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Howrey LLP
The California State Board of Equalization, in an opinion which became final on April 18, 1997, has decided an important issue for contractors. The cost of client furnished materials under a cost-plus contract will be taken into account in the contractor's apportionment formula, with a potentially significant effect on the California tax liability of multistate contractors.
The Issue
California, along with many other states, uses a three-factor formula of property, payroll and sales to determine what percentage of the income of a multistate or multinational business is apportioned to California. The sales factor of the apportionment formula is defined as a fraction, the numerator of which is the total sales of the taxpayer in California in the relevant year, and the denominator of which is the total sales of the taxpayer everywhere during that year. "Sales" are defined simply as all gross receipts of the taxpayer. Regulations provide that in the case of cost-plus contracts, the contractor's "sales" include the entire reimbursed cost plus the fee.
The Franchise Tax Board and the taxpayer agreed that the entire cost of materials incorporated in a project constructed under a cost-plus contract is includible in the contractor's sales factor when title to the materials passes from the vendor/supplier to the contractor before passing on to the owner. The issue was whether the cost of materials purchased in the owner's name ("client furnished materials"), whether by the contractor acting as agent for the owner or under a purchase order executed by the owner itself, is similarly includible.
The Decision
The Board of Equalization, in Appeals of Bechtel Power Corporation, et al., March 19, 1997, held that the cost of client furnished materials under a cost-plus contract is properly treated as gross receipts of the contractor, includible in its sales factor. The Board based its decision on the fact that the purpose of the apportionment formula is to treat as derived from California sources that portion of business income which fairly reflects business activity in California and its finding that the nature and extent of the contractor's services and the amount of its fee were not affected by whether or not, under the law of sales, title to the materials passed through the contractor.
The case is one of first impression in California. Indeed, the issue does not appear to have been squarely addressed in a published opinion in any of the other states which have adopted the Uniform Division of Income for Tax Purposes Act ("UDITPA") or otherwise use an apportionment formula similar to California's. Staff of the Board of Equalization has recommended that the decision be published. Publication should occur within the next few months.
Impact of the Decision
The decision will reduce the California apportionment percentages of those contractors who perform the bulk of their cost-plus work outside California and who have not been including the cost of client furnished materials in their sales factors. In the reverse situation, it will increase the California apportionment percentages. Given the number of states which have adopted UDITPA or a similar apportionment formula, and California's prominence, the decision can be expected to have ramifications outside California.
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For more information about the issues covered in this report, please contact Paul Berning in our San Francisco office at 415-848-4996 or at paulberning@howrey.com or contact your Howrey attorney. For more information about Howrey's Construction Practice Group, click here.
©1997 Howrey LLP
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