Worldwide Combined Reporting

On November 30, 1990, the Barclays Bank case (225 Cal. App. 3d 1342) was decided by the California Court of Appeals. The court ruled that worldwide combined reporting as applied to a multinational foreign parent is unconstitutional.

The case involves a foreign parent, Barclays Bank International Ltd., whose U.K. subsidiary conducts business in California. The Franchise Tax Board employed the worldwide combined (unitary) reporting method to compute the tax liability of the two subsidiaries engaged in business in California. The Court held that worldwide combined reporting as applied to a unitary group headed by a foreign parent is unconstitutional under the Foreign Commerce Clause. The Appeals Court based its decision almost entirely on the fact that worldwide combined reporting "not only implicated foreign policy issues which must be left to the federal government but violated a clear federal directive as well." The court also concluded that worldwide combined reporting prevents the federal government from "speaking with one voice."

The State Does Not Give Up

The state has appealed the decision to the California Supreme Court which has recently decided to hear the appeal. If the state loses at this level, it is likely that it will appeal the decision to the U.S. Supreme Court. Thus, the issue will not be resolved until a final judgment is entered by one or both of these courts. In any event, it is important for taxpayers that are affected by the Barclays decision to file a protective claim for refund with the California Franchise Tax Board for each year that is not already closed by the statute of limitations.

The California statute of limitations is generally four years from the due date of the return, including extensions. One interesting issue to keep in mind regarding the statute of limitations is that if the corporation's federal income tax return for any year is under audit by the IRS, and the taxpayer has agreed to extend the statute for federal purposes, the California statute of limitations is automatically extended until six months after the expiration of the federal statute.

Right behind Barclays in the California court system is Colgate- Palmolive. At the end of 1988, a California Trial Court Judge held worldwide combined reporting unconstitutional as applied to a domestic multinational. Thus, both domestic and foreign parent multinationals have victories against worldwide combination.

Interestingly, Gray Davis, the Controller of California, estimates that approximately $300 million could be due to foreign corporations like Barclays, if the decision is not reversed. He also estimates that the refund total could increase to approximately $500 million if pending administrative appeals and audits are included. Extending the ruling to cover U.S. based corporations such as Colgate-Palmolive could cost the state approximately $3.3 billion.

Diverse Lines of Business

Another significant development in California deals with the taxation of corporations operative diverse lines of business. In the past, the state has taken the position that corporations conducting diverse businesses generally do not constitute a unitary group. Obviously, these findings disregard the regulatory presumption that the activities of a taxpayer are unitary when strong centralized management exists.

However, in the recent case of Mole-Richardson Co. v. Franchise Tax Board (California Court of Appeals May 22, 1990, modified June 21, 1990), a corporation engaged in the manufacture and sale of lighting equipment and farm and ranch operations, was found to be conducting a unitary business substantially based on its strong centralized management. The Court of Appeals held that functional integration is not a new concept in determining the unitary issue and that it includes centralized management within its scope.

The Appeal of Sierra Production Service, Inc. (State Board of Equalization, September 12, 1990), followed Mole-Richardson in supporting the California regulations, holding that functional integration is not a new test, but is merely a descriptive term covering the basic elements of a unitary business, including strong centralized management and meaningful centralized services.

In fact, the State Board of Equalization criticized the Franchise Tax Board for failing to apply its own regulations, i.e., when strong centralized management is present, the diverse activities of a taxpayer are presumed to be unitary. By way of background, Sierra was an oil and gas well servicing firm, and its subsidiary was a general aviation sales and service firm. As a result of these cases, diverse businesses can be deemed unitary if strong centralized management exists. Consequently, it is very important to posture activities so as to maximize planning opportunities in this area.

Develop Planning Strategies

In light of the recent developments in California, taxpayers should consider pursuing certain planning strategies. For example, foreign- based multinationals that have been filing California worldwide combined reports should determine the benefit of excluding their foreign operations from their California returns. If excluding foreign operations is beneficial, amended returns should be filed for all years not barred by the statute of limitations. U.S. based multinational corporations should also consider filing protective refund claims in California because legislative or perhaps judicial action may eventually equalize the different treatment afforded foreign based multinationals.

Taxpayers should also focus on general planning opportunities as they relate to combined (unitary) reporting in all states. For example, taxpayers should consider taking steps either to strengthen unitary relationships or to eliminate them depending upon the implications of filing on a unitary basis.

If unitary status is desired, it may be relatively easy to achieve. For example, a formerly "discrete business group" (that is, one not unitary with its affiliates) could be made unitary in a number of ways, including:

* Exercising day-to-day operational control of subsidiaries;

* Creating intercompany transactions; and

* Centralizing various functions such as accounting, legal, marketing, and capital formation.

Breaking a unitary relationship is generally more difficult, especially if a substantial flow of value exists between the members of the corporate group. Steps that can be taken to weaken unitary ties between companies include, for example, eliminating common officers and directors and reducing common administrative functions or centralized financing. It should be noted that many activities can be structured to either minimize or enhance unitary relationships.

The key to successful planning in this area is to thoroughly analyze the implications of unitary reporting and implement the appropriate strategy on a timely basis.

By Richard W. Genetelli, CPA, Cooper & Lybrand