United States: Inclusion of Business Income Dividends in The Sales Factor post-CERIDIAN and FARMER BROS.

Originally published March 10, 2004

On December 4, 2003, the California Franchise Tax Board (FTB) issued Legal Ruling 2003-3 to address the issue of when income-producing activity exists with respect to a business income dividend so that the dividend is includible in the payee’s sales factor.

In general, dividends that are business income fall within the meaning of the term "sales" for purposes of their inclusion in the sales factor under California Revenue and Taxation Code (RTC) § 25134. RTC § 25136 provides that sales, other than a sale of tangible personal property, will be sourced to the state in which the income-producing activity took place. Regulation 25136(b) states that the mere holding of intangible personal property is not, of itself, an income-producing activity.

Section 7562 of the FTB’s Multistate Audit Technique Manual (MATM) states that because the mere holding of stock is not an income-producing activity, dividend income should be excluded from the sales factor if the taxpayer does not engage in any other identifiable activity with respect to the stock. MATM § 7562 notes, on the other hand, that if the taxpayer has an active treasury department which manages a stock portfolio, the treasury function activities may be considered to be income-producing activities with respect to dividend income arising from that portfolio.

In Legal Ruling 2003-3, the FTB held that a dividend payee that participates in the management and operations of the dividend payor is engaged in "income producing activity" with respect to the dividend so that the dividend is includible in the payee’s sales factor. The FTB’s position in Legal Ruling 2003-3 appears to be a departure from the FTB’s position as previously stated in MATM § 7562.

We recently have become aware that the FTB has applied the principles under Legal Ruling 2003-3 to dividend payees that are commercially domiciled in California and have received insurance company dividends. In the aftermath of Ceridian, the FTB’s position is that such dividends are no longer deductible under RTC § 24410. Furthermore, based on the principles in Legal Ruling 2003-3, the FTB has asserted that such dividends should be included in both the numerator and denominator of the payee’s sales factor.

Taxpayers should be aware that the FTB also may apply Legal Ruling 2003-3 to RTC § 24402 dividends in light of the United States Supreme Court’s recent denial of certiorari in Farmer Bros. In addition, although Legal Ruling 2003-3 may have a detrimental effect on California commercially domiciled taxpayers, the ruling could be beneficial to non-California domiciled taxpayers potentially reducing the taxpayer’s California apportionment percentage.