Were interest receipts generated by independent investment managers included in a California manufacturer's sales factor when the managers acted on its behalf and employees provided only minimal oversight?

Plain-English summary

California Chief Counsel Ruling 2007-2 held that investment receipts generated by independent outside managers were excluded from the taxpayer's sales factor under the 2007 income-producing-activity rules.

The managers acted as agents under written investment-management agreements but made the day-to-day investment decisions. Regulation 25136(b) excluded activities performed on behalf of a taxpayer from the taxpayer's own income-producing activity.

The taxpayer's employees performed only a monthly performance review taking about 2 percent of their time. FTB treated that oversight as de minimis and found no identifiable taxpayer activity to which the receipts could be assigned.

The outsourced treasury arrangement

The redacted Delaware corporation manufactured and distributed products and was commercially domiciled outside California.

It managed part of its short-term investment portfolio through its own treasury employees but outsourced a substantial portion to third-party investment managers. Those managers invested cash equivalents and marketable securities and generated interest income for the taxpayer.

The written agreement appointed each manager as the taxpayer's agent and authorized it to direct investment and reinvestment in its discretion, subject to detailed guidelines covering objectives, philosophy, liquidity, performance, restrictions, derivatives, loss calculations, notifications, and manager relationships.

For purposes of the ruling, FTB assumed the managers were neither members of the taxpayer's unitary group nor employees of any unitary-group member.

What the taxpayer's employees did

Four internal employees continued to manage the investments that were not outsourced.

Their oversight of the outside managers consisted of monthly performance-report reviews. That work generally took about four hours, or approximately 2 percent of an employee's monthly time.

The employees did not direct the outside managers' day-to-day decisions and did not evaluate their performance daily or weekly.

The 2007 sourcing rule

Revenue and Taxation Code section 25136 sourced sales other than tangible-property sales by where the income-producing activity occurred, using costs of performance when activity occurred in more than one state.

Regulation 25136(b) defined income-producing activity as transactions and activity directly engaged in by the taxpayer in its regular business for profit. It expressly excluded activity performed on behalf of the taxpayer, including activity conducted by an independent contractor.

Regulation 25137(c)(1)(C) required intangible-property income to be excluded from the sales-factor denominator when it could not readily be attributed to a particular income-producing activity of the taxpayer.

Why the receipts were excluded

FTB found that the outside managers performed their investment activities on behalf of the taxpayer. Their work therefore was not attributable to the taxpayer as its own income-producing activity.

The employees' occasional oversight did not change the result. Because it was minimal and did not generate the receipts, FTB concluded that it did not rise to the level of income-producing activity under Regulation 25136(b).

With no identifiable taxpayer activity that could assign the receipts to any state's numerator, Regulation 25137(c)(1)(C) required the receipts to be excluded from the sales-factor denominator and therefore from the sales factor.

Holding

The third-party managers' investment activity was not the taxpayer's income-producing activity.

Because the taxpayer had no other income-producing activity related to those receipts, the receipts were excluded from the sales factor.

The ruling did not cover investments managed by the taxpayer's employees or the income and receipts from funds the taxpayer continued to manage internally.

What this means for you

Corporate treasury departments

Keep the investment-management agreement, discretion provisions, manager guidelines, employee time records, reporting cadence, and evidence showing who makes daily investment decisions.

Corporate tax departments

Separate outsourced receipts from internally managed investment receipts. The ruling's result depended on the managers being independent outsiders and the employees' oversight being de minimis.

Tax advisers

This ruling applied the sourcing and sales-factor rules in force in 2007. Verify the law for the tax year at issue before applying its analysis to a current return.

Common questions

Q: Did calling the outside managers agents make their activity the taxpayer's activity?

A: No. Regulation 25136(b) excluded activities performed on behalf of the taxpayer, including independent-contractor activity.

Q: Was monthly employee oversight an income-producing activity?

A: No. FTB treated the roughly 2 percent time commitment and lack of daily direction as de minimis.

Q: Were the receipts assigned outside California instead?

A: No. With no identifiable taxpayer income-producing activity, the ruling excluded them from the sales factor rather than assigning them to another state's numerator.

Q: Did the holding cover the taxpayer's internally managed investments?

A: No. The ruling expressly excluded employee-managed funds and the resulting income and receipts.

Q: Would the result necessarily apply to a unitary affiliate acting as manager?

A: No conclusion was issued on that fact. The ruling assumed the outside managers were not unitary-group members or employees.

Citations and references

• Cal. Rev. & Tax. Code §§ 25136 and 25137
• Cal. Code Regs., tit. 18, §§ 25136(b)-(c) and 25137(c)(1)(C)
• FTB Legal Ruling 2006-2 (May 3, 2006)

Source

• Landing page: Chief Counsel Ruling index
• Official ruling: Chief Counsel Ruling 2007-2

Original ruling text

STATE OF CALIFORNIA
JOHN CHIANG
FRANCHISE TAX BOARD – Legal Department
Chair
PO Box 1720
Rancho Cordova, CA 95741-1720
BETTY T. YEE
Telephone (916) 845-5265
Member
FAX (916) 843-2588
MICHAEL C. GENEST
Member

June 4, 2007
** Chief Counsel Ruling 2007-2

RE: APPORTIONMENT TREATMENT OF RECEIPTS GENERATED FROM INVESTMENT ACTIVITIES CONDUCTED BY THIRD PARTY INVESTORS

Dear **:

In your correspondence dated **, you requested advice concerning the apportionment treatment of receipts generated from investment activities conducted by third party investors, pursuant to written agreement between *on the one hand, and a third party investor on the other. Your letter enclosed a specimen "Investment Management Agreement" ("the Agreement") as an example of a typical third party investor agreement. Attached to the Agreement was
***"Guidelines for External Fixed Income Investment Managers."

FACTS

**("*") is a Delaware corporation, commercially domiciled in *, engaged in the business of manufacture and distribution of ****.

** manages some of its assets internally through its own treasury department, but outsources a substantial amount of its treasury function to third party investors. On behalf of
*, these investors generate interest income from managing and investing in various types of cash equivalents and marketable securities. The contractual investment arrangement between
and the third party investors ("Managers") is memorialized by a written agreement, in the form of the Agreement that was attached to your correspondence. Managers act as 's agents in managing a portion of 's investment portfolio, subject to the terms and conditions set forth in the Agreement and its attachments. For purposes of this Chief Counsel Ruling, it is assumed that the third party investors are neither members of 's unitary group, nor employees of members of 's unitary group. 1 1 Such facts relative to third party investors' membership status in unitary group or status as employees of any member of unitary group are not stated in either your ***letters, nor are such facts implied therein or inferred by the Franchise Tax Board. The statement is made for the purpose of limiting the factual and legal scope of the Chief Counsel Ruling as requested by the taxpayer, and to exclude them from the ambit of FTB Legal Ruling 2006-2, infra.

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Chief Counsel Ruling 2007-2
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The Agreement recites that (1) **, through its own employees, manages a substantial investment portfolio, consisting primarily of short-term investments; and (2) * wishes to engage Managers as agents to manage a portion of ***'s investment portfolio, and the Managers are willing to accept such engagement, subject to the terms and conditions set forth in the Agreement and its attachments. The Agreement has one attachment, entitled "Guidelines for External Fixed Income Investment Managers" (the "Guidelines"). The Guidelines contain the following sections:

• Cash management objective
• Investment philosophy
• Investment manager objectives
• Liquidity considerations
• Manager performance evaluation
• Restrictions and limitations (on investments, generally, as well as on derivatives) • Calculation procedures (to determine loss budget, net capital losses, and loss budget utilization)
• Notification and escalation procedures • Manager relationships
• Other issues

Whereas each of these sections contains certain specific instructions to, or limitations upon the Managers as **'s investment Managers, the section entitled "Investment Philosophy" states:

Upon execution of the Agreement, a Manager becomes authorized to direct the investment and reinvestment of ** assets (primarily cash and securities), in its discretion, that
* from time to time has on deposit in a separate account with and ***.

In addition to outsourcing investments through contractual agreement with Managers, ** will continue to manage and invest a portion of its assets internally. **** employs four internal employees who will continue to handle the management of all investments that are not outsourced. The primary function of these employees is to invest internally managed cash. While these employees are also responsible for oversight of external investment managers, this oversight consists of the monthly review of reports of external investment performance, which generally takes about four hours of the employee's time - approximately 2% of his or her time over the course of a month. The managers do not guide or direct the outside investment managers in their day-to-day investment decisions, nor do they evaluate their performance on a

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Chief Counsel Ruling 2007-2
Page 3

daily or weekly basis. The only monitoring of outside investment managers is the monthly performance review conducted by the internal employees.

ISSUE

Whether the investment activities of third party investors who manage investments on behalf of **, pursuant to written agreement, constitute "income producing activity" of ****, within the meaning of Revenue and Taxation Code 2 section 25136, and California Code of Regulations 3 section 25136.

If the activities of the third party investors are not income producing activities that are attributable to **, should the resulting receipts be excluded from the sales factor?

APPLICABLE LAW

On pages 4-5 of your ** letter, you correctly cite section 25136 and Regulation 25136 as controlling authority regarding sales of intangible property. Section 25136 provides:

Sales, other than sales of tangible personal property, are in this state if:

(a) The income-producing activity is performed in this state; or

(b) The income-producing activity is performed both in and outside this state and a greater proportion of the income-producing activity is performed in this state than in any other state, based on costs of performance.

Regulation 25136 provides, in pertinent part:

(b) Income Producing Activity: Defined. The term "income producing activity" applies to each separate item of income and means the transactions and activity directly engaged in by the taxpayer in the regular course of its trade or business for the ultimate purpose of obtaining gains or profit. Such activity does not include transactions and activities performed on behalf of a taxpayer, such as those conducted on its behalf by an independent contractor.

(c) Costs of Performance: Defined. The term "costs of performance" means direct costs determined in a manner consistent with generally accepted accounting principles and in accordance with accepted conditions or practices in the trade or business of the taxpayer.

(Italics added.)

2
All statutory references are to the Revenue and Taxation Code unless otherwise noted. 3 Specific sections from Title 18, California Code of Regulations are identified by the term "Regulation" and then the section number, e.g., "Regulation 25136."

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On pages 5-6 of your letters, you cited section 25137 and particularly Regulation 25137(c)(1)(C) as being pertinent to **'s circumstances that are the subject of its request for a Chief Counsel's Ruling. Regulation 25137(c)(1)(C) provides:

(c) Where the income producing activity in respect to business income from intangible personal property can be readily identified, such income is included in the denominator of the sales factor and, if the income producing activity occurs in this state, in the numerator of the sales factor as well. . . .

Where business income from intangible property cannot readily be attributed to any particular income producing activity of the taxpayer, such income cannot be assigned to the numerator of the sales factor for any state and shall be excluded from the denominator of the sales factor. For example, where business income in the form of dividends received on stock, royalties received on patents or copyrights, or interest received on bonds, debentures or government securities results from the mere holding of the intangible personal property by the taxpayer, such dividends and interest shall be excluded from the denominator of the sales factor.

LAW AND ANALYSIS

As indicated in italicized text above from Regulation 25136(b), the threshold question is whether there is any income producing activity attributable to **, from receipts generated by third party investors under contractual agreement with *. Under Regulation 25136(b), an activity that is performed "on behalf of" 4 the taxpayer does not result in income producing activity attributable to the taxpayer. Therefore, if the third party investors perform investment activities "on behalf of" within the meaning of Regulation 25136(b), then these activities do not constitute income producing activities that will be attributable to ***.

If the activities of the third party managers are excluded by virtue of the "on behalf of" rule, the inquiry then becomes whether there might be other income producing activities performed by the taxpayer, in respect to the ** employees' oversight of the third party investors' activities. The facts provided in your * letters indicate that *** employees perform no activities of their own that are directed towards generating the receipts in question, but merely provide occasional oversight of the third party investors' activities. Time spent on such oversight activities is therefore de minimis, and the activities do not rise to the level of income producing activities contemplated under Regulation 25136(b).

Because there are no identifiable income producing activities that can be used to assign the receipts in question to the numerator of any state, then under Regulation 25137(c)(1)(C) such income "shall be excluded from the denominator of the sales factor."

DETERMINATION

4
See, FTB Legal Ruling 2006-2 (May 3, 2006)

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A third party investor who undertakes investment activity on behalf of ** pursuant to written agreement, in the form of the Agreement, is not performing an "income producing activity" that can be considered as an income producing activity of ****, within the meaning of Regulation 25136(b).

Because ** has no other income producing activities related to these receipts, the receipts cannot be readily attributed to any particular income producing activity of ****, the taxpayer. Therefore, under Regulation 25137(c)(1)(C), these receipts shall be excluded from the sales factor.

This ruling does not apply to investment activities of ** employees, or to the income or receipts resulting from their investment and/or management of funds that **** does not outsource (as discussed on pages 2-3 of your May 15, 2007 correspondence.)

Please be advised that the tax consequences expressed in this Chief Counsel Ruling are applicable only to the named taxpayer and are based upon and limited to the facts you have submitted. In the event of a change in relevant legislation, or judicial or administrative case law, a change in federal interpretation of federal law in cases where our opinion is based upon such an interpretation, or a change in the material facts or circumstances relating to your request upon which this opinion is based, this opinion may no longer be applicable. It is your responsibility to be aware of these changes, should they occur.

This letter is a legal ruling by the Franchise Tax Board's Chief Counsel within the meaning of paragraph (1) of subdivision (a) of section 21012 of the Revenue and Taxation Code. Please attach a copy of this letter and your request to the appropriate return(s) (if any) when filed or in response to any notices or inquiries which might be issued.

Very truly yours,

Eric R. Brown
Tax Counsel