STATE AND LOCAL TAXATION

May 2000

CALIFORNIA'S NEW APPROACH TO APPORTIONMENT IS A THROWBACK TO THE OLD

By Peter Desmond M. Hopkins, CPA, David Tarlow & Co., P.C.

The California Franchise Tax Board (FTB) has proposed an amendment to the California Code of Regulations (18 Prop. C.C.R. section 25106.5) that would revive a long-standing corporate income apportionment rule that had been in effect for more than 20 years until it was struck down by a board of equalization decision in 1988. The amendment may also signal a refund opportunity for some groups filing California corporate returns.

General Framework of the Unitary Concept

A member of a group of two or more related corporations is generally required to file a combined California return if the group meets the definition of a "unitary group." A unitary group exists where the corporations conduct business as a single economic enterprise. It is rare that related corporations can avoid combined reporting by contending that they do not constitute a unitary group. This is the mechanism California uses to ensure that the amount of income apportioned to the state is not easily manipulated by shifting income and deductions between multiple corporations.

The unitary group's combined business income is apportioned to California using the typical three-factor formula: property, payroll, and sales. These factors are calculated as percentages and averaged to determine an overall apportionment percentage that is then applied to the group's worldwide income. Sales are accorded double weight, except for groups engaged primarily in the extractive, agricultural, banking, and financial industries.

Sourcing of Sales

In general, sales of tangible personal property are considered California sales if the goods are shipped to a customer in California. However, when a unitary group of corporations is involved, it is often the case that one or more members of the group do not have nexus to California, because the members' activity is limited to solicitation of orders. In such a case, Federal law (P.L. 86-272, 15 U.S.C. sections 381­384) protects those members from California's taxing jurisdiction. Conversely, group members that are subject to California tax may ship goods to customers in states that have no authority to tax the sale. Since use of the sales factor in apportioning income is quite common, the interplay of P.L. 86-272 with the sourcing of sales by destination could result in some of a corporation's sales being assigned nowhere. To combat this, many states, including California, have adopted throwback rules. Under these rules, sales are sourced in the state from which the goods were shipped (thrown back) if they cannot be sourced in the destination state due to P.L. 86-272 immunity.

Two approaches can be taken in determining whether the sales are protected from taxation in the destination state (and, therefore, thrown back): the member approach and the group approach. Under the member approach, sales are thrown back to the state from which they are shipped if that member has P.L. 86-272 protection, even if other group members are subject to the destination state's taxing jurisdiction. Under the group approach, sales are not thrown back if any member of the unitary group is subject to taxation in the destination state.

Evolution of California's Approach

In 1966, the California State Board of Equalization (SBOE) took the member approach in Appeal of Joyce, Inc. (Cal. SBOE, 69-SBE-069, Nov. 23, 1966). In Joyce, the SBOE ruled that including sales of a group member that was protected by P.L. 86-272 based on their California destination would effectively impose a tax on income that was immune under Federal law. Thus, it effectively ruled that these sales are properly assigned (or thrown back) to the state from which the goods were shipped.

In 1988, the SBOE reversed itself in Appeal of Finnigan (Cal. SBOE, 88-SBE-022, Aug. 25, 1988). In Finnigan, the SBOE applied the group approach in finding that sales shipped from California to another state were not thrown back to California as long as any member of the unitary group was subject to taxation in the destination state, even if the corporation that made the sale was protected by P.L. 86-272. This is theoretically consistent with California's unitary framework. Since Finnigan involved outbound sales and Joyce involved inbound sales, it was unclear at the time of the decision whether the principles set forth in Joyce still applied.

In 1990, the SBOE removed the uncertainty. It issued a decision denying a petition for rehearing in Finnigan (88-SBE-022, Jan. 24, 1990), noting that the Joyce and Finnigan decisions were inconsistent, and made it clear that the decision in Finnigan was establishing a new rule for computing California apportioned income.

In taking the group approach, Finnigan effectively stated that sales shipped to California are included as California sales in calculating the sales factor, even if they originated from a group member whose income is immune from California taxation. It was questionable whether this approach violated Federal law, and much litigation has ensued. Recently, the FTB attempted to end the controversy with a proposed regulation that returns to the member approach embodied by Joyce. The regulation, if finalized, will generally be effective for tax years beginning on or after April 22, 1999, the date on which the SBOE decided in Appeal of Huffy, Inc. that the group approach was inappropriate and urged the FTB to adopt regulations (which were already in the works) requiring the member approach on a prospective basis.

Planning Opportunities and Pitfalls

The return to the Joyce rule creates some planning opportunities and some traps for the unwary. A group can exclude sales shipped to California from the sales factor if the member that consummates the sales is immune from California income taxation. This will not only lower the group's California tax liability, but it could provide a windfall if the sales will not be thrown back to the state from which they were shipped, either because that state has no throwback rule or because that state uses a group approach in determining which sales are thrown back.

Clearly, for groups involved in interstate commerce, careful planning can result in a lower California tax by using multiple corporations. Where the savings are significant, for many groups of corporations it will be more than worth the cost and effort needed to design the structure. Nontax factors such as increased shipping and administrative costs and potential delivery delays must also be considered.

A drawback to the member approach is found where sales are shipped outside of California to a state that applies the group approach. In this case, these sales will be double counted--by both California and the destination state--in the sales factors. Therefore, it is imperative that operations be carefully reviewed to avoid such undesirable results.

Potential Refunds

The resolution (at least for now) of this controversy also means a potential refund opportunity for many California corporate filers. Although the proposed regulations apply to years beginning after April 22, 1999, clearly, the SBOE and FTB have come to the realization that the prior administrative practice of applying the group approach was in error. Therefore, any group with significant sales that were consummated by a group member not subject to tax in California but were nevertheless apportioned to the state should strongly consider filing refund claims for all open years. Such a group would appear to have a strong argument should litigation ensue. Other groups that do not have a potential refund large enough to merit litigation should seriously consider filing protective refund claims for all open years to preserve their rights should another taxpayer win a favorable decision from the California courts. Refund claims may be filed with the state within four years of the original due date of the return without regard to extensions of time to file, or within one year of the date the tax was paid, whichever is later.

Hunt-Wesson Inc.

In a related matter, a February 23, 2000, release reported that in the U.S. Supreme Court decision on Hunt-Wesson Inc. the Court held that California's interest deduction offset provision (against nonunitary dividend and interest income) is not a reasonable allocation of expense to income, thus creating another refund opportunity. *