Tales From the California Tax Controversy Trenches: Navigating FTB Sales Factor Audits
Proper planning can lead to a successful audit— or at least a more tolerable one

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One of the California Franchise Tax Board’s1 guiding principles is to “administer the Revenue and Taxation Code . . . and be vigorous in requiring compliance with the law.”2 Our decades-long experience with California tax controversy provides perspective on the FTB’s vigor for compliance. This vigor is never more apparent than during audits of a multistate taxpayer’s apportionment of income to California.

Since 2013, companies other than financial institutions, farms, and extractive industries that conduct multistate activity are subject to California income tax based on a single-sales-factor apportionment formula, which is the ratio of gross receipts within California to total gross receipts during the taxable year. An issue that frequently arises on audit is whether the multistate taxpayer has properly computed its sales factor, which requires sourcing receipts to California according to a series of cascading rules. Determining which sourcing rule applies depends on the facts and circumstances of the transaction. Receipts from the sale of an intangible property right are sourced according to one rule, whereas receipts from the sale of services are governed by another.

This area of the law is complex and remains a work in progress, with the state having yet to clarify a number of open questions. It is in this legal environment that taxpayers can expect the state to raise questions about their sourcing methodology. Anticipating the FTB’s scrutiny by preparing for an audit will help taxpayers to shape and substantiate a narrative leading to a favorable determination or, if necessary, lay the groundwork for potential litigation.

This article provides practical tips for preparing for an FTB audit and identifies sourcing issues that the FTB frequently flags.

Framing a California Tax Controversy

A California income tax audit may appear daunting but is reasonably transparent and formal. The FTB’s audit begins with an initial contact letter (ICL) that may or may not identify the issues. Taxpayers should consider using a designated representative familiar with the process and California law at the outset. It may be worth preparing a California Form 3520-BE (Power of Attorney Declaration) to apply to all years at issue and to grant a representative the power to add or remove representatives, which would ensure greater flexibility as the audit unfolds.

Following the ICL, the auditor prepares an audit plan. It is beneficial to engage with the auditor at this stage to identify the scope and timing of the audit. Prior to any exchange of information, the parties may meet for an opening conference, discuss the plan and processes, and agree to the time frame and deadlines for submissions. The auditors generally have a list of items to review that taxpayers may obtain to prepare the company’s audit plan.

Communications during an audit are critical. Although the auditor’s objective is to verify compliance with the law, the audit should be viewed as a precursor to potential litigation. Auditors will use responses to information document requests (IDRs) to frame the facts and application of law. Taxpayers should be mindful that these requests set the record and effectively serve as administrative discovery. Taxpayers should treat their response to IDRs that request a legal position as an opportunity to state their position clearly and succinctly, but not as an invitation to brief the entire issue. Choose language carefully as reflected in the law and avoid phrases like “more likely than not” or “we think” or “it appears.”

For factual IDRs, consider what the auditor is verifying and if there is any issue with the information available. Provide what is requested and no more. If a request appears irrelevant to the subject, seek to clarify the auditor’s intention before stating that the item is not relevant. If the item continues to appear irrelevant, explain why.

After concluding the audit, the auditor will issue an audit issue presentation sheet (AIPS) detailing the proposed adjustments. The AIPS will ask for the taxpayer’s agreement or disagreement on an issue. Signing these documents is not required but may expedite the closure of the audit. Taxpayers may disagree with the AIPS and provide a written explanation. Doing so is advisable, since the audit manager will review the disagreement, which gives taxpayers an opportunity to convince the FTB of their position prior to the issuance of a notice of proposed assessment (NPA).3

General Audit Tips

Although each audit is unique, taxpayers should employ several general recommended practices:

  • prior to the audit, ensure that books and records are preserved and well organized;
  • review records and work papers for thoroughness and weed out extraneous comments;
  • do not sacrifice accuracy for speed and request extensions when necessary;
  • be succinct and address only the questions presented; and
  • although an audit may be the start of a controversy, be courteous and helpful.

Managing a California audit is illustrated by current controversies surrounding the sales factor.

Sales Factor Audit Issues

Since California adopted a single sales factor for most business taxpayers in 2011, the source of gross receipts became the primary driver of taxable income. Concurrent with this change, California adopted market-based sourcing for sales of other than tangible personal property that generally focuses on where the customer receives the benefit from the transaction. Following these changes, California issued Regulation 25136-2 to clarify how the market-based sourcing rules apply to various transactions and certain industries. The regulation has been updated since its adoption, and proposed amendments have been pending adoption for about two years.4 The current regulation and the proposed regulation leave many unanswered questions.

Although a full discussion of the sales factor could fill a treatise, challenges in audit management may be demonstrated with selected examples.

Pharmaceutical and Biopharmaceutical Drug Development

The pharmaceutical and biopharmaceutical industries at times enter into agreements whereby one company may provide another the right to use a drug compound as part of a collaboration agreement. Such a right may be exchanged for an upfront payment with no repayment requirement, the income from which may be recognized at the time of payment. Often these payments are large enough to create taxable income in a single year and constitute the vast majority of total business receipts, which in turn determines the income sourced to California.

Consider a hypothetical company, Biopharma, located in California that developed a cancer-fighting compound. The cancer research division of another hypothetical company, Big Pharma in State X, pays Biopharma a $100 million upfront payment conferring the rights to use the cancer-fighting compound in further cancer research that will be conducted in clinical trials across the United States and an option to participate in a future commercial drug. Biopharma will perform certain research as part of the collaboration in California. The payment is recognized for income tax purposes in the year of receipt.

The regulation states that services provided to a business are sourced based upon a cascading set of priority rules starting with the location where the customer benefits as noted in the books and records or contract. Absent a clear source, a taxpayer may reasonably approximate the benefit location. If this is not available, then one may use the order location, and finally the billing address. The license of intangible property is sourced based upon where the intangible is used. To provide clarity, the proposed regulations would source upfront payments to the location where the continuing research is conducted.

One may reasonably interpret the regulation or proposed regulation to source the payment to:

  • California (the location where the compound was developed);
  • California (the location where Biopharma will conduct ongoing research);
  • partially California (the percentage of locations where the research will be conducted);
  • partially California (the benefit is reasonably approximated based on the population of worldwide cancer patients in California); or
  • State X (where the customer is located).

Biopharma should consider these potential outcomes when crafting audit responses and verify whether records such as term sheets, email correspondence, research logs, and deliverables indicate Big Pharma’s State X location. Biopharma may consider highlighting Big Pharma’s location and activity. Biopharma may also consider characterizing the upfront payment as an intangible license to keep focus on where the intangible will be used prospectively. Further, to the extent the location of the future research is unknown, Biopharma may consider reinforcing a narrative that Big Pharma is located in State X, the cancer research team will benefit in State X, the order location is in State X, and the billing is to State X.

Asset Management Services

Another controversial area is asset management services, including fees for managing an investment fund. According to the proposed regulation, the “benefit of the asset management services is received at the domiciles of the investors in the assets.”5 This is effectively a look-through approach whereby the benefit of the service is not determined based upon where the investment fund is located but is deemed received by the investors in the fund.

This look-through approach raises significant questions about how far beyond an immediate customer one must look to determine the benefit. The US Supreme Court once remarked, “[a]llocating income among various taxing jurisdictions bears some resemblance . . . to slicing a shadow.”6 Although the Court’s comment invoked the difficulty of apportioning income, the sentiment is even more profound in this case. If apportioning income is as difficult as slicing a shadow, then apportioning assets management income looking through to the investors is like slicing a shadow’s shadow.

The look-through approach itself is perplexing, but even more so is the auditors’ application of the proposed amendment prior to its adoption. The current iteration of the regulation specifically states that “sales from services are assigned to this state to the extent the customer of the taxpayer receives the benefit of the service in this state.”7 There is no mention of the customer’s customer.

Consider the following. An asset manager provides services to a fund that has twenty-five percent individual investors in California. Another ten percent investor is a California-based pension fund with fifty percent of its beneficiaries in California. Another ten percent investor is a donor-advised fund located in State Y. The remaining investors are other individuals. The proposed regulation would treat twenty-five percent of the management fees as California-sourced based on the address of the individual investors. Beyond this measure, may one consider another five percent California-sourced based on the percentage of California individuals in the pension fund? Or is all ten percent included because the pension fund is located in California? Must we look through the donor-advised fund to the charities in California it supports?

Taxpayers should consider an optimal strategy at the outset of the audit. If the asset manager is located outside California, the narrative may focus on the current regulation and the lack of any look-through language. Consider the services provided under the asset management agreement to craft the position that their activities are localized outside California. In contrast, if the asset manager and fund are located in California, then looking through to the investors, and in turn looking through the pension fund to its investors, may be the most beneficial approach.

Given the lack of clarity in the regulation and its application, taxpayers may select which shadows to slice.

Throwback Sales

California law requires sales of tangible personal property (TPP) to be sourced to California if those sales are made to a state in which the taxpayer is not taxable.8 A taxpayer is taxable in another state if it is “subject to tax” in that state or if that state “has jurisdiction to subject the taxpayer to a net income tax regardless of whether, in fact, the state does or does not.”9 Whether a taxpayer is taxable in another state is based on determining whether the taxpayer’s activity in that state would be sufficient to give the state jurisdiction to impose a tax based on net income, by reason of such business activity, under the Constitution and statutes of the United States.10

For purposes of determining whether a taxpayer is taxable in another state, we look to California’s interpretation of the economic nexus “doing business” standard11 and the imposition of tax upon those whose activities exceed the protections of Public Law 86-272.12 Further, based upon FTB legal division guidance, taxpayers are required to aggregate proceeds from sales of TPP with sales of other-than-TPP to determine whether the taxpayer has met California’s economic nexus standard for doing business in the state.13 The FTB auditors may not be aware of the legal division guidance or may interpret such guidance differently. The following illustration highlights auditors’ approach to these rules.

A hypothetical company, Medical Inc., manufactures and distributes medical devices. In addition to providing sales of TPP, the company conducts research and engineering services in California and whose benefit is received in State Z. Medical sells devices to State Z in the amount of $500,000 during 2019 and has no property or payroll located within State Z. Additionally, the company sources to State Z $200,000 of its sales of engineering and research services performed in California and whose benefit is received in State Z. Medical files its original 2019 California return on time and does not include the sales to State Z in the numerator for its California sales factor, as it determines it is taxable in State Z based on its aggregate sales exceeding the $610,395 threshold that California imposed for purposes of economic nexus in 2019.

Thereafter, the FTB audits the company’s 2019 returns and concludes sales to State Z should have been thrown back to California, since Medical is protected by Public Law 86-272 because the company has no physical presence in the state and its sales of services do not exceed the economic threshold of $610,395. The auditor posits that the company must have a physical presence in State Z to be subject to tax, appearing to contradict FTB legal division guidance.

The situation above presents a choice. A taxpayer should resist the temptation to immediately disagree with the auditor’s position. The path of least resistance may be to substantiate that the company did have a physical presence in the state from employees traveling to State Z. The company may produce travel records, affidavits from engineers, or contract terms. The auditor may agree with the position based upon the facts even if the legal basis for the position is disputable. If the records are difficult to gather or in-state activity is not supportable, then the taxpayer may consider responding to the IDRs by stating the position that the company is subject to tax in State Z and then request a review by an audit supervisor or technical specialist. If the auditor continues to disagree, the company should disagree with the AIPS and may suggest the involvement of FTB legal staff to resolve the issue.

California sales factor audits are meant to verify compliance with the law but present challenges when the law lacks clarity. When facing a California sales factor audit, taxpayers should:

  • take opportunities early to identify issues and plan the narrative;
  • understand the auditor’s interpretation of the applicable law, including whether the auditor intends to apply the proposed regulations;
  • understand the risks of alternative interpretations;
  • develop and implement an overall strategy;
  • review available documents and facts thoroughly; and
  • craft responses carefully.

An audit is an opportunity to frame the facts and tax positions favorably. Approaching the audit with vigor is the best defense.

Eric Anderson, Esq., is a managing director in the state and local tax (SALT) practice at Andersen and is based in San Francisco. Michael Vigil, Esq., is a director in the SALT practice at Andersen and is based in Sacramento. Vik Kohli, Esq., is a senior associate with Andersen’s SALT practice in California.


  1. The FTB is the California agency responsible for collecting income tax from businesses and individuals.
  2. FTB 985 Publication (Audit, Protest, Appeals the Process), State of California Franchise Tax Board, accessed April 30, 2021, ftb.ca.gov/forms/misc/985.html [emphasis added].
  3. Taxpayers who disagree with the additional assessment must protest the NPA within sixty days. After this protest concludes, the FTB will send a notice of action (NOA) to confirm, edit, or withdraw from the assessment. Taxpayers who disagree with the FTB’s NOA after the protest can file an appeal with the Office of Tax Appeals (OTA). Additionally, taxpayers who want to circumvent the protest process may, in certain circumstances, elect to pay the proposed liability amount after audit and directly appeal to the OTA or bring an action in court. The OTA was established in 2017 and began hearing oral arguments in January 2018.
  4. Notice of Fifth Interested Parties Meeting on Market-Based Rules for Sales Other Than Sales of Tangible Personal Property – California Code of Regulations, Title 18, Section 25136-2, State of California Franchise State Board, accessed April 30, 2021, ftb.ca.gov/tax-pros/law/regulatory-activity/07212020-meeting-notice.pdf.
  5. Drafted language of Regulation 25136-2(c)(2).
  6. Container v. FTB, 463 U.S. 159 (1983).
  7. Regulation 25136-2(c)(2).
  8. California Revenue and Taxation Code, Section 25135(a)(2).
  9. California Revenue and Taxation Code, Section 25122.
  10. Regulation Section 25122(c).
  11. Enumerated within California Revenue and Taxation Code, Section 23101.
  12. Public Law 86-272 restricts a state’s ability to impose a tax based upon net income if the activities of the taxpayer are limited to the solicitation of sales of TPP.
  13. Chief Counsel Ruling 2016-03, State of California Franchise Tax Board, July 5, 2016, ftb.ca.gov/tax-pros/law/chief-counsel-rulings/2016-03.pdf.

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