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Asset Management Intelligence - May 2015 - State Income Taxation of Cross-Border Asset Management Services

May 6, 2015

As institutional investors increase their allocations to non-traditional investment vehicles, the states are taking notice.  There are state income tax issues that lurk just below the surface which include the treatment of sourcing and destination of asset management services rendered to alternative investment vehicles other than mutual funds (regulated investment companies or “RICs”).

The Sourcing of Services – Historical Background and Context

As a general matter, the attribution of receipts for state income tax purposes from sale of services raises both tax policy and practical questions. The tax policy question is whether the taxing state should be the market state of the services and not the production or performance state. The practical matter relates to the “location question” – what is the location of the taxable service when the source income-producing activity is in one state, and the benefit or destination of the service is in one or more other states.  Asset management services that are performed in one state, where the ultimate beneficiaries of the advisory services are located in multiple different states, raise state income tax issues unique to the industry.

These vexing questions were not always present.  In the mid-1960s, when the states developed methods of apportioning the income of multi-state enterprises, the state that imposed the income tax on services and the location of the services were one and the same.   Services were generally localized – among others, consulting services, repair services and other professional services were performed almost always in the same state jurisdiction as the state where the benefit or delivery of the service was received; and, there was a single recipient.  Thus, the inclusion of a taxpayer’s receipts from the performance of a service never raised a location issue.

In that era, most states rested their apportionment methods on three factors – property, payroll and sales.  The presence of ‘brick and mortar’ manufacturing and retail afforded a tangible basis for imposing a state income tax based upon the physical location of property and payroll.  The migration over the years to a service economy, compounded with the advance of technology and advent of the Internet commerce, has resulted in a sea change in the way that services are rendered.  It is no longer expected that the income-producing activity be located in the same state where the benefit of the service is received.  One of the most outstanding examples of an impacted industry in this setting is asset management services.  

How the Rules Have Changed – “Factor Presence” Nexus and Apportionment

Since 2011, a taxpayer is also deemed to be “doing business” in California if it meets the “factor presence” test.  That test – which applied to taxpayers as a whole but not explicitly to asset management services -- specified that a taxpayer is doing business if its sales, property, or payroll in California exceed 25% of its total sales, property or payroll; or if the taxpayer’s sales, payroll, or property exceeds one of the following applicable amounts: $529,562 in sales, $52,956 in property, and $52,956 in payroll, respectively, for 2014 (these amounts will be adjusted each year for inflation).

Then in 2014, the Franchise Tax Board’s (“FTB”) proposed regulation amendments added examples of factor presence specific solely to the assignment of receipts derived from asset management services rendered to non-RICs.  Assuming formal adoption of these examples, the FTB plans to make the change applicable to taxable years beginning on or after January 1, 2015.

The examples to the proposed regulations provide that these receipts are assigned to the domicile of the shareholders, beneficial owners, or investors in a non-RIC entity (i.e., pension plan, retirement plan, limited partnership, hedge fund, private equity fund, or other alternative investment vehicle).  Further, if such domicile cannot be determined, then domicile may be “reasonably approximated.”  The FTB considers the California population to be a reasonable approximation.  Accordingly, where the ultimate beneficiaries, shareholders or investors are nationwide, the ratio of California population over total U.S. population is reasonable.   California has approximately 38 million residents, or 12% of the population of the United States.

This means that if an entity is providing asset management services, and it cannot otherwise determine the actual domicile of the ultimate beneficiaries or investors, then – based on “factor presence” criteria  -- an entity with either 25% of its total fees, or with $4,413,017 of receipts and applying a reasonable approximation (i.e., California population over total U.S. population, or 12%), would have over $529,562 sourced to California and thus, beginning with 2015, may have a filing requirement regardless of the absence of other in-state activity.
The novelty of market-based sourcing, the absence of a consensus in theory regarding the location where the benefit or delivery of a service might occur, and the advent of the ever-broadening variety of dissimilar situations impacted, coupled with the pressures on the states to generate revenue and correspondingly aggressive views on income tax nexus, have created an abundance of practical challenges that are here to stay.  Many of these issues will be litigated in the coming months and years.  It’s incumbent upon fund managers and their advisors to stay abreast of developments, and, within reason, to comply with state income tax requirements without at the same time creating unnecessary state income tax costs.

Asset Management Intelligence - May 2015

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