California has finalized significant changes to its market-based sourcing regulations that will directly affect how asset managers calculate their California tax obligations. After nearly a decade in development, the California Franchise Tax Board (FTB) has adopted amendments to California Code of Regulations Section 25136-2, effective for tax years beginning on or after January 1, 2026. For fund managers with California investors, these changes will likely require changes to tax positions and compliance requirements.

The most significant change for asset managers is how management fees must now be sourced to California. Under the new regulation, “asset management services” are broadly defined as the direct or indirect provision of management, distribution, or administrative services to funds. Previously, many asset managers sourced their management fees based on the location of the fund itself. The new regulation eliminates that approach, requiring instead that receipts be sourced based on the domicile of the fund’s investors or beneficial owners, not where the fund is organized or located. A fund organized in Delaware or the Cayman Islands with investors in California will now generate California-sourced receipts, regardless of where the fund entity exists or where services are performed. This look-through approach has long been the FTB’s stated position, and the new regulation formally codifies it.

The regulation assigns management fee receipts to California in proportion to the average value of fund interests held by investors domiciled in California. For example, if California-domiciled investors represent 30% of total fund asset value on an average basis during the year, then 30% of management fees are sourced to California. Determining investor domicile starts with the billing address in the fund’s records. That address creates an initial determination of domicile, but it can be overridden with evidence that the investor’s actual primary residence or principal place of business is elsewhere. When precise investor domicile data is unavailable, the regulation allows for reasonable approximation. In appropriate cases, population data can serve as a proxy, using California’s share of the U.S. population based on the most recent census data. If funds can demonstrate that a meaningful portion of beneficial owners are located outside the United States, foreign population data can be incorporated to avoid overstating California-sourced income.

The regulation also draws an important distinction when an investor holds fund interests on behalf of others. In that case, sourcing looks through to the domicile of the beneficial owner rather than the nominal titleholder. However, decision-makers for pooled or corporate investment structures (such as master funds and feeder funds) and participants in defined benefit plans are excluded from the beneficial owner definition. For these structures, additional look-through analysis may be required to identify the underlying economic beneficiaries.

It is also worth noting that not all funds are treated the same under these rules. Asset managers who work exclusively with mutual funds have long operated under a separate set of sourcing rules that remain unchanged. The new rules apply broadly to other fund types, including hedge funds, private equity funds, and venture capital funds. Asset managers who serve a combination of fund types will need to apply the appropriate sourcing rules to each.

Asset managers should take the following steps for the 2026 tax year:

Review current sourcing methodology. If management fees have been sourced based on fund location, the new regulation requires a different approach, and the financial impact of that change should be assessed.

Evaluate beneficial owner domicile data. If that information is not already on hand, steps should be taken to collect it, whether through updated subscription documents, coordination with fund administrators, or establishing data-sharing arrangements.

Evaluate economic nexus exposure. Asset managers who do not currently file a California return should determine whether the look-through methodology pushes California-sourced receipts above the economic nexus threshold (currently $757,070 for 2025), which would trigger a new filing obligation.

Consider prior open tax years. The FTB may assert that these regulations clarify existing law rather than create new rules, which could expose prior years to challenge. On the other hand, if the look-through approach would have resulted in less California-sourced income in prior years, there may be opportunities to file amended returns or refund claims.

Prepare necessary documentation. Whether precise data or reasonable approximations are used, thorough contemporaneous documentation of the sourcing methodology will be essential if the approach is questioned on audit.

These changes are technically complex and can have a meaningful impact on California tax obligations for asset managers of all sizes. Our team is actively working with investment management clients to assess exposure, develop compliant sourcing methodologies, and address prior year considerations. Asset managers with questions about how the new regulation applies to their specific situation are encouraged to contact us. We are here to help navigate these changes as they take effect in 2026.