United States: Farmer Brothers Refund Claims Should Be Filed in Light of S.B. 1064

In Farmer Bros. Co. v. Franchise Tax Board, 103 Cal. App. 4^th 976 (2003), the California Court of Appeal recently held that California Revenue and Taxation (RTC) § 24402, which allows a dividend received deduction for dividends received from certain corporations doing business in California, is unconstitutional under the Commerce Clause. On August 27, 2003, the California Supreme Court denied review. The Franchise Tax Board (FTB) is preparing to file a petition for writ of certiorari with the United States Supreme Court.

The Farmer Bros. decision follows the Court of Appeal’s decision in Ceridian Corp. v. Franchise Tax Board, 85 Cal. App. 4^th 875 (2000), in which the Court similarly held unconstitutional RTC § 24410, which provided a dividend received deduction for dividends received from 80-percent or more owned insurance companies doing business in California. In both Farmer Bros. and Ceridian, the Court held that the proper remedy was to allow the deduction and grant a refund to the taxpayer at issue.

In the aftermath of Ceridian, the FTB adopted as its policy the allowance of a Ceridian deduction to taxpayers that timely filed claims for pre-1997 years and a disallowance of deductions and claims for post-1996 years. To stem the potential revenue loss to the state, the California Legislature earlier this year considered, but failed to enact, legislation (A.B. 263) which would have scaled back the amount of insurance subsidiary dividends deductible under RTC § 24410 and eliminated the deduction entirely if the FTB did not achieve certain tax revenue targets.

However, the Legislature did enact S.B. 1064, which was signed by Governor Davis on October 2, 2003. S.B. 1064 was passed in response to the decisions by the State Board of Equalization (SBE) in LSI Logic, Inc. and Cypress Semiconductor Corp., Nos. 142330 and 173287 (Aug. 6, 2003), upholding the taxpayers’ claims for sales tax refunds in lieu of the manufacturers’ investment credit (MIC). S.B. 1064 overturns the LSI and Cypress decisions on a prospective basis and permits only taxpayers that filed a MIC in-lieu claim under RTC § 6902.2 on or before August 6, 2003, the date of the SBE’s decisions in LSI and Cypress, to obtain that refund.

If the Farmer Bros. decision is not overturned, the potential revenue loss to the State of California would be huge. The Legislature and the FTB may look for ways to minimize the loss. Although S.B. 1064 applies to sales tax and the MIC, S.B. 1064 may suggest the Legislature’s approach to a Farmers Bros. remedy which would limit refunds to claims that were filed prior to the date that Farmers Bros. becomes final. In light of S.B. 1064, taxpayers – whether they file on a separate company, domestic or worldwide combined report or water’s edge basis – should explore the impact of Farmers Bros. on the deductibility of all of their dividends. If taxpayers previously have not filed refund claims or claimed deductions under Farmers Bros., they should consider the possibility of filing refund claims for all open years as soon as possible and prior to any action by the United States Supreme Court in the Farmers Bros. case. Taxpayers should understand, however, that given the FTB’s post-Ceridian stance, the filing of Farmers Bros. claims for open years does not guarantee that the FTB or the Legislature will allow refunds for such claims.