California Administrative Tribunal Upholds Special Industry Apportionment Formula for Mutual Fund Service Provider

The BR State + Local Tax Spotlight

By Irwin M. Slomka

An investment management company subject to California corporate franchise tax was required to source its receipts from the provision of management, administrative, and distribution services furnished to mutual funds based on the locations of the mutual fund shareholders and could not source the receipts using the California market-based sourcing statute. Appeal of Janus Capital Group, Inc. and Subsidiaries, Case No. 20096605 (Calif. Office of Tax Appeals, July 27, 2023, released Sept. 2023).

The Facts: Janus Capital Group, Inc. (“Janus”), an investment management company headquartered in Colorado, provides management, administrative, and distribution services to mutual funds. In its original California corporate tax returns filed for the years 2013 through 2016, Janus sourced its gross receipts from those services based on the locations of the mutual funds’ shareholders, as required under the California Franchise Tax Board (“FTB”) mutual fund service provider regulation (Cal. Code Regs. Tit. 18, § 25137-14, the “Regulation”). Janus subsequently filed refund claims seeking to source the receipts to the locations of the mutual funds themselves, none of which were located in California. The FTB denied the refund claim, rejecting Janus’ position, and this appeal followed.

The Dispute: At the Office of Tax Appeals (“OTA”), Janus first argued that the Regulation was not properly promulgated under the State Administrative Procedure Act (“APA”).

Janus also claimed that the FTB was required to make a showing of distortion before applying the Regulation, which employs a “look-through” approach. Janus asserted that it was entitled to source its receipts based on the California market-based sourcing statute, which looks to where the “purchaser of the service” receives the “benefit of the services.” According to Janus, since the Regulation conflicted with the market-based sourcing statute, the Regulation could be applied only if application of the statute was shown to result in distortion.

The Decision: On Janus’ first argument, the OTA found that as a state administrative agency, it had no authority to rule on whether a regulation was adopted in compliance with the California APA. On Janus’ second argument, the OTA held in favor of the FTB, finding that the Regulation constituted a proper invocation of the FTB’s authority to cure distortion relating to the mutual fund service provider industry under the standard California apportionment method. Therefore, having properly promulgated the Regulation, it became the standard apportionment methodology for mutual fund service providers such as Janus, unless Janus, as the party seeking to deviate from that methodology, showed distortion, which it did not do.

The OTA concluded that the FTB had no obligation to show that application of the market-based sourcing statute resulted in distortion. It noted that numerous special industry apportionment regulations under FTB Regulation 25137 significantly deviate from the standard apportionment methodology in order to cure distortion.

It is not clear from the decision, however, what “distortion” the Regulation was seeking to cure. The OTA reasoned that “declining to apply the relief [under the Regulation] to the industry would allow significant tax loopholes that would be susceptible to manipulation.” This suggests that the OTA may consider the “distortion” to be the hypothetical possibility of “locating” mutual funds in other states in order to reduce the service provider’s California tax liability.

This update is one in a series of updates written for the September 2023 edition of The BR State + Local Tax Spotlight.

© 2023 Blank Rome LLP. All rights reserved. Please contact Blank Rome for permission to reprint. Notice: The purpose of this update is to identify select developments that may be of interest to readers. The information contained herein is abridged and summarized from various sources, the accuracy and completeness of which cannot be assured. This update should not be construed as legal advice or opinion, and is not a substitute for the advice of counsel.