In Chief Counsel Ruling 2019-03[1], the Franchise Tax ruled on the application of California’s market based sourcing rules as applied to an outside director that attended a shareholder or board of directors meeting in California.

Market based sourcing is increasingly being used by states to determine whether the state has the right to impose an income tax on the amounts paid to an out of state organization or resident for services rendered. Previously states had generally looked to the location of the sale being tied to where the services were primarily performed.

Under California’s market based sourcing rules, the sale will be sourced to where the service recipient is deemed to receive the benefit of the services.[2] Under California Regulation section 25136-2(b)(1) the benefit is deemed received where the customer has directly or indirectly received the benefit of the service.

In this case the company had independent directors on its board of directors who made up a majority of the board. This governance rule is a requirement for the company to be listed on New York Stock Exchange. The Company is domiciled outside California[3]

The ruling seeks to answer the following question:

Whether compensation paid to an independent director, who is a nonresident of California, is sourced to California if the Company holds a shareholder meeting or board of directors meeting in California which the director attends?[4]

The ruling, looking at the situation in question, gives the following analysis of where the benefit of the service is received:

Here, the independent director is providing a service to the Company and its shareholders that is unique — to act, with the other directors, to govern the Company. One role of the Board of Directors is to oversee management's assessments of major risk factors facing the Company and review options to mitigate such risks. Directors also serve on Board committees which require their independence to meet best practices and NYSE requirements with respect to audit policies, compensation practices and other corporate governance requirements.

The benefit of that service is received where the Company received value from the delivery of that service. The value of an independent director's services does not derive from the place from which the Board of Directors confers and makes decisions, but rather from that place the decisions and actions of the Board detailed above are executed. Unlike consulting or similar services, these services do not merely recommend actions that may be taken by management. Independent directors are in a very distinct class of service-providers. The Board of Directors, acting as a body, gives authority to and directs management to take action. Since these services go to the core of the governance of the Company and the implementation of any such decisions are taken by the highest echelons of management, the location of that benefit is the place where the highest-ranking corporate officers carry out these directions.[5]

Thus, the ruling comes to the following formal answer to the question initially posed:

No. The fees or other compensation received from the Company by the independent director of the Company for services performed in California will be sourced to where the highest-ranking corporate officers carry out the Board's directions.[6]

When advisers consider the reason for states moving to market-based sourcing, the answer makes perfect sense even if the state in this case is passing on being able to tax the fees paid to these directors, assuming the highest ranking officers perform their services outside of California. Market based sourcing is meant to remove the incentive to locate service providing employees outside of a state. If a company wishes to sell services to residents of the state in question, the company is going to have a sale in the state regardless of where the service is performed.

By looking not to where directors’ meetings are held but rather to where the headquarters of the organization is, the ruling serves to remove an incentive for organizations to hold such meetings outside California.

But the ruling is not necessarily good news—it suggests that any individual located anywhere performing such governance services for an organization headquartered in California will have California source income.

[1] Chief Counsel Ruling 2019-03, California Franchise Tax Board, October 7, 2019, https://www.ftb.ca.gov/tax-pros/law/chief-counsel-rulings/2019-03.pdf, retrieved October 22, 2019

[2] California Revenue and Taxation Code §25136

[3] Chief Counsel Ruling 2019-03, California Franchise Tax Board, October 7, 2019, https://www.ftb.ca.gov/tax-pros/law/chief-counsel-rulings/2019-03.pdf, retrieved October 22, 2019, p. 1

[4] Chief Counsel Ruling 2019-03, California Franchise Tax Board, October 7, 2019, https://www.ftb.ca.gov/tax-pros/law/chief-counsel-rulings/2019-03.pdf, retrieved October 22, 2019, p. 2

[5] Chief Counsel Ruling 2019-03, California Franchise Tax Board, October 7, 2019, https://www.ftb.ca.gov/tax-pros/law/chief-counsel-rulings/2019-03.pdf, retrieved October 22, 2019, p. 3

[6] Chief Counsel Ruling 2019-03, California Franchise Tax Board, October 7, 2019, https://www.ftb.ca.gov/tax-pros/law/chief-counsel-rulings/2019-03.pdf, retrieved October 22, 2019, p. 3