United States: California Tax Developments - February 2014

Happy 2014! The start of the New Year invites a look back on highlights from the past year. In case you missed it, here's a recap of what happened in the great Golden State during the last quarter of 2013.

1. Cases to Watch

(a) Comcast decision expected shortly

After a trial that included 19 days of testimony before the Los Angeles Superior Court, closing briefs were filed in Comcon Prod. Services I, Inc. v. Franchise Tax Board ("Comcast").1 Two issues were before the court: (1) whether Comcast and its subsidiary QVC formed a unitary business, and (2) whether the termination fee Comcast received from MediaOne as the result of a failed merger generated business income apportionable to California, or nonbusiness income allocable outside California.

In California, a unitary relationship exists if any of three unity tests is satisfied. These include the Mobil2 three-factor test, the three unities test3, and the contribution and dependency test4. Comcast presented evidence and testimony at trial that focused chiefly on the three factors of the Mobil test to show that it was not engaged in a unitary business with QVC. Under that test, unity is established with a showing of centralized management, functional integration, and economies of scale between the entities in question. The Franchise Tax Board, however, focused on the application of the contribution and dependency test, which, as its name implies, focuses on whether the entities contribute to, or depend on, one another, in its attempt to affirmatively show unity between Comcast and QVC. Comcast's discussion of the contribution and dependency test was minimal. It will be interesting to see how the court decides the issue since each party relied on a different test to support its position.

In addressing the issue of whether the MediaOne merger termination fee constituted business income, Comcast relied on the test articulated by the California Supreme Court in Hoechst Celanese5. In that case, the Supreme Court held that for an item of income to be business income, it must satisfy both a transactional test and a functional test. In order to satisfy the transactional test, the transaction giving rise to the income must be in the regular course of the taxpayer's business. In order to satisfy the functional test, the property generating the income must be an integral part of the taxpayer's regular trade or business. Comcast argued that neither test was met because its receipt of the termination fee was a "once-in-a-corporate lifetime experience" that was not part of its regular trade or business, nor was the contractual right to the termination fee an integral part of its trade or business as a cable company. The FTB rebutted Comcast's position by focusing on the fact that Comcast regularly bought and sold other cable companies as its primary trade or business. Thus, it highlighted the fact that Comcast made seven acquisitions in the same tax year as the failed MediaOne merger, to demonstrate that the termination fee was indeed income received in the regular course of, and integral to, its trade or business as a cable company in the business of buying and acquiring other cable companies.

The court had until February 18, 2014 to issue its decision. However, shortly before this update, the case was reassigned to a new judge. Such a late reassignment is very rare, and it could require resubmissions of evidence, including witness testimony. This reassignment will likely result in the decision being substantially delayed.

Takeaway. Unitary business and business/nonbusiness income cases tend to be driven by the facts; the Comcast case is no exception. Given that the parties argued the facts with reference to different unitary business tests, if the outcome of this case is appealed, the decision of an appellate court could make a considerable mark in California case law. In the event of an appeal, the appellate court decision may give taxpayers and the FTB much-needed guidance on the correct test to use for determining whether businesses are unitary.

(b) Appellate Court limits retroactive application of increased promoter penalty

In Quellos Group, LLC v. Franchise Tax Board6 , the Court of Appeal decided whether the FTB was permitted to retroactively apply a 2003 amendment to the California Revenue & Taxation Code7 that sharply increased the penalty for promoting abusive tax shelters. A large amount of potential penalty liability was at stake because the amendment increased the penalty from $1,000 to 50 percent of the gross income derived from the tax shelter promotion activity. If the court permitted the FTB to apply the increased penalty retroactively, the tax shelter promoters would be liable for $27 million of penalties, plus interest; but, if the court barred the retroactive application of the increased penalty, the tax shelter promoters would be liable for only $2,000 of penalties.

In a published decision, the Court of Appeal affirmed the trial court, concluding that the increased penalty applied prospectively only. It based its decision largely on "Section 15,"8 an uncodified provision enacted with the 2003 amendments in which the Legislature explicitly stated that, "this act shall apply with respect to any penalty assessed on or after January 1, 2004, on any return for which the statute of limitations on assessment has not expired. All other provisions of this act shall apply on or after January 1, 2004."9 The court explained that, with the plain language of the statute silent on the issue of retroactivity, the uncodified law enacted with the 2003 version of the statute, particularly Section 15, was of great importance. The court looked at the entirety of the uncodified law to ascertain the Legislature's intent as to whether the provision applied retroactively. It invited the reader to "[l]ook at the language of section 15. Really look at it, all of it."10 Section 15's terms were clear as to retroactivity and, "[a]s citizens and taxpayers, we might debate whether the Legislature let the shelter promoters too easily off the hook . . . . Maybe the Legislature truly intended that, as between promoters and taxpayers, it should be the promoters who are more sternly disciplined. Maybe that is a conclusion we would like to reach. Certainly it is a conclusion that appears in the best interest of the California fisc. But it is not a conclusion we can endorse."11 Because of the lack of express language allowing retroactive application of the increased penalty in the 2003 version of the penalty statute, and no language in the uncodified law that rebuts the presumption against retroactivity, the court affirmed the decision of the court below.

Takeaway. The court's decision is a reminder of the strong presumption against applying a statute retroactively. Absent a clear expression of legislative intent to do so, statutes should only be applied prospectively.

2. Looking Forward: The FTB's 2014 Rule-Making Calendar

At its December 2013 meeting, the FTB highlighted several new regulations and amendments to existing regulations that it aims to address in 2014. We highlight several of these regulations below. We will keep you informed on the progress of the rule-making calendar throughout the year.

(a) Market-based rules for sales other than sales of tangible personal property

Revenue and Taxation Code section 25136 provides rules for assigning sales, other than sales of tangible personal property, for taxpayers that file a combined report and elect to apportion income pursuant to the single sales factor apportionment formula. The application of this section became mandatory for most taxpayers that file a combined report for taxable years beginning on or after January 1, 2013.

Regulation 25136-2, which implements section 25136, became effective March 27, 2012. It includes provisions for the assignment of receipts from sales of corporate stock or interests in pass-through entities, and for the incorporation of special industry rules, including those for mutual fund service providers.12 The FTB has identified two major deficiencies in the current version of the regulation: (1) it does not address how to source receipts from sales of certain services; and (2) it does not address how to source receipts from the sale of certain intangible property.

The FTB is proposing to amend Regulation 25136-2 to address these perceived deficiencies.

Marketable securities. Because the term "marketable securities" is used throughout the regulation, the FTB proposes to add language that would define marketable securities as securities that are actively traded in an established securities market, defined as one registered under the Securities Act or a foreign exchange similar to one registered under the Securities Act.

Assigning receipts from sales of marketable securities. The FTB proposes adding a section to provide rules to determine whether a customer is "in California" for purposes of assigning receipts from the sale of marketable securities. Under this new section, for individuals, the receipts are assigned to California if the customer's billing address is in California. For corporations and other business entities, the receipts are assigned to California if the customer's commercial domicile is in California. If the billing address or commercial domicile cannot be determined, each can be reasonably approximated.

Assigning receipts from the provision of asset management services. The FTB proposes including examples to aid in making the determination of how to assign receipts from the provision of asset management services. The examples generally follow the assignment rules in the mutual fund service provider regulation, and will illustrate how to determine the domicile of shareholders, beneficial owners, or investors, and how to assign receipts based on the ratio of California shareholders, beneficial owners, or investors to shareholders, beneficial owners or investors everywhere.

Dividends, Interest, Goodwill. To be consistent with Mobil Oil13, the FTB is proposing to add language providing that the rules for assigning receipts from the sale of stock also apply to assigning receipts from dividends, interest, or goodwill.

Cascading rules. The current regulation provides for the sourcing of receipts from a sale of equity in a corporation or pass-through entity (other than marketable securities) based on the property and payroll factors of the entity if 50 percent or more of the entity's assets are real or tangible personal property, and on the sales factor of the entity if more than 50 percent of the assets of the entity are comprised of intangible property. The FTB is also proposing to add rules on how to source receipts from the sale of equity in situations when the taxpayer either (i) does not know the composition of the assets of the entity whose equity was sold, or (ii) does not have access to the entity's property, payroll, and sales factor information.

The FTB held an Interested Parties Meeting October 18, 2013 to discuss these proposals. At the meeting, the FTB acknowledged that there are still gaps in the amendments, particularly in the definitions of marketable security and startup company, and the rules for sourcing interest and receipts from sales of goodwill. The FTB plans to schedule another Interested Parties Meeting to address these gaps.

(b) Assignment of credits to combined group members

Revenue and Taxation Code section 23663 allows taxpayers to elect to assign credits among affiliated members of a combined reporting group. However, taxpayers have been facing problems when a defective election is made, particularly because the election to assign a credit is irrevocable.14 As it stands, taxpayers have no clear guidance on how to correct a defective election or how to allocate credits that would otherwise remain unallocated as a result of a defective election. In preparing this new regulation implementing Revenue and Taxation Code section 23663, the FTB so far has provided default allocation rules for defective elections, a framework for alternative allocations, and a process for correcting defective elections.

The FTB proposes default rules aimed to provide clarity in the ordering of credits in certain difficult scenarios. For example, if the assignor has fewer credits than originally assigned, the assignee will receive all the assignor's credits (multiple assignees will receive the credits pro-rata).

Takeaway. The credit assignment rules were implemented without much consideration into how they would apply in common situations, particularly how to cure the allocations in the event of a defective election. The FTB is now taking a proactive approach to make the rules more workable. The proposed rules may provide useful relief for taxpayers who may have otherwise been left with unused or unusable credits as a result of a defective election or a misallocation of credits after such an election.

(c) Apportionment and allocation of partnership income

Regulation 25137-1 governs the apportionment and allocation of a partner's distributive share of partnership income that has its source in California or that is included in the partner's business income. The regulation was last amended in 1985 and does not address many of the partnership issues that have emerged since that amendment. In August 2008, the FTB began an effort to revise the outdated regulation. Five years later, in October 2013, the FTB held its second Interested Parties Meeting as a follow-up to that first meeting.

The FTB identified eight issues of importance to discuss in amending the regulation, including addressing the treatment of distributive share items from non-unitary partnerships; indirect ownership of business assets; intercompany sales between partners and partnerships; and, amending parts of the current regulation so that it conforms with federal rules governing accounting periods between partners and partnerships. There is no draft language yet on any of these issues, but rather discussion points identified by the FTB.

Takeaway. The FTB has expressed a desire to maintain momentum to update this outdated regulation. Yet, it has only published discussion points and no concrete draft language amending the almost 30-year-old regulation. It is difficult to estimate when the next action will take place.

3. Meet the Team: Marty Dakessian

Mardiros "Marty" Dakessian is a partner in Reed Smith's Los Angeles office. His primary focus is on California state and local tax controversy at the administrative and judicial levels with respect to corporate and personal income tax, sales and use tax, property tax, payroll tax, business license tax, and other taxes and fees administered by state and local government. Prior to joining Reed Smith, Marty was a member of another national SALT practice, had his own law practice, worked at a Big 4 Accounting firm, and worked for State Board of Equalization Members Claude Parrish and Dean Andal. These experiences gave Marty an inside look into state government, which has shaped his passion to represent his clients' interests against government overreaching. Law360 recently named Marty a Tax MVP. In selecting Marty, Law360 cited his "blockbuster $100 million in tax relief" obtained in 2013, and his success in forcing California to roll back unconstitutional portions of a small business stock incentive, as just two of the reasons he earned the coveted title. It also noted his $1.2 million attorney fee award in a corporate income tax case, Daniel V Inc. v. Franchise Tax Board.15 Marty attributes his success to the fact that his practice squares with his own philosophy of a limited government bound by law, the strength of the Reed Smith State Tax team, and the wonderful clients he has had the privilege of serving.

When not at work, Marty enjoys spending time with his wife Maria, his two sons Aram (14) and Haig (10), and his daughter Vana (5). Marty also enjoys spending time with his two dogs, a German Shepherd named Blitz and a Maltese puppy named Jolie.

Marty is mindful of the sacrifices of those who came before him.

Footnotes

1. Case No. BC489779 (L.A. Sup. Ct.).

2. Mobil Oil Corp. v. Comm'r, 445 U.S. 425 (1980) (consisting of functional integration, centralized management, and economies of scale).

3. Butler Bros. v. McColgan, 17 Cal. 2d 664 (1941) (consisting of unity of ownership, unity of operation, and unity of use).

4. Edison Cal. Stores, Inc. v. McColgan, 30 Cal. 2d 472 (1947) (consisting of whether the operation of the portion of the business done within the state is dependent upon or contributes to the operation of the business without the state).

5. Hoechst Celanese Corp. v. Franchise Tax Bd., 25 Cal. 4th 508 (2001) (stating that income is business income if it satisfies either a transactional or functional test).

6. 221 Cal. App. 4th 647 (2013).

7. Rev. & Tax. Code § 19177.

8. Stats. 2003, ch. 654, § 15; Stats. 2003, ch. 656, § 15(a).

9. See 221 Cal. App. 4th at 651, citing Stats. 2003, ch. 654, § 15; Stats. 2003, ch. 656, § 15(a).

10. 221 Cal. App. 4th at 670.

11. 221 Cal. App. 4th at 672.

12. Rev. & Tax. Code § 25137-14.

13. Mobil Oil Corp. v. Comm'r of Taxes of Vt., 445 U.S. 425 (1980).

14. Rev. & Tax. Code § 23663(c).

15. LASC Case No. BC457301.e one

This article is presented for informational purposes only and is not intended to constitute legal advice.

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