'm not a fan of the people voting for tax stuff. I'm not. But then again, the legislature has not always done a bang up job either.

So I don't know. But yeah, people don't understand what they're voting for on these technical things. I mean, I looked at that.

I'm like, okay, I understand this as good as anybody. I see what's going on and then I turn to the next one and I'm like, okay, this is something that I know nothing about.

And I'm like, they're saying this, but what is it really? I don't know. So you just vote based on what they say, but you don't know what they're saying.

Anyways, getting Back to like, why am I going through all of this? So at the time that this was an election, so FTB is like, wow, we need to come up with some rules for this market based sourcing.

Because it was basically what the statute has. The Statute's got like 20 words benefit assignment to the, where the purchaser receives the benefit of the service.

So they're, we need to figure this out. So it was a very short period of time. FTB had to get the initial regs in place.

One of the things they were, the big one was, okay, what about Internet advertising? That was like, okay, well how do we do this? And we don't have a lot of time. There's a lot of issues with this.

And they came up with this, the, the population ratio, like, hey, we don't know. And if you have data to show where these viewers view the advertisement, that's great. But who has the data? Not everybody.

So let's use a population ratio. They had to go through these regs quickly. They got them in. They did the best they could. I mean, I don't want to like bag on them.

They, they were handed a very difficult assignment and so they put something together as quickly as they could because it was needed to for compliance.

hing is, and that was back in: 2010

But they've stuck with the structure that they set up initially, which was kind of hurried and I think that's causing some problems. One of the things that they're getting rid of now is they had this rule for assignment of sales services.

When you're, when your customer, your purchaser is an individual there they said go for it, use billing address. That's great. That's simple. I think, you know, a huge percentage. It's just like that's the right answer.

But there was some concern with corporations and playing around and hey, let's just put your billing address in Nevada and we were good. Or put it in somewhere else away from California. Even though the benefit of the services here. So they did not do that for business entities.

So then we get this whole cascading rule about, well, how do we figure this out for business entities? Well, let's look to the contract. That's the first rule.

There is not a single example in these regs that are over 50 pages about how that would ever apply. Is the contract going to show where the benefit of the service is provided. So I would love to see an example of when that would, would apply.

Hey, should we just type in our contracts of the benefit of the service? It's applied wherever we want. That's not going to work. That, that's not reasonable. So I don't understand really what the point of it is.

The contract itself is certainly evidence, but as the first tier, it's very rarely, never in my experience applied right away. So then we go, okay, well books and records and the contract, we don't get anything there.

Now let's reasonably approximate and that's where you get the population ratio or just give your best guess, make up some stuff, get some data, try to show it any way you can. And then, and only if you can't do that, then you can use a billing address. It's this, the bottom tier. We don't like billing address at all.

So now with these latest amendments, they're getting rid of the billing address for individuals. They're just like, no, we're not going with the billing address now. And instead what they've done is they've replaced it with.

You can use a billing address if you provide a particular service to like 100 or more people during the year. Yeah, I know. It's like you have to have a certain volume and be in a certain service industry.

I mean to me this has kind of got special interest written all over it. Like someone's like, hey, this is our industry, can we get this? And lo and behold, there it is.

So if you're not like represented in your industry to get certain things in there, you're going to be kind of stuck with. Which is to me the worst case scenario for a client is hey, reasonably approximate where the benefit of the services is provided.

So that's kind of where we're at now.

I'm kind of a fan of use the billing address and then have the ability, in the event that that's not correct or abusive, for FTB to come out and say we're not going to let you use billing address. But then all the state and local tax people that are working would have less work to do. So now it's okay.

How do we figure out where the benefit of the service is? Sometimes maybe you're not well advised or you don't have a lot of money or resources to spend developing it and maybe you overpay.

And then there are others who are very well advised and can set something up and support position where they're paying less. So kind of like Tax law like the well advised do well and those who are taken by surprise tend to not do so well. So that's a. The big one.

I think the biggest one in California right now is what, what's, what are they going to do? My feeling is they're not going to change much of what they've already changed and they're going to kind of, kind of leave that as it is.

But we'll see, we'll see. We'll see if they're willing to make any modifications during the, the public hearing.

Meredith: 00:22:11

But those look through provisions are going to stay.

Meredith: 00:22:16

Yeah, I don't see that. Like, yeah, I wait to see. That's something I don't know though.

It's like they have some look through provisions but they're like in examples and then they have the legal rulings that I was mentioning before that apply this look through but they're not in the regulation. Like these rules aren't in the regulation. Right. So we'll see. And how much are we going to see as far as guidance from FTB going forward?

I suspect maybe less than we had been accustomed to. Although hopefully legal rulings will keep going.

my suspicion, this gets to PL: 86272

as well as their publication: 1050

But so now FTP is like, okay, well they pulled them off their website, you can't find their TAM anymore and you don't see a lot of stuff in legal rulings, technical advice, those sort of things. Now they're very measured. I think this is my speculation with what they're going to be willing to do because it just could get.

Someone might just sue them and get thrown out.

ies are impacted or whether PL: 86272

Michael: 00:24:26

Right.

Meredith: 00:24:27

So that's for a later day and I think they're probably because New York's got the same thing, but they actually put it in a regulation. So now that's being challenged. And I mean, if I were ftb, I would wait and see what happens there and perhaps.

Michael: 00:24:43

Well, right.

Meredith: 00:24:43

Do something.

Michael: 00:24:44

And that was. Yeah. And that's really kind of what we also wanted to, you know, ask you from a, you know, from the state's perspective, are they looking at it?

Meredith: 00:24:54

Right.

Michael: 00:24:54

Because it's easy enough. Well, easy enough for them to then pass it under the proper procedures and. But then we know that also New Jersey passed it.

But we've, so far I've not seen any litigation there. But we know we're, but we're following New York. Right, to see what's happening there.

Meredith: 00:25:14

And it's so it's very state by state as far as what you can do to challenge things that are in a regulation. It's like, what are the state laws with respect to being able to do that?

Because there's a lot of roadblocks to getting into court for challenging cases. And it's like, hey, did you pay? Did you exhaust your administrative remedies in California?

They didn't have to worry about that because they were challenging the validity of it as a regulation. They're saying this is a regulation. You didn't go through the process. So I don't know what New Jersey's rules are on that and they've got some.

And I don't know what their process is for challenging a regulation once it, once it's out there. So there's going to be piecemeal stuff. I haven't seen anything audit wise that doesn't mean it hasn't happened.

s taking the position that PL: 86272

We'll just have to do an audit, go to appeals, go to court and then find out that way.

Meredith: 00:26:26

Well, and you got to pick a big enough company, right, that's going to litigate it potentially.

n't have the ability to claim: 86272

Meredith: 00:26:58

ies don't really care about PL: 86272

It's fine with us. So it's really like the small people. Oh, totally. Smaller. Totally. Are the ones who are. And I mean, I say small, but I mean, I'm not publicly traded.

Companies still, you know. Right. Decent amount of money. Those are the ones that will have to fight it. Someone will fight it.

I think even if it's a smaller company, there will be people out there who would challenge it.

Meredith: 00:27:34

Or you have the kind of trade organizations. Right. That are kind of acting on behalf of. Right. That ACMA did.

Meredith: 00:27:41

That's what. Yes, they did there. So I don't think that'll necessarily work when they're actually imposing it because you'll have a taxpayer.

I mean, they could join, right?

Meredith: 00:27:51

Yeah, yeah.

Meredith: 00:27:52

But you have to, as the taxpayer, you got to fight it. And I don't. I think there will be people who. There will be people who will stand up and fight it. You know, you have to have the right dollars.

Like you said. Like, if it's like, hey, we're applying. We're saying your PL82 72 doesn't work because of Internet activities, and here's your bill of $800.

I don't think anyone's gonna. Gonna sign up to fight that one. Maybe someone will, though.

Meredith: 00:28:21

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