United States: California FTB Clarifies Economic Nexus Principles Do Not Apply To Throwback Rule For Tax Years Before 2011

The California Franchise Tax Board (FTB) has issued a Technical Advice Memorandum to explain that economic nexus standards do not apply when applying the throwback rule to tax years beginning before January 1, 2011.¹ During these prior tax years, California law required physical presence to establish substantial nexus for purposes of the Commerce Clause of the U.S. Constitution. Thus, a taxpayer must demonstrate physical presence in the destination state to establish that it is subject to taxation in that state in order to avoid the throwback rule for tax years prior to 2011.

Throwback Rule and Nexus Standards

In determining that a taxpayer must have a physical presence in the destination state to avoid the throwback rule for tax years prior to 2011, rather than asserting the existence of substantial sales in a destination state without physical presence, the FTB reviewed California's statutory and regulatory throwback provisions, the nexus requirements and California's new economic nexus standard.

Throwback Rule

For purposes of the sales factor component of the formula used to apportion income to California, tangible personal property shipped from California is generally assigned (thrown back) to California if the taxpayer is not taxable in the destination state.² For purposes of the throwback rule, a taxpayer is taxable in another state if: (i) in that state it is subject to a net income tax, a franchise tax measured by net income, a franchise tax for the privilege of doing business or a corporate stock tax; or (ii) that state has jurisdiction to subject the taxpayer to a net income tax regardless of whether, in fact, the state does or does not.³

If a sale is destined for a foreign country, U.S. Constitutional standards are used to determine whether a taxpayer is subject to taxation in that country.⁴ A taxpayer's sales will not be thrown back to California if: (i) the taxpayer is subject to an income tax in the foreign country; or (ii) the foreign country could impose an income tax under U.S. Constitutional standards.⁵

Substantial Nexus Requirement

Before a state may impose an income tax, the Due Process and Commerce Clauses of the U.S. Constitution require that nexus exists between the taxpayer and the taxing state.⁶ For purposes of the Due Process Clause, nexus exists if an out-of-state company purposely avails itself of the benefits of an economic market in the state, even though it may not be physically present in the state.⁷ Nexus is present under the Commerce Clause if the activities the state seeks to tax have substantial nexus with the state.⁸ As explained by the FTB, the rules concerning whether the Commerce Clause's substantial nexus standards require physical presence have evolved over time. However, the FTB noted that "California authorities have consistently provided that physical presence is required in order for a taxpayer to have sufficient nexus to be subject to tax."⁹

Economic Nexus Standard

California defines "doing business" as "actively engaging in any transaction for the purpose of financial or pecuniary gain or profit."¹⁰ For taxable years beginning on or after January 1, 2011, a corporation is doing business in California if the taxpayer's sales in California exceed the lesser of $500,000 or 25 percent of the taxpayer's total sales.¹¹

Physical Presence Required Prior to 2011

Based on the authority discussed above, the FTB determined that the new economic nexus standard only applies to tax years beginning on or after January 1, 2011. According to the FTB, "[b]y enacting legislation providing that a taxpayer is doing business in California where a taxpayer's only contact with this state are sales exceeding $500,000, California's Legislature determined for the first time that substantial economic presence meets Constitutional standards under California law." The FTB further stated that "[i]n enacting this statutory provision, California's Legislature determined that under California law, physical presence is no longer required in order for the state to subject a business to tax." Therefore, for throwback purposes in tax years before 2011, a taxpayer must demonstrate physical presence¹² in the destination state to prove that it is subject to taxation in that state. If it meets this requirement, the taxpayer is not required to throw back these sales for tax years prior to 2011.

Commentary

Earlier this year, the FTB released a Chief Counsel Ruling that applied California's new economic nexus standard, the Finnigan rule, and market-based sourcing to determine when the throwback rule applies to sales of items shipped from California to another jurisdiction.¹³ When examining the interplay between the economic nexus standard and the throwback rule, the FTB noted that it was not considering the potential applicability of the economic nexus rules for tax years prior to 2011, perhaps with the knowledge that the FTB was considering the issuance of this Technical Advice Memorandum. As a result of both releases, taxpayers are provided with guidance concerning the throwback rule for tax years before 2011 (when the economic nexus standard was not in effect) as well as subsequent tax years (when the economic nexus standard is in effect).

Apparently, some taxpayers have argued that the economic nexus standard applied to tax years beginning before 2011 for purposes of the throwback rule, particularly as many states other than California have administered their corporate-level taxes with statutory, regulatory or policy-driven economic nexus rules. Under this argument, substantial sales in the destination state would be sufficient to avoid the throwback rule. This guidance clarifies the FTB's position that physical presence is necessary to escape the throwback rule for tax years prior to 2011. Thus, a taxpayer must have a stronger connection with the destination state in these prior tax years if it does not want to throw back its sales.

Footnotes

1 Technical Advice Memorandum 2012-01, California Franchise Tax Board, Nov. 29, 2012.

2 CAL. REV. & TAX. CODE § 25135.

3 CAL. REV. & TAX. CODE § 25122.

4 CAL. CODE REGS. tit. 18, § 25122.

5 Id.

6 Quill Corp. v. North Dakota, 504 U.S. 298 (1992).

7 Id.

8 Id.

9 The FTB cited Appeal of Dresser Industries, Inc., California State Board of Equalization, No. 82-SBE- 307, June 29, 1982, rehearing No. 83-SBE-118, Oct. 26, 1983; Appeal of John H. Grace Co., California State Board of Equalization, No. 80-SBE-115, Oct. 28, 1980; as well as some unpublished decisions.

10 CAL. REV. & TAX. CODE § 23101(a).

11 CAL. REV. & TAX. CODE § 23101(b). The statute also provides that a taxpayer is doing business in the state if the taxpayer's tangible property or payroll in the state exceeds $50,000 or 25 percent of the taxpayer's total property or payroll.

12 Note that this can be established either directly or through agents or independent contractors.

13 Chief Counsel Ruling 2012-03, California Franchise Tax Board, Aug. 28, 2012. For more information, see GT SALT Alert: California FTB Chief Counsel Ruling Applies New Economic Nexus Principles to Use of Throwback Rule, Nov. 15, 2012.

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