Legal ruling 1997-1

Exclusion of Gross Receipts from Incidental or Occasional Sales of Intangible Property from the Sales Factor

Issue

If substantial amounts of gross receipts arise from an incidental or occasional sale of intangible property which is held or used in the regular course of a taxpayer’s trade or business, should such gross receipts be excluded from the sales factor?

Facts

A taxpayer sells an intangible asset, generating substantial amounts of gross receipts. Such asset, for example, may be a patent used in the taxpayer’s trade or business or stock of an affiliate whose sale creates business income. The taxpayer engages in income producing activity and has costs of performance in connection with the sale.

Law and Analysis

Revenue and Taxation Code (R&TC) § 25134 states:

The sales factor is a fraction, the numerator of which is the total sales of the taxpayer in this state during the income year, and the denominator of which is the total sales of the taxpayer everywhere during the income year.

R&TC § 25120 states, in pertinent part:

(e) "Sales" means all gross receipts of the taxpayer not allocated under Sections 25123 through 25127 of this code.

R&TC § 25137 states:

If the allocation and apportionment provisions of this act do not fairly represent the extent of the taxpayer’s business activity in this state, the taxpayer may petition for or the Franchise Tax Board may require, in respect to all or any part of the taxpayer’s business activity, if reasonable:

(a) Separate accounting;
(b) Exclusion of any one or more of the factors;
(c) The inclusion of one or more of additional factors which will fairly represent the taxpayer’s business activity in this state; or
(d) The employment of any other method to effectuate an equitable allocation and apportionment of the taxpayer’s income.

Title 18, California Code of Regulations (CCR) § 25137(c)(1)(A) states:

Where substantial amounts of gross receipts arise from an incidental or occasional sale of a fixed asset used in the regular course of the taxpayer’s trade or business, such gross receipts shall be excluded from the sales factor. For example, gross receipts from the sale of a factory or plant will be excluded.

The exclusion from the sales factor pursuant to 18 CCR § 25137(c)(1)(A) of substantial amounts of gross receipts from an incidental or occasional sale of a fixed asset is based on the rationale that such gross receipts do not fairly reflect the taxpayer’s day-to-day business activity and therefore cause excessive income to be apportioned to the state where the occasional sale took place. This is especially so if the growth of built-in appreciation occurs over a substantial period of time, because taking the gross receipts into account in the year of a recognition event does not reflect the gradual effects of appreciation over several years.

The same rationale can be applied to gross receipts from an incidental or occasional sale of intangible property held or used in the regular course of taxpayer’s trade or business. There is no logical basis for distinguishing between fixed assets and intangibles. Accordingly, under authority of section 25137, gross receipts from an incidental or occasional sale of intangible property held or used in the regular course of taxpayer’s trade or business will be excluded from the sales factor, if substantial.

Where some income producing activity has been identified, the "occasional sale" analogy to 18 CCR § 25137(c)(1)(A) will be utilized to exclude from the sales factor substantial amounts of gross receipts from an incidental or occasional sale of intangible property, held or used in the regular course of taxpayer’s trade or business. [Note, however, if a taxpayer does not in fact engage in any income producing activity or have cost of performance with respect to the sale of an intangible described by this ruling, the receipt from the sale is, under any circumstances, properly excluded from both the numerator and denominator of the sales factor pursuant to 18 CCR § 25137(c)(1)(C).]

Holding

If substantial amounts of gross receipts arise from an incidental or occasional sale of intangible property, held or used in the regular course of taxpayer’s trade or business, such gross receipts shall be excluded from the sales factor. In the facts described, gross receipts from the sale of a patent, or affiliate stock will be excluded.

Drafting Information

The principal author of this ruling is Caglar Caglayan of the Franchise Tax Board Legal Branch. For further information regarding this notice, contact Ms. Caglayan at the Franchise Tax Board Legal Branch, P.O. Box 1720, Rancho Cordova, CA 95741-1720.