Taxpayers in California must generally use a three-factor apportionment formula with a double-weighted sales factor.  For purposes of the sales factor, most sales of services and intangibles are sourced based on costs of performance (at least until January 1, 2011 when California will switch to a market based sourcing state pursuant to legislation enacted last year).  A special rule applies, however, for businesses engaged in franchising.  Those businesses must use a three-factor apportionment formula in which receipts from receipts from franchising must be sourced under a modified market based approach including a throwback rule for sales sourced to states or countries where the taxpayer is not subject to tax. 

Most people think of franchising as something used mainly in industries such as fast food, oil changes, etc.  In a ruling issued on May 11, 2010 (Chief Counsel Ruling 2010-2), however, the FTB’s Chief Counsel applied a much broader definition found in Cal. Code Reg., tit. 18, § 25137-3, subd. (a).  That section defines franchising as “a trade or business which includes the granting of a license by a taxpayer (franchisor) of a trademark, trade name or service mark, to market or use a product or service under such trademark, trace name or service mark in accordance with methods and procedures prescribed by the taxpayer.”  Reading that definition very broadly, the Chief Counsel found that a business licensing its trademark for use on products marketed by licensee fell under this definition requiring the use of the special sourcing rules.

Grant Thornton has issued a very good summary of this ruling and its possible effects for taxpayers that have intangible licensing agreements with third parties (including agreements with foreign subsidiaries not included in a California water’s-edge return).  Please click here to read their write-up.