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California FTB Proposes New Regulation to Tax Fees Earned By Fund Asset Managers

The California Franchise Tax Board (the “FTB”) has proposed an amended version of California Code of Regulations (“CCR”) title 18, section 25136-2 (the “Proposed Regulation”), which would impose California income tax on certain fees received by asset managers regardless of whether the relevant funds to which an asset manager provides services or the asset manager itself maintain any presence in California. Under the Proposed Regulation, discussed in detail below, an asset manager based outside of California that receives fees from any hedge fund or private equity fund with California-domiciled shareholders, beneficial owners, or investors (“Investors”) will be subject to California income tax on its net income in proportion to the fees received from California Investors. Because the Proposed Regulation, when finalized, would be effective retroactively to January 1, 2015, it may impose new California tax filing and liabilities on asset managers based outside of California for the current tax year.

California Income Sourcing Rules

Under California law, a corporate taxpayer (including a limited liability company or other entity taxed as a corporation) with income from sources both within and without California must follow a statutory formula to determine what portion of its net income is allocable to California and therefore subject to California taxation. A pass-through entity is also required to apportion its California income in the same manner for purposes of determining each of its owners’ distributive share of the entity’s California source income.¹

As a result of the passage of Proposition 39 in 2012, multistate businesses are now required to determine their California income according to a “single sales factor”.² Under California Revenue & Tax Code (“CR&T Code”) section 25134, the sales factor is generally determined by dividing (i) the business’s gross receipts from sales that occur or are treated as occurring within California by (ii) the business’s global gross receipts. The CR&T Code sources gross receipts from the sale of services to the location where the purchaser “received the benefit of those services”; thus, a service provider is viewed as making sales in California to the extent California law treats the benefit of services as having been received in California. The sales factor is then multiplied by the business’s net income to determine the amount of income allocable to California for California tax purposes.

Where Do Fund Investors “Receive the Benefit” of Asset Management Services?

Current law does not specify where the benefit of asset management services provided to a hedge fund or private equity fund is received, leaving open the question of whether the benefit is received in the domicile of the fund, the asset manager, or the Investors.

The FTB has issued a regulation, however, that addresses the sourcing of asset management fees received from “regulated investment companies” (“RICs”)—generally mutual funds and other similar funds.³ That regulation provides that the “purchaser” of the asset manager’s services are the RIC’s Investors and those Investors receive the benefit of the asset manager’s services in their own domiciles, irrespective of the domicile of the fund or the asset manager. The fees received by an asset manager of a RIC are therefore sourced to California to the extent those fees are attributable to California-domiciled Investors in the RIC.

On December 4, 2014, the FTB formally began the process for enacting the Proposed Regulation. Among other changes, the Proposed Regulation includes an example that concludes that like RIC Investors, Investors in other investment vehicles, such as hedge funds or private equity funds, are also deemed to receive the benefit of their asset managers’ services in their domiciles and therefore that fees received by asset managers for those other investment vehicles are to be sourced accordingly. As a result, under the Proposed Regulation an asset manager of a private equity fund or a hedge fund (or in the case of an asset manager that is a pass-through entity, the owners of the asset manager) would be subject to California income tax on their net income in proportion to the gross fees attributable to the fund’s California Investors.⁴

Consequences of the Proposed Regulation

To illustrate, consider a hypothetical corporation domiciled in New York that provides asset management services exclusively to a private equity fund domiciled in Delaware. The asset manager receives $10 million in fees in consideration for services provided to the fund during 2015, $1 million of which are attributable to California Investors, and has net income of $5 million. Under the Proposed Regulation, the sales factor would equal 10% ($1 million in California-sourced receipts divided by $10 million in total fees). The asset manager must therefore apportion 10% of its $5 million net income to California for purposes of determining its California income tax liability. Thus, the asset manager will owe California income tax (at the corporate rate of 8.84%) on $500,000 of its net income.

As the laws, regarding the sourcing of asset management fees, differ from jurisdiction-to-jurisdiction, both within the United States and internationally, asset managers based outside of California (and in the case of asset managers that are pass-through entities, their non-California based owners) will need to carefully consider the availability of tax credits and other relief to offset any California tax liability resulting from the Proposed Regulation.

The Proposed Regulation is not binding until it is finalized. As drafted, however, it would apply retroactively starting with the tax year beginning January 1, 2015. Taxpayers may also elect to apply the Proposed Regulation to open tax years beginning on or after January 1, 2012.

The Proposed Regulation remains under formal review by the FTB and will subsequently be submitted to the California Office of Administrative Law for approval and public comment. Although not certain, we expect that the Proposed Regulation will ultimately be finalized before the end of 2015, subject to any revisions as a result of the public comment period.
O’Melveny & Myers LLP can assist private fund clients with analyzing and complying with the new rules. Please contact the attorneys listed on this Client Alert or your O’Melveny & Myers LLP counsel for questions regarding the information discussed herein.

[1] CR&T Code § 23101 provides a taxpayer that is not organized or domiciled in California is nevertheless considered to be “doing business” in California if it receives more than the lesser of approximately $530,000 in gross receipts (this value was $529,562 for 2014 but is indexed to inflation and therefore is expected to increase in 2015 and beyond) or 25% of its gross receipts from sources within California. The Proposed Regulation will also affect the calculation of gross receipts for purposes of determining whether an entity is “doing business” in California. If a taxpayer is deemed to be doing business in California, it must pay an annual minimum tax regardless of its taxable income.
[2] Proposition 39 was codified in relevant part as CR&T Code § 25128.7.
[3] 18 CCR § 25137-14.
[4] The Proposed Regulation also provides that in the event the asset manager cannot determine the domicile of the Investors using books and records kept in the ordinary course, it must “reasonably approximat[e] the domicile” of the Investor using “zip codes or other statistical data” or otherwise exclude the sales from the calculation entirely. There, of course, could be significant practical difficulties in determining the domiciles of investors in certain funds, such as pension plans.

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Luc Moritz, an O'Melveny partner licensed to practice law in California, and Billy Abbott, an O'Melveny associate licensed to practice law in California and New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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