United States: California Franchise Tax Board Updates Regulations Concerning Treatment Of Intercompany Transactions

The California Office of Administrative Law (OAL) approved amendments to a regulation concerning the treatment of intercompany transactions between members of a combined reporting group, including instructions regarding the treatment of a deferred intercompany stock account (DISA) and general conformity to Internal Revenue Service (IRS) Treasury Reg. Section 1.1502-13 as amended through April 1, 2012.¹ While the amendments are effective April 1, 2014 and will apply to transactions occurring on or after January 1, 2001, a taxpayer may elect to apply the provisions of the regulation affecting its DISA balances prospectively as of April 1, 2014.²

Background

The prior version of the California regulation designed to provide rules for reporting intercompany transactions incorporated IRS Treasury Reg. Section 1.1502-13 as of March 17, 1997 to the extent possible consistent with combined reporting principles.³ Exceptions arose due to the differences between the composition of the federal consolidated return group, the requirements of California allocation and apportionment provisions, jurisdictional limitations, and treatment of members of a combined reporting group as separate entities for many purposes under the California Revenue and Taxation Code. The primary concept adopted by California continues to be one of deferring recognition of gains or losses from intercompany transactions between related entities to mirror the effect of transactions between divisions of a single corporation.⁴

The California DISA rules bear some resemblance, but are not analogous to the federal consolidated basis adjustment rules⁵ and the federal excess loss account (ELA) rules.⁶ The federal investment adjustment rules are generally intended to adjust the federal tax basis of a given subsidiary within the consolidated group in tandem with increases or decreases of the subsidiary's adjusted income or loss under the federal consolidated reporting rules.⁷

Federal ELAs can occur when a consolidated group subsidiary borrows money from a third party and either distributes the funds within the consolidated chain or incurs losses (pursuant to such borrowed funds) which are absorbed, from a federal tax perspective, by entities within the federal consolidated reporting group chain. In concert with the federal investment adjustment rules, the federal ELA rules are intended to provide for the inclusion of negative stock basis adjustments pursuant to the federal consolidated investment adjustment rules to the extent that the usage of deductions, losses, and distributions exceed the parent's basis in the subsidiary's stock.⁸

California does not directly adopt the federal investment adjustment rules or the ELA rules. Instead, California has adopted the DISA concept, defining the term "DISA" as:

Like ELAs, DISAs can arise from the absorption of losses or deductions deemed to be distributions that are governed under Internal Revenue Code (IRC) Section 301(c)(3). Note that under the IRC, corporate distributions are considered to be dividends to the extent of that corporation's earnings and profits (E&P).¹⁰ Distributions in excess of E&P are considered to be a return of capital to the extent of stock basis.¹¹ Finally, distributions in excess of stock basis are considered to be capital gains by the recipient of the distribution (these are the non-dividend distributions which are the subject of the DISA rules).¹²

In contrast with the federal ELA rules, DISAs historically could not be reduced by positive investment adjustments or subsequent capital contributions. Under the previous version of the California intercompany transaction regulations, DISAs could be triggered by the following events: (i) partial sale of the distributor; (ii) liquidation of the distributor into the recipient; (iii) liquidation of the recipient into the distributor;¹³ (iv) removal of the distributor or recipient from the combined group; (v) conversion of the distributor to a limited liability company taxed as a partnership; or (vi) other events triggering the California intercompany transaction acceleration rule.¹⁴ In addition to being responsible for calculating the amount of each DISA, a taxpayer has the added responsibility of annually disclosing DISA balances on the taxpayer's tax returns.¹⁵

DISA Provisions Adopted by Amended Regulations

Normally, the amount of a DISA resulting from an intercompany distribution exceeding California earnings and profits and a parent's basis in its subsidiary's stock is treated as deferred income when created. The DISA balance is taken into account by the parent as income or gain when a sale, liquidation, redemption or other disposition of shares of the subsidiary's stock occurs.¹⁶ Pursuant to the amended regulations, a disposition of stock will not occur (and the DISA will not be immediately taken into account by the holder of the DISA as income) when members of a combined reporting group merge into one another, provided the majority of the voting shares of the stock of each is owned by other members of the combined reporting group. The amount of DISA attributable to each share of the surviving member's stock following the merger will be based on the sum of the DISA attributable to the surviving member and the non-surviving member, divided by the total number of the surviving member's shares of stock following the merger. Upon disposition of the surviving member's stock, the corresponding amount of DISA must be taken into account as income.¹⁷

The amended regulations also allow for DISAs to be reduced or even eliminated by subsequent capital contributions, with further capital contributions serving to increase a parent's basis in its subsidiary's stock.¹⁸ To the extent that a parent transfers the stock of its subsidiary to another member of the combined group, the parent's intercompany item from the DISA is deferred, and if the other member receiving the stock already has stock of the subsidiary with positive basis, the DISA attributable to the shares transferred by the parent is reduced by the basis in the stock held by that other member.¹⁹ Pertinent examples are included in the regulations demonstrating how to compute DISA balances under these circumstances.²⁰ Continuing with the theme of requiring full disclosures of transactions implicating DISAs, taxpayers are required to disclose all DISA balances that have been previously reduced and/or eliminated as a result of any subsequent capital contributions.²¹

The amended regulations eliminate the potential to create multiple DISAs in the context of tiered distributions. To avoid the potential of double counting, the amended regulations provide that when a member distributes an amount of money or property to another member, and the other member thereafter distributes an amount of money or the same property to another member in a related distribution, any DISA arising from the initial distribution will be treated as earnings and profits for purposes of determining the DISA, if any, arising from the subsequent distribution in a related series of distributions.²²

Apportionment Factor Simplifying Rule Clarification

The amended regulations clarify that when an election is made under Cal. Reg. Section 25106.5-1(e), which applies the simplifying rules of IRS Treasury Reg. Section 1.1502- 13(e), to currently recognize income or loss from an intercompany transaction by accounting for the income or loss from the transaction on a separate entity basis, the receipts from that transaction are not included in the taxpayer's sales factor in the year of election.²³ Instead, the receipts are included in the sales factor only when the items in the transaction are sold outside of the combined group, giving rise to economic gain or loss to the group as a whole. If the receipts were to be recognized currently due to the election, including in the sales factor the receipts that arise when the items are eventually sold outside the group would result in twice recognizing the single economic activity.

Commentary

The complex DISA tracking and reporting computations required by the California Franchise Tax Board continue to provide a unique example of state decoupling from federal income tax concepts, and the issues that often result from the different composition of federal and state filing groups. With the adoption of these amended regulations, taxpayers are for the first time afforded an opportunity to reduce or eliminate existing DISAs through capital contributions. Taxpayers should carefully consider whether elimination of DISA balances in this manner could provide a benefit as well as determine whether prospective adoption of the regulations, rather than retroactive, would be beneficial. The amended regulations could also have potential financial statement consequences, as they could affect tax provision calculations and reporting with respect to any DISA-related deferred taxes. While taxpayers must continue to comply with the DISA tracking and reporting rules, these amended regulations provide some degree of taxpayer flexibility and relief.

Footnotes

1 CAL. CODE REGS. tit. 18, § 25106.5-1, amended effective April 1, 2014.

2 CAL. CODE REGS. tit. 18, § 25106.5-1(k)(2).

3 CAL. CODE REGS. tit. 18, § 25106.5-1(a)(2), previous version.

4 CAL. CODE REGS. tit. 18, § 25106.5-1(a)(1).

5 Treas. Reg. § 1.1502-32.

6 Treas. Reg. § 1.1502-19.

7 See, in general Treas. Reg. § 1.1502-32(a).

8 Treas. Reg. § 1.1502-19(a).

9 CAL. CODE REGS. tit. 18, § 25106.5-1(b)(8).

10 IRC § 301(c)(1).

11 IRC § 301(c)(2).

12 IRC § 301(c)(3).

13 Note that an elective special 60-month deferral is available for DISAs triggered in certain liquidation transactions. CAL. CODE REGS. tit. 18, § 25106.5-1(f)(1)(B)(2).

14 See, in general CAL. CODE REGS. tit. 18, § 25106.5-1(d), (f)(1)(B).

15 CAL. CODE REGS. tit. 18, § 25106.5-1(b)(8).

16 CAL. CODE REGS. tit. 18, § 25106.5-1(f)(1)(B). The amended regulation clarifies that redemption could cause recognition of a gain from a DISA.

17 CAL. CODE REGS. tit. 18, § 25106.5-1(f)(1)(B).2.

18 Id.

19 CAL. CODE REGS. tit. 18, § 25106.5-1(f)(1)(B).4.

20 CAL. CODE REGS. tit. 18, § 25106.5-1(f)(2), Examples 8-10.

21 CAL. CODE REGS. tit. 18, § 25106.5-1(j)(7).

22 CAL. CODE REGS. tit. 18, § 25106.5-1(j)(4).

23 CAL. CODE REGS. tit. 18, § 25106.5-1(a)(5)(A).4.

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