Mofo New York Tax Insights - Fall 2013

"OCCASIONAL SALES" AND SINGLE SALES FACTOR APPORTIONMENT IN CALIFORNIA

By Eric J. Coffill

For decades, California utilized a mandatory corporate franchise tax equally-weighted three factor apportionment formula of payroll, property and sales, thus assigning a 33% weight to the sales factor. In 1993, California double-weighted sales in the three-factor formula, increasing the weight of the sales factor to 50%.1 Recently, following a number of unsuccessful attempts over the years by the California Legislature to change the apportionment formula to mandatory use of single-factor sales, the California voters passed Proposition 39 at the November 6, 2012 General Election requiring, for taxable years beginning on or after January 1, 2013, corporate taxpayers to apportion using single-factor sales.2 Accordingly, with three possible exceptions,3 current California law relegates payroll and property factor issues to obscurity. For example, a taxpayer with all of its manufacturing capacity (i.e., 100% property) and all of its employees (i.e., 100% payroll) outside of California, but with all of its sales assigned to California, will have a 100% California apportionment formula.4

Now, it is all about sales. If single-factor sales were not enough, for taxable years beginning on or after January 1, 2013, sales of other than tangible personal property are assigned for sales factor purposes based on a so-called "market" approach, instead of costs of performance.5 Also, recall that for taxable years beginning on or after January 1, 2011 California returned to a Finnigan approach under which all sales of a combined reporting group properly assigned to California will be included in the California sales factor, regardless of whether the member of the combined group making the sale is subject to California tax.6

The trend toward hyper-weighting the California sales factor—now to 100% sales beginning in 2013—continues to increase the tax value of that factor. There have been, and will continue to be, a wide variety of sales factor issues in California and all those issues now take on a heightened importance in terms of tax effect. One such issue, the inclusion in the sales factor of receipts from so-called "occasional sales," is the subject of this article. As more fully discussed below, California Franchise Tax Board ("FTB") Regulation 25137(c)(1)(A) generally provides that when substantial gross receipts arise from an occasional sale of a fixed asset or other property held or used in the regular course of the taxpayer's trade or business, those receipts must be excluded from the sales factor.7

Regulation 25137(c)(1)(A)

Regarding the preliminaries, the sales factor is a fraction, the numerator of which is the total sales of the taxpayer in California during the income year and the denominator of which is all gross receipts everywhere not allocated.8 Over the years, and often following in the footsteps of the Multistate Tax Commission, the FTB has promulgated a number of special regulations under the authority of California Revenue and Taxation Code9 Section 25137, which provides special rules for apportionment. Such special regulations are not to be taken lightly. If a relevant special formula is specifically provided in the FTB's Section 25137 regulations ("25137 Regulations") and the conditions and circumstances delineated in such a regulation are satisfied, the California State Board of Equalization ("SBE") has held that the method of apportionment prescribed in that regulation shall be "the standard" by which taxpayers and the FTB are to compute the taxpayer's apportionment formula.10 In other words, once found to be applicable to the particular situation, 25137 Regulations "will control."11

The FTB's special regulatory sales factor rules for so-called "occasional sales" are found in Regulation 25137(c)(1)(A),12 which provides in full:

(A) Where substantial amounts of gross receipts arise from an occasional sale of a fixed asset or other property held or used in the regular course of the taxpayer's trade or business, such gross receipts shall be excluded from the sales factor. For example, gross receipts from the sale of a factory, patent, or affiliate's stock will be excluded if substantial. For purposes of this subsection, sales of assets to the same purchaser in a single year will be aggregated to determine if the combined gross receipts are substantial.

1. For purposes of this subsection, a sale is substantial if its exclusion results in a five percent or greater decrease in the sales factor denominator of the taxpayer or, if the taxpayer is part of a combined reporting group, a five percent or greater decrease in the sales factor denominator of the group as a whole.

2. For purposes of this subsection, a sale is occasional if the transaction is outside of the taxpayer's normal course of business and occurs infrequently.

Accordingly, the key operative concepts under Regulation 25137(c)(1)(A) are: (1) substantial (vs. insubstantial) sales amounts; (2) from an occasional sale; (3) of a fixed asset or other property; (4) which is held or used in the regular course of the taxpayer's trade or business.

"Substantial Amounts"

While "substantial amounts" is a key term long found in Regulation 25137(c)(1)(A), it was only defined therein by the FTB's amendments to the regulation filed on January 30, 2001 and operative as of January 1, 2001.13 The 2001 amendments added the definition, now found in Regulation 25137(c)(1)(A)(1), that a sale is "substantial" if its exclusion results in a 5% or greater decrease in the taxpayer's sales factor denominator or, if the taxpayer is part of a combined reporting group (i.e., is unitary), a 5% or greater decrease in the sales factor denominator of the group as a whole. The FTB staff's explanation for the creation of this 5% standard is...