California court invalidates FTB’s P.L. 86-272 guidance

On Dec. 13, 2023, the California Superior Court for San Francisco County struck down guidance released by the California Franchise Tax Board (FTB) on Public Law 86-272 (P.L. 86-272) protection because it constituted a regulation that was not promulgated in compliance with prescribed administrative procedures.¹ The American Catalog Mailers Association (ACMA) successfully argued that the FTB’s two guidance documents are void as “underground” regulations for failure to comply with the requirements of the California Administrative Procedure Act (APA).

Background

P.L. 86-272, a federal law enacted in 1959, limits the state and local taxation of income from sales of tangible personal property if the taxpayer’s only business activities in the state are the solicitation of orders that are approved and shipped from outside the state.² In 2021, the Multistate Tax Commission (MTC) adopted a revised statement interpreting P.L. 86-272 as it applies to the modern economy and internet business activities.³ In 2022, the FTB released guidance, Technical Advice Memorandum (TAM) No. 2022-01,⁴ and revised FTB Publication 1050⁵ to address the application of P.L. 86-272 to companies with internet transactions. The FTB’s guidance does not explicitly adopt or reference the MTC’s revised statement, but the guidance generally is consistent with the positions set forth in the statement, by addressing the same internet activities that are outlined in the MTC’s statement and reaching the same conclusions.

ACMA is a non-profit trade association advocating on behalf of catalog, online, direct mail, and other remote retailers and their suppliers. With approximately 120 to 140 members across the country, ACMA is a trade association that does not sell tangible products or pay income tax (though its members do). In its original complaint seeking a declaratory judgment, ACMA alleged that the FTB’s guidance is invalid because: (i) it contradicts P.L. 86-272 and the U.S. Constitution; (ii) the FTB failed to comply with rulemaking under the APA;⁶ and (iii) it is substantively invalid (or alternatively should have limited application prospectively). ACMA moved for summary judgment on the first count seeking a declaration that the guidance is invalid because it contradicts P.L. 86-272 and the U.S. Constitution, but it did not seek a ruling on the other two counts.⁷

On Aug. 24, 2023, the court denied ACMA’s motion for summary judgment because ACMA failed to show that the FTB’s guidance concerning internet transactions contradicted P.L. 86-272 on its face.⁸ The court also found that the TAM and Publication 1050 are regulations subject to the APA, but the court was required to deny ACMA’s motion for summary judgment because it was not brought on this ground.

Guidance void as improper regulation 

In the instant matter, the ACMA moved for summary judgment seeking a judicial declaration that the TAM and Publication 1050 are invalid underground regulations that fail to follow the requirements of California’s APA. After denying the FTB’s procedural objections, the court agreed with ACMA that the TAM and Publication 1050 are regulations subject to challenge under the APA because they are generally applicable and describe how the FTB will apply P.L. 86-272 to out-of-state businesses engaged in interstate commerce over the internet. If a rule constitutes a “regulation” under the APA, “it may not be adopted, amended, or repealed except in conformity with basic minimum procedural requirements that are exacting.”⁹ Furthermore, “(a)ny regulation . . . that substantially fails to comply with these requirements may be judicially declared invalid.”¹⁰ The court determined that the TAM and Publication 1050 are regulations under California law. A “regulation” is defined by the APA to include “every rule, regulation, order, or standard of general application or the amendment, supplement, or revision of any rule, regulation, order, or standard adopted by any state agency to implement, interpret, or make specific the law enforced or administered by it, or govern its procedure.”¹¹ The California Supreme Court held in Tidewater Marine Western, Inc. v. Bradshaw that a regulation subject to the APA has two principal characteristics: (i) “the agency must intend its rule to apply generally, rather than in a specific case;” and (ii) “the rule must implement, interpret, or make specific the law enforced or administered by [the agency], or govern [the agency’s] procedure.”¹²

According to the court, both Tidewater tests were met. First, the court determined that the TAM and Publication 1050 indisputably are rules of general application. The court noted that the TAM includes 12 fact patterns that apply to a class of businesses that make sales to California customers, are commercially domiciled outside California, and have no activities in the state other than those described in each fact pattern. Also, Publication 1050 is intended to serve as general guidance to taxpayers. In determining that the second Tidewater test was satisfied, the court noted that the FTB did not dispute that the TAM and Publication 1050 interpret the FTB’s application of P.L. 86-272 to out-of-state businesses. The documents expressly provide that their purpose is to address the protections provided by P.L. 86-272 and to provide notice regarding how the state will apply the statute. The court noted that the FTB’s own declaratory statements confirmed the TAM and Publication 1050 were generally applicable and interpret the FTB’s application of P.L. 86-272.

The FTB unsuccessfully argued that the TAM and Publication 1050 do not constitute regulations because they are not a “binding” rule. Specifically, the FTB asserted that its auditors were not bound by the guidance found in the TAM and Publication 1050. The court determined that contrary to the FTB’s argument, for the first prong of the Tidewater test to be met, the rule of general applicability does not need to be formal or binding on the agency or public. The term “regulation” applies to a broad range of agency policies or procedures, regardless of whether they are formal or binding. The FTB conceded that the guidance is intended to guide auditors and the public on the applicability of P.L. 86-272 to particular types of business activity conducted by out-of-state businesses.

The court rejected the FTB’s reliance on the California Court of Appeal’s decision in Modesto City Schools v. Education Audits Appeal Panel.¹³ In Modesto, the court held that an audit guide was not an underground regulation because a California statute provided that the audit guide was a suggested resource and the auditors had discretion to follow alternative procedures. This was distinguishable from the instant case because there is no statute providing that FTB auditors can ignore the TAM in conducting their work. Rather than providing suggested procedures that may be ignored, the TAM contains rules of general application interpreting P.L. 86-272. Because the TAM and Publication 1050 were not promulgated in compliance with the APA’s requirements, the court held that the guidance is void and granted ACMA’s motion for summary judgment.

Commentary

This decision expressly invalidates the FTB’s guidance on the application of P.L. 86-272 to certain transactions conducted over the internet. California was the first state to publicly react to the MTC’s new statement on P.L. 86-272 when it released the TAM in February 2022. Given the high-profile nature of this controversy and the potential wide-ranging effects of the decision, the FTB will likely consider an appeal. The decision also potentially calls into question the validity of other TAMs and publications issued by the FTB outside the formal rulemaking process. Based on this decision, other administrative guidance that may constitute regulations by meeting the two Tidewater tests could similarly be subject to challenge.

Beyond California, other states may be monitoring this litigation as they continue to formulate their responses to the MTC’s revised P.L. 86-272 statement. At least two states have taken an approach similar to California by adopting the principles of the statement through informal guidance. For example, New Jersey has issued a Technical Bulletin that is consistent with the revised MTC guidance but has not promulgated formal regulations at this point.¹⁴ In April 2023, the Minnesota Department of Revenue issued a draft revenue notice that would adopt and apply the current MTC guidance on the scope of internet business activity performed by out-of-state sellers protected and not protected by P.L. 86-272.¹⁵ Of course, the rulemaking procedures differ by state and the California decision does not necessarily indicate that another state’s informal P.L. 86-272 guidance is not valid. In contrast, New York took a more formal approach of adopting the MTC’s guidance. The New York State Department of Taxation and Finance recently finalized its corporate income tax reform regulation that addresses the application of P.L. 86-272 to internet-based activities largely based on the MTC statement.¹⁶

1 American Catalog Mailers Ass’n v. Franchise Tax Board, California Superior Court, San Francisco County, No. CGC-22-601363, Dec. 13, 2023. 
2 Pub. L. No. 86-272, 15 U.S.C. §§ 381-384.
3 Statement of Information Concerning Practices of Multistate Tax Commission and Signatory States Under Public Law 86-272, Multistate Tax Commission, revised Aug. 4, 2021. Generally, when a business interacts with a customer via the business’s website or app, it is engaged in “business activity” within the customer’s state that exceeds P.L. 86-272 protection. In contrast, if the website merely presents static text or photos, there is no engagement or facilitation within the customer’s state. The statement provides a listing of 11 different activities conducted by internet businesses and explains whether they are protected or unprotected for P.L. 86-272 purposes.
4 Technical Advice Memorandum (TAM) 2022-01, California Franchise Tax Board, Feb. 14, 2022. For a discussion of this guidance, see GT SALT Alert: California guidance covers P.L. 86-272 protection.
5 FTB Publication 1050, Application and Interpretation of Public Law 86-272, California Franchise Tax Board, revised May 2022.
6 Cal. Gov’t Code §§ 11340-11361. 
7 ACMA specifically challenged the two hypotheticals in the guidance indicating that P.L. 86-272 protection is lost if a company provides live chat and email through its website, or places internet “cookies” onto the computers or other electronic devices of California customers that are used to gather customer information.
8 For a discussion of the Aug. 24, 2023 ruling, see GT SALT Summary: California court denies summary judgment in P.L. 86-272 challenge. 
9 Morning Star Co. v. State Board of Equalization, 132 P.3d 249 (Cal. 2006).
10 Id.
11 Cal. Gov’t Code § 11342.600. 
12 927 P.2d 296 (Cal. 1996).
13 123 Cal. App. 4th 1365 (2004). 
14 Technical Bulletin TB-108, New Jersey Division of Taxation, Sept. 5, 2023. For further discussion of this guidance, see GT SALT Alert: New Jersey guidance addresses nexus, combined reporting, GILTI.
15 Draft Revenue Notice #23-XX: Corporate Franchise Taxes – Nexus – Internet Activities and Public Law 86-272, Minn. Department of Revenue, circulated for comment on Apr. 25, 2023. For further discussion of the Minnesota draft guidance, see GT SALT Summary: “Minnesota considering adoption of MTC’s guidance on P.L. 86-272.”
16 N.Y. Comp. Codes R. & Regs. tit. 20, § 1-2.10, published Dec. 27, 2023. For further discussion of this regulation when it was in draft form, see GT SALT Alert: New York finalizing corporate business tax reform.