California Finalizes Market-Based Sourcing Changes

Effective for tax years beginning on or after January 1, 2026, taxpayers selling services or intangible property to customers in California must source income by looking to the customer’s location under recently finalized amendments to Regulation 25136-2. Asset management fees must be sourced using a look-through approach.

The final regulations closely mirror the proposed amendments that were published on May 20, 2025.

Clarification on Services and Intangibles Sourcing

California’s market-based sourcing rules for services and intangibles have been in place since 2011. These rules require taxpayers to source income from services to the location where their customers receive the benefit from these services, and income from intangibles to the location where the customer uses the property. The amendments clarify how to determine where the benefit of a service is received or where an intangible is used by the customer.

A Tiered Approach to Sourcing

The updated regulation includes a cascading, multi-tiered framework for businesses and individuals to assign revenue:

• Presumption Rules: Rely on the taxpayer’s contracts or books and records to substantiate where the benefit of a service is received. The location is presumed to be California when the service predominantly relates to real property located in the state, personal property that is in the state, intangible property used in the state or provided to individuals who are present in the state when the service is provided.
• Reasonable Approximation: If a taxpayer does not have adequate books and records that meet the presumption rules, they must use all available information to approximate the customer’s location.
• Fallback Methods: If ambiguity remains, taxpayers may use fallback methods such as the customer’s billing address.

If a reasonable approximation method is adopted, it must be used consistently in future years unless the FTB grants approval for a change. This consistency requirement is designed to prevent cherry-picking favorable sourcing methods each year.

Asset Management Fees and Look-Through Sourcing

Asset management fees must now be sourced using a look-through method based on the average value of interests held by California-domiciled investors.

This look-through method requires detailed investor records, proportional allocation of fees based on investor location, and documentation of beneficial ownership when applicable.

Domicile is presumed to be the billing address unless the taxpayer has knowledge of a different principal place of business or residence.

If asset management fees attributable to California exceed the economic nexus threshold — currently $735,019 — the asset manager is considered to have California nexus. This means they must file a California tax return, regardless of whether or not they have physical presence in the state.

Documentation Requirements

With California’s updated market-based sourcing rules now finalized, businesses face a higher bar for compliance.

Taxpayers must rely on contracts, books, and records maintained in the normal course of business to demonstrate where the benefit of the service is received or where the intangible is used. These records must clearly support the sourcing position taken on the return.

If primary documentation is insufficient, taxpayers may use a reasonable approximation.

Audit Readiness and Risk Management

If taxpayers do not properly document sourcing positions, audit risk increases significantly.

Businesses should:

• Review nexus exposure in California and other states
• Conduct a sourcing methodology review
• Implement internal controls to ensure consistent application
• Prepare for increased scrutiny during audits and correspondence with the FTB

Our experienced SALT advisors can ensure a smooth transition and help you understand how these changes impact your business.