California About to Impose Tax on Fees Paid to Non-Resident Asset Managers

California’s Franchise Tax Board intends to soon finalize regulations originally proposed over a decade ago¹ that would impose an income tax on asset management fees—even if the asset manager or any fund they manage has no presence in the state. Under the new regulations (the “Regulations”), an asset manager based outside California who receives fees for their services will be subject to California income tax on net income in proportion to the fees they receive from California-resident investors.

What is not new: A taxpayer who is not resident in California is generally subject to California income tax on any income they earn from California sources. If that taxpayer receives income sourced from sales (including sales of services) both inside and outside California, that income is taxed by California based on a “single sales factor.”² The sales factor is generally equal to a business’s gross receipts from sales within California divided by the business’s gross receipts globally. The amount of a taxpayer’s income from the business that is taxable by California is the product of that sales factor and the taxpayer’s total net income from the business. Whether income is generated from sales within California is determined by the place where the purchaser “received the benefit of those services.”

Definition of Asset Management Services. The Regulations define asset management services as providing direct or indirect management, distribution, or administration services to a fund (i.e., an investment vehicle that gathers capital from one or more investors). Each component of the definition is defined very broadly—the Regulations include a list of examples but specify that such services are “not limited” to those listed.

• Administration services include the provision of accounting, record-keeping, internal auditing, legal, and tax services, among others, to a fund, but only if the same service provider also provides management or distribution services to that fund.
• Distribution services include advertising, servicing, and marketing or selling interests in the fund, but only if the service provider is either engaged in the business of selling fund interests or affiliated with another person engaged in that business.
• Management services include advising about investments and determining when to buy or sell securities.

Benefit of Asset Management Services. The Regulations specifically address where the benefit of asset management services is received: It is determined based on the domicile of the recipient fund’s investors (or, if applicable, the domicile of their beneficial owners).

The domicile of an investor is presumed to be the investor’s (or beneficial owner’s) billing address as indicated in the fund’s or asset manager’s records. But if a service provider has actual knowledge that the investor’s principal place of business—or a beneficial owner’s primary residence or principal place of business—is different from the recorded billing address, the presumption does not control.

The Regulations define a beneficial owner as a person who made an independent (and one not required by contract or other agreement, other than pursuant to law) decision to invest in assets. Beneficial owners do not include feeder funds and similar pooling entities, shareholders of a public corporation where the board decides to invest in an investment vehicle, or participants in defined benefit plans.

Allocation of Receipts. Receipts from asset management services are allocable to California in proportion to the average percentage of interests in the fund held by California-domiciled investors.³ If the asset manager does not know that average percentage, the receipts allocable to California are determined by a “reasonable estimate” of the interests held by investors or beneficial owners domiciled in California.

It will not be particularly easy for asset managers to determine the domicile of many beneficial owners. For example, from a tax perspective, a domestic partnership that invests in a fund would only be required to provide an IRS Form W-9, and that partnership would generally not be required to provide any information regarding its investors under federal tax rules. So, to comply with the Regulations, funds that count partnerships among their investor base will likely need to expand their subscription documents to collect that information. Otherwise the fund will have to rely on a reasonable estimate.

The Regulations do include an example of a “reasonable estimate.” In that example, a fund has two investors: one is domiciled in California and holds a 20% interest in the fund, while the other is a vehicle for the investment of retirement plan assets for public employees of another state. In those circumstances, the manager can make the reasonable assumption that the other investor’s beneficial owners are resident outside California.

Outside of that example, however, the Regulations are quite vague about how to make a “reasonable estimate,” and it will often be challenging. Most investors are not retirement plans for out-of-state employees. What to do then? Would it be reasonable to assume that 12% of a domestic investor’s beneficial owners reside in California since that is the percentage of the United States population that resides in the Golden State? What if the investor’s beneficial owners are a mix of domestic and foreign persons? The Regulations offer no advice on how to answer this question.

Though they will not be final until public hearings take place and written comments from the public have been considered, the Regulations are intended to apply to taxable years beginning on or after January 1, 2024. So, some asset managers—i.e., those who do not live or work in California but advise funds with investors domiciled in California—may have to file California income tax returns for the first time for 2024. While some interested parties are asking to delay the effective date (and a hearing on this is expected in January), asset managers should prepare now; they may need to move quickly to comply with Regulations that may go into effect with some retroactivity.⁴

O’Melveny will monitor all further developments on the Regulations. Please contact the attorneys listed on this Client Alert or your O’Melveny counsel if you have any questions.

¹ See our article discussing an earlier version of the Regulations at https://www.law360.com/articles/680155/calif-tax-on-asset-manager-fees-would-have-wide-reach.

² This rule results from the passage of Proposition 39 in 2012.

³ The average value of interests is determined by adding the percentage of California-domiciled investors as of the beginning of the taxable year and as of the end of the taxable year and dividing by two.

⁴ In future years asset managers may, if they are eligible to do so, want to consider making a “pass-through entity” election in California as well to maximize the deductibility of California taxes at the federal level.

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. Billy Abbott, an O’Melveny partner licensed to practice law in California and New York, and Luc Moritz, an O’Melveny partner licensed to practice law in California, 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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