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Service Providers Beware: You Could Have Nexus in California Without Having Physical Presence

California’s 2009–2010 budget, which was signed by Governor Arnold Schwarzenegger on February 20, 2009, contains significant changes to California tax law. These changes could impact companies with sales to California customers even if the companies do not have a physical presence in California. Below are details on some of the significant changes.

“Doing Business” Definition Revised

Under existing corporate income tax law, “doing business” means being “actively engaged in any transaction for financial or pecuniary gain or profit.” Effective for taxable years beginning on or after January 1, 2011, a taxpayer will be considered “doing business” in California under any of the following conditions:

• The taxpayer is organized or commercially domiciled in California
• The taxpayer’s California sourced sales exceed the lesser of $500,000 or 25% of the taxpayer’s total sales
• The taxpayer’s real property and tangible personal property in California exceeds the lesser of $50,000 or 25% of the taxpayer’s total of such property
• Amounts paid in California by the taxpayer for compensation exceed the lesser of $50,000 or 25% of total compensation paid by the taxpayer

California appears to have effectively adopted an “economic nexus” standard, whereby physical presence in California is no longer required to have nexus. It should be noted that Public Law 86-272¹ still applies to taxpayers selling tangible personal property. However, the California tax law changes are of significant importance for service providers as Public Law 86-2721 does not apply to services.

An example of how the California tax law changes might impact taxpayers is provided below:

An Illinois-based consulting firm, which does not have employees or independent contractors entering into California, secures California clients based on word-of-mouth advertising. Total sales from the California clients are $600,000. Under the existing law, the consulting firm would have no income tax nexus in California as there is no physical presence. Under the new law, the consulting firm would have income tax nexus and filing obligations in California because sales to its clients located in California exceed $500,000. Similarly, if the company’s total sales amount to $1,000,000 and sales to the clients located in California total $300,000 rather than $600,000, the consulting firm would still have income tax nexus and filing obligations in California under the new law since the $300,000 exceeds 25% of the company’s total sales.

Sourcing of Service Revenue Based on Benefit Received

Under existing corporate income tax law, revenue from services are sourced based on the cost of performance. For tax years beginning on or after January 1, 2011, sales from services are considered to have taken place “in” California “to the extent the purchaser of the service received the benefit of the service” in California.

An example of how this California tax law change might impact taxpayers is provided below:

An Illinois-based law firm, which files a California income tax return, performs legal services for a customer located in California. Although the benefit of the services is presumably received in California, the greater cost of performing the service occurred in Illinois. Under the existing law, no sales would be sourced to California on the law firm’s California income tax return as the greater cost of performance occurs in Illinois. Under the new law, the law firm should source all of the sales to California as the benefit of the service was received in California.

Adoption of Finnigan Rule for Combined Filers

Effective for taxable years beginning on or after January 1, 2011, sales of tangible personal property to a person or entity located in California are included in the sales factor numerator if any of the companies within a combined group has California nexus. On the flipside, sales are not “thrown back” to the California sales factor numerator if the sales are made to a state where any member of the combined group is taxable in that state.

An example of how this California tax law change might impact taxpayers is provided below:

Company X, which has California-sourced sales, is included in a California combined income tax return but does not have California nexus on a stand-alone basis. Under the existing law, Company X’s California-sourced sales are excluded from the sales factor numerator as Company X does not have California nexus. Under the new law (Finnigan rule), Company X’s California sourced sales are included in the sales factor numerator since at least one of the members in the combined return has income tax nexus in California.

We Can Help Reduce the Tax Impact

Regarding the California tax law changes discussed above, California appears to be targeting out-of-state service providers, especially ones with revenue from California customers. Although these changes will not be effective until 2011, it’s important to identify possible tax exposure and implement tax planning strategies to minimize the tax impact as early as possible. Further, with the FIN 48 disclosure requirements, it is more important than ever to proactively address these issues.

If you would like to discuss possible California tax exposure and tax planning strategies for your company, please contact Vu Vinh at 312-980-2923 or Deb Rood at 312-980-2995.

 

¹The federal law that prohibits states from imposing net income tax upon companies whose activities are limited to the mere solicitation relating to the sale of tangible person property. It is important to note that service providers are not protected under this law.

 

This publication is part of Blackman Kallick’s marketing of professional services, and is not written tax advice directed at the specific facts and circumstances of any person and/or entity. Contents of this publication are of a general nature, and you should not act on this information without obtaining professional advice from your business advisor that is appropriately tailored to your individual needs and circumstances. This written advice is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.